By Jason Watson, CPA
Posted Wednesday, November 1, 2023

The main problem here is a lot of employees might want to convert to an independent contractor status with their former employer so they can qualify for the Section 199A deduction. For example, you make $100,000 as a W-2 employee. This probably costs your employer around $25,000 in payroll taxes, vacation, sick pay, 401k contributions and other benefits for a total of $125,000. You stroll up to the boss and say “Hey, make me a contractor; you save $25 large and I deduct $20 large, and everyone wins.” This could be abused, right?

But what about the legitimate relationships where an employee retires but is retained as a contractor? Or a company’s risk department and other departments believe it is better to have more independent contractors than employees. Section 199A holds a presumption that if you are performing substantially the same services as a contractor as you were as an employee, you will be considered an employee for the purposes of Section 199A qualified business income deduction.

So, theoretically you could be on the hook for self-employment taxes since that is how one part of the tax code is defining you but also not be eligible for the Section 199A deduction because that part of the tax code reads No. Not cool. Here is a blurb from the final regulations–

The final regulations provide that an individual may rebut the presumption by showing records, such as contracts or partnership agreements, that are sufficient to corroborate the individual’s status as a non-employee for three years from the date a person ceases to treat the individual as an employee for Federal employment taxes.(page 108)

Additionally, the SSTB designation is a direct response to what the IRS and Congress consider disguised W-2 compensation. Their position is that a doctor running an S Corp as an independent surgeon to a hospital is simply a disguised W-2, and as such all his or her income should be subjected to Social Security (up to the limits) and Medicare taxes.

Historically most personal services were performed by employees but the trend is now more independent contractors. In addition, to prevent W-2 converted to 1099 contractor abuse in the future in light of the wonderful Section 199A deduction, Congress created the SSTB designation. Simply, the tax code doesn’t want more employees to be converted to contractors.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Interestingly, removed from the traditional service profession are engineers and architects. But an engineer operating a business based on his or her reputation or skill might still be a specified service trade or business. In other words, reputation or skill might trump the fact that engineers and architects were purposely left off the list. Every consultant is suddenly going to reclassify themselves as an engineer; software consultant is now a software engineer. Watson Business Engineers has a nice ring to it. Hmm….

The above terms were in the original Section 199A tax code. On August 8, 2018, the IRS published proposed regulations to help better explain the Section 199A Qualified Business Income Deduction including anti-abuse rules (yes, we are always gaming the system… just like in the backyard with cops and robbers). On January 18, 2019, the IRS published final Section 199A regulations. Here is a link to review the Section 199A Final Regulations-

wcginc.com/8323

One of the areas that was addressed was SSTBs which is the acronym for specified service trade or business. This becomes super important if you find your taxable household income exceeding the top of the 24% marginal tax bracket. Here is the dirty baker’s dozen, the unlucky 13-

Health

This encompasses all the people you think it would. Does not include health club operators but it does include physical and massage therapists. So, if you are a traveling nurse providing home health care, you are considered an SSTB. But, this same nurse buys and operates a nursing home, he or she would not be deemed an SSTB.

We have consulted with clients who are practicing doctors, but they also sell personal property (like prosthetics). Now what? You are able to split up SSTB activities (being a doctor) and non-SSTB activities (selling medical devices), but rules are tricky and are beyond the scope of this book. Pharmacists also sell stuff; drugs and other “retail” items that are used for administration of health but they are wholly snagged in the health specified service trade or business.

Veterinarians wanted it both ways. At parties, we are doctors. At the IRS office, we are just animal lovers making a buck. All kidding aside, veterinarians argued that pets are retail property and are not patients in the truest sense. The Treasury Department and the IRS relied on Revenue Ruling 91-30 from 1991, and other nuggets of code and case law to “to continue the long-standing treatment of veterinary services as the performance of services in the field of health for purposes of section 199A and these final regulations.” (Final Regs, pages 80-81).

Law

Not just attorneys, but also mediators, arbiters and paralegals.

Accounting

Not just CPAs, but any tax return preparer, enrolled agent (EA), financial auditor, forensic accountant, business valuator and bookkeeper. This designation does not necessarily rise and fall on credentials, such as CPA or EA. It would be nice if the regulations called out all Colorado Springs CPAs as a) pretty cool and b) exempt from Section 199A limits because of their coolness, but it doesn’t. Our request was denied with prejudice.

Actuarial Science

Does not include analysts, economists, mathematicians and statisticians. Thank goodness, but then again how many mathematicians make over $326,600 (end of the 24% marginal tax bracket for 2020)? We want that job! Hats off to John Nash and his game theory mathematics however. Watch War Games again for some flashbacks; “Shall we play a game?”

Performing Arts

Includes who you think it would include plus directors, writers, singers and musicians, but does not include those people or businesses supporting the performing arts such as make-up technicians, camera operators, maintenance personnel and other specialists. What does a key grip do anyway?

