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Last year's sweeping tax overhaul, the Tax Cuts and Jobs Act of 2017 (TCJA), introduced a new tax break for owners of many businesses called the deduction for qualified business income. It’s also known as code Section 199A deduction. If you qualify for it, you will receive a 20% deduction on your qualified business income.

Qualified Business Income - Qualified business income means the net income from a qualified trade or business. However, qualified business income does not include certain investment-related income, including:

Short and long-term capital gain and losses;
Dividend income, income equivalent to a dividend, or payment in lieu of a dividend;
Any interest income other than interest income properly allocable to a trade or business;
Net gain from foreign currency transactions and commodities transactions;
Income from notional principal contracts, other than items attributable to notional principal contracts entered into as hedging transactions;
Any amount received from an annuity that is not received in connection with the trade or business; and
Any deduction or loss properly allocable to any of these bulleted items described above.

Qualified Trade or Business – Qualified trade or business means any trade or business other than:

Employee
A Specified Service Trade or Business

Employee - As an employee you can never qualify for this deduction no matter what.

Specified Service Trade or Business – A specified service trade or business is defined as any trade or business involving the performance of services in the following fields:

Health.
Law.
Accounting.
Actuarial science.
Performing arts.
Consulting.
Athletics.
Financial services.
Brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities,
Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees. Catch all rule.

Engineering & Architecture Services - Are specifically excluded from the definition of a specified service trade or business. Therefore, they qualify.

Some of the categories and fields listed above are fairly clear in their meaning. Others - such as "consulting" and "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees" - are vague, and will be difficult to apply until the IRS provides guidance.

While doctors, accountants, and attorneys will clearly fall victim to the specified fields found in this definition, many businesses will not fit so neatly into one of the disqualified categories. For example, while an actor is in the field of performing arts, is a director? A makeup artist? A producer?

The catch all definition is a bit concerning that a disqualified business includes any trade or business of which the principal asset is the reputation or skill of one or more of its employees or owners. The most obvious problem posed by the catch-all is that it threatens any taxpayer who is not engaged in one of the businesses specifically listed as a disqualified field. Consider the case of a "personal trainer to the stars": Using the definition of "a specified service business" in the law the argument can be made that the trainer is not in the fields of health or athletics. Application of the catch-all, however, would likely yield a different result. What is the principal asset of a celebrity? personal trainer if not the reputation and expertise of that trainer?

To further illustrate the complications caused by the catch-all, compare two restaurants - the first a prominent chain, the second a stand-alone bistro with a world-renowned, five-star chef. Neither restaurant is in a listed disqualified service nor so the initial presumption is that both eateries generate qualified business income eligible for the deduction. Now, consider the application of the catch-all. The principal asset of the chain restaurant is clearly not the skill of its employees or owners; after all, if the chef at one of the locations leaves the restaurant, he or she will be replaced and life will go on. As a result, the chain restaurant should not fall victim to the catch-all. The bistro, however, may not be so fortunate. In this scenario, it is much more likely that the business's principal asset is the skill and reputation of the five-star chef who prepares its food. Put in simple terms, if that chef leaves the bistro, the business probably shutters its doors, adding further evidence that it is the expertise of the chef that drives the business. Thus, based on the current structure of the law it would not be unreasonable to conclude that the second restaurant is a specified service business. But why should the owners of the two restaurants be treated differently when they both provide the same mix of food and services to customers?

As one can see, until further guidance is issued that narrows the scope of the catch-all, it threatens to ensnare far more taxpayers than the specifically delineated disqualified fields.

Real Estate Activities – An emerging consensus among practitioners and expert commentators is that most rental real estate activities other than those involving triple net (NNN) rentals will qualify as trades or businesses, because such rental activities typically involve the regular provision of substantial services to tenants. Also, the fact that last-minute changes were made to the bill to make the deduction more readily available to rental property owners is seen an indication that Congress intended that rental income would be eligible for the deduction.

Limitations – There are three limitations that come into play at different income levels. They are:

Specified Service Trade or Business Limitation – if you are a specific service trade or business, married and your taxable income is $315,001 to $415,000 or single $157,501 to $207,500, your deduction will be limited. Above these thresholds it will be completely denied and you will not qualify for the deduction. The limitation is based on the amount that you are over the $100,000 allowed for married and $50,000 for single.
Wage Limitation – The W-2 wage limitation on the deduction for qualified business income is based on either W-2 wages paid by the trade or business, or W-2 wages paid plus tangible assets owned by the trade or business. It is the greater of:

50% of the W-2 wages paid with respect to the qualified trade or business, or
The sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted tax basis, immediately after acquisition, of all qualified property.

Taxable Income Limitation – The qualified business income deduction can never be more than 20% of your taxable income.

Wages – Only W-2 wages paid and reported to the Social Security Administrator qualify. Thus wages paid by an S Corporation to its sole shareholder/employee qualify. However, guaranteed payments paid by a partnership (LLC, GP, LP or LLP) to its member(s) do not. Therefore, in some cases an S Corporation will qualify for the deduction while partnerships that have no employees will not.

Furthermore, IRS is very specific that a partnership cannot pay/issue a W-2 to its members. Only to its non-member employees.

Who Can Claim the Deduction – Shareholders of S Corporations, members/partners of Limited Liability Company (LLC), partners of a general partnership (GP), partners of a limited partnership (LP), members/partners of a limited liability partnership (LLP), independent contractors and sole proprietorships. Going forward the Code refers to these businesses as a “Pass-Through Business”. Trusts and estates qualify for the tax break as well.

Different Rules Apply at Different Levels of Taxable Income – Therefore, we have created three categories of income to address each rule that is applicable to that category. They are:

Category 1 – Married with taxable income of less than $315,000 or single less than $157,500.

Category 2 - Married with taxable income of $315,001 to $415,000 or single $157,501 to $207,500.

