The New Qualified Business Deduction

I spent a fair amount last week looking over the new IRS Regulations on the qualified business deduction. It was a breezy and compact 184 pages, although it reads longer than that.

I debated blogging on this topic. While one of the most significant tax changes in decades, the deduction is difficult to discuss without tear-invoking side riffs. 

But – if you are in business and you are not a “C” corporation (that is, the type that pays its own taxes) - you need to know about this new deduction.

Let’s swing the bat:

1.    This is a business deduction. It is 20% of something. We will get back to what that something is.

2.    There historically has been a spread between C-corporation tax rates and non-C-corporation tax rates. It is baked into the system, and tax advisors have gotten comfortable understanding its implications. The new tax law rattled the cage by reducing the C-corporation tax rate to 21%. Without some relief for non-C-corporation entities, lawyers and accountants would have had their clients folding their S corporation, partnership and LLC tents and moving them to C-corporation campgrounds.

3.    It is sometimes called a “passthrough” deduction, but that is a misnomer. It is more like a non-C-corporation deduction. A sole proprietorship can qualify, as well as rentals, farms and traditional passthroughs like S corporations, LLCs and partnerships. Heck even estates and trusts are in on the act.

4.    But not all businesses will qualify. There are two types of businesses that will not qualify:

a.     Believe it or not, in the tax world your W-2 job is considered a trade or business. It is the reason that you are allowed to deduct your business mileage (at least, before 2018 you were). Your W-2 however will not qualify for purposes of this deduction.

b.    Certain types of businesses are not invited to the party: think doctors, dentists, lawyers, accountants and similar. Think of them as the “not too cool” crowd.

                                                   i.There is however a HUGE exception.

5.   Congress wanted you to have skin in the game in order to get this 20% deduction. Skin initially meant employees, so to claim this deduction you needed Payroll. At the last moment Congress also allowed somebody with substantial Depreciable Property to qualify, as some businesses are simply not set-up with a substantial workforce in mind. If you do not have Payroll or Depreciable Property, however, you do not get to play.

a.     But just like (4)(b) above, there is a HUGE exception.

6.   Let’s set up the HUGE exception:

a.     If you do not have Payroll or Depreciable Property, you do not get to play.

b.    If you are one of “those businesses” - doctors, dentists, lawyers, accountants and similar - you do not get to play.

c.     Except …

                                                   i. … if your income is below certain limits, you still get to play.

                                                 ii. The limit is $157,500 for non-marrieds and $315,000 for marrieds.

                                              iii. Hit the limit and you provoke math:

1.    If you are non-married, there is a phase-out range of $50 grand. Get to $207,500 and you are asked to leave.

2.    If you are married, double the range to $100 grand; at $415,000 you too have to leave.

                                               iv. Let’s consider an easy example: A married dentist with household taxable income of less than $315,000 can claim the passthrough deduction, as long as the income is not from a W-2.

1.    At $415,000 that dentist cannot claim anything and has to leave.

                                                 v. Depending on the fact pattern, the mathematics are like time-travelling to a Led Zeppelin concert. The environment is familiar, but everything has a disorienting fog about it.

1.    Why?

a.     The not-too-cool crowd has to leave the party once they get to $207,500/$415,000.

b.    Simultaneously, the too-cool crowd has to ante-up either Payroll and/or Depreciable Property as they get to $207,500/$415,000. There is no more automatic invitation just because their income is below a certain level.

c.     And both (a) and (b) are going on at the same time.

                                                                                                               i.     While not Stairway to Heaven, the mathematics are … interesting.

7.    The $207,500/$415,000 entertainment finally shows up: Payroll and Depreciable Property. Queue the music.

a.     The deduction starts at 20% of the specific trade or business’s net profit.

b.    It can go down. Here is how:

                                                   i. You calculate half of your Payroll.

                                                 ii. You calculate one-quarter of your Payroll and add 2.5% of your Depreciable Assets.

                                              iii. You take the bigger number.

                                               iv. You are not done. You next take that number and compare it to the 20% number from (a).

                                                 v. Take the smaller number.

c.     You are not done yet.

                                                   i. Take your taxable income without the passthrough deduction, whatever that deduction may someday be. May we live long enough.

                                                 ii. If you have capital gains included in your taxable income, there is math. In short, take out the capital gain. Bad capital gain.

                                              iii. Take what’s left and multiply by 20%.

                                               iv. Compare that number to (7)(b)(v).

1.    Take the smaller number.

8.    Initially one was to do this calculation business by business.

a.     Tax advisors were not looking forward to this.

b.    The IRS last week issued Regulations allowing one to combine trades or businesses (within limits, of course).