Writers argued that writing does not require a unique skill, which is true if you recall that last bad movie you watched. The Treasury Department and the IRS said No with “to the extent that a writer is paid for written material, such as a song or screenplay, that is integral to the creation of the performing arts, the writer is performing services in the field of performing arts.” (Final Regs, page 84).

Here is an example from Section 199A’s final regulations–

Gordon Lightfoot, a singer and songwriter, writes and records a song while driving on a highway. Gordon is paid a mechanical royalty when the song is licensed or streamed. Gordon is also paid a performance royalty when the recorded song is played publicly. Gordon is engaged in the performance of services in an SSTB in the field of performing arts within the meaning of section 199A(d)(2) or paragraphs (b)(1)(v) and (b)(2)(vi) of this section. The royalties that Gordon receives for the song are not eligible for a deduction under section 199A. (Final Regs, page 229)

Consulting

Here is the verbiage right from the Final Regulation 1.199A; the performance of services in the field of consulting means the provision of professional advice and “counsel to clients to assist the client in achieving goals and solving problems.” Note the words advice and counsel.

If you can honestly say you don’t offer direct advice or counsel, then you are not a consultant as it relates to specified service trades or businesses. The word consultant is watered down in life.

Also, consulting services in connection with a sale or delivery of goods does not count either. A great example is a building contractor who is offering all kinds of advice and counsel to the client in an attempt to achieving goals and solving problems. Since this advice is inextricably embedded and is ancillary to the construction of a building, it is not considered consulting.

What is the lesson here? If you think you are a consultant, spend some time thinking about exactly what you do. A person might consider themselves a software consultant, but in reality they are more of a software developer since they do not provide advice or counsel. Rather they do their thing, and sell apps for $1.99 making millions.

Here is an example from Section 199A’s final regulations-

Bill Gates is in the business of licensing software to customers. Bill discusses and evaluates the customer’s software needs with the customer. Bill advises the customer on the particular software products it licenses. Bill is paid a flat price for the software license. After the customer licenses the software, Bill helps to implement the software (in real life, Paul Allen would have). Bill is engaged in the trade or business of licensing software and not engaged in an SSTB in the field of consulting within the meaning of section 199A(d)(2) or paragraphs (b)(1)(vi) and (b)(2)(vii) of this section. (Final Regs, page 231)

Some states or regulatory agencies require certain professions to bill separately for consulting services. Those separate billings might be considered an SSTB.

Athletics

Sure. Got it. But be careful since it also includes coaches and team managers.

Financial Services

All the usual suspects but the preamble to the proposed regulations states that banking services such as taking deposits and lending money are not considered financial services. This makes sense since taking deposits and lending money is a retail activity in several ways, where advice and counsel (not those words again) specific to a client is a financial service.

What about insurance agents? Here is a blurb from the Section 199A final regulations-

The Treasury Department and the IRS decline to categorically exclude services provided by insurance agents from the definition of financial services as financial services such as managing wealth, advising clients with respect to finances, and the provision of advisory and other similar services that can be provided by insurance agents. However, the Treasury Department and the IRS note that the provision of these services to the extent that they are ancillary to the commission-based sale of an insurance policy will generally not be considered the provision of financial services for purposes of section 199A.

Brokerage Services

Anyone who facilitates a transaction for a commission or a fee. Slow down though! The proposed regulations specifically say brokerage services do not include services provided by real estate agents and brokers, or insurance agents and brokers. Help someone sell their business, you are a specified service trade or business. Help someone sell their house, not so much. Gotta love a good lobby.

Investing and Investment Management Services

Again, the usual suspects. Does not include property management however. You can see why the Proposed Regs 1.199A had to mention this since technically property managers are managing investments although the investments are houses.

Trading Services and Dealing in Securities

Trading securities, eleven. Dealing Securities, twelve. Got it.

Reputation or Skill

This is the hammer. Unlucky number 13! The direct verbiage reads, “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 or owners.” This will be heavily litigated and shaped over time. This will also be the catch-all if the IRS challenges your trade or business to deem it a SSTB.

A bit of caution here. Business owners are proud, and for good reasons. As such they think their reputation or skill is the primary source of revenue. Perhaps. Perhaps not. We like to use the example of Dr. James Andrews; he is the go-to guy for the NFL on all knee injuries. Certainly his reputation or skill is known all over the country, and people ask for him by name.

