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Law in the Marketplace: How should accountants compute your federal pass-through deduction?

Written by: John M. Cunningham

Published in the Concord Monitor (1/16/2021)

Many federal tax scholars have described the section 199A pass-through deduction available to qualified taxpayers as “overwhelmingly complex.” (Under section 199A, “qualified taxpayers” means owners of sole proprietorships, of S corporations and of entities, such as multi-member LLCs, taxable as partnerships.) But the deduction is tremendously important to these taxpayers – it can be up to 20% of their shares of the net business income of their business.

I taught a Zoom webinar last Wednesday on pass-through deductions to members of the Massachusetts CPA Society. The basis for the webinar was a sentence outline that, if you’re interested, you can access under the “Form 6.2” button at the top of my website. The link for the website is www.llc199A.com. Since some readers of this column are accountants and others are qualified taxpayers, I’ll summarize below the key points in the sentence outline.

-- President-elect Biden has indicated that at some point after he takes office, he will amend section 199A so that it will apply only to qualified taxpayers whose annual joint or single taxable income is less than $400,000. It is unclear whether he will extend the section beyond 2025, when its terms provide that it will expire. However, I’m confident that before 2025, Congress will extend the section indefinitely, since, otherwise, many tens of millions of qualified taxpayers will be seriously harmed.

-- The pass-through deduction computation rules in section 199A can vary dramatically depending on whether a business owner owns a “qualified trade or business” or a “specified service trade or business.” Exhibit A in my sentence outline lists the 13 types of specified service trades and businesses under section 199A. All other businesses are qualified trades or businesses.

-- Scattered through the provisions of section 199A are identifications of seven distinct classes of qualified taxpayers and the distinct pass-through deduction computation rules applicable to each of them. Table B of my sentence outline identifies these seven categories and rules.

-- However, there is a special rule concerning the section 199A “trade or business” requirement that applies to qualified taxpayers who are retired or who have full-time jobs but who conduct part-time businesses consisting of acquiring and holding residential or commercial real property and renting this property to tenants. There are probably thousands of such individuals in New Hampshire alone and millions more nationwide. An IRS ruling says that these individuals can get the pass-through deduction if they and their property managers, employees and independent contractors work in their part-time real estate rental business for at least 250 hours a year. However, I think that if they follow certain rules, these taxpayers can obtain the pass-through deduction on the basis of far less time if they follow a “profitability” rule I outline in the sentence outline.

-- When they are doing the tax returns for their clients and making pass-through deduction claims for them, it should be obvious to accountants that some of these clients need to radically restructure their tax and legal arrangements and sometimes even their business and personal arrangements in order to obtain or maximize their pass-through deductions.

For example, most shareholders of C corporations should change their federal tax regimen to Subchapter S or Subchapter K (partnership taxation) to obtain their pass-through deduction. And many partners in partnerships should change their partnership agreements (which in many cases will be LLC operating agreements) so that these agreements no longer provide for partner salaries (called “guaranteed payments” in partnership terminology). Under Internal Revenue Code section 761(c), these amendments can often be made retroactively.

-- What if accountants do or should realize that particular tax preparation clients of theirs need section 199A restructuring but they fail to advise their clients? If their clients realize that they need this restructuring but that their accountants haven’t so advised them, can these clients sue their accountants? The law is unclear, but certain cases suggest that the answer is yes.

In short, section 199A is not only complex but also, for accountants, potentially dangerous.

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