Section 199A: Unintended Tax Consequences for Small Business Owners

LFG Marketing | April 01, 2019

LFG Marketing | April 2019

In December 2017, Congress enacted “once-in-a-generation” income-tax changes, which took effect in 2018. Some changes were obvious: increases for standard deductions, elimination of personal exemptions, and caps on deductions for state and local taxes. For other changes, the consequences are just now coming into focus.

One of the reasons for the delayed understanding is the complexity. Take Section 199A. This new regulation, per taxadviser.com, “allows taxpayers other than corporations a deduction of 20% of qualified business income earned in a qualified trade or business, subject to certain limitations.” Clarifying the limitations required 247 pages of guidance from the Internal Revenue Service, and it wasn’t released until January 18, 2019 – more than a year after the law went into effect.

In a February 2019 article (“How the New QBI Deduction-Reduction Ruins the Value of Pre-Tax Retirement Plans for Small Business Owners”), CPA Jeffrey Levine says the “New deduction (is) a powerful way for many business owners to reduce their tax liability, (but) it comes at a price…complexity.” And business owners eligible for the Section 199A deduction may find an unpleasant surprise. Per Levine:

(T)he Section 199A deduction will dramatically reduce the value of tax-deductible retirement plan contributions. (F)or some S corporation owners, a contribution to an employer-sponsored retirement plan will effectively result in a partial deduction, but still subject the entire contribution, plus all future earnings, to income tax upon distribution.”

This is a big deal. A business owner who makes contributions to a qualified retirement plan (like a SEP) does so under the assumption the deposits will be fully deductible from current income taxation, with the deposit and appreciation taxable as income on distribution. One of the possible consequences of Section 199A is that retirement contributions may in fact be only partially deductible when deposited (even though the tax return suggests otherwise).

Section 199A: The (Very) Short Version

In August 2018, Forbes issued an online review of Section 199A, based on what was known at that time. If you printed a copy, it ran 35 pages. Here is a summary of the most salient features.

The Section 199A deduction is available to any taxpayer “other than a corporation.” This includes:

* Individual owners of sole proprietorships, rental properties, S corporations, or partnerships, and

* An S corporation, partnership, or trust that owns an interest in a pass-through entity.

But just because you are the owner of an entity “other than a corporation” doesn’t mean Section 199A applies to you.

Section 199A then eliminates certain types of businesses and activities from eligibility for this deduction. Two broad restrictions: Some are disqualified if the business performs “services as an employee,” others are excluded if they involve the performance of trades or services in select fields, (such as law, accounting, financial services, athletics, the performing arts), where the business’s principal asset is the reputation or skill of one or more owners or employees. These exclusions are very specific and nuanced.
Once a business qualifies for Section 199A, it must determine its Qualified Business Income (QBI). A business may have taxable income from multiple sources, such as profits, rents, capital gains, etc., but not all taxable income is considered Qualified Business Income and eligible for a 20% deduction. And this is where the surprise comes.

A deduction taken from taxable income affects QBI. But depending on the specifics, the impact may be disproportional. Levine gives an example of a business owner named Robin who qualifies for a Section 199A deduction of $18,000. But if Robin decides to make a $20,000 contribution to her SEP, the 199A deduction will decrease to $14,000.

There are two ways to process this outcome. The first is to see a $20,000 deduction for the SEP contribution, and $14,000 for the Section 199A calculation, for a combined deduction of $34,000. This is how the transaction is reported on the tax return.

But from Levine’s perspective (and other CPAs), a Section 199A deduction of $18,000 would have been available whether a SEP contribution was made or not. A $20,000 contribution to the SEP only produces $16,000 of additional deductions. However, because the $4,000 “difference” is deposited in the SEP, it will be taxed at distribution as if it had received a deduction when it was deposited – even though it did not.

Says Levine: “It’s almost like Robin is making a $4,000 nondeductible contribution to a SEP IRA, but not getting any credit for basis for having made that nondeductible contribution!”

Levine concludes:

“The final regulations (for Section 199A) significantly expand the number of small business owners for whom there is now a reduced (yes reduced!) incentive to make tax-deductible contributions to employer plans.

“There are ripple effects which make it necessary to take a fresh look at every element of a business owner’s tax plan, including which type of retirement plans will really provide maximum benefit in the future!”

Did Congress intend to decrease retirement plan deductions for small business owners? Probably not. But that’s what can happen with new rules. If you’re a small business owner, you might want to explore or revisit alternatives.

Lifetime Financial Growth, LLC is an Agency of The Guardian Life Insurance Company of America® (Guardian), New York, NY. Securities products and advisory services offered through Park Avenue Securities LLC (PAS), member FINRA, SIPC. OSJ: 244 Blvd of the Allies, Pittsburgh, PA 15222 (412) 391-6700. PAS is an indirect, wholly-owned subsidiary of Guardian. This firm is not an affiliate or subsidiary of PAS. 2019-77341 EXP 3/2021