The Section 199A final regulations summarize the reputation or skill issue fairly well-

If Congressional intent was to exclude all service businesses, Congress clearly could have drafted such a rule. Accordingly, the final regulations retain the proposed rule limiting the meaning of the reputation or skill clause to fact patterns in which an individual or RPE (relevant pass-thru entity) is engaged in the trade or business of receiving income from endorsements, the licensing of an individual’s likeness or features, and appearance fees. (Final Regs, page 98)

Here is an example from Section 199A’s final regulations-

Gordon Ramsay is a well-known chef and the sole owner of multiple restaurants each of which is owned in a disregarded entity. Due to Gordon’s skill and reputation as a chef, Gordon receives an endorsement fee of $500,000 for the use of his name on a line of cooking utensils and cookware. Gordon is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, Gordon is also in the trade or business of receiving endorsement income. Gordon’s trade or business consisting of the receipt of the endorsement fee for Gordon’s skill and/or reputation is an SSTB within the meaning of section 199A(d)(2) or paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section. (Final Regs, page 232)

Specified Service Trade or Business Summary

Sit on the ledge, sure, but don’t jump off a bridge just yet. The specified service trade or business problem only comes up when your taxable income exceeds the limits. So, a financial advisor making $150,000 might still enjoy the Section 199A deduction. Please read this again! We have been stuck in a handful of debates with clients about the specified service trade or business designation just to find out they make $100,000 as a household.

Where does WCG land on all this? Quite simple. In matters where it is unclear, like the software consultant who could argue he or she is a software developer, our firm will present both sides of the argument to you. At the end of it all, you decide. Secretly we would rather error on the side of client advocacy in cases where it is not clear. Ultimately it remains your decision (again, in matters where it is unclear or very subjective).

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Here are some common questions and answers that have come up during recent consultations with clients. Some of these might be repetitive if you’ve been paying attention.

Do I have to create an LLC to get the Section 199A deduction?

No. It is available to sole proprietors (no entity formation), rental property owners (as far as the activity rises to the level of a Section 162 trade or business or meets the safe harbor test), S corporation shareholders and partnerships (multi-member LLCs, LLPs, and all the other goofy variants). Having an LLC is a good idea for other reasons, but the Section 199A deduction is not one of them.

Is the Section 199A deduction a business deduction?

No. It is a deduction taken on the owner’s individual tax return on page 1 of your individual tax return (Form 1040) on line 13 for the 2020 tax year. Don’t look at your 2017 tax returns for line 13… the IRS decided to chop up Form 1040 into multiple parts and relabeled them Schedules for the sake of everyone’s desire to have a postcard tax return. No one seems to complain about state tax returns which can easily exceed 3 pages (California).

Back to the IRS and Form 1040 being chopped up… For example, Schedule 1 is titled Additional Income and Adjustments to Income which is essentially page 1 of old school Form 1040.

Is the Section 199A deduction available to rental property owners?

Yes, but there are rules outlined in IRS Notice 2019-7 including safe harbor requirements.

Why did they make the Section 199A deduction on the individual tax return of the owner?

Simple. The way Section 199A is written, there are limitations based on household income so it would be difficult for the business entity tax return to have visibility into each owners’ individual tax situation (not to mention privacy concerns).

What is the specified service trade or business nonsense I hear about?

Section 199A defines certain professions where the deduction is limited when certain income thresholds are exceeded. The list is health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing services and securities trading services. Plus 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 or owners.

I am a CRNA operating an S Corp. Am I considered a specified service trade or business?

Yes. The proposed regulations 1.199A expanded the definitions of SSTBs and the final regulations offered some more insight. Specifically for health, the regs state that anyone who provides medical services is considered a specified service trade or business. This means that nurses, nurse anesthetists, chiropractors, physical therapists, massage therapists, etc. Don’t forget pharmacists and veterinarians.

I am a realtor operating an S Corp. Am I considered an SSTB?

No. The proposed regulations 1.199A specifically call out real estate agents as not being a specified service trade or business and this was not altered in the final regulations. Yes, the political lobby must be very good.

I am an insurance agent operating an S Corp. Am I considered an SSTB?

No. The Section 199A final regulations have lumped insurance agents and brokers in this real estate agents and brokers, even if commissions are earned in connection with wealth management (such as life insurance).

Where is the specified service trade or business determined?

SSTB is determined at the entity level. So, if an entity is designated a specified service trade or business, all owners are subject to this possible limitation regardless of their individual title or contribution to the business. For example, let’s say Fred Flintstone and Mr. Slate are owners together. And Mr. Slate’s reputation or skill is known all over the world and it is the primary catalyst for the success of the business. Fred will also be deemed an owner of a specified service trade and business, and could further be limited on his Section 199A deduction. Guilty by association. Yabba dabba doo!

If the business is deemed to be an SSTB, do I lose my Section 199A deduction?

Maybe. Perhaps. You might. Yes and No. This is one of the biggest confusions out there. If you are a married doctor making $300,000 as a household you do not lose your Section 199A deduction, but if you make $500,000 you do. Read that again. Being labeled as a specified service trade or business isn’t bad until you meet income thresholds, which are $157,500 for singles and $315,000 for married filing joint. These numbers represent the end of the 24% marginal tax bracket, and the next tax bracket is 32%. This means the 32%, 35% and 37% represent the wealthier taxpayers and as such the Section 199A deduction becomes limited.

What if I file married filing separately? Can I get around the SSTB limitations?

Nice try. The IRS is smart. Congress is smart. The Joint Committee on Taxation is smart. Stop laughing… really, they are! And they saw you coming a mile away… probably heard you too.

