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Compensation and Benefits Aspects of Code Section 199A

This overview discusses the compensation planning considerations for owners and hiring considerations related to the new QBI deduction under Code Section 199A.

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Compensation and Benefits Aspects of Code Section 199A

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  1. Compensation and Benefits Aspects of Code Section 199A September 13, 2018 Amy E. Sheridan asheridan@sandw.com 617-338-2897

  2. Overview • New QBI Deduction – Background • Three Limitations of the QBI Deduction • Specified Service Business Limitation • Wage and Property Limitation • “Qualified” Business Income (“QBI”) Limitation • Impacts • Compensation Planning for Owners • Hiring Considerations • Employee/Independent Contractor Considerations • Choice of Entity Considerations

  3. Background • New deduction available for taxpayers who own interests in certain trades or businesses operating through a pass-through structure • Includes sole proprietorships, partnerships, LLCs ,and S corporations • Not available to C corporations • Application to tiered entities unclear • Deduction generally equal to 20% of “qualified business income” • QBI is generally net taxable income from business (but not investment-type income such as capital gains, interest, and dividends) • Subject to 3 limitations: the “specified service business” limitation, the wage and property limitation , and the “qualified” business income limitation • Where fully applicable, highest marginal tax rate for qualifying pass-through business income is reduced to 29.6% (from highest marginal individual tax bracket of 37%) • Available through 2025

  4. Specified Service Business Limitation • If taxable income exceeds $415,000 for joint filers ($207,500 for all others) indexed for inflation, QBI deduction is not available for “specified service businesses” • If taxable income is less than $315,000 (filing jointly)/$157,500 (all others), no specified service business limitation • If between $315,000/$157,500 and $415,000/$207,500, phase-in calculation applies • Specified service businesses include: • Those in the field of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services; • Where the “principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners”; and • Involving investing and investment management, trading or dealing in securities, partnership interests, or commodities

  5. Specified Service Business Limitation • Service-level questions • What are “consulting” services? • Proposed regulations: If compensated for selling products or other services, not a consultant • Lobbying is consulting; education/training are not • Does “investment management” include management of real estate? • Proposed regulations: Yes, but real estate brokerage services do not • What does it mean for the “principal asset” of a trade or business to be the skill of owners or employees? • Proposed regulations: Narrow definition picks up only product endorsement or “appearance fees” (presumably includes speakers fees) • Other interesting tid-bits from proposed regulations • Generally (with some exceptions) follow existing law under Code Section 448 (cash method of accounting for qualified service corporation) • Return preparers, enrolled agents, financial auditors and bookeepers are specified service businesses

  6. Specified Service Business Limitation • Trade or business questions • What is a “trade or business”? • Proposed regulations: Code Section 162 definition • Proposed regulations: establish a standard for determining how much “de minimis” non-qualifying business activity is problematic • If a trade or business has >$25M of gross receipts; not a specified service business if <5% of gross receipts are attributable to the performance of services in a specified service business • If ≤ $25M of gross receipts, not a specified service business if <10% of gross receipts attributable to the performance of services in a specified service business

  7. Specified Service Business Limitation • Can a trade or business undertaken by multiple regarded entities constitute a single “trade or business”? • Permissive aggregation: • Each trade or business must be a non-specified specified service business • The same person or group of persons must own a majority of each business • Family attribution rules apply • Non-majority owners can benefit from common ownership, but no required information sharing • Individuals/trusts must meet two of three factors: • The businesses provide products and services that are the same or customarily provided together • The business share facilities or centralized business elements (personnel, accounting, human resources etc.) • The business coordinate with or rely on other businesses in the aggregated group (e.g., supply chain interdependence) • Once you aggregate must continue to aggregate for all years, although can add new businesses

  8. Specified Service Business Limitation “Cracking” good and bad businesses Owners Owners Good and Bad Businesses Good Business with Wages Bad Business