Category 3 - Married with taxable income over $415,001 or single over $207,501.

Category 1 – Married with taxable income of less than $315,000 or single less than $157,500

If you fall under this category, everyone who is a Pass-Through Business, regardless of what trade or business you are in, will qualify for the deduction. However, the taxable income limitation applies.

For simplicity in all examples below, we will assume either the taxpayer is married or single, has no dependents, mortgage interest or property taxes to deduct.

Example 1A: Assume that the taxpayers are married. One spouse receives $50,000 of W-2 income and the other $250,000 from any trade or business. Their qualified business income deduction is $50,000 ($250,000 x 20%). Therefore, they will pay federal income tax on $250,000 ($300,000 - $50,000) not $300,000. Their federal income tax liability is approximately $42,900.

Example 1B: Assume that the taxpayers are married. One spouse receives $50,000 of W-2 income and the other $250,000. They do not qualify for the qualified business income deduction because both are employees. Their federal income tax liability is approximately $55,300.

As employees the taxpayers will pay approximately $12,400 more in federal tax.

Example 1C: Assume that the taxpayers are married. One spouse does not work. The other spouse has $300,000 of income from any trade or business. Their qualified business income deduction should be $60,000 ($300,000 x 20%). However, their taxable income is $276,000 ($300,000 minus the standard deduction of $24,000). Based on the taxable income limitation their qualified business income deduction is the lesser of:

20% of the qualified business income, $60,000 ($300,000 x 20%) or
50% of wages paid – Not applicable since they are below the threshold of $315,000 or
20% of their taxable income, $55,200 ($276,000 x 20%).

Their qualified business income deduction is $55,200. Their federal income tax liability is approximately $41,600.

Example 1D: Taxpayer is single and an employee, but not an owner, of a qualified business. Taxpayer receives a salary of $100,000 in 2018. Taxpayer does not qualify for the deduction because he or she is only the employee of the qualified business and not an owner.

If you are an employee, it may be tax advantageous for you to consider becoming a Pass-Through Business such as an S Corporation.

Category 2 - Married with taxable income of $315,001 to $415,000 or single $157,501 to $207,500

If you fall under this category you can still claim the qualified business income deduction but you are subject to the specified service trade or business, wage and taxable income limitations. Therefore, your deduction can either be limited or denied.

Example 2A: Single taxpayer has taxable income of $187,500, of which $150,000 is from a specified service trade or business. Assume that the specified service trade or business has paid sufficient W-2 wages to its employees. He or she is over the threshold allowed by $30,000 ($187,500 - $157,500). The maximum amount allowed that a single taxpayer can be over is $50,000. Therefore, he or she is 60% ($30,000 / $50,000) over the maximum amount allowed. Thus, he or she is only allowed 40% (100% - 60%) of the maximum amount of the qualified business income. The qualified business income is $150,000 x 20% = $30,000. However, he or she only claim 40% of it. Therefore, the deduction for the qualified business income is $12,000 ($30,000 x 40%).

Example 2B: Single taxpayer has taxable income of $187,500, of which $150,000 is from a specified service trade or business. Assume that the specified service trade or business has paid $40,000 in W-2 wages to its employees. He or she is over the threshold allowed by $30,000 ($187,500 - $157,500). The maximum amount allowed that a single taxpayer can be over is $50,000. Therefore, he or she is 60% ($30,000 / $50,000) over the maximum amount allowed. Thus, he or she is only allowed 40% (100% - 60%) of the maximum amount of the qualified business income. But, he or she has only paid $40,000 in wages. Thus, the maximum qualified business income that the taxpayer qualifies for is the lesser of:

20% of the qualified business income, $30,000 ($150,000 x 20%) or
50% of wages paid, $20,000 ($40,000 x 50%).

However, the taxpayer can only claim 40% of the lesser amount since he or she was over the threshold. Therefore, the deduction for the qualified business income is $8,000 ($20,000 x 40%).

Example 2C: Single taxpayer has taxable income of $217,500, of which $150,000 is from a specified service trade or business. Since its taxable income is more than the maximum threshold allowed, $207,500, the taxpayer does not qualify for the qualified business deduction.

Example 2D: Single taxpayer has taxable income of $187,500, of which all of it is from a qualified trade or business and it paid $60,000 in W-2 wages to its employees. The qualified business income deduction is the lesser of:

20% of the qualified business income, $37,500 ($187,500 x 20%) or
50% of wages paid, $30,000 ($60,000 x 50%).

Therefore, the deduction for the qualified business income is $30,000, the lesser of the two figures above.

Category 3 - Married with taxable income over $415,001 or single over $207,501

If you fall under this category the only way that you will qualify for the deduction is if you have a qualified trade or business. You will not qualify for the deduction if your only source of income is from a specified service trade or business. The wage and taxable income limitations apply.

Example 3A: Robert is single and the sole shareholder/employee of ABC, Inc., an S corporation that is a qualified trade or business. ABC has net income in 2018 of $250,000 after deducting Robert's salary of $150,000. Assume that the $150,000 salary paid to Robert is the only W-2 wages paid. Robert’s tentative qualified business income deduction is $50,000 ($250,000 x 20%). However, he has to calculate the wage limitation to determine if its less. The wage limitation is $75,000 ($150,000 x 50%). Therefore, Robert can deduct the $50,000 because the wage limitation is bigger.

Example 3B: Taxpayers owns residential or commercial rental properties through an LLC. His or her share of the rental income earned by the LLC is $800,000. The LLC pays no W-2 wages, but taxpayer’s share of the unadjusted basis of the building is $5 million. Taxpayer’s tentative qualified business income deduction is $160,000 ($800,000 x 20%). However, taxpayer has to calculate the wage limitation to see if its less. Taxpayer has the option of choosing the greater of the following for the wage limitation calculation:

50% of W-2 wages= $0; or
25% of W-2 wages, $0, plus 2.5% of qualified property = $125,000 ($5M x 2.5%).