                                                   i. And tax advisors breathed a collective sigh of relief.

c.     But not unsurprisingly, the IRS simultaneously took away some early planning ideas that tax advisors had come up with.

                                                   i. Like “cracking” a business between the too-cool and not-too-cool crowds.  

And there is a high-altitude look at the new qualified business deduction.

If you have a non-C-corporation business, hopefully you have heard from your tax advisor. If you have not, please call him/her. This new deduction really is a big deal.

The IRS Will Be Looking At Deferred Compensation Plans

The IRS recently launched a limited audit effort to gauge how well nonqualified deferred compensation plans are complying with the tax Code. My understanding is that the number of companies to be contacted will be less than 100. The IRS will use this effort to refine its audit techniques in three areas of nonqualified deferred compensation:

1. Initial election to defer compensation
2. Subsequent election to defer compensation
3. Eventual payment of said compensation

Before proceeding further, let’s define the “nonqualified” part of this term. Someone is deferring compensation. Perhaps someone (say, Tom Brady) is earning $15 million this year, but some or all of it will not be paid until some future date. It happens all the time, and the IRS has limited “preapproved” ways to do so. The classic way is stock options, for example.

Deviate in any way from the IRS-preapproved road, however, and the plan is referred to as “nonqualified.” I use nonqualifieds on a common basis, as they allow more flexibility in their planning and implementation than qualifieds. There is no connation of good or bad to being “nonqualified.”

The IRS is looking at Section 409A, a particularly nasty Code section.

What was the purpose of Section 409A? Let’s go back to 2000 and 2001. We are now talking about Enron, an energy and commodities company headquartered in Houston and one of the most scandalous business frauds of all time. Enron executives pushed their way to the front of the line by accelerating the payout of their deferred compensation before the company went under. You may recall that the average employees were blocked-out of their 401(k)s, with the result that they saw their retirement dwindle if not evaporate while company fat cats, like Kenneth Lay and Jeffrey Skilling,  walked away with wheel barrels full of cash.

How did it evaporate? There were two primary drivers:

(1)  Enron made its 401(k) matching contribution with company stock. Then it put in a lockdown, preventing employees from selling that stock until age 50.

(2)  Enron decided to transfer the administration of its 401(k). Unfortunately, this occurred during the period the stock collapsed, and employees were preventing from selling their stock even if they could and wanted to.

The truth of the matter is that many companies, not just Enron, use their own stock to fund a 401(k). For example, Coca Cola employees keep more than 80% of their 401(k) assets in Coca Cola stock. At Proctor & Gamble, the percentage is over 90%.

So what we have is an issue of corporate 401(k) matching, as well as an issue of the interregnum between plan administrators. That was not sufficient for Congress, which loves nothing more than a good scandal (unless it is their own, of course). In response, Congress passed Sarbanes-Oxley in 2002. It then passed the American Jobs Creation Act – containing Section 409A – in 2004.

Congress was after deferred compensation.  

Section 409A starts off easy enough: it applies to any “plan” that provides for the “deferral of compensation” to “service providers.” A “plan” does not need to be reduced to writing, and “”service providers” can included independent contractors as well as employees. “Deferral” means any payment (to which a service provider has a legally binding right) that may be received in a future tax year.

            STEP ONE: Carpet bomb. Look for survivors later.

The IRS had to start excluding something, otherwise this thing was going to dragnet everything- think accrued sick leave or accrued vacation pay - into its wake. Remember: any compensation not paid IMMEDIATELY could potentially detonate this tax trap.

It didn’t matter how much money you made, either. This thing was not limited to the big wigs. Section 409A swept up the small and large alike.

How ridiculous does this go? A number of years ago the IRS decided that schoolteachers were violating Section 409A by deferring their salary over 12 months rather than being paid over the 9 months comprising a school year. Let that sink in: the IRS felt driven to protect Americans from the rapaciousness of schoolteachers wanting to budget their salary over 12 months.

NOTE: The IRS received so much bad press that it was forced to reverse its position. That was fine, but a more cogent question was whether the law was so deeply flawed that its logical progression inevitably led to absurd results.

Therefore, the IRS gave us a few exceptions, including:

·       “Short term deferrals”

o   This means being paid by March 15 of the following year

·       Qualified plans, which means pension and profit-sharing plans, including your 401(k)

o   Obvious

·       Certain welfare plans, such as vacation and sick leave plans

o   Obvious

·       Grants of incentive stock options (ISOs) and employee stock purchase plans (ESPPs)

o   Have their own rules

·       Options to buy the stock of the service recipient, but only if the exercise price is not less than the market value of the stock on the date of grant

o   This means that – if you work at P&G and can buy P&G stock through a plan, you had better pay full retail price. If P&G gives you a discount – say you buy for 90 cents on the dollar – the IRS sees this as a “feature for the deferral of compensation.”