All kidding aside, the tax code is very, very careful to prevent simple tax arbitrage based on tax filing status. If you are married filing separately, your $315,000 becomes $157,500 anyway. And… if you are in a community property state it might not make a difference since the K-1 will be the tax document coded with the specified service trade or business designation and splitting your income 50-50 (like in California) doesn’t appear to help.

Does capital gains income affect my Section 199A limitation?

Yes. If you are considering the basics where the Section 199A is available on the lessor of 20% of net business income or 20% of taxable income. For your business income, capital gains, dividends and interest income are excluded. For your individual income, capital gains are also excluded from the Section 199A deduction calculation.

How does Section 199A affect expats or expatriates?

Similar to other areas of the tax code involving foreign earned income exclusions, income that is already excluded does not count towards a Section 199A deduction. In other words, you cannot double-dip. If your earned income exceeds the foreign earned income exclusion, then there is a proration that is available.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Partnerships (Form 1065) and S Corporations (Form 1120S) must report a bunch of additional crud on the generated K-1s. Just another tax return preparation fee hike courtesy of your Section 199A lawmakers.

Each partnership or S Corp must determine if any of its trades or businesses are specified service trades or businesses, and report this as such on the K-1. So now there is huge risk by the accounting firm preparing the K-1 for the partner or shareholder who is relying on that data for individual tax return preparation. Yes, there was always this risk, but now it is much larger since the SSTB determination will be one of the deciding factors in the Section 199A waterfall.

The K-1 will also have the partner or shareholder’s allocable share of qualified business income, W-2 wages and unadjusted basis immediately after acquisition of qualified property.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

This is one of the dorky accountant questions… which number on the W-2 do I use? The IRS defined three safe harbors for the use of Section 199 Domestic Production deduction back when that was a thing. Later, in IRS Notice 2018-64 released August 8, 2018, the IRS scratched in the letter A like Hester Prynne and used the same safe harbors for Section 199A. Here are the three W-2 safe harbors-

• Unmodified Box Method– lessor of Box 1 or Box 5.

• Modified Box Method– start with Box 1 and make adjustments for things like sick pay, 401k or 403b, deferral, etc.

• Tracking Method– start with total wages subject to federal income tax withholding and adds Box 12 coded D, E, F, G and S. D and E are the most common… 401k and 403b.

This is all very exciting. Frankly, using Box 5 in 99% of the situations out there will work just fine. Box 5 = Box 1 + Box 12. But wait! There’s more… if you are a greater than 2% shareholder in an S corporation you must add self-employed health insurance (SEHI) premiums and HSA contributions to Box 5 for determining the Section 199A deduction. Huh?

Here is a blurb from IRS Notice 2018-64–

Section 199A(b)(4)(C) provides that W-2 wages shall not include any amount that is not properly included in a return filed with the Social Security Administration (SSA) on or before the 60th day after the due date (including extensions) for such return.

Here is another blurb from IRS Notice 2008-1–

Accident and health insurance premiums paid or furnished by an S corporation on behalf of its 2-percent shareholders in consideration for services rendered are treated for income tax purposes like partnership guaranteed payments under § 707(c) of the Code. Rev. Rul. 91-26, 1991-1 C.B. 184. An S corporation is entitled to deduct the cost of such employee fringe benefits under § 162(a) if the requirements of that section are satisfied (taking into account the rules of § 263). The premium payments are included in wages for income tax withholding purposes on the shareholder-employee’s Form W-2, Wage and Tax Statement, but are not wages subject to Social Security and Medicare taxes if the requirements for exclusion under section 3121(a)(2)(B) are satisfied.

Ok. So what do we have here? A mess, Yes, correct. IRS Notice 2008-1 is stating that self-employed health insurance premiums are considered wages subjected to income tax withholding purposes. IRS Notice 2018-64 states that wages must be included on a return filed with the SSA and by filing a W-2 (W-3 transmittal) this is satisfied.

Further in IRS Notice 2018-64 under the modified box method (see above) states-

W-2 wages under this method are calculated as follows—

(A) Total the amounts in Box 1 of all Forms W-2 filed with SSA by the taxpayer with respect to employees of the taxpayer for employment by the (B) Subtract from the total in paragraph .02(A) of this section amounts included in Box 1 of Forms W-2 that are not wages for Federal income tax withholding purposes, including amounts that are treated as wages for purposes of income tax withholding under section 3402(o) (for example, supplemental unemployment compensation benefits within the meaning of Rev. Rul. 90-72);

There is also similar language in IRS Notice 2005-8 which speaks to Health Savings Accounts (HSA). Therefore, self-employed health insurance (SEHI) and (HSA) amounts are considered wages for Section 199A purposes. Another way to look at this is on Schedule C.

Let’s say you didn’t have an S Corp election on your LLC since the business was new and only earned $30,000 in net income with $10,000 in self-employed health insurance premiums. The premiums would not reduce your net business income and therefore your Section 199A deduction would be 20% of $30,000 or $6,000, but your pay income taxes on $20,000. Same thing here.