Therefore the taxpayer’s qualified business income deduction is $125,000.

Example 3C: Taxpayer is a sole proprietor. During 2018, the business generates $400,000 of qualified business income, pays $120,000 of W-2 wages, and has $1.5M of qualified property. Taxpayer flies jointly with his or her spouse and their combined taxable income for the year, including the qualified business income, is $600,000. Taxpayers’ tentative deduction is $80,000 ($400,000 x 20%). However, taxpayers’ have to calculate the wage limitation to determine if its less. Taxpayers have the option of choosing the greater of the following for the wage limitation calculation:

50% of W-2 wages = $60,000 ($120,000 x 50%)
25% of W-2 wages, $30,000 ($120,000 x 25%) plus 2.5% of unadjusted basis of qualified property $37,500 ($1.5M x 2.5%) = $67,500 ($30,000 + $37,500).

Therefore, taxpayers’ qualified business income deduction is $67,500.

Reasonable Compensation - S corporations have long had an incentive to classify payments made to shareholder-employees as dividends rather than wages, because wages are subject to employment taxes such as social security and Medicare dividends are not. The IRS, however, can re-characterize "dividends" that are paid lieu of reasonable compensation for services performed for the S corporation to wages. So, "reasonable compensation" of an S corporation shareholder refers to any amounts paid by the S corporation to the shareholder, up to the amount that would constitute reasonable compensation.

Example 4A: Assume taxpayers A & B own identical businesses. Neither business has any employees or quailed property. Each business generates $500,000 of qualified business income before any wages are paid. A operates his business as a sole proprietor; B an S corporation.

Because A's business has no employees and because, as a sole proprietor, A cannot pay himself a wage, A has a W-2 wage limitation and its zero. Thus, A does not get a deduction.

B as the shareholder of his S Corporation, must comply with the reasonable-compensation requirement. As a result, assume B pays himself $80,000 in 2018.

B's is the lesser of:

20% of the qualified business income, $84,000 (20% x $420,000) or
50% of wages $40,000 ($80,000 x 50%).

B’s qualified business income deduction is $40,000 because B paid him or herself $80,000 of W-2 wages and was able to qualify for the deduction. If B was a member/partner of a LLC and received an $80,000 in guaranteed payments, he or she would not have qualified for the deduction because guaranteed payments do not count as wages.

Example 4B: Assume the same facts as in the previous example, except the income earned in each business is $150,000, not $500,000. Assume further that both A and B have taxable income below the $315,000/$157,500 thresholds. A, the sole proprietor, is entitled to a deduction of $30,000 (20% of

$150,000). B, the sole shareholder of the S corporation, remains required to pay himself reasonable compensation. Assume he is paid W-2 wages of $70,000.

This reduces the qualified business income B receives from the S corporation to $80,000 ($150,000 - $70,000) and in turn reduces B's deduction to $16,000 ($80,000 x 20%). Thus, when income is below the threshold, the reasonable-compensation requirement works against the shareholder in the S corporation, reducing both his qualified business income and deduction. A, the sole proprietor, has no such requirement and thus preserves the full amount of his qualified business income, giving him a deduction of $30,000, when his S corporation shareholder counterpart receives a deduction of only $16,000.

Netting of Qualified Business Income and Loss – The deduction must be determined separately for each qualified trade or business. After calculating the qualified business income deduction for each trade or business, the taxpayer totals the amounts. If there is an overall loss, no deduction is allowed for that year and the loss is carried over to next year.

Example 5A: In 2018 taxpayer is allocated qualified business income of $20,000 from qualified business 1 and a qualified business loss of $50,000 from qualified business 2. Taxpayer is not permitted a deduction in 2018 and has a carryover qualified business loss of $30,000 to 2019.

Unadjusted Tax Basis - Only the unadjusted basis of qualified property is counted toward the limitation. Qualified property is tangible property subject to depreciation. As a result, the basis of raw land and inventory, for example, would not be taken into account.

The basis of property used to determine the limitation is unadjusted basis determined before the close of the tax year. The depreciable period begins on the date the property is placed in service and ends on the later of:

10 years after the date placed in service; or
The last day of the last full year in the applicable recovery period that would apply to the property under Sec. 168

Example 6A: On April12, 2010, Partnership AB, a calendar-year partnership, places in service a

piece of machinery purchased for $50,000 that has a five-year life. The partners may take into account their allocable share of the $50,000 unadjusted basis of the property in 2018, despite the fact that the asset was fully depreciated before the year began. This is because the depreciable period runs for the longer of:

10 full years from April12, 2010 (to April12, 2020); or
The last day of the last full year in the recovery period, which for a five-year asset placed in service during 2010 would have been 2014.

The partners will also take into account the $50,000 unadjusted basis of the property in 2019. The basis will not be taken into account in 2020, however, because the depreciable period ends on April12, 2020, before the end of the 2020 tax year. Alternatively, assume the machinery

was placed in service on June 1, 2008. The partners of Partnership AB would not take the $50,000 unadjusted basis into account in 2018 because the depreciable period ended on June 1, 2018, before the close of the 2018 tax year.

How to Avoid Specified Service Trade or Business Status – We are constantly being asked by clients that are a specified service trade or business, what they can do to qualify for the deduction?