  9. Specified Service Business Limitation • To what extent can you “crack” a non-service business from a specified service business? • Proposed regulations: If a trade or business provides ≥ 80% of property or services to a specified service business and there is ≥ 50% common ownership, that portion of the business is treated as part of the specified service business • EXAMPLE: Law firm divides into three partnerships: • Partnership 1: performs legal services (specified trade or business); • Partnership 2: owns an office building, which it rents to partnership 1; and • Partnership 3: employs admin staff and contracts with Partnership 1 to provide admin staff All owned by same partners RESULT: Because overlapping common ownership and Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, all of the partnerships are treated as one specified service business

  10. Wage and Property Limitation • If taxable income exceeds $415,000 for joint filers ($207,500 for all others) indexed for inflation, QBI deduction is limited by the greater of: • 50% of wages paid (as reported on Form W-2) in each trade or business • 25% of wages paid in each trade or business plus 2.5% of the unadjusted tax basis of qualifying property • If taxable income is less than $315,000 (filing jointly)/$157,500 (all others), no wage and property limitation • Between $315,000/$157,500 and $415,000/$207,500, phase-in calculation applies

  11. Wage and Property Limitation • Wage prong • Wages must be properly reported on a Form W-2 • How are wages paid by a PEO handled? • Proposed regulations: will be counted toward the client’s limitation • Can wages paid by a related entity (e.g., a payroll entity or general partner) count? • Proposed regulations: Yes – if meet the aggregation rules described above • 3 methods to determine wages: • Method 1: lesser of Box 1 (taxable compensation) or Box 5 (Medicare wages) • Method 2: Box 1, less amounts that are not “wages” under Section 3402(o) (e.g. SUB pay plans), plus amounts reported in Box 12, Code D,E,F,G or S (pre-tax elective deferrals to retirement plans); or • Method 3: Wages subject to withholding, plus amounts reported in Box 12, Code D, E, F, G or S

  12. Wage and Property Limitation • Property prong • Qualified property – • Tangible property of a character that is subject to depreciation • Held by a qualified trade or business at the close of the tax year • Used in the production of QBI • “Depreciable period” has not ended – the later of: • 10 years after property is placed in service; or • The last day of the last full year in the applicable recovery period under section 168 (without application of ADS recovery periods) • Proposed regulations: Property acquired within 60 days of end of year and disposed within 120 days generally not qualified property (unless used in business for 45 days prior to disposition) • Proposed regulations: In the case of a like-kind exchange, use carryover basis in exchanged property as of the date of the exchange and exchanged property’s placed in service date • Proposed regulations: Partnership special basis adjustments (734(b) and 743(b)) are not treated as separate qualified property

  13. QBI Limitation • “Qualified” business income is all income from a trade or business except - • Capital gains (long term or short term) • Interest or dividend income • Net gain from currency 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 • Must be effectively connected with a U.S. trade or business (“ECI”) • Reasonable compensation, guaranteed payments to partners, and payments to partners in a nonpartner capacity excluded • Net losses from a qualified trade or business carry over to the following year for purposes of determining QBI for the following year

  14. QBI Limitation • How are section 1231 gains treated? • Proposed regulations: To the extent gain or loss is treated as capital, it is not included in QBI • Will QBI be “tainted” if allocated to an entity partner engaged in a specified service business? • Proposed regulations: To the extent an upper-tier entity receives a guaranteed payment or 707(a) payment, it does not constitute QBI • Proposed regulations: If partner or passthrough entity engages in multiple trades or business, have to allocate QBI among those trades or businesses using a reasonable method

  15. A Simplified Example A partnership with two equal partners and not engaged in a specified service business has $1,400,000 of business income and no depreciable property. The partnership pays $600,000 in employee wages. For each partner, QBIis therefore $400,000 ($700,000 allocable share of business income less $300,000 allocable share of wages). 20% of QBI is $80,000 (20% x $400,000). Each partner’s wage and property limitation is $150,000 (50% x $300,000). Each partner’s QBI deduction is therefore $80,000 (the lesser of 20% of QBI or the wage and property limitation).