Keep in mind that typically most shareholder’s reasonable salary will be much higher than 27.9% such that self-employed health insurance premiums do not affect the calculus. In turn, you will then be limited by net business income for the Section 199A deduction rather than W-2 wages.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

There are provisions for aggregating multiple businesses under common control or ownership (similar to controlled group rules). This might be to your advantage since you must compute Section 199A limitations for each business entity prior to adding them together. Therefore, if you are being limited in one entity based on W-2 Section 199A limits, then you can “rob” W-2 wages from another entity. There are all kinds of rules and technical issues of course.

Entities, such as partnerships and S corporations, cannot make this election since Section 199A is an individual deduction on an individual tax return. Specified service trades or business cannot be part of a Section 199A aggregation; so an online retailer who is also an attorney cannot aggregate the entities.

The aggregated business entities must meet the ownership or control rules. Makes sense, but they also must satisfy at least two of the following factors-

• The entities provide products and services that are the same or customarily offered together, or

• The entities share facilities or share significant centralized business elements, or

• The entities are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (such as supply chain interdependence).

Just like Meatloaf… 2 out of 3 ain’t bad. This will be very complicated very quickly. Good luck!

Also keep in mind that the Section 199A deduction is limited on two levels; the entity level and the individual’s taxable income level. Huh? The first calculation is done at the entity level to determine a W-2 and / or depreciable asset limitation. These limits are later aggregated and “sent over” to the individual tax return for the partner, member or owner as designated on the K-1.

The second limit is then based on the taxable income of the individual tax return (Form 1040). In other words, there are two hurdles with the Section 199A deduction and each hurdle can give a haircut to the tax deduction.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

More cops and robbers. If you are finding yourself limited in Section 199A qualified business income deduction because of depreciable assets (2.5% of the unadjusted cost basis right after acquisition is the calculation), you might be inclined to buy something on December 31 and sell it on January 1.

Nope. According to proposed regulations 1.199A-2(c)(1)(iv) if you buy qualified property within 60 days of the taxable year-end, dispose it within 120 days of purchase date, and do not enter the qualified property into service for at least 45 days, it does not count towards the Section 199A calculation. The final regulations retained this rule, and no comments were received.

Nice try however. Remember, IRS consultants and attorneys read tax planning articles too. There are many talented and gifted people working in certain IRS departments. Stop laughing! It’s totally true.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

If you have qualified business income that would normally enjoy a Section 199A deduction, and that income is negative, it must be netted against other income. This is another cops and robbers anti-abuse provision since it would be very easy to split an entity into two, drive income way up in one, grab your Section 199A deduction, and then net the incomes together to reduce taxable income from the businesses. A double dip of sorts. Yes, you would need other income sources to ensure the taxable income Section 199A limit on the tax return is not triggered to play out this game, but the IRS eliminated the temptation. Good idea, right?

There are some specific rules on how this works, but you get the general concern.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Defining a trade or business is easy for the most part, however certain activities are murky and one of them is rental properties. On one hand an argument that rental property income is already tax advantaged can be made since it is not subject to self-employment taxes (Social Security and Medicare). However, if it were subject to SE tax, people would simply create management entities, elect S Corp status, ding the rental a management fee and achieve a Section 199A deduction that way. This is perhaps one reason the IRS isn’t raising a big stink on rental properties.

Commenters in reference to August 2018’s proposed Section 199A regulations asked for a regulatory definition, a bright-line test, a factor-based test or a safe harbor. Something that can be pointed to on a chart. The Treasury declined to do so and relied on the Higgins and Groetzinger tax court cases to help shape the definition. This is good; while we nerdy accountants want 1 + 1 to equal 2, this squishy definition allows for wiggle room.

In Higgins v. Commissioner, 312 U.S. 212 (1941), the Supreme Court noted that determining whether a trade or business exists is a factual determination. Because there is no statutory or regulatory definition of a Section 162 trade or business, courts have established elements to determine the existence of a trade or business.

• One, in relation to profit motive, is said to require the taxpayer to enter into and carry on the activity with a good faith intention to make a profit or with the belief that a profit can be made from the activity.

• Second, in relation to the scope of the activities and is said to require considerable, regular, and continuous activity.

Along came Commissioner v. Groetzinger, 480 U.S. 23 (107 S.Ct. 980, 94 L.Ed.2d 25) where the U.S. Supreme Court in 1987 stated, “we do not overrule or cut back on the Court’s holding in Higgins when we conclude that if one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the statutes with which we are here concerned.” This is re-affirming a 1941 holding in 1987; no narrowing; no re-shaping.

Review those two elements again; fairly straightforward, right? Intend to make a profit, and perform your activities regularly and continuously. Got it… easy!