Option 1 - One strategy that has been discussed is to infuse a qualified business into a disqualified business - for example, a law firm might acquire commercial real estate that it rents to tenants, or a famous actor might launch a clothing line – in the hopes that it "muddies the waters" enough to convert the entire enterprise into a qualified business. This strategy faces two significant hurdles. First, because the law requires that the deduction be determined on a business-by-business basis, the IRS may force a taxpayer to distinguish among multiple lines of business within the same entity, denying a deduction attributable to any disqualified business line. But even if the businesses could be commingled, the law treats as a disqualified specified service business any business involving the performance of services in the fields of health, law, etc. Thus, the language suggests that even a small amount of services provided in a disqualified field could taint an entire business. Thus, in the examples above involving the law firm/real estate company or actor/clothing line scenarios, because each business would continue to provide some element of personal services in a disqualified field, those services could taint the entire business, potentially preventing the rental income or the income from the clothing line from being treated as qualified business income.

Option 2 - Perhaps a more prudent alternative to maximizing the deduction involves the opposite approach: Having a disqualified business "spin off" the activities of a potentially qualifying business into a separate entity.

Example 7A: Assume Doctor A currently owns a medical/dental S Corporation, S Corporation 1. He or she is the sole shareholder/owner. It has a net income of $500,000 after it pays Doctor A wages of $200,000 and $300,000 to other employees. Doctor A is married. If Doctor A does nothing, he/she will not qualify for the deduction because being a doctor or dentist a specified service trade or business and his or her taxable income is over $415,000.

Doctor A’s federal tax liability will be approximately $189,500.

Example 7B: Same facts as Example 7A. Doctor A creates two new S Corporations. S Corporation 2 which will do the billing for S Corporation 1. S Corporation 2 which will provide professional services such as administration, purchasing, billing paying and hiring non-licensed professionals for S Corporation 1. These types of organizations are know by many names such as Professional Service Organizations (PSO), Professional Employer Organizations (PEO), Management or Medical Service Organizations (MSO), Dental Service Organization (DSO) and etc.

To make the math simple, assume the only expenses S Corporations 2 and 3 have are the employees that used work for S Corporation 1 to the billing, $50,000, and the non-licensed employees, $100,000. Thus, S Corporation’s 1 salaries and wages expense will decrease by $150,000 ($50,000 + $100,000) because going forward they will be paid by S Corporations 2 and 3.

S Corporation 1 pays fair market fees to S Corporation 2 of $100,000 and $200,000 to S Corporation 3 for the services that they provide it. S Corporation 1 now has a net income of $350,000 ($500,000 - $100,000 - $200,000 + $150,000). Assume S Corporation 2 pays $50,000 in wages so its net income is $50,000 ($100,000 - $50,000) and S Corporation 3 pays $100,000 in wages so its net income is $100,000 ($200,000 - $100,000).

Doctor A’s federal tax liability will be approximately $178,400.

By “spinning-off” the activities of his or her medical/dental practice into three separate entities that two qualify as a qualified trade or business, Doctor A was able to reduce his or her federal tax liability by approximately $11,100.

The above structure is not limited to medical or health professionals. Law firms can do the same. Real estate management companies can “spin off” the janitorial and repair divisions into separate entities. Financial planners can hire their spouses to provide them with administrative services and etc.

The “spin off” division would take the position that because its new business not in the field of health, it is not a specified service trade or business. The IRS could craft regulations which provide that administrative and support services provided to a specified service trade or business are treated as the provision of services in that same specified service trade or business. If this were the case, rendering administrative and support services to a doctor group would be treated as services provided in the field of health, converting that business from a qualified to a disqualified or specified service trade or business.

Furthermore, you need to take into account the cost, management & etc. associated with opening new entities.

Option 3 - Perhaps a safer alternative is for a specified service trade or business - for example, a doctor - forms a new LLC that purchases the building it currently leasing, which then rents the building to the medical practice at the highest justifiable rate. It is unlikely future regulations would deny such a structure, provided the rent were fairly valued, because, in this example, it is property, rather than services, that is being provided to a specified service trade or business.

Example 7C: Same facts as Example 7B. However, Doctor A purchases the building he or she practices out of for $5M. Assume the rent that was paid to the old landlord, $60,000 per year, is now paid to Doctor A’s LLC. Assume the LLC has no other income, expenses or employees.

The LLC qualifies for the deduction it even though it has no employees. The tentative deduction is 20% of the qualified business income, $12,000 ($60,000 x 20%). Or the lesser of:

50% of the W-2 wages paid, which is zero or,
The sum of 25% of the W-2 wages, zero, plus 2.5% of the unadjusted tax basis which is $125,000 ($5M x 2.5%).

Thus the deduction is $12,000.

Advantages & Disadvantages S Corporation versus Sole Proprietorships – The following are the advantages of conducting your business through an S Corporation versus a sole proprietorship:

Payroll Tax Savings – S Corporations pay payroll taxes on the wages paid to its shareholder/employee(s). Sole proprietorships pay payroll taxes on the net income of the business. Payroll tax is made up of:

Social Security or FICA – 12.4% on the first $128,400 of wages and
Medicare – 2.9% and there is no limit.
Hospital Insurance (HI) - 0.9% of wages over $250,000 for married and $200,000 for single.

Example 8A: Taxpayer is single and the sole shareholder/employee of his or her S Corporation. Its net income is $330,000 before wages. The S Corporation pays the taxpayer wages of $80,000. Taxpayer will pay the following payroll taxes:

$9,920 in Social Security or FICA – 12.4% x 80,000

$2,320 in Medicare – 2.9% x $80,000

$0 in Hospital Insurance

Total payroll tax paid by the taxpayer is $12,240.

Example 8B: Same facts as above except that the taxpayer is a sole proprietorship. Thus, its net income is $330,000. Taxpayer will pay the following payroll taxes:

$15,923 in Social Security or FICA – 12.4% x $128,400

$9,571 in Medicare – 2.9% x $330,000

$943 in Hospital Insurance - .9% x ($330,000 – $200,000 - $15,922 - $9,570)

Total payroll tax paid by the taxpayer is $26,437. By being an S Corporation and receiving a reasonable compensation the taxpayer saved $14,197 ($26,437 - $12,240) in payroll taxes.

