By Paul S. Hamann & Jack Salewski, CPA, CGMA
If you’ve sat down with pencil and paper or an Excel spreadsheet and attempted to map out what Section 199A deduction for Qualified Business Income (QBI) means to your pass-through business clients, then you’ve likely encountered circular logic, or with Excel – the circular reference error. And if you’ve been paying attention, even a little bit, to the conversations regarding Section 199A, then you have heard (over and over again) that this section of the Tax Cut and Jobs Act (TCJA) is arguably one of the most, if not the most challenging provision.
Since the TCJA passed, Jack and I have been fielding countless calls and emails from advisors wondering what affect Reasonable Compensation will have on entity selection and the Section 199A deduction. And without doubt (and with good reason) advisors are frustrated with the way Section 199A was crafted, and hungry for Congress and the IRS to clarify the provision.
Jack and I are fortunate to have built a vast network of thought leaders across many spectrums – including top educators, former IRS examiners & appeals agent’s, valuation experts and niche practitioners specializing in closely-held businesses. The conversations we’ve had so far are for the most part, inconclusive. To share much of what we have discussed would be irresponsible because most of what is being discussed right now is speculation. Speculation on what Congress’s intent was, what regulations the IRS will put into place, and what changes will be made this year.
There are, however, three points that just about everyone we have talked with agrees upon.
- First: Reasonable Compensation is the X factor when it comes to entity planning.
- Second: A successful IRS Reasonable Compensation challenge will have shocking consequences to the taxpayer and their preparer.
- Third: All Reasonable Compensation figures should be documented using an independent, unbiased source (and the TCJA gives advisors the perfect opportunity to require that documentation if they’re not already doing so).
The consensus on these three points comes from the same circular logic we referenced at the start:
The 199A deduction relies on the business’s profit and the taxable income of the taxpayer as reported on their 1040 (which includes W-2 income AKA Reasonable Compensation). If filing a married filing joint tax return this would be the joint taxable income. Therefore a change to the business’s income or the amount of Reasonable Compensation paid will cause changes on the taxpayers 1040, and those changes on the 1040 will impact the 199A deduction, that in turn may impact the optimum entity type for that taxpayer for that tax year… Ouch my head is aching again.
Now if it were a simple process to select the optimum entity type each year by just checking a box when filling out the tax return, then the impact of section 199A may not be as severe. However that’s not the case and most of us are also quite aware of the wide swings in income that most closely-held businesses experience.
Most experts agree that ball-parking, estimating or otherwise guessing at a Reasonable Compensation figure for an S Corp. owner is both irresponsible and reckless. Because of the circular logic built into section 199A, being unreasonably low or unreasonably high could negatively impact your client’s 199A deduction, so there is no simple rule of thumb or safe harbor that advisors can use (and there never was – don’t get us started…) The best course of action is an independent, unbiased Reasonable Compensation Report that protects both the tax preparer and their client.
While we all wait for better direction, rules and regulations from Congress and the IRS, you have the perfect opportunity to sit down with your clients (or if a meeting isn’t feasible, to send them an issue letter) and explain the new realities of Reasonable Compensation, the QBI and its effects on their overall tax position.
Below are links to a few of the better thought-out articles on section 199A:
- The New ‘Qualified Business Income Deduction’ Varies Based On Your Business Type – Or Does It? – Forbes
- Tax Reform Puts Broader Spotlight on Reasonable Comp – BVR (you may need an account to view full article)
- Navigating the new pass-through provisions: A technical explanation – The Brookings Institution
- First Look at the Tax Cuts and Jobs Act – The CPA Journal
- Tough decisions for pass-throughs – Accounting Today
RCReports Releases Version 4.0
Denver/Colorado/May 01, 2018
RCReports completed a comprehensive upgrade of its Data Sets, Methodologies, Approaches, and Reports offered to all users. This release includes the addition of Industry Specific Wage Data, two additional Approaches, and one new Report type making this the biggest upgrade to RCReports platform since initial release in 2012. RCReports now has the capacity to generate reports using all three IRS recognized approaches, making it the only solution advisors need for determining Reasonable Compensation for small and medium closely-held businesses.
“The RCReports Team has infused V4.0 with new Report options, a fresh, Responsive Interface, enhanced Intuitive Features and integral Tool-tips throughout”, stated Paul S. Hamann, President of RCReports, Inc. “Our enthusiastic support team proactively reaches out to all new users, offering ‘Jump Start’ One-on-One training for an on boarding experience that delights, with the focus on empowering our users to hit the ground running”.
RCReports is a cloud platform that determines Reasonable Compensation for Closely-Held Business Owners. RCReports is used by CPA’s, EA’s, Tax Advisors, Valuators, Forensic Accountants and Attorneys when they need to determine a Reasonable Compensation figure for a client. Whether for Tax Compliance, Normalization or Planning, RCReports has a report to fit your need.
April showers bring May flowers… Hopefully your lawn & garden are ready for open-air living; if not, you can hire a Landscape Architect to design the outdoor living area of your dreams. In fact, of the almost 143 million people employed in the US, only about 20,000 are landscape architects. Expect to pay the most for these professionals in Buffalo, New York where the top 10% make $73.17/hour. Landscape architects in St. Landry Parish, Louisiana are the lowest paid at $9.37/hour*.
*Wage only available from RCReports