In terms of rental activities rising to the level of a trade or business, the summary of the Section 199A final regulations read-

In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease). (Final Regs, page 16)

The operable word is “might.” Read it again… “relevant factors might include…” Might and must are wholly different just like may and shall. Certainly using the relevant factors including the wording as you pitch your “Higgins” argument will bolster your position. Having said this, the IRS released Notice 2017-9 which creates a rental safe harbor; the massive takeaway is this- your rental activities may rise to the level of a trade or business without complying with the IRS Notice per the preamble.

What is also a bit noteworthy is that the Section 199A proposed regulations summary released in August 2018 for rental activities had an example of a landowner who leased unimproved land to an airport for parking lots. People got hung up on the use of land this way, and leaped to the argument that all land rental activities rise to the level of a trade or business. The final regulations for Section 199A removed the land examples and stated that land rental activities might or might not be a trade or business depending on the facts and circumstances. Like Peyton Manning in his SNL United Way skit, “I’m not saying I’ve killed a snitch; I’m not saying I haven’t.”

Don’t read too much into the words “earn a profit.” This does not mean it must earn a profit… but your intentions for conducting the activity is to earn a profit. Whether you earn a profit or not does not necessarily alter your intentions. Make sense? In other words, “I wanna earn a profit. I’m doing all the right things to make a buck, yo, but right now times are tight and this depreciation thing is killing me.”

The IRS and the Treasury Department recognized this conundrum so they released IRS Notice 2019-7. In that Notice they defined a safe harbor for taking the Section 199A deduction for rental properties-

Solely for the purposes of section 199A, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the taxable year with respect to the rental real estate enterprise:

• Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;

• For taxable years beginning prior to January 1, 2023, 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental enterprise; and

• The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to taxable years beginning prior to January 1, 2019.

There are some other devils in the details such as not being able to combine commercial and residential rentals into a single enterprise, and there are lease type rules as well.

Self-rentals pose an interesting situation as we alluded to in a previous section. For example, you own some equipment personally and lease it back to your business. Provided the arrangement is at market rates, we believe this still qualifies for the Section 199A deduction as a rental business for two reasons. First, how is this any different than an external business who leases the equipment to unrelated parties? That ordinary income would qualify. Second, you are moving dollars from your right pocket to your left pocket, and absent of the SSTB designation, you are just swapping Section 199A dollars.

Caution: the self-rental consideration has not been challenged in a tax court; there is a lot of risk since your Section 199A deduction on a self-rental is predicated upon being able to demonstrate that it rises to the level of a trade or business.

The IRS was concerned that a specified service trade or business (SSTB) could shift income that would normally not qualify for a Section 199A deduction into self-rental income that may qualify. This was part of the “crack and pack” strategy of splitting up an entity into SSTB and non-SSTB operations, thus being able to qualify for a Section 199A deduction on the non-SSTB operation (provided you hit those income limits that required the secondary SSTB test with the sliding scale of phaseout).

The proposed regulations 1.199A-5(c)(2) (and later finalized in the regulations) added provisions preventing this. So, if an accountant owns the firm and the building in separate entities, the self-rental income becomes “tainted” and is considered SSTB income. This is because both entities have greater than 50% common control. And No, you cannot have your spouse own the building and you own the SSTB business; attribution rules get in the way and state that you both own everything. Again, common control. Here is a blurb right from the regulations-

Example. Law Firm is a partnership that provides legal services to clients, owns its own office building and employs its own administrative staff. Law Firm divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and through a contract with Partnership 1 provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Law Firm). Because there is 50% or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 will be treated as one SSTB under paragraph (a)(6) of this section.

This is unfortunate in our opinion. This same law firm leases office space from an unrelated party; the law firm might not qualify for the Section 199A deduction because of SSTB income limitations but the landlord might. Provided the rent charged in a self-rental situation is market rent, why can’t the law firm also be a landlord? We want to say Yes, but the IRS says No. We believe this will be challenged in some fashion since it appears on its face to be discriminatory, and provided the self-rental is at market rates it appears to treat two rental operations differently depending on the relationship between landlord and tenant.

For non-specified service trade or business situations, the big takeaway is make sure this transaction has all the appearances of an arms-length transaction, fair dealings (versus self-serving), fair market pricing, etc.

So, as of right now, rental property owners are able to calculate and use the Section 199A qualified business income deduction if they meet the requirements in IRS Notice 2019-7. Also, be cautious when considering the self-rental situation. Rental property ownership is also where depreciable assets come into play for determining the Section 199A limitations. No, you do not need to pay a W-2 salary from your rental property to enjoy the qualified business income deduction since your depreciable assets should trump this limitation.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Given what we know about salary optimization and the Section 199A deduction, why not just bump up the shareholder salary to 27.9% every time? You can… sure… but let’s look at the cost to do that.

Here’s another telling table-

Net Business Income Before Salary	200,000
Old Reasonable S Corp Shareholder Salary	40,000
Section 199A Optimized Shareholder Salary	55,800
Section 199A W-2 Limit	20,000
Section 199A Net Business Income Limit	31,360
Lost Tax Deduction at 22% Income Tax Rate	2,499
Additional Social Security and Medicare Taxes*	2,195
Section 199A Optimization Benefit	305

What did we do here? We assumed a $200,000 net business income before a reasonable shareholder salary is paid. Let’s say we were paying $40,000 and we read this amazing book on WCG’s website that suggests a salary of $55,800 would maximize Section 199A deduction. How does that convert into cash in pocket?

