Under the Tax Cuts and Jobs Act, Congress is now offering a new 20% deduction for “pass-through” businesses – i.e. businesses that are not corporations. With the corporate tax rate being reduced under the new law to a flat 21%, the 20% deduction for other forms of businesses was designed to give a reduction to these businesses approximating the lower corporate tax rate. If applicable, the 20% deduction can be claimed by the owners of S corporations, partnerships, sole proprietorships, and even the beneficiaries of trusts. These are business entities that do not pay income tax at the business entity level (such as corporations), but where the profits and other income of the business go to or “pass-through” to the owners (or to the beneficiaries in the case of a trust). However, this 20% deduction, found in new Internal Revenue Code § 199A, is saddled with exclusions, phase-outs, technical issues, and uncertainties so that many well-meaning non-corporate business owners may not receive the benefit, at least in full, of this new deduction.
www.sctaxlawyers.com contains a series of posts on this important new deduction, including blogs on “The Return of Corporations for Small Businesses”, “The 20% Deduction for ‘Pass-Through” Businesses’”, and “The new 20% Pass-Through Deduction: Can Real Estate Owners Claim it?” This post focuses on the undecided issue of how owner compensation for a pass-through business is treated in the calculation of the deduction (if at all).
For most pass-through business owners, the deduction is the lesser of (1) the “combined qualified business income” of the taxpayer, or (2) 20% of the excess of taxable income over the sum of any net capital gain. The term “combined qualified business income” is then defined as the lesser of (1) 20% of the business owner’s “qualified business income” (QBI) or (2) the greater of (A) 50% of the W-2 wages of the business allocable to the owner or (B) 25% of the W-2 wages of the business plus 2.5% of the unadjusted tax basis in property of the business allocable to the business owner. QBI is generally profit from the active income and expenses from the operation of the pass-through business, and does not include “passive income” such as interest, dividends, and even capital gains as well.
The starting point in determining the deduction is “QBI”. Unfortunately, this is a difficult starting point conceptually as the deduction is function of “profit” of a business. You first calculate business “profit” (sales less expenses), then apply 20% to this profit amount (but subject to the limitations above, and others as well), and this “artificial” 20% amount “passes through” to the owners as a deduction which the owners can claim on their individual income tax returns to offset other taxable income (e.g. wages, dividends, interest, and other forms of income).
Many small pass-through businesses operate as a Subchapter S corporation (S Corporation), limited liability company (LLC), or even as a LLC and where a special election is filed with the IRS to be taxed as an S corporation. Where an owner actively works in the S corporation/LLC business, the IRS requires the owner to pay him or herself “reasonable compensation”; that is, a salary for S corporation owners, and a “guaranteed payment” for owners of an LLC who actively work in the business of the LLC. Under this structure, the “owner-employee” is required to include her or her compensation from the pass-through business as ordinary income (taxed at high ordinary income rates) and where this same compensation is also subject to federal employment taxes (FICA/FUTA and self-employment taxes). The benefit of this structure is that, while wages and guaranteed payments are subject to both income and employment taxes, any profit from the pass-through business is NOT subject to federal employment taxes.
Many owners of S corporations and LLCs, who actively work in their business, do pay themselves a reasonable salary or “guaranteed payment” for their services, paying income and employment taxes on this compensation but otherwise receiving profits from the business that are not subject to employment taxes. However, this same structure has unfortunately been abused as well, and is a major audit focus for the IRS. The IRS has found that many pass-through business owners, particularly owners of S corporations (and LLCs with an S corporation election) do not pay themselves a “reasonable compensation” and some do not pay themselves anything at all. The IRS then comes in, audits, determines what a “reasonable compensation” amount for the owner may be, and essentially “recharacterizes” profit of the business as wages to the owner, and additional employment taxes (and penalties and interest) are due from the business (and the owner) as a result.