In Example 4B, A the sole proprietorship received a bigger deduction than B the sole shareholder/employee of the S Corporation. However, you have to take into account the additional payroll tax cost to accurately calculate if there is a tax savings as a sole proprietorship.

Liability Protection – Generally S Corporations provide liability protection to their shareholders. A sole proprietor is liable for his or her business. This is a legal issue and it should be discussed with an attorney.
Audit Protection – S Corporations have the least chance of being audited by IRS. Sole proprietors have a higher chance.

The following are the disadvantages of conducting your business through an S Corporation versus a sole proprietorship:

Incorporation Fee – There is a one-time fee to incorporate with the Secretary of State.
Annual Minimum Franchise Tax – State a California charges the greater of $800 or 1.5% of the S Corporation’s net income as a franchise tax. Thus, at minimum you will pay $800 a year in franchise tax.
Quarterly & Annual Federal and State Payroll Tax Returns – You have to file quarterly and annual federal and state payroll tax returns.
Annual S Corporation Income Tax Returns – You have to file annual federal and California S Corporation income tax returns. Furthermore, you need to keep separate books and records for the corporation. Therefore, you should have some kind of a bookkeeping system implemented.

We are able to provide you with any and all of the services listed above. We can incorporate your business, provide bookkeeping services, prepare the required quarterly and annual payroll tax returns and prepare your annual S Corporation income tax returns.

Gain on the Sale of Depreciable Asset Used in a Trade or Business, Section 1231 Gain – The law is silent on the treatment of the gain when you sell an asset that you have used in your trade or business for more than one year. This is called a Section 1231 gain.

Is the gain qualified business income? Since Section 1231 asset is specifically excluded from the definition of a capital asset it seems like until guidance from the IRS provides otherwise, it is reasonable to include the gains and losses in qualified business income.

Like-Kind Exchanges - Regulations will provide rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions.

Tiered Entities - Future regulations will provide guidance on how to determine the deduction in the case of tiered entities.

Commonly Controlled Entities - At present, the law does not allow for an allocation of the W-2 wages paid by the management company to each of the operating companies. As a result,

assuming the shareholders of the operating companies have taxable income exceeding the threshold amounts, they would be precluded from claiming a deduction, courtesy of the W-2 limitations. Similar problems arise in the case of employees leased through a professional

employer organization (PEO) or employee leasing firm.

Increased Exposure to Underpayment Penalty - Generally, for taxpayers other than C corporations, the understatement is substantial if its amount for the tax year exceeds the greater of:

10% of the tax required to be shown on the return for the tax year; or
$5,000

Under the new law, substantial understatement penalty is applied when:

5% of the tax required to be shown on the return for the tax year; or
$5,000

This lower threshold is particularly harsh, given the lack of guidance surrounding key aspects of this new law and the resulting challenges taxpayers and their advisers face in implementing the

provision. Importantly, the changes do not require the substantial understatement to be attributable to the qualified business income deduction. Thus, any taxpayer who claims the deduction will be subject to the lower threshold, even if the understatement on the return is unrelated to the qualified business income deduction.

Conclusion - While the purpose of the deduction is clear, its statutory construction and legislative text is anything but clear. The provision is rife with limitations, exceptions to limitations, phase-ins and phase-out’s, and critical but poorly defined terms of art. As a result, the new law has created ample controversy since its enactment, with many tax advisers anticipating that until further guidance is issued, the uncertainty surrounding the provision will lead to countless disputes between taxpayers and the IRS. Adding concern is that, despite the ambiguity inherent in the law, Congress saw fit to lower the threshold at which any taxpayer claiming the deduction can be subject to a substantial understatement penalty.

Right now is a great time for tax planning and creating an analysis specific to your business to determine if you qualify for the deduction. If you do not qualify for the deduction we can advise you on other options that may be available to you. Please do not hesitate to call us.

The information within this email is an accumulation from many sources; especially, Parker Tax Pro Library and The Tax Adviser April 2018 issue.

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The IRS began its "Dirty Dozen" list for 2022, which includes potentially abusive arrangements that taxpayers should avoid. The tax scams in this series focus on four transactions that are wrongfully promoted and will likely attract additional agency compliance efforts in the future. Those four abusive transactions involve charitable remainder annuity trusts, Maltese individual retirement arrangements, foreign captive insurance and monetized installment sales. These are the first four entries in this year’s Dirty Dozen series.

Taxpayers who have already claimed the purported tax benefits of one of these four transactions on a tax return should consider taking corrective steps, including filing an amended return and seeking independent advice. Where appropriate, the IRS will challenge the purported tax benefits from the transactions on this list and may assert accuracy-related penalties. Further, the IRS informed that to combat the evolving variety of these potentially abusive transactions, the IRS created the Office of Promoter Investigations (OPI). The IRS has a variety of means to find potentially abusive transactions, including examinations, promoter investigations, whistleblower claims, data analytics and reviewing marketing materials.

Further, the IRS reminded taxpayers to watch out for and avoid advertised schemes, many of which are now promoted online, that promise tax savings that are too good to be true and will likely cause taxpayers to legally compromise themselves. Additionally, the IRS informed that taxpayers who have engaged in any of these transactions or who are contemplating engaging in them should carefully review the underlying legal requirements and consult independent, competent advisors before claiming any purported tax benefits.

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The IRS announced that is completing the processing on a key group of individual tax returns filed during 2021. Business paper returns filed in 2021 will follow shortly after. The Service began 2022 with a larger than usual inventory of paper tax returns and correspondence filed during 2021 due to the pandemic. The IRS will continue to work on the few remaining 2021 individual tax returns that have processing issues or require additional information from the taxpayer. As of June 10, the IRS had processed over 4.5 million individual paper tax returns received in 2021.

