New Regulations clear the path for tax savings.
Internal Revenue Code Section 199A was enacted as part of the 2017 Tax Cuts and Jobs Act (TCJA), and slightly modified in 2018. This provision provides a tax deduction of up to 20% of the net income that a taxpayer receives from an active trade or business, which may include rental real estate and professional practice income other than wages.
There were well over 100 unanswered questions when the statute came out, and these were narrowed down significantly when Proposed Regulations were issued by the Service last August.
On Friday, January 19th, Final Regulations were released, along with two IRS Notices and commentary from the IRS that answers most, but not all, of the questions that practitioners had about the statute. Tony Nitti did his usual amazing job of summarizing these rules in his post of Saturday, January 19th, entitled IRS Publishes Final Guidance On The 20% Pass-Through Deduction: Putting It All Together.
While it will take most advisors at least a few weeks to get their arms around these rules, the time has come for many taxpayers to be informed of their choices for planning, and to make decisions and implement them now that we know how the IRS will interpret the vast majority of the revisions, and the primary ways of taking advantage of this deduction.
A complete list of all questions that you should ask your tax advisor about Section 199A and your planning would go well beyond the length of a reasonable blog post, but the following items can have high importance to a great many readers:
1. Should my business or profession be under an S corporation or an LLC disregarded for income tax purposes?
Until Section 199A was enacted, the answer to this question for most moderately to very successful businesses and professions, other than real estate entities, would be to use an S corporation, which must pay out a reasonable salary to the owner, with remaining income not being subject to employment or Medicare taxes.
Wages are not eligible for the Section 199A deduction, so smaller businesses and moderately successful professionals may be better off being treated as independent contractors who own their own business and report the income on the Schedule C of their personal Form 1040 to have the Section 199A deduction on all net income.
2. Should my business or profession consider having a defined benefit or cash balance pension plan in place for 2019?
Do not contribute any money to any simplified employee pension, 401(k), or other retirement vehicle before you get the answer to this question, because such contributions may disqualify you from implementing a special kind of pension plan that can dramatically decrease your taxable income, which may assist you in qualifying for the Section 199A deduction on remaining income.
Yes, a higher pension contribution will entitle your employees to higher benefits, but you will be surprised at how little it may take to provide you with a more robust, substantial tax deductible, creditor protected, and financially secure pension program.
If your advisor is not intimately familiar with defined benefit and cash balance pension plans, then make sure to confer with a qualified actuary who specializes in this area. They will typically not charge to give you a proposal that you may find to be very attractive.
3. If you are a landlord, what changes need to be made to assure that you can be considered to be an active trade or business to qualify for the Section 199A deduction if you have net income from the rentals?
A new Notice (IRS Notice 2019-7) provides a safe harbor that can enable landlords to be sure that they will qualify as an active trade or business to receive this deduction, assuming that they do not have triple net leases.
The requirements include having the taxpayer and other individuals and contractors spend at least 250 hours per year engaging in landlord related duties, which can include building repair and maintenance, spending time with tenants, collecting rent, verifying information contained in tenant applications and advertising to rent or lease the property or properties. The time spent will not include doing things like arranging for financing, purchasing properties, studying and reviewing financial statements or reports and time spent traveling to and from real estate.
Also, contemporaneous records need to be kept. You can read this Notice on your own and have a pretty good understanding of what it means, but always ask a tax advisor how this applies to you and what you would need to do to qualify for the deduction.
My prior posts entitled Proposed Regulations Blow The Roof Off Of Many Real Estate Deductions, Does Rental Income Qualify For The New 20% Section 199A Deduction?,and Real Estate Investing With Section 199A: Don’t Let Your Deductions Fly Out The Window give a lot more information that should be of interest for real estate investors, and we will soon provide updates to explain how the rules have changed based upon the new Final Regulations, which will not impact most real estate investors or professionals, other than as described above.
The new regulations also indicate that triple net leased properties cannot be aggregated to test whether a taxpayer has a commonly owned trade or business. Many landlords will be approaching tenants to ask about renegotiating lease terms by increasing the rent and landlord’s responsibilities and services to qualify under this new safe harbor.
We also have a white paper on how to qualify as an active trade or business that can apply for those who cannot meet the safe harbor test provided by the Revenue Procedure.
4. Is my trade or business a Specified Service Trade or Business as defined in the statute, and, if so, is my taxable income more than the amount that permits me to have a full 20% Section 199A deduction?
Health care, legal, accounting, professional entertainment, athletes and certain other professionals and professional business owners are not able to deduct dividend and profit distributions if their income exceeds the now CPI modified limits of $160,700 in 2019 for a single person, or $321,400 in 2019 for a married couple filing jointly. The deduction is reduced on a sliding scale so that there is complete loss when a single person has taxable income exceeding $210,700 or a married couple filing jointly has income exceeding $421,400, or a sliding scale for income in-between.
Many professionals can cause their businesses to purchase equipment or even commercial building components, like a new roof, that will bring income down by being fully and completely depreciable in the year of acquisition, and others may allow lower income family members who work in the practice or business to have higher earnings, within reason, to reduce the owner’s earnings when this is supportable.
Older professionals may decide to work less if their marginal tax rate will be 29.6% instead of 37%, and part ownership in Specified Service Trades or Businesses or management companies that can be set up to provide services for Specified Service Trades or Businesses can be given to children, parents, grandchildren, as described in my blog post entitled 678 Ways To Qualify For The 199A 20% Deduction.
5. Should your business or investment entity pay more wages or have qualified property to enable you to have a full 20% of profits deduction, if you are a high earner taxpayer?
Individuals who earn more than $210,700, and married couples filing jointly who earn more than $421,400 in 2019, will not be able to take Section 199A deductions on trade or business income, or will have their deduction limited to the greater of 50% of wage expenses paid by the applicable entity, or the sum of (a) 25% of wage expenses, plus (b) 2.5% of the cost of qualified property.
Wages will include pension contributions, wage taxes, medical insurance for employees, and other items. The cost of qualified property that can be multiplied by 2.5% can be complicated by the history of the property, which includes furniture and equipment that has not been in service more than ten years, but excludes forms of land, buildings that have been completely depreciated and have been in service for more than ten years, and certain other items. Some taxpayers will convert independent contractor arrangements into employment arrangements to pay more wages, and may acquire new assets that qualify for the 2.5% test described above in order to maximize Section 199A deductions.
Do not try this at home! Use a tax lawyer or CPA who is familiar with these rules and also agrees to sign your tax return because they are confident that they are giving the right advice.
6. Should I aggregate different business interests for wage and qualified property tabulation purposes, or consider them to be separate on my personal tax return?
One of the most complicated parts about dealing with Section 199A is whether to take advantage of the option to consider two or more separate trades or businesses that a taxpayer may own interests in as grouped together for purposes of the wage and qualified property test. For example, an individual may own 30% of one S corporation that repairs houses and has many employees, and 20% of another S corporation that remodels kitchens and bathrooms and has no employees.
As long as the taxpayer and one or more individuals have more than 50% common ownership of these two companies (such as if one other person owned at least 30% of each company), then the taxpayer can elect to treat these as one entity, so that wages paid by the first company can be used to qualify the income from both companies for the Section 199A deduction.
Once two or more entities are aggregated, they can never be pulled apart, unless there are significant changes in circumstances that would cause them to no longer be eligible for aggregation.
Rental properties can also be aggregated, but residential rental property operations cannot be aggregated with non-residential rental operations under the new regulations.