small or home-based business


Still confused about the business expense deduction for meals and entertainment under the Tax Cuts and Jobs Act (TCJA)? In the months following the new law, taxpayers and tax professionals alike weren’t sure what the new limits and restrictions would mean for businesses. In October of 2018, the Internal Revenue Service (IRS) offered transitional guidance on the rules. At the time, the IRS indicated that it would provide additional guidance, and now it has issued proposed regulations on the business expense deduction for meals and entertainment.

Under prior law, the rule was that you could deduct 50% of entertainment, amusement, or recreation expenses directly related to your trade or business. Under the TCJA, the meals deduction remained but there is no deduction for any item generally considered to constitute entertainment, amusement, or recreation. 

The TCJA did not change the definition of entertainment. Where things get tricky, though, is whether providing food and beverages might constitute entertainment, especially if they were tied to an activity considered to be entertainment.

Today In: Taxes

Under the transitional guidance issued in Notice 2018-76 (downloads as a PDF), taxpayers may deduct 50% of meals so long as the expense is ordinary and necessary to carry on a trade or business. Just as before, the costs may not be lavish or extravagant under the circumstances (context matters). And, the taxpayer or an employee of the taxpayer must be present when the food or beverages are served (you can’t just offer up a smorgasbord and walk away).

The proposed regulations largely incorporate the guidance in Notice 2018-76 with a few additional clarifications. 

For example, the proposed regulations make clear that the 50% deduction for food and beverages remains in place. They also make clear that entertainment expenses are not deductible, even if the two are mixed and even if the expense is related to or associated with the active conduct of a trade or business. To help you sort it out, the proposed regulations include the following examples:

  • Taxpayer A invites B, a business associate, to a baseball game to discuss a proposed business deal. A purchases tickets for A and B to attend the game. The baseball game is entertainment, and thus, the cost of the tickets is an entertainment expenditure and is not deductible by A.
  • Assume the same facts as above except that A also buys hot dogs and drinks for A and B. The cost of the hot dogs and drinks, which are purchased separately from the game tickets, is not an entertainment expenditure. Therefore, A may deduct 50% of the expenses associated with the hot dogs and drinks purchased at the game if they otherwise meet the deductibility requirements.

The proposed regulations also provide that the amount charged for food or beverages on a bill, invoice, or receipt must reflect the venue’s usual selling cost for those items if they were to be purchased separately from the entertainment, or must approximate the reasonable value of those items. And as before, unless food or beverages provided at or during an entertainment activity are purchased or stated separately, the entire amount is a nondeductible entertainment expenditure. Yep, that means that you may not, on your own, decide on an allocation.

Again, some examples:

  • Taxpayer C invites D, a business associate, to a basketball game. C purchases tickets for C and D to attend the game in a suite, where they have access to food and beverages. The cost of the basketball game tickets, as stated on the invoice, includes the food or drinks. The basketball game is entertainment, and the cost of the game tickets is a nondeductible entertainment expense. The cost of the food and beverages, which are not purchased separately from the game tickets, is not stated separately on the invoice. Thus, the value of the food and drink is considered entertainment. C may not deduct the cost of the tickets or the food and drinks associated with the basketball game.
  • Assume the same facts as above except that the invoice for the basketball game tickets separately states the cost of the food and beverages and reflects the venue’s usual selling price if purchased separately. The basketball game is still entertainment, and the value of the game tickets, other than the cost of the food and beverages, is a nondeductible entertainment expense. However, the cost of the food and beverages, stated separately on the invoice for the game tickets, is not an entertainment expenditure, and C may deduct 50% of the expenses associated with the food and beverages provided at the game if they meet the other deductibility requirements.

One change in the proposed regulations involves the requirement in Notice 2018-76 that the food and beverages be provided to a business contact, which was described in the notice as a “current or potential business customer, client, consultant, or similar business contact.” The proposed regulations make clear that the food or beverages must be provided to a “person with whom the taxpayer could reasonably expect to engage or deal in the active conduct of the taxpayer’s trade or business such as the taxpayer’s customer, client, supplier, employee, agent, partner, or professional adviser, whether established or prospective.” Since employees are included in the list, that means the 50% deductibility rule applies to employer-provided meals as well as to situations in which a taxpayer provides meals to both employees and non-employee business associates at the same event.

That’s a big change. Under prior law, expenses for food or beverages that were excludable from employee income as de minimis fringe benefits were not subject to the 50% deduction limitation: they could be fully deducted. Following the TCJA, expenses for food or beverages excludable from employee income are also subject to the 50% deduction limitation unless another exception applies.

Some meals continue to be deductible in full as exceptions to the 50% rule. They include: 

  1. Expenses for food and beverages if the costs are treated as compensation to the recipient;
  2. Expenses for food and drinks if the costs are treated as income to a person other than an employee as compensation for services;
  3. Expenses incurred by a taxpayer in connection with the performance of services for another person (whether or not the other person is an employer) under a reimbursement or other expense allowance arrangement;
  4. Expenses for food or beverage paid or incurred for recreational, social, or similar activities primarily for the benefit of employees like company parties or annual picnics (but events that discriminate in favor of highly compensated employees, officers, shareholders or others who own a 10% or greater interest in the business are not considered paid or incurred primarily for the benefit of employees).
  5. Expenses for food and beverages made available to the general public (general public includes customers, clients, and visitors, but does not include employees, partners, or independent contractors); and
  6. Expenses for food and beverages that are sold to customers in a bona fide transaction for adequate and full consideration in money or money’s worth (customer includes anyone who is sold food or beverages in a bona fide sale, including employees if they pay fair market value prices).

