Sec 199A(c)(4) - sole proprietor - "reasonable compensation"

Technical topics regarding tax preparation.
#1
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I'm wary of telling my Schedule C independent contractor clients that they'll be entitled to the 20% Sec 199A deduction against their full self-employment income. Sec 199A (c)(4) says:

(4) TREATMENT OF REASONABLE COMPENSATION AND GUARANTEED PAYMENTS.—Qualified business income shall not include—
(A) reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business,


Won't the IRS argue that Sched C self-employed individuals will need to reduce QBI by an amount equal to "reasonable compensation" for the services they provide to the business?

(I guess they'd then need to restrict SE tax to apply only to the amount deemed as "reasonable compensation", similar to how it works with single-owner S Corps and W-2 wages.)

EDIT: Seems to have been discussed here, to some extent, but I don't see that any concensus was reached...
 

#2
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Checkmark RIA observation: Although qualified business income passes through from partnerships and S corporations to the partners or shareholders, in the case of an S corporation, IRS requires that a shareholder receive reasonable compensation from the S corporation for his services, see FTC ¶H-4329 . Similarly, in the case of a partnership interest received by gift, the Code requires that the donor partner receives reasonable compensation from the partnership for his services, see FTC ¶B-3423 ; USTR ¶7044.13 . Thus, where a business is conducted through a partnership or an S corporation, a portion of its income may have to be treated as compensation, which is not qualified business income. In contrast, in the case of a business conducted by a sole proprietor or a single member LLC that is treated as a disregarded entity, all of the business's income can be qualified business income.
 

#3
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I've been wondering the same thing - see post #17
viewtopic.php?f=8&t=10765
and #2
viewtopic.php?f=8&t=10739
and #2
viewtopic.php?f=8&t=10735

We are the only two people worried about it!
 

#4
Jake  
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Schedule C - been doing this for decades - all net income goes to the proprietor. So what is the issue? So if my net is $50,000, I only pay income tax on $40,000, not sure what I pay FICA tax on. Tax software will know. In Ohio, for us small guys, 100% of our net is now free of income tax. Is that stupid or what? I wish it was that way years ago when i was making some real money.
 

#5
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RiversideCPA wrote:...In contrast, in the case of a business conducted by a sole proprietor or a single member LLC that is treated as a disregarded entity, all of the business's income can be qualified business income.


This was published recently, in response to the new tax bill / 199A?
 

#6
Wiles  
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tb_in_sf wrote:We are the only two people worried about it!

Make that three. I understand, from the committee reports, Congress intended this reasonable compensation rule apply only to partnerships & S-Corps. However, the law we now have was not written this way.

In addition to Sch C's, what about partnerships that do not pay a "reasonable" guaranteed payment or no guaranteed payment at all? Do we have to carve out a portion of the partner's allocable ordinary income as compensation? If so, then it seems reasonable the same would be required of a Sch C profit.
Last edited by Wiles on 3-Jan-2018 7:41am, edited 1 time in total.
 

#7
Webster  
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Make it four of us. A coworker and I have been batting the idea around the office in relation to preparing 2018 estimates for clients. I agree that the way the law is written it does not exclude sole proprietorships. (If someone can show me otherwise I would be indebted.)

Anyone else think there will be a rash of court cases?
 

#8
Lmaris  
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Pretty sure you could add a few zeros behind your estimate of number of people concerned about this.

Passing this bill at the end of the year with effective dates Jan 1 then going on vacation to celebrate is like someone leaving a flaming bag of feces on your porch.
 

#9
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WilsonCA wrote:
RiversideCPA wrote:...In contrast, in the case of a business conducted by a sole proprietor or a single member LLC that is treated as a disregarded entity, all of the business's income can be qualified business income.


This was published recently, in response to the new tax bill / 199A?


Yes, "New Law Special Study: Highlights of the Tax Cuts and Jobs Act".
 

#10
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The IRS will come out with regulations on §199A. Hopefully the regulations come in sooner rather than later but I'm not optimistic given the budget and morale at the IRS.

That said, I see no reason to expect that Schedule C clients will not get the full deduction, all else equal, because otherwise the IRS will be taking an enormous sledgehammer to decades of regulatory history (and run the risk of court challenges to the regs). I think S Corps are relatively easy to plan for, but beware that it will be another incentive to audit S corps for reasonable compensation. Partnerships are the most vague in what the statute says and will require the most regulatory work.

If you're worried about this for 2018 estimates, just estimate high and let the client have a happy surprise in 15 months' time.
 

#11
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Jake wrote:Schedule C - been doing this for decades - all net income goes to the proprietor. So what is the issue? So if my net is $50,000, I only pay income tax on $40,000, not sure what I pay FICA tax on. Tax software will know. In Ohio, for us small guys, 100% of our net is now free of income tax. Is that stupid or what? I wish it was that way years ago when i was making some real money.


The 20% deduction reduces taxable income only. Unlike DPAD (which has been repealed) it will not reduce AGI.
 

#12
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Pretty sure you could add a few zeros behind your estimate of number of people concerned about this.


I’ll take one of zeros…but my zeros would start with zero and end with zero.

Newsflash: A sole-proprietor’s business does not pay compensation to the sole-proprietor, reasonable or otherwise.

However, the law we now have was not written this way.


Sure it was. If you have a regarded entity, that pays wages/guaranteed payments to the owner, all the law is saying is that you can’t also count that compensation as QBI. The business of a sole-proprietor doesn’t “pay compensation” to the sole proprietor.

This was published recently, in response to the new tax bill / 199A?


Well, seeing that it specifically references, “qualified business income,” I’d wager a “yes.”

Do we have to carve out a portion of the partner's allocable ordinary income as compensation?


