20% Deduction – Let The Games Begin - Your Tax Matters Partner

Originally published on Forbes.com.

The 20% deduction for qualified business income is the implementation of one of the stupidest ideas I have ever heard – the notion that people who have income from ownership of a business should pay less in tax on that income than people who have salaries is absurd. If we wanted to simplify things we would say that income is income and tax it all on the same rate table. A flat rate would make it even simpler, but the progressive rates are not a major source of complexity.

Instead of income is income, we have income that comes in many flavors. Here they are in order of how onerous they are under 2017 law. Income that is never recognized. Income that is not currently recognized. Capital gains not subject to NII. Capital gains subject to NII. Ordinary income. Ordinary income subject to SE tax. Ordinary income subject to NII. Seven is not enough. In 2018 we will have three more Qualified Business Income (QBI). QBI subject to SE. QBI subject to NII. By the way, I have probably missed a few flavors, but really that is enough to make the point.

Learn To Live With It – And Love It

Reilly’s First Law Of Tax Planning – It is what it is. Deal with it. Having gotten my frustration with what poor tax policy the deduction is, I have moved into various ways that it can be gamed. That’s because doing stuff like that is how I have been making my living for the most part. It’s not such a bad thing to do. As Learned Hand wrote:

Over and over again courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands: taxes are enforced exactions, not voluntary contributions. To demand more in the name of morals is mere cant.

On the other hand, I can’t say for certain whether the world is better or worse from resources being in the hands of my clients as opposed to being part of the commonwealth. It’s just that you have to do something to feed your family and tax work is what I fell into.

Provision Not Well Understood

One of the aspects of the 20% deduction which is widely misunderstood is which trades are excluded from it when taxable income is over a threshold. On a joint return it phases out between $315,000 and $415,000. That is taxable income without considering the 20% deduction. I discussed that provision at some length here. Once you are past the phaseout you have to have W-2 wages paid or depreciable assets in order to get any deduction. (The deduction is the lesser of 20% of your qualified business income or the greater of 50% of you W-2 wages paid or 25% of W-2 wages plus 2.5% of the unadjusted basis of your depreciable assets).

There is something else though. Some trades or businesses are flat out excluded once you are past the taxable income limit specifically:

business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners

Also

performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2))

As Abraham Lincoln Said Don’t Believe Everything You Read On The Internet

You have to be really careful when you read about the tax law in random internet articles – even though I am giving you the straight dope. A lot of time the specific provisions get summarized and then explained to a reporter who tries to interpret them so somebody with a seventh grade reading level can understand them. For example in this New York Times story we have:

The bill sets limits for how much people with high incomes can deduct. People in professional service industries, like partners in law firms, are the most restricted;

I would think it was reading something like that that caused somebody to tweet me:

Is rental property management a service business?

Oddly enough there was a link to my post which included the actual provision. You really shouldn’t ask me a tax question thinking that I have to answer it in 140 characters, particularly when it is is clear that you are probably asking the wrong question.

The Scheming Begins

Just to give you an example of how my scheming mind works, I would ask you – What about a physician?. You’re clever and already on to me, but just play along for now like you get all your tax information from the New York Times instead of just sticking with them for book reviews and obituaries like I do. You will say – Of course a physician. And I will say – Where in the provision do you see the word physician? And you will say – But, but, here is an article in Modern Healthcare

For instance, very high-income real estate developers in pass-through entities will receive the 20% deduction while very high-income physicians and other healthcare professionals will not.

Well the article is by Harris Meyer, a senior reporter providing news and analysis on a broad range of healthcare topics. And frankly, it is a pretty good article, but Mr. Meyer writes about health care. He doesn’t stay up at night scheming after having gone through over a thousand pages of statute and conference report several times.

Are all physicians working in the field of health? Actually some are not. And, I’m just talking tax law here and mean no disrespect, but plastic surgeons who stick with purely cosmetic procedures are not involved in the “field of health”. Here is my authority for that.

Why Cosmetic Surgery Is Not In The “Field Of Health”

Code Section 213(d)(9)

Cosmetic surgery.

(A)In general. The term “medical care” does not include cosmetic surgery or other similar procedures, unless the surgery or procedure is necessary to ameliorate a deformity arising from, or directly related to, a congenital abnormality, a personal injury resulting from an accident or trauma, or disfiguring disease.

(B) Cosmetic surgery defined. For purposes of this paragraph , the term “cosmetic surgery” means any procedure which is directed at improving the patient’s appearance and does not meaningfully promote the proper function of the body or prevent or treat illness or disease.

That does not nail it, but it is clear that plastic surgeons doing strictly cosmetic work are not providing “medical care”. The committee report helps, but still lacks the magic word.

In addition, the committee determined that expenses for cosmetic surgery and other similar procedures should not be eligible for the medical expense deduction, unless the procedure is necessary to ameliorate a deformity arising from a congenital abnormality, a personal injury resulting from an accident or trauma, or disfiguring disease. Expenses for purely cosmetic procedures that are not medically necessary are, in essence, voluntary personal expenses, which like other personal expenditures (e.g., food and clothing) generally should not be deductible in computing taxable income.

But there is more:

In addition, the conference agreement clarifies that if expenses for cosmetic surgery are not deductible under this provision, then amounts paid for insurance coverage for such expenses are not deductible under section 213 and reimbursement for such expenses is not excludable from the gross income of an individual under a health plan provided by an employer (including under a flexible spending arrangement) ( Emphasis added)

Then we have in Eriem Surgical Inc v United States

The district court concluded that Bernhard has been running Eriem, which is conducting the same business as Micrins notwithstanding Carol’s ostensible ownership and the change of focus from instruments used in health care to instruments used by cosmetic surgeons.