The proposed regulations apply to taxable years that begin on or after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. Until then, you can rely on the proposed regulations for entertainment expenditures and food or beverage expenses paid or incurred after December 31, 2017. In addition, you can rely on the guidance in Notice 2018-76 until these proposed regulations are finalized.

The IRS will hold a public hearing on the proposed regulations on April 7, 2020.

If you have your business tax payments set to auto-pilot, check those addresses: The IRS is closing business payment P.O. Boxes in the Cincinnati and Hartford areas beginning July 1.

Payments mailed to a closed payment location will be returned to the sender. To help ensure timely receipt, check Where to File before mailing in a payment.

To keep things simple, you can also use IRS Direct Pay to pay a tax bill or estimated tax payment directly from a checking or savings account.

Taxpayer asks:

Since 2002, I have owned (via a single-member LLC) an office complex in upstate new york. I purchased it as an investment to either sell or rent. Unfortunately, this property has been vacant and producing no income as a result of town opposition to the use of the property for office purposes. Similarly, the market value was destroyed by the Town. 

My property taxes paid 2018 are approx 20,000.00. My CPA says that his CCH program does not allow for the full deduction and that it defaults to the 10,000 SALT limit.

I am wondering if you have any experience with the applicability of the SALT deduction to a vacant rental or investment property. Any help would be appreciated. Thanks,

Taxgirl says:

The $10,000 SALT limits cap the aggregate of individual state and local taxes, including real estate taxes. But some taxes don’t apply – those are spelled out at section 164 of the Tax Code which says:

The preceding sentence shall not apply to any foreign taxes described in subsection (a)(3) or to any taxes described in paragraph (1) and (2) of subsection (a) which are paid or accrued in carrying on a trade or business or an activity described in section 212. (emphasis added)

In other words, the cap doesn’t apply to state and local taxes that are paid or accrued in carrying on a trade or a business or an activity described in section 212. Section 212 says:

In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year:

 (1) for the production or collection of income;

 (2) for the management, conservation, or maintenance of property held for the production of income; or

 (3) in connection with the determination, collection, or refund of any tax.

So that rental real estate you have? You’re using it to produce income, right? Then it should not be subject to the cap. The cap is intended to apply to those state and local taxes claimed on a Schedule A.

I don’t know whether your CPA is getting hung up on the vacancy bit. The timing could be an issue. You didn’t say how long the property has not been producing income, but the IRS likes to see businesses making money. A good rule of thumb is that you should be showing a profit three of five years. If you have not made money for years, it may be that your CPA is treating the investment as a hobby or personal asset instead of as a business. I’d ask him to explain his thinking, and if you’re not satisfied with the answer, seek a second opinion.

Before you go: be sure to read my disclaimer. Remember, I’m a lawyer and we love disclaimers.
If you have a question, here’s how to Ask The Taxgirl.

The Internal Revenue Service (IRS) Large Business and International division (LB&I) has announced six additional compliance campaigns for taxpayers. A compliance campaign is a targeted directive on a particular issue; they happen when the IRS determines that there are taxpayer issues that require a response from the agency. When the IRS announces a campaign (or campaigns), it’s a signal that they will be dedicating time, resources, training, and tools towards a tax compliance goal.

Campaigns are identified through LB&I data analysis, suggestions from IRS compliance employees, and feedback from the tax community. Issues that IRS ultimately target are those which represent a risk of noncompliance that can be addressed most efficiently.

To date, LB&I has announced a total of 59 campaigns, including the following six new campaigns: 

S Corporations Built-In Gains Tax. When C corporations convert to S corporations, they may be subject to the Built-in Gains (BIG) tax. The BIG tax (go ahead, giggle, I know you want to) applies if those corporations have a net unrealized built-in gain and sell assets within five years after the conversion. The tax is assessed to the S corporation, but LB&I has found that S corporations don’t always pay the tax when they sell the C corporation assets after the conversion. The goal of this campaign is to increase awareness and compliance with the law. Taxpayers can expect issue-based examinations and soft letters; the IRS will also be conducting outreach to practitioners.

Post OVDP Compliance. The IRS launched the Offshore Voluntary Disclosure Program (OVDP) in 2009 to encourage compliance with foreign asset reporting. Structured as a tax amnesty program, it allowed U.S. taxpayers to come forward and avoid criminal prosecution for not reporting foreign accounts. In 2011, in response to the Foreign Account Tax Compliance Act (FATCA), the IRS announced a new amnesty program to take the place of the 2009 program; the official title was the 2011 Offshore Voluntary Disclosure Initiative (OVDI). In 2014, the IRS modified the program yet again. At the time of the relaunch, the IRS made it clear that there would be no set deadline for taxpayers to apply for the program, and in March of 2018, the IRS announced the program would be ending. Now, the IRS is targeting taxpayers’ failure to remain compliant with their foreign income and asset reporting requirements. The IRS will address tax noncompliance through soft letters and examinations.

Expatriation. In most cases, you cannot simply abandon your U.S. tax obