Earlier this week, the Internal Revenue Service (IRS) issued proposed regulations for Section 199A, a key element of the Tax Cuts and Jobs Act. The section 199A deduction, sometimes called the pass-through deduction, allows sole proprietors and owners of pass-through businesses a deduction of up to 20% on business-related income to bring the overall rate lower. If that sounds like it could be tricky, it is. And as tax professionals and taxpayers alike try and sort it all out, it’s apparent that the cost of compliance will be not insignificant.
(You can read my summary of the proposed regulations here.)
The proposed regulations for Section 199A take up a whopping 184 pages. The guidance on W-2 wages constitutes an additional 14 pages. And there is more guidance likely to come.
So how much time will it take to get taxpayers up to speed? The proposed regulations could tack on 25 million hours in new annual reporting requirements for 10 million corporations and partnerships. The average increased reporting burden—on a flat scale—works out to 2.5 hours per affected taxpayer per year.
How do we know this? It’s in the proposed regulations. Whenever new regulations are proposed, federal agencies may have to offer details about the cost of compliance, the estimated burden for those affected, and the reasons for collection of data.
Similarly, the proposed regulations include several pages of explanations and findings regarding reporting and compliance. For example, the IRS notes that the “[i]t is necessary to report the information to the IRS in order to ensure that taxpayers properly report in accordance with the rules of the proposed regulations the correct amount of deduction under section 199A. The collection of information is necessary to ensure tax compliance.”
The Treasury Department and the IRS expect the majority of affected entities to be small and medium in size. Those taxpayers who will be most impacted are likely individuals with qualified business income from more than one trade or business as well as most partnerships, S corporations, trusts, and estates that have qualified business income.
Of course, not all taxpayers will have an equal compliance burden. The estimated compliance average per taxpayer is 30 minutes to 20 hours, depending on individual facts and circumstances. That makes sense if you think about it since a sole proprietorship under the threshold amount would calculate the deduction as it applies to business income, which is a much simpler formula. That’s why the IRS believes that “the burden on small entities is expected to be at the lower end of the range (30 minutes to 2.5 hours).” However, a taxpayer with income over the threshold amount or multiple businesses may have to do more calculations, bumping them to the higher end.
Not all taxpayers will have increased recordkeeping requirements under the proposed regulations. For example, the de minimis rule would allow taxpayers with a trade or business that provides a small number of services in a specified service activity to not be considered a specified service trade or business (SSTB). That exception is expected to reduce compliance costs associated with section 199A for “millions of U.S. businesses.”
The IRS also anticipates that the aggregation rules, those that apply to grouping trade or business activities and rental activities, will result in reduced overall costs for taxpayers “because some taxpayers would restructure their business arrangements in order to receive the benefit of the deduction.” It’s also unclear whether the IRS included the costs of restructuring in the overall estimate; I don’t believe that it’s included, which feels like a little bit of a cheat. It’s like saying that taxpayers who move to avoid the state and local tax (SALT) cap will save money without including the costs of the move.
Overall, the cost of compliance is expected to be approximately $1.3 billion over ten years—a curious figure since the deduction is, as currently written, only in place through the 2025 tax year. Remember: The deduction is not part of the permanent tax cuts for corporations, but instead part of the temporary tax cuts for individuals.
(You can read more about the TCJA here and see the new tax rates here).
Keep in mind that the estimate doesn’t take into account any reductions in compliance nor does it take into account any increases due to inflation or higher wages. Additionally, it’s worth noting that compliance costs may be higher in the first few years that the deduction is allowed and lower in future years once taxpayers—or their tax professionals—have it all figured out.