What happens if you are pulled into this thing?

·       The plan better be in writing

·       You better make a timely election to defer

·       Distributions to you may only be made upon occurrence of six IRS-approved events

·        You better not be able to accelerate your deferred benefits

What is a timely election? It is not what you may think. Timely in this context means “before you earn it.” For example, if your 2014 bonus is payable in 2015, you had better have your election in place in 2013.

What if you want to make a change to an existing deferral?

·       The payment must be deferred for at least another five years

o   So if you were to start in 2017, you can now start no earlier than 2022

·       And you better make this change at least 12 months before the payment was scheduled to be paid

What do you have to do to get to your money?

·       Death

·       Disability

Good grief! What else have you got?

·       Separation from service

This means you have to be fired. 

·       Change in control

This means that there is a change in ownership or control of the company. I suppose you could sell the company AND get yourself fired, just to be certain.

·       Unforeseen emergency

Think illness or accident or property loss. Even then, you have to show that expenses could not otherwise be met by insurance or your liquidation of other assets. Goes without saying that amount of distribution is limited to the amount needed for the emergency, plus taxes.

·       Date certain or fixed schedule

Finally, here is the heart of the matter. The IRS wants you to select when the deferred monies are to be paid and how (lump sum, series of payments) and then stick to it. It wants you to decide this way ahead of time, and then severely penalize you if later life events cause you to change in your mind.

What happens if you botch it?  Well, Section 409A will kick-in. 

·       There is tax on the distribution

·       There is interest (called a “stinger”) equal to the regular underpayment rate plus 1%

·       There is a 20% penalty

What if you take a distribution early? Bam – you have tax, interest and penalty.

What if you do not do anything wrong, but the company flubs the paperwork? Bam – you have tax, interest and penalty.

Can you say lawsuit?

That 20% penalty is not calculated as you would expect, either. A reasonable person would anticipate the penalty to be 20% of the tax, or possibly 20% of the tax plus the stinger. It is not, however. The penalty is 20% of the deferred balance, whether received by you or not. 

            STEP TWO: Bayonet the survivors.

What if you are in several plans simultaneously and one goes south? Does one plan contaminate the other? 

Of course it does.

STEP THREE: Repeat steps one and two. 

So what did Congress really accomplish with Section 409A?

·       Inability to distinguish publicly-traded from privately-owned

I scratch my head why Congress thinks that my auto mechanic down the street can get himself in the same trouble as a Humana or a General Electric.

Publicly-traded stock is almost like cash. These companies can buy other companies with it. They can pay employees with it. They can fund retirement plans with it. They can … well, they can play Enron with it.  

A privately-owned company however cannot.  Privately-owned companies are playing with their own money. Even the most reckless take a pause when reaching into their own wallet. A publicly-traded executive is closer to a Washington politician than any of the business owners I am likely to represent.

·       Crippling tax bombs for the unadvised

Change your deferral payment date 363 days – rather than 366 - before scheduled payout and risk tax annihilation. 

Does Congress expect that every businessperson can keep a tax attorney on retainer?

·       Yet another tax “industry”

There are advisors out there specializing in Section 409A. There has to be. You could endanger a large company by implementing a faulty plan. 

However, this is not quite the same contribution to the economy as Steve Jobs introducing the iPhone, is it?   

·       Insinuation into routine business transactions

We have a client who recently hired a business development manager. Their intention is to grow the company for 7 or so years, then sell out. It is their retirement program of sorts, I guess. The deal with the development manager includes deferred compensation, driven off year-over-year business growth and eventual sale of the company. What should be a routine tax matter now requires a Section 409A specialist, to be sure the employment package doesn’t blow up.

You want an alternative to 409A? How about this: all accelerations of executive deferred compensation (remember: Enron was only about acceleration) have to go to a shareholder vote. While we are at it, let’s lock down the executives for the same period as the rank-and-file are locked out of their 401(k)s.

And if Enron was caused by acceleration, why does 409A penalize additional deferrals? What is the point?

So the IRS is going to be looking at 50 – to 100 large companies to check on their 409A compliance. I suspect these companies will be fine, as they have the people, resources and advisors to navigate Section 409A. I would give you a different answer were the IRS to train its attention on privately-owned companies, however.