Probably so, unless you want the IRS to do it for you. But that puts you in a pickle, doesn’t it? Here you are, overtly asserting on a 1040, by manually adjusting down QBI, that you didn’t take reasonable comp…

If so, then it seems reasonable the same would be required of a Sch C profit.


Not in my view. RIA has it 100% right.

I agree that the way the law is written it does not exclude sole proprietorships. (If someone can show me otherwise I would be indebted.)


The law I’ve read talks about “paying compensation.” If you don’t understand how that concept fits in to general tax principles, as they relate to the taxation of a sole proprietor, then your issue isn’t with the new law, it’s with the underlying concept.

Anyone else think there will be a rash of court cases?


Not me.

Passing this bill at the end of the year with effective dates Jan 1 then going on vacation to celebrate is like someone leaving a flaming bag of feces on your porch.


Only if you don’t understand how sole-proprietorships operate from a tax standpoint. I for one am not of the opinion that a sole-proprietorship business “pays compensation” to the sole-proprietor. I had this opinion both before and after this new law was passed.
 

#13
Wiles  
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Jeff-Ohio wrote: The law I’ve read talks about “paying compensation.” If you don’t understand how that concept fits in to general tax principles, as they relate to the taxation of a sole proprietor, then your issue isn’t with the new law, it’s with the underlying concept.

Only if you don’t understand how sole-proprietorships operate from a tax standpoint. I for one am not of the opinion that a sole-proprietorship business “pays compensation” to the sole-proprietor. I had this opinion both before and after this new law was passed.

I do agree with you about this concept, but it was only a month ago when the House's first version of the bill (Tax Cuts and Jobs Act H.R. 1) said this:
Under current law, businesses organized as sole proprietorships, partnerships, limited liability companies, and S corporations are generally treated for Federal income tax purposes as “pass-through” entities subject to tax at the individual owner or shareholder level rather than the entity level.

...

Under the provision, a portion of net income distributed by a pass-through entity to an owner or shareholder may be treated as “business income” subject to a maximum rate of 25 percent, instead of ordinary individual income tax rates. The remaining portion of net business income would be treated as compensation and continue to be subject to ordinary individual income tax rates.
 

#14
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The House version is irrelevant to what passed.
 

#15
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a portion of net income distributed by a pass-through entity


If you expound on the “a portion” part, you’ll see why it’s a completely different animal that what was ultimately passed.
 

#16
Wiles  
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The majority of House passed their original version with the belief that a Sch C profit included two components - compensation & business income. They went so far as to create a standard allocation of 70%/30%, . Of course, what eventually passed was different. For some of us, though, the wording in 199A is not yet clear enough.
Last edited by Wiles on 3-Jan-2018 2:12pm, edited 1 time in total.
 

#17
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Jeff-Ohio wrote:Newsflash: A sole-proprietor’s business does not pay compensation to the sole-proprietor, reasonable or otherwise.
...
I for one am not of the opinion that a sole-proprietorship business “pays compensation” to the sole-proprietor.


My question is whether people here believe this is a (/s) news-flash or an opinion-flash. Therein lies the concern.

For now, I'll go along with the Checkpoint RIA observation posted above, and assume that nothing has or will change about how we deal with "compensation" (or lack thereof) with regards to payments to a sole proprietor and payments (other than guaranteed payments) to a partner. I'd say that the very fact that 199A(c)(B) and (C) exist make it appear that Congress is not trying to expand the technical definition of "compensation" to include those types of payments; otherwise, (B) and (C) would probably be redundant/unnecessary.

But... that's just me, and my reading. The IRS certainly could try to change things, and I believe they'd have some ground to stand on.

(Wouldn't there be more logical consistency to the tax code if sole proprietors were required to classify a certain portion of their income as "reasonable compensation" for purposes of exclusion from QBI, with the remaining "profits" portion excluded from SE tax? My opinion: yes. Would the Tax Court allow the IRS to take this position, if they tried? I think not, but I'm not sure, thus my original question.)
 

#18
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(Also: this of course carries no real weight, but see here: https://www.irs.gov/businesses/small-bu ... g-yourself

Last sentence: "You cannot deduct the sole proprietor's own salary or any personal withdrawals made from the business." So at least here, the IRS does indicate that sole proprietors can pay themselves a "salary", even though it's explicitly not a deductible expense. It'd be difficult to argue that something called a "salary" is not a form of paid compensation.)
 

#19
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WilsonCA wrote:(Also: this of course carries no real weight, but see here: https://www.irs.gov/businesses/small-bu ... g-yourself

Last sentence: "You cannot deduct the sole proprietor's own salary or any personal withdrawals made from the business." So at least here, the IRS does indicate that sole proprietors can pay themselves a "salary", even though it's explicitly not a deductible expense. It'd be difficult to argue that something called a "salary" is not a form of paid compensation.)


That’s a fallacy. The irs only said it’s not deductible and the reasoning could be because it’s not possible to pay yourself a wage. I can’t put money from my left pocket into my right pocket and call it income to the right side and an expense to the left. It’s actually a nonevent for income tax purposes and all other purposes. If you have a disregarded entity there may be other non-income-tax implications.
 

#20
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The legislature is made up in large part of lawyers, who typically aren't able might not bother to distinguish between "income" and "cash flow" which is why they don't realize there's a difference in our industry between "distributed income" and "distributable income" which is why they toss concepts like "flow-through entity" around without ever carefully and thoroughly defining them. BS artists.

This is my first, and possibly not my last, rant under the "new tax law" cuz I'm now obsolete, remember?
Last edited by Harry Boscoe on 3-Jan-2018 1:12pm, edited 1 time in total.
 

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