To date, more than twice as many returns await processing compared to a typical year at this point in the calendar year. A greater percentage of this year’s inventory awaiting processing is comprised of original returns that, generally, take less time to process than amended returns. To address the unprocessed inventory by the end of this year, the IRS has taken aggressive steps including significant, ongoing overtime for staff throughout 2022, creating special teams of employees focused solely on processing aged inventory and expediting hiring of thousands of new workers and contractors. Additionally, the IRS has improved the process for taxpayers whose paper and electronically filed returns were suspended during processing for manual review and correction.

The IRS reminded taxpayers who have not yet filed their 2021 tax returns this year, including those who requested an extension until October 17, to make sure they file their returns electronically with direct deposit to avoid delays. The IRS urged taxpayers to file as soon as they are ready and to not wait until the last minute before the October 17 extension deadline. Filing sooner avoids potential delays for taxpayers and assists the larger ongoing IRS efforts to complete processing tax returns this year.

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Internal Revenue Service Commissioner Charles Rettig is pushing back on assertions that the agency is spending less time targeting wealthy taxpayers for audit in favor of lower income taxpayers.

"This is damaging to tax administration in this country when people say IRS audits more lower income people than higher income people," Rettig told attendees June 23, 2022, at the NYU Tax Controversy Forum.

He asserted that audit rate figures can be skewed depending on when the calculation is taking place. For example, he noted that if data is published on rates of audit for the 2021 tax year in 2022, the numbers will be considerably off.

"[W]hen you see these audit rates, don't jump on that train and say IRS is only auditing .0000 something," he said. "I go, Wow. Who are these folks we picked up? Right? The average audit gets picked up, particularly for high wealth taxpayer at least 16 months after that return has been filed. Why would we audit in the same calendar year that it's filed?"

Rettig noted that wealthy people may be filing later toward the extended filing deadline and filing more returns covering multiple years simultaneously, which would push back when audits take place. The would give the appearance that audits for more wealthy taxpayers may not be happening as much as for lower income taxpayers when examining a single-year audit rate.

But in reality, he said that audit rates for those who make more than $10 million "runs right around seven or eight percent. And as of this year, it’s at 8.7 percent. You will see that the $5 to $10 million group runs about 4.2%. You will see the $1 to $5 million group runs about 2.2%. Most of you have done the math and you understand exactly what I'm telling you, you go for the higher income folks."

After that, the numbers drop off "considerably," he said.

"The $1 million-and-under person is really the executive who has W-2 and 1099 income and we have that information," Rettig said. "The over $1 million person is the entrepreneur who has a lot of pass-through entities and whatnot, we don't have that information," and they get audited more because of it.

Rettig also used the forum to continue advocacy for more funding and guaranteed funding over multiple years to help improve not only enforcement, but to help improve the services that the agency provides to taxpayers, including hiring for call centers and providing better outreach.

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Republican members of the Senate Finance Committee are the latest group to call on the Internal Revenue Service to implement 2-D barcoding technology on individual tax forms.

"We are writing to strongly encourage the Internal Revenue Service (IRS) to work with tax return software companies to implement 2-D barcoding technology for use during the 2023 tax filing season for the 1040 family of paper returns," the GOP senators, led by Ranking Member Mike Crapo (R-Idaho), said in a May 24, 2022, letter to IRS Commissioner Charles Rettig.

Similar calls have been made by other stakeholders, including the National Taxpayer Advocate, who sent a directive to the IRS in March to implement 2-D barcoding in time for use with the 2023 tax season.

The GOP senators noted that the IRS is financially capable of doing this now. In the letter, the senators referenced the 2017 budget request of $8.4 million for implementation of 2-D barcoding and the $1 billion earmarked in the American Rescue Plan of 2021 for IT modernization, of which they state only $98.5 million so far has been spent.

The group also called on the agency to "stop chasing technological perfection" in the letter.

"If we were to wait for the promise of better technology, nothing would ever get implemented," the letter states. "To the contrary, the fact that 2-D technology is a bit older probably means it has been tested and is less expensive. Many states currently use 2-D barcoding for tax returns, so we have proof it works."

2-D barcoding came back into the forefront of needed IT upgrades for the IRS during the pandemic that caused a significant backlog of unprocessed paper returns. As of April 29, the agency still had more than 18 million unprocessed paper returns, though Commissioner Rettig has stated in numerous congressional hearings that the backlog will be back to its "normal" levels by the end of 2022.

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The IRS Whistleblower Office has released the fiscal year (FY) 2021 annual report to Congress. In FY 2021, the Whistleblower Office made 179 award payments to whistleblowers totaling $36,144,926, including 20 awards paid under Code Sec. 7623(b). Whistleblower claim numbers assigned in FY 2021 grew by 55 percent year over year and claim closures increased by 13 percent. Additionally, this year’s report introduces the Code Sec. 7623 Payment and Claim Processing Analysis. The analysis shows Code Sec. 7623(b) awards were paid on average in 17 days.

Code Sec. 7623 Payment and Claim Processing Analysis

The average claim processing time for Code Sec. 7623(b) award payments made during FY 2021 increased by 2.9 percent from the prior year and average claim processing time for Code Sec. 7623(a) award payments increased by 10.4 percent. The report stated that it is likely average claim processing times will continue to increase as claim inventory continues to age while the Whistleblower Office awaits audits, exams, investigations, appeals, tech services, collection, statutes to expire, and whistleblower litigation.

Ten Most Common Allegations Submitted In FY 2021

The ten most common allegations submitted on Form 211, Application for Award for Original Information, for FY 2021 were:

unreported income;
general allegations of fraud, tax fraud, wire fraud, insurance fraud, and related allegations;
false dependent exemptions;
employee vs. subcontractor;
failure to file;
wage under reporter;
capital gains tax;
wages being paid in cash or under the table;
rental income; and
false deductions or expenses.