Back to the 20% deduction and QBI. Again, the starting point for the deduction is QBI. QBI is essentially the active sales income and expense of a business. The deduction is generally 20% of QBI. Simple enough.
However, and related to this “reasonable compensation” issue, Congress added the following:
“(4) Treatment of reasonable compensation and guaranteed payments.
Qualified business income shall not include—
(A) reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business,
(B) any guaranteed payment described in paid to a partner for services rendered with respect to the trade or business, and
(C) to the extent provided in regulations, any payment … to a partner for services rendered with respect to the trade or business.”
Under a reading of this limitation to QBI (and hence a limit to the 20% pass-through deduction), both “reasonable compensation” paid to an S corporation owner-employee and a “guaranteed payment” to an owner who actively works in a LLC are “not included” in the calculation of QBI. Does this mean reasonable compensation/guaranteed payments are “taken out” or “removed” in the QBI calculation, or does the QBI calculation simply “not consider” these payments? Is there also an argument that reasonable compensation/guaranteed payments, if they have been deducted by the business, should actually and properly be “added back” in the QBI calculation. Some examples will serve to highlight the confusion.
Say, John is the sole shareholder of Corporation A, which is an S Corporation. Corporation A had $1 million in active income and also has $800,000 in related and deductible expenses, or a profit and potential QBI of $200,000. The 20% pass thru deduction from Corporation A to John could be $40,000 (20% x $200,000). John also paid himself a salary of $100,000, and which was deducted by Corporation A and included in its $800,000 of expenses. John paid income taxes on the $100,000 wages he received and employment taxes (FICA/FUTA) were also paid on these same wages.
Also, we have Fred and Corporation B. Corporation B is an S Corporation and Fred is its sole shareholder. Corporation B also had $1 million in active income. Fred actively worked in Corporation B business, but paid himself no salary whatsoever. An equivalent salary for Fred’s work (if Corporation B had to hire an outside person to do Fred’s work) would be $100,000. Corporation B had $700,000 in expenses. If Corporation B had paid Fred his $100,000 salary, Corporation B, like Corporation A, would have been able to deduct this salary payment, and would have had $800,000 in expenses. However, because Corporation B did not pay Fred any salary, it had a profit and potential QBI of $300,000 ($1 million less $700,000). The 20% pass thru deduction from Corporation B to Fred could be $60,000 (20% x $300,000), and Fred is also importantly not paying employment taxes, like John on the salary Corporation A paid to John.
If John does what the law requires and dutifully pays himself a reasonable compensation and related employment taxes on his wages from his business, why should John receive only a $40,000 pass-through deduction, while Fred, who does not pay himself a required salary and related employment taxes, gets a $60,000 deduction under new Section 199A? Section 199A, from the quoted language above, could be construed to read that where a business owner, like Fred, does not pay himself reasonable compensation, the IRS will “deem” this amount to him. This will then put Fred in the same condition as John, each with an S corporation with $1 million in income, $800,000 in expense, profit and QBI of $200,000, and a related 20% pass-through deduction of $40,000; however, since Fred never actually paid himself anything in terms of salary, the IRS will most likely then “rechararterize” $100,000 of Corporation B’s business profit as “salary” to Fred, and with the result that while both John and Fred ultimately receive the same $40,000 20% pass-through deduction and also both corporations have the same taxable profit ($1 million – $800,000 = $200,000), Corporation B and Fred must pay federal employment taxes (and penalties and interest) on the $100,000 in “deemed” salary paid to Fred.
The result above is by no means certain. The IRS must develop and release regulations to clarify this issue, as well as many other issues arising under Section 199A and the new tax law; however, the IRS, as a regulatory agency, is now significantly understaffed, and it may be many months, or even years, before this guidance is issued. In the interim, business owners, particularly owners of S corporation and LLCs, must consult with their tax advisors to share their particular facts, so that tax advisors can provide advice and recommendations for the owners to maximize their potential 20% pass-through deduction and not run afoul of potential employment tax and other issues.