By having a salary too low we lost $2,499 assuming a 22% marginal tax rate. In other words, since our Section 199A deduction is limited by our W-2 of $40,000, we lost $2,499 in tax benefit. The calculation is 22% x the difference in Section 199A calculations between W-2 limit and net business income limit ($11,360 x 22% is $2,499).

But the cost of increasing reasonable S Corp shareholder salary to $55,800 also increased Social Security, Medicare and other payroll taxes by $2,195 (employee and employer portions). A quick note of caution here- the employer portion was assumed to be 8% however, there is an income tax deduction since this 8% decreases the net business income and therefore reduces income taxes. In other words, 8% is truly 8% x (1 – 22%) or about 6.24%. We are getting deep into the weeds here, but you get the idea.

All these gyrations end up with $305 in your pocket. Not bad. A night at Gallagher’s on the house!

Also keep in mind that as salaries increase beyond the Social Security wage and unemployment wage caps, the payroll tax portion will change resulting in a different equilibrium percentage. This is why we suggest that the 28.57% number floating around out there on the internets, yes, plural, is practical but not exact.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Speaking of W-2s, there is some optimization that is necessary for a small business owner to get the most from the Section 199A deduction. On one hand we want to reduce W-2 salaries to shareholders to minimize self-employment taxes. This was obvious in an early chapter on the benefits of an S Corp. On the other hand, we want to increase W-2 salaries so they do not limit the amount of Section 199A that is deducted.

You might have seen a number of 28.57% on the internets. This is practically correct, but technically incorrect since it does not factor in employer payroll taxes. We say practically correct since the difference is immaterial.

Let’s look at the data-

Biz Income	100,000	100,000	100,000
Salary	25,000	40,000	27,935
Payroll Tax (Employer) @8%	2,000	3,200	2,235
Net Biz Income (NBI)	73,000	56,800	69,830
Section 199A W-2 Limit	12,500	20,000	13,968
Section 199A NBI Limit	14,600	11,360	13,966
Salary %	25.0%	40.0%	27.9%

We assumed that the employer payroll tax portion is 8% of the salary. This includes Social Security, Medicare and unemployment taxes. This might be higher in some states, but let’s play along with 8%.

As you can see, the $83,000 salary (or 20%) results in Section 199A deduction being limited by W-2 amount. Next, the $145,250 salary results in Section 199A deduction being limited by net business income (NBI). Recall that the Section 199A deduction is the lower of these two numbers.

Using Excel’s solver plug-in, or manually changing the salary to bracket the two limits, results in a salary of $27,935 or 27.9%. This magical W-2 optimization for maximizing Section 199A deduction means that both W-2 and net business income limits are the same, and neither is specifically controlling.

Keep in mind that this is all wages paid! If you have employees besides yourself then you have do a few more steps in determining the optimized salary-

Biz Income After Wages	500,000
All Wages	125,000
Biz Income Before Wages	625,000
Section 199A Optimized Wages @ 27.9%	174,375
less Wages Already Paid	125,000
Deficit	49,375

In this example, wages paid needs to increase $49,375. In other words, the owner(s) should take a bonus so that the Section 199A deduction is not wage-limited. We recently consulted with a retailer who made about $9M after wages. We did the above computation, and concluded that he needed to bonus out another $1,1M to himself as wages. After factoring in the additional Medicare taxes and the cost for the payroll amendments (since it was the prior year), he put $245,000 in his pocket. We proved this with before and after tax returns. Yeah, he was playing around with some big numbers, but you get the idea.

Our tax software is very expensive, and it has a wonderful worksheet that sorts through the limits, and we can easily make adjustments of salary based on the limiting factor. However, keep in mind that most S corporations are paying anywhere from 30% to 40%, and sometimes as high as 60%, in salary to the shareholders. So, the 27.9% Section 199A optimization percentage is somewhat theoretical, and primarily reserved for only a handful of S Corps such as retailers.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

When the proposed Section 199A regulations were released in August, the IRS received well over 300 comments. One of the comments concerned itself with the interplay of qualified business income deduction, W-2 wage limitations and S Corp reasonable shareholder salary. Furthermore the concern was that this interplay would cause disparities between different entity structures and elections.

For example, let’s assume a business makes a $100,000 net business income after expenses and deductions. As a garden-variety LLC, the entire $100,000 would be eligible for the Section 199A deduction. However, if the business owner elects S Corp status on the LLC he or she must pay a reasonable salary; let’s assume a shareholder salary of $45,000 which includes the employer’s portion of payroll taxes. Now this same $100,000 is reduced to $55,000 and as such the Section 199A is nearly halved (spoiler alert: the reduction of Section 199A deduction is eclipsed by the savings of self-employment taxes).