The report also provided other information including disclosures made under Taxpayer First Act, additional information on submissions received in FY 2021, information on claim numbers issued, claims remaining open and claims that were closed in each FY from 2019 to 2021, geographic location of all whistleblowers by region, open Code Sec. 7623(b) claims as of FY 2021, and reasons for closures that occurred during FY 2021.

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Department of the Treasury Secretary Janet Yellen is continuing to promote the agreement on international taxes reached by most members of the Organisation for Economic Co-operation and Development on a global corporate minimum tax, but acknowledged that its overall impact will be determined by the final details.

Testifying before the Senate Finance Committee at a June 7, 2022, hearing about the White House’s fiscal 2023 budget request, Secretary Yellen noted in her opening remarks that she is "keenly focused on moving forward on the global agreement on international tax reform, including a global minimum tax that will level the playing field and raise crucial revenues to benefit people around the world."

However, she noted that because the specific details of how the international tax reforms will be defined and implemented, the impact on American businesses cannot be determined.

In response to a question as to whether the agency will provide Congress with the analysis of data currently available on whether the pillar one agreements will have a positive or negative impact, she said "that it could go either way, depending on the details which have not yet been decided. In the pillar one negotiations, the impact on fiscal revenues will be small."

Yellen continued: "Pillar two has a big impact. Pillar one will have a small impact. We're a very large market economy. We will gain revenue from our ability to tax foreign corporations that are doing business in the United States where we consume those services, we will lose some from revenue. Yet, it could be positive or negative, depending on details that have not yet been worked out. And that's why we've not provided data. We will when those details are clear."

That being said, Yellen also highlighted that countries will not be able to skirt the requirements of the treaty, responding to a question on whether China, a signee of the agreement, can be expected to comply with it when the nation has a questionable record complying with other international agreements.

Secretary Yellen testified that she expects China to comply with the terms of the agreement, but if it fails to do so, "this agreement contains an enforcement mechanism that will allow the United States or any other country that has adopted the global minimum tax to impose taxes on China's companies that would be the same as if China had complied. So there is a tough enforcement mechanism in this deal."

She also testified that Treasury will be negotiating on the details to ensure that business tax credits and subsidies will not negatively impact corporations once the international tax reforms are implemented.

Defending the Budget

During the hearing, she also addressed a number of issues that have become common themes among Biden Administration officials in recent months, including a recent focus on the tax gap and the disparities in auditing following a Government Accountability Office report that highlighted those concerns.

"Tackling that $600 billion annual tax gap is absolutely important in ensuring fiscal responsibility," Yellen told members of the Senate Finance Committee in response to a comment that the White House is requesting $80 billion over 10 years to address this. "It would generate substantial revenue in a manner that's efficient and fair. It would enable deficit reduction and help these price pressures by providing the funding a part of the funding we need for the urgent fiscal priorities."

She reinforced a common call to better fund the Internal Revenue Service to make sure it has the proper personnel in place to do things such as conducting more complicated audits to ensure the top earners are paying their fair share of taxes, in addition to helping the IRS serve the overall population and update its information technology infrastructure.

"We absolutely have to invest in the IRS to close that tax gap, which reflects opaque sources of income, mainly by high income earners that are not taxed," she said. "And they need the resources to serve taxpayers to be able to answer their phones to be able to ensure that they receive the payments that they are due, and they need to modernize their technology which is really the oldest dating back to the [19]60s in the federal government."

Yellen also took the opportunity to encourage Congress to extend the child tax credit, noting that while it may have played a minor role in contributing to the inflation issues the nation is tackling, it has had a significant effect on helping to reduce childhood hunger.

"It enabled families to get a little bit of breathing room and to help their kids afford nutritious food and clothing and back to school supplies." Yellen said.

She also mentioned during the Senate Finance Committee hearing that the Treasury Department is looking forward to working with Congress to get a tax deduction for union dues reinstated after it was cut in 2017.

A day later, on June 8, 2022, Secretary Yellen appeared before the House Ways and Means Committee in a hearing also advertised as a review of the White House budget but one that focused heavily on inflation, current energy policy, and international tax reform.

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The American Institute of CPAs is calling on Congress to fund the Internal Revenue Service at the level requested by the White House in its fiscal year 2023 budget request. Separately, the group offered its suggestions on the IRS Guidance Priority List. "In advance of the Fiscal Year 2023 appropriations cycle, we request that you fund the Internal Revenue Service (IRS) at necessary levels to allow it to handle all the duties required of it by Congress, including properly administering and enforcing our nation’s tax laws as well as providing needed assistance to taxpayers and their advisers in a timely and professional manner," AICPA said in a May 25, 2022, letter to Democratic and Republican leadership in both the House and Senate Appropriations Committees.

AICPA expressed concern that "service challenges will persist long after the pandemic has ended unless sufficient, targeted funding for technology improvements, human talent and training, and taxpayer services are appropriated."

The organization also noted that there needs to be more than money thrown at the agency to help its functioning. "It should be clear that funding alone will not solve the IRS’s problems,” AICPA wrote. “Structural reforms and organizational alignment from Congress, the President, the Secretary, and the Commissioner are necessary to delivering the promised goals. We look forward to working with all parties involved to this end and create an IRS that taxpayers deserve."

Priority Guidance Recommendations

In a separate letter sent to the IRS May 24, 2022, AICPA outlined its suggestions for the guidance that the agency should be prioritizing. The guidance recommendations cut across a range of programs and legislation, such as the Tax Cuts and Jobs Act, the SECURE Act, and the CARES Act and covering a number of areas such as corporation and shareholder taxation, employee benefits taxation, individual taxation, and international taxation.

R&E Recommendations

AICPA is also recommending the Internal Revenue Service issue specific regulations related to the treatment of research and experimental (R&E) expenditures under Sec. 174.

