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New IRS FAQs on Section 199A

On April 11, likely after you filed your tax return, the IRS updated its Section 199A frequently asked questions (FAQs) by increasing the number of questions and answers from 12 to 33. The IRS often publishes FAQs on its website to help educate you on various tax law provisions. Section 199A is no different: the IRS has been updating its FAQ website with additional questions and answers on the new qualified business income (QBI) tax deduction.

 We noted three of the FAQs that help fill in some holes in the final Section 199A regulations but will cause problems for many taxpayers. In fact, there will be taxpayers who will need to file amended tax returns because of the FAQs.

  

FAQ 29: QBI Subtractions for Partnerships

  

In this FAQ on partnerships, the IRS hints at the following:

·        Unreimbursed partnership expenses and business interest expenses reduce QBI in some, if not all, circumstances.

 

·        Traditional IRA contributions based on self-employment income don’t reduce QBI (since the IRS didn’t include them), while SEP, SIMPLE, and qualified plan deductions do reduce QBI.

 

FAQ 32: QBI in Final vs. Proposed Regulations

In FAQ 32, the IRS clearly states that the definition of QBI is the same in both the proposed and the final regulations. Since the definition was clarified in the final regulations, this was a surprise to many. 

 

And what this means is that you reduce QBI by the self-employed health insurance deduction, the one-half of self-employment tax deduction, and the qualified retirement plan deductions.

 

 FAQ 33 Has to Be Wrong

FAQ 33 states that an S corporation shareholder who owns more than 2 percent may have to reduce QBI at both the entity (S corporation) and the shareholder (1040 tax return) levels. 

 We don’t agree with the double subtraction indicated in IRS FAQ 33, for three reasons:

  

1.     The final regulations state that you reduce QBI “to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction.” Unlike the proprietorship, the S corporation reduces its business income by reimbursing or paying for the health insurance that it puts on the more than 2 percent shareholder’s W-2. 

2.     Under Notice 2008-1, the self-employed health insurance deduction for the 2 percent S corporation shareholder requires that you include the insurance cost as shareholder wages. The wages reduce QBI.

3.     And income from the trade or business of being an employee is not QBI.

 

Website Is Not an Authority 

If you don’t like the positions taken on the IRS’s FAQ website, then there’s one silver lining: FAQs don’t constitute an authority for tax return positions.

IRS Section 199A Final Regs Shed New Light on Service Businesses

Remember, new tax code Section 199A offers you a 20 percent tax deduction gift if you have

  • pass-through business income (such as from a proprietorship, a partnership, or an S corporation), and

  • 2018 taxable income of $315,000 or less (married, filing jointly) or $157,500 or less (filing as single or head of household).

But once your taxable income is greater than the relevant amount listed above (which Section 199A calls a “threshold”), your Section 199A tax deduction becomes more complicated. Under the rules that apply to this new Section 199A tax deduction, the tax code creates two types of businesses:

  • Business that are in favor and can realize the new deduction regardless of taxable income.

  • Business that are out of favor. The tax code calls the out-of-favor business a “specified service trade or business.”

If you own an out-of-favor specified service trade or business, you suffer a zero Section 199A tax deduction on that business’s out-of-favor income when you have 1040 taxable income greater than $415,000 (married, filing jointly) or $207,500 (filing as single or head of household). 

With taxable income greater than the $315,000/$157,500 threshold and less than the $415,000/$207,500 upper limit, Section 199A reduces the tax deduction available to your out-of-favor specified service trade or business.

This brings us to the question: What if your taxable income is above the limit, but your pass-through business has one part that’s out of favor and another part that’s in favor? You will like what the rules have done for you if you are in this situation. The new regulations make it clear that it is possible for you to benefit from the de minimis rule.

The rule. If the trade or business has annual gross receipts of $25 million or less, it is an in-favor business if it gets less than 10 percent of its gross receipts from an out-of-favor specified service trade or business, such as (among others) law, consulting, accounting, and health care. If gross receipts are greater than $25 million, substitute 5 percent for the 10 percent.

De Minimis Example 1


Green Lawn LLC sells lawn care and landscaping equipment and also provides advice and counsel on landscape design for large office parks and residential buildings. 

The landscape design services include advice on the selection and placement of trees, shrubs, and flowers and are considered under Section 199A an out-of-favor consulting business. 

Green Lawn LLC separately invoices for its landscape design services and does not sell the trees, shrubs, or flowers it recommends for use in the landscape design. Green Lawn LLC maintains one set of books and records and treats the equipment sales and design services as a single trade or business.

Green Lawn LLC has gross receipts of $2 million, of which $250,000 is attributable to the landscape design services, a consulting business. Because consulting services are 10 percent or more of total gross receipts, the entirety of Green Lawn LLC’s trade or business is an out-of-favor specified service trade or business.


De Minimis Example 2


Veterinarian LLC provides veterinarian services performed by licensed staff and also develops and sells its own line of organic dog food at its veterinarian clinic and online. The veterinarian services are in the out-of-favor specified service trade or business of health care.

Veterinarian LLC separately invoices for its veterinarian services and the sale of its organic dog food. It maintains separate books and records for its veterinarian clinic and its development and sale of dog food. Veterinarian LLC also has separate employees who are unaffiliated with the veterinary clinic and work only on the formulation, marketing, sales, and distribution of the organic dog food products. 

Veterinarian LLC treats its veterinary practice and the dog food development and sales as separate trades or businesses for purposes of Sections 162 and 199A. It has gross receipts of $3 million. Of the gross receipts, $1 million is attributable to the out-of-favor veterinary services. 

Although the gross receipts from the services in the field of health care exceed 10 percent of Veterinarian LLC’s total gross receipts, the dog food business is a separate, in-favor business.

Note that Animal Care wins because it has two trades or businesses, which it proves with its financial books and its separation of its employees. 

Green Lawn LLC, in the previous example, failed because it had one business only, which it also proved by the way it kept its books.

If you would like to learn more about how to implement strategies like this in your business, contact our team by clicking the button below.