Frankly, it is not a slam dunk argument, but I would work on ways to bolster it. The first step would be to pay attention to the Principal Business or Professional Activity Code (page C-17) that goes on corporate and partnership returns and Schedule C. Nobody pays much attention to it in preparing returns after the first year, when a code is decided on. Preparers should think about in 2017 to set the stage for 2018. And a plastic surgeon who focuses on cosmetic surgery should not be classified as 621112 – Offices of physicians – because that is under the larger category of Health & Social Assistance.

By the way, I’m also thinking about professional golfers. I mean how athletic is golf?

But What About That Catch-all Category?

Sticking with my plastic surgeon, your next objection is going to be – But clearly your plastic surgeon, and just about any other professionals in business for themselves falls under ” any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners”. Well you clearly haven’t seen my plastic surgeon’s website:

At Beauty Team Associates we have state of the art facilities, where you will be guided through the beautification process by a team of professionals including your personal beautification consultant who will coach you through the process until she hands you off to the caring nurses who will have you comfortably situated. And of course there is a surgeon, who is pretty darn good, but not the whole deal by any means.

It needs work, but you get the idea. Professionals who have an arguable way out of one of the “fields” may need to check their egos at the door if they want to shore up that 20% deduction.

Nobody Knows What It Means

Here is the thing about that ” any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners” (Call it RS). Nobody knows what the hell RS means.

I have been an accountant for nearly forty years. One of the things that I learned at the very beginning of my training is that assets go on the balance sheet. Since then, I have looked at thousands of balance sheets. Not once have I seen reputation or skill as an asset. OK maybe goodwill. But if there is no non-compete, then it is personal goodwill, not an asset of the trade or business.

At this point, you need to consider Reilly’s Third Law Of Tax Planning – Any clever idea that pops into your head probably has a corresponding rule that makes it not work. So you might expect rulings and regulations and the like that will foil my clever plans. Well you might. Let’s look into that a bit, you need to go to the Conference Report for that. New Code Section 199A starts on page 23. On Page 41 we see Section 199A(f)(4).

REGULATIONS.—The Secretary shall prescribe such regulations as are necessary to carry outthe purposes of this section, including regulations—

‘‘(A) for requiring or restricting the allocation of items and wages under this section and

such reporting requirements as the Secretary

determines appropriate, and

‘‘(B) for the application of this section in

the case of tiered entities.

I’m really looking forward to the ones about tiered entities. Those will be a blast. There is something a little curious about those regulations. After page 503, there are some signatures and then the page numbers start over as we get int the Joint Explanatory Statement of The Committee of Conference. On page 555 of that sequence we get the Tax Complexity Analysis. Starting on page 556, we get this about 199A

It is not anticipated that individuals will need to keep additional records due to the provision. It should not result in an increase in disputes with the IRS, nor will regulatory guidance be necessary to implement this provision.

No regulations required. Its so simple a child could figure it out. You don’t need to understand it better than the greatest CPA like our President does. By the way I don’t know who the greatest CPA is, but I would caution the President to be careful where he puts his hands when he finally meets her.

The favorite dictionary of the Tax Court is Webster’s II. The definition of “assets” is “The entries on a balance sheet showing all properties and claims against others that may be directly or indirectly applied to cover liabilities”. Gee, your Honor, I looked all up and down that balance sheet and didn’t see any skill or reputation there, so I figured that didn’t apply to my client.

By the way, do you know what you have to study to be a Revenue Agent? Accounting. Go figure.

Entity Choice

The 20% deduction has made entity choice much more complicated. S corporations used to have an edge, because after a reasonable salary the remaining income would not be subject to FICA and Medicare tax. There still might be reasons to prefer a proprietorship or partnership, but the calculation changes now. The salary now reduces the amount of your income that is subject to the 20% deduction. On smaller organizations with profits under $120,000 there still might be an advantage to the S corporation, because you will be saving both FICA and medicare. Once the income is high enough that a salary below the FICA maximum is not plausible, the deduction is more valuable.

Partnerships and proprietorships won’t have owner salaries dragging down the profit subject to the 20% deduction, which seems like a plus. There is that alternative 50% of W-2 test to deal with, though (Let’s assume negligible depreciable assets to keep things simple). Once over the phaseout, a proprietor or partner has to have substantial W-2 deductions or there is no 20% deduction. An S corporation owner with no employees can meet the requirement with an owner’s salary. Good chance that the right number is 28.57% of profit before salary, but that is the subject of another post.

Another Option

Reilly’s Second Law of Tax Planning – Sometimes it’s better to just pay the taxes. If my plastic surgeon is making a million dollars a year, my scheming might save about $75,000. But for how long? Is it worth turning the practice upside down ? Particularly given that we don’t how things will really work. Many people are not really very proactive in their tax planning. Some of their tax preparers won’t spend much time thinking about the deduction for another year, when they notice that there is another form to fill out. I can’t say for sure that they are wrong to take that passive approach, but I need to tell you something.

You probably think that this fantastic blog is the result of my individual skill and its success is tied into my great reputation (My twitter followers grew by the scores in the last couple of weeks). Well you are wrong. I have a fantastic research service and this really cool three screen computer setup. And my partner in business and life makes sure I eat a healthy diet and is always asking me questions that spark my creativity. With those resources, just about anybody could have a tax blog as good as this one. That’s my story and I’m sticking to it.

20% Deduction – Let The Games Begin

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