In a May 26, 2022, letter to the IRS, AICPA said that the Department of the Treasury and the IRS should "issue regulations providing that section 174(a) expenditures include direct costs, including employee compensation, contract labor, and materials, and at the taxpayer’s election, allocable indirect and overhead costs."

AICPA also said that Treasury and the IRS "should issue regulations that illustrate, using detailed examples, which costs are ‘incident to’ the development or improvement of a product as per Reg. §1.174-2."

If the agency doesn’t issue new regulations, AICPA recommended guidance to cover these requests.

Additionally, AICPA identified issues that have arisen with Rev. Proc. 2000-50, which covers the treatment of costs paid or incurred to develop, purchase, or lease computer software.

"IRS should modify the scope limitation under section 4 of Rev. Proc. 2000-50 to clarify that the limitation on costs that a taxpayer has treated as R&E expenditures under section 174 only applies to costs previously subject to an irrevocable election under section 174, including 174(b) or charging the expenses to capital account."

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The Department of the Treasury is continuing its push to get funding for much needed information technology infrastructure upgrades from Congress.

During a June 14, 2022, hearing before the Senate Appropriations Committee’s Subcommittee on Financial Services and General Government, Treasury Deputy Secretary Wally Adeyemo testified as to why the funds were needed.

The "IRS’ technology is decades out of date, written in a programming language no longer taught, and incredibly expensive to maintain the master file that under grids," Adeyemo told the committee in his opening statement. "The tax system dates back to the 1960s when there was no internet, no cell phones, and no spreadsheets or automatic payments."

The White House is requesting a 12 percent budget increase in fiscal year 2023 compared to 2022 enacted levels "to begin to remedy this mismatch between the IRS’ responsibilities and its resources."

Treasury’s request for increasing funds to help address IT infrastructure upgrades for the IRS did not come up during the hearing’s question-and-answer period, as the committee focused its attention on Russian sanctions, the role of using cryptocurrency to evade sanctions, energy policy and independence, and other criminal-focused activities.

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The U.S. Supreme Court has granted a petition for certiorari in the case of A. Bittner, CA-5, 2021-2 USTC ¶50,242 . In Bittner, the U.S. Court of Appeals for the Fifth Circuit held that each failure to report a qualifying foreign account on the annual Report of Foreign Bank and Financial Accounts (FBAR) constituted a separate reporting violation subject to penalty. This means that the penalty applies on a per-account basis, not a per-form basis. The Fifth Circuit disagreed with a Ninth Circuit panel that adopted a per-form interpretation ( J. Boyd, CA-9, 2021-1 USTC ¶50,112).

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Background

U.S. citizens and residents must keep records and/or file reports when the person makes a transaction or maintains a relation for any person with a foreign financial agency ( 31 USC 5314). Each person with a financial interest in a financial account in a foreign country must report the relationship to the IRS for each year the relationship exists by providing specified information on and filing the FBAR. The FBAR generally must be filed by June 30 of each calendar year for foreign financial accounts over $10,000 maintained during the previous calendar year (31 C.F.R. §§1010.350, 1010.306).

If the person fails to file the FBAR, the IRS can impose a penalty of up to $10,000 for non-willful violations, unless the violation was due to reasonable cause. For a willful violation, the maximum penalty is the greater of $100,000 or 50 percent of (1) the amount of the transaction when a violation involves a transaction, or (2) the balance in the account at the time of the violation when a violation involves a failure to report the existence of an account. There is no reasonable cause exception for willful violations ( 31 USC 5321).

Fifth Circuit: FBAR Penalty Per Account

In A. Bittner, the Fifth Circuit ruled that the text, structure, history, and purpose of the relevant statutory and regulatory provisions showed that the "violation" of 31 USC 5314 contemplated by the 31 USC 5321 penalty was the failure to report a qualifying account, not the failure to file an FBAR. Therefore, the $10,000 penalty cap applied on a per-account basis, not a per-form basis.

The Fifth Circuit agreed with the government that the district court had erred in determining what constituted a "violation" under 31 USC 5314 by focusing on the regulations under section 5314 to the exclusion of section 5314 itself. Section 5314 does not create the obligation to file a single report, stated the Fifth Circuit, but instead gives the Treasury Secretary discretion to prescribe how to fulfill the statute’s requirement of reporting qualifying accounts.

The Fifth Circuit observed that by authorizing a penalty for any "violation of ... any provision of section 5314," as opposed to the regulations under section 5314, section 5314 "naturally reads" as referring to the statutory requirement to report each account, not the regulatory requirement to file FBARs in a particular manner. Further, the circuit court stated that the reasonable cause exception for non-willful violations was framed in terms of "the transaction" and "the account," and thus it also "naturally reads" as excusing the failure to report a transaction or account, not the failure to file an FBAR.

Ninth Circuit: FBAR Penalty Per Form

In J. Boyd, the Ninth Circuit ruled that the IRS can impose only one non-willful penalty when an untimely but accurate FBAR is filed, regardless of the number of foreign financial accounts. The Ninth Circuit determined that the statutory and regulatory scheme under 31 USC 5314 authorizes a single non-willful penalty for the failure to file a timely FBAR, and that the taxpayer’s conduct in failing to timely file the FBAR amounted to one non-willful violation.

The Ninth Circuit was not persuaded by the government's argument that, based on the statutory scheme as a whole and legislative intent, the penalty amount could be assessed on a per-account basis. The Ninth Circuit found nothing in the statute or regulations to suggest that the penalty could be calculated that way for a single failure to file a timely FBAR that is otherwise accurate. The Ninth Circuit presumed that Congress had purposely excluded the per-account language from the non-willful penalty provision because it had included such language in the previously-enacted willful penalty provision. Further, the inclusion of per-account language in the reasonable cause exception supported the view that Congress had intentionally omitted per-account language from the non-willful penalty provision.

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