Under the 2017 Tax Cuts and Jobs Act, Congress enacted a new Section 199A 20% profit deduction for owners of pass-through businesses, and which include Subchapter S corporations, LLCs, sole proprietorships, and even certain trusts. Section 199A is intended to provide a deduction to owners of these pass-through business entities who do not otherwise benefit from the new 21% flat tax Congress has given to corporations under the new tax law. While Section 199A is intended to benefit these generally smaller types of business entities and their owners, the new tax law is riddled with complexity and exceptions, and so that many well-meaning small business owners may not receive the deduction, or at least its full amount.
The 20% pass-through deduction is not applicable generally to businesses that provide services, such as doctors, lawyers, accountants, athletes, stock brokers, and others, except where the service provider has taxable income of less than $315,000 (married) or $157,500 (individual). The benefit to these service providers is phased out over these income thresholds (another $100,000 for married filers and $50,000 for individuals), so that where a married filer has over $415,000 in taxable income or an individual filer has over $217,500 in taxable income, the 20% deduction is lost for the service provider’s business. Thus, there is no benefit here to businesses of higher-paid service providers..
For most pass-through business owners, the deduction is the lesser of (1) the “combined qualified business income” of the taxpayer, or (2) 20% of the excess of taxable income over the sum of any net capital gain. The term “combined qualified business income” is then defined as the lesser of (1) 20% of the business owner’s “qualified business income” (QBI) or (2) the greater of (A) 50% of the W-2 wages of the business allocable to the owner or (B) 25% of the W-2 wages of the business plus 2.5% of the unadjusted tax basis in property of the business (generally the original cost of certain depreciable assets) allocable to the business owner.
For pass-thru business owners with higher income having W-2 employees is a must, unless the business has substantial depreciable assets in the alternative, because the deduction is essentially “capped” for most businesses by 50% of the W-2 wages the business pays. If the business has no W-2 employees, then the business may not even receive the deduction. This issue can be especially challenging where the business utilizes contractors in its workforce (Form 1099 contractors) rather than W-2 employees. Payments to 1099 contractors, as compared to wage/salary payments to W-2 employees, do not count in the calculation of the 199A deduction.
Due to the importance now of the new Section 199A deduction to many business owners, businesses which utilize 1099 contractors in their workforce may consider changing these contractors now to W-2 employees. In so doing, the owner of a pass-thru business may now be able to take advantage, or better advantage, of this new deduction provided by Congress.
However, the IRS in final regulations recently issued under new Section 199A has offered an important alternative – leased employees. Initially identified by the IRS in proposed regulations issued under Section 199A back in August 2018, the IRS has issued final regulations on January 18, 2019 and provided guidance where “wages are paid by a person other than common law employer”. This guidance, now in final IRS Regulation §1.199A-2(b)(2)(ii), provides that in determining W-2 wages of a business for purposes of the deduction, the business may take into account W-2 wages paid by a third party and reported by the third party on Forms W-2 provided the W-2 wages were paid by the third party to “common law employees or officers” of the business and for employment by the business. In this instance, the third-party actually paying and reporting the W-2 wages cannot include the W-2 wages for Section 199A purposes – only the business owner can. The IRS in the final regulations identifies these relationships as involving “certified professional employer organizations”, and certain other relationships.
Professional employer organizations (PEO) and “certified” (by the IRS) professional employer organizations have existed for many years, well before the final regulations, and essentially involve “employee leasing” by contract. Thus, if a pass-thru business owner enters into an agreement with a PEO or CPEO, and where the employees, and even contractors of the business, are transferred over to the PEO/CPEO for payroll processing, payments, and issuance of annual Forms W-2 to these workers now (but not Forms 1099), the amount of the annual Form W-2 payments made by the PEO/CPEO for the workforce may qualify for purposes of the Section 199A deduction. Use of a PEO/CPEO can reduce administrative/payroll costs and burdens of the business as well.
With the adoption of the new Section 199A 20% profit deduction, higher income business owners must generally have a W-2 workforce, or substantial depreciable property, in order to take advantage of this new deduction. With the increased use of 1099 contractors, particularly by small business owners, Congress is clearly using the new Section 199A deduction as a legislative “tax carrot” to change this behavior. The new deduction is indeed a powerful one – designed to give pass-thru business owners a tax rate equivalent to the 21% flat tax for corporations. Business owners can certainly change their workers, from 1099 contractors to W-2 employees – and then accept the administrative, withholding and other burdens that come along with this responsibility; however, and as blessed now by the final IRS regulations, the business owner can enter into an agreement and transfer these burdens and responsibilities over now to a PEO/CPEO instead (and for a fee, of course), but the business owner will retain the full benefit of the W-2 wages being paid to its workforce for purposes of the Section 199A deduction.