  16. A More Complex Example • Background • Unmarried taxpayer • Taxable income of $187,500 • $140,000 attributable to a law practice • Taxpayer’s share of W-2 wages from law practice is $50,000 • Taxpayer’s share of unadjusted basis of qualified property is $24,000 • Step 1: Determine amount of QBI, Wages and Property • Specified Service Business Phase-In Calculation Taxpayer has a specified service applicable percentage of 40%: • QBI = 40% x $140,000 = $56,000 • Wages = 40% x $50,000 = $20,000 • Unadjusted basis in qualified property = 40% x $24,000 = $9,600

  17. A More Complex Example • Step 2: Determine Initial Wage and Property Limitation • 50% of W-2 Wages = 50% x $20,000 = $10,000; and • 25% of W-2 wages plus 2.5% of allowable basis of property= • 25% x $20,000 = $5,000, plus • 2.5% x $9,600 = $240 • TOTAL = $5,240 • Initial wage and property limitation greater of $10,000 or $5,240 = $10,000 • Step 3: Initial QBI Deduction • 20% of QBI = 20% x $56,000 = $11,200 • Initial wage and property limitation = $10,000 • 20% of QBI exceeds initial wage and property limitation by $1,200, initial QBI deduction would be $10,000

  18. A More Complex Example • Step 4: Second Phase-in calculation • 20% of modified QBI ($11,200) > the initial wage and property limitation ($10,000), and TI is between thresholds, so ignore wage and property limitation • Instead, reduce 20% of QBI ($11,200) by an additional limitation calculation -- • (a) the amount by which the QBI limitation exceeds the tentative wage and property limitation - $1,200 ($11,200-$10,000), multiplied by • (b) the following ratio: • 60% x $1,200 = $720 • QBI deduction = $11,200 - $720 = $10,480

  19. Compensation Planning for Owners • “Golden ratio” • Wage and property limitation creates incentive to maximize “wage” payments (including to owners) (or to maximize wages and purchase property) • QBI limitation creates disincentive to pay wages or purchase property, since every dollar paid out decreases the amount of QBI • Each trade or businesses will have its own equilibrium point where the amount of wages paid (or wages paid and property purchased) maximizes the QBI deduction (the “golden ratio”) • Assuming no property, the golden ratio occurs where wages equal 2/7ths of net income (before wages)

  20. Golden Ratio

  21. Compensation Planning for Owners • If wages are below the Golden Ratio • Active S corporation owners – incentive to increase wage payments to owners • Benefit of QBI deduction (18.5% = 37% x 50% of wages) will outweigh FICA tax costs • As written, wage and property limitation not limited by “reasonable compensation” • Partners • Long-standing IRS practice is that partners cannot be employees of the same entity • Grants of profits interest reduce “wages” • Will employees push for partner status to be eligible for deduction?

  22. Compensation Planning for Owners Incentive to increase wage payments to owners

  23. Hiring Considerations If wages are below the Golden Ratio, subsidy (18.5% of wages) to hire

  24. Employee/IC Characterization If wages are below the Golden Ratio, incentive to characterize independent contractors as employees

  25. Choice of Entity Considerations • If wages are above the Golden Ratio • Active S corporation owners have an incentive to decrease wages • QBI is by statute limited by “reasonable” compensation, provides statutory grounds to recharacterize S corporation income as wages • Partners • QBI limited by guaranteed payments and payments to a partner in a nonpartner capacity • Proposed regulations: IRS will not impose a “reasonable compensation” standard on partners • May make partnership form more favorable than S corporation form for certain businesses

  26. Choice of Entity Considerations Preference for partnership form

  27. Importance of Reasonable Comp • Statutory definition of QBI (but not wage and property limitation) excludes unreasonable compensation • EXAMPLE: S Corp not in a specified service business - $700,000 of business income, no depreciable property, $200,000 wages to owner • If originally below golden ratio • IRS asserts only $100,000 is “reasonable” compensation • QBI = $600,000 ($700,000 - $100,000) • 20% of QBI = $120,000 (20% x $600,000) • Wage and property limitation = $100,000 (50% x $200,000). • QBI deduction = $100,000 • If originally above golden ratio • IRS asserts $300,000 is more reasonable compensation • QBI = $400,000 ($700,000 - $300,000) • 20% of QBI= $80,000 (20% x $400,000) • Wage and property limitation = $100,000 (50% x $200,000). • QBI deduction = $80,000

  28. Questions?

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