The converse problem occurs where a garden-variety LLC makes $500,000 net income after expenses and deductions. Let’s also assume taxable income is $500,000 for the sake of illustration. Since an LLC cannot pay wages to its owner, this $500,000 would not be eligible for the Section 199A deduction because of the W-2 wage limitation. Furthermore, let’s assume this business operates in New York City or Tennessee, and the local S Corp taxation rate kills whatever federal tax savings are in play. In this case, the business owner would be compelled to elect S corporation status and pay wages just to receive a Section 199A deduction.

The Treasury Department and the IRS recognized this issue, but declined to make any changes when the final regulations were published.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Remember that taxable income is all income for the household, and the following numbers are the “base” numbers for 2018 but indexed annually. Simply put, these numbers represent the top of the 24% marginal tax bracket.

Specified Service Trade or Business (as defined above)-

• If taxable income is less than $157,500 (single) / $315,000 (married) then the 20% deduction for your pass-through entity is fully available.

• If taxable income is greater than $157,500 / $315,000 but less than $207,500 / $415,000 then a partial deduction is available. The phase-in of the limit is linear.

• If taxable income is greater than $207,500 / $415,000 then you are hosed. Sorry. Hosed is a technical term accountants often use to illustrate an untenable situation.

All Others-

• If taxable income is less than $157,500 / $315,000 then the 20% deduction is fully available.

• If taxable income is greater than $157,500 / $315,000 but less than $207,500 / $415,000 then a partial deduction is available with the W-2 and depreciable asset limit calculations phase in.

• If taxable income is greater than $207,500 / $415,000 then the 20% deduction is compared to the full W-2 and depreciable asset limit calculations (see Betty in an earlier chapter).

As mentioned earlier, we will show you examples and side-by-side comparisons in the next chapter. We have Fred, Barney, Hot Shot Surgeon, Goat Herder, and all kinds of nonsense.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

The proposed regulations for Section 199A had a provision where a trade or business that provides more than 80% of its property or services to an SSTB is treated as an SSTB if there is 50% or more common ownership of the trades or businesses. This kills the self-rental income where an accountant, for example, owns the office building and leases it back to the accounting firm. Yuck. This seems silly since if the accounting firm rented from anyone else, the landlord would enjoy a Section 199A deduction. So, why not make an arms-length and fair market rent requirement? We digress…

One takeaway on this is the final regulations for Section 199A remove the 80% binary threshold-

Accordingly, the final regulations provide that if a trade or business provides property or services to an SSTB and there is 50 percent or more common ownership of the trade or business, the portion of the trade or business providing property or services to the 50 percent or more commonly-owned SSTB will be treated as a separate SSTB with respect to related parties. (Final Regs, pages 104-105)

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Pass-through entities and structures include-

• Sole proprietorships (no entity, Schedule C).

• Real estate investors (no entity, Schedule E).

• Disregarded entities (single-member LLCs).

• Multi-member LLCs (Form 1065).

• Any entity taxed as an S corporation (Form 1120S).

• Trusts and estates, REITs and qualified cooperatives.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

The basic Section 199A pass-through deduction is 20% of net qualified business income, which is huge. If you make $200,000, the deduction is $40,000 times your marginal tax rate of 24% which equals $9,600 in your pocket. Who says Obamacare isn’t affordable now?

Here is the exact code-

(2) DETERMINATION OF DEDUCTIBLE AMOUNT FOR EACH TRADE OR BUSINESS. The amount determined under this paragraph with respect to any qualified trade or business is the lesser of-

(A) 20 percent of the taxpayer’s qualified business income with respect to the qualified trade or business, or

(B) the greater of-

(i) 50 percent of the W-2 wages with respect to the qualified trade or business, or

(ii) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property.

There are some devils in the details of course. The best way is to show some examples which we do later in the following chapter. For now, let’s define some terms especially the specified service trade or business designation.

By Jason Watson, CPA
Posted Wednesday, November 1, 2023

Section 199A deduction also known as the Qualified Business Income Deduction (QBID) arises from the Tax Cuts & Jobs Act of 2017. This is a significant tax break for small business owners but there are rules and limits of course.

As with any major revision to the tax code, there will be modifications and interpretations which will change how Section 199A can be used for pass-through businesses such as S Corps and partnerships. On August 8, 2018, the IRS released Proposed Regulations 1.199A that introduced new definitions, procedures and restrictions. On January 18, 2019 the Treasury Department and the IRS released the final regulations for Section 199A after reviewing the comments from the proposed regulations.

Here is a quick list links to various things that we’ve put together for Section 199A enthusiasts-

wcginc.com/8323	Section 199A Final Regs (1.199A) PDF (Full)
wcginc.com/8326	Section 199A Final Regs (1.199A) PDF (Pertinent Pages)
wcginc.com/8313	Section 199A Tax Return Samples

Stay tuned to updates as additional guidance is released by visiting our blog-

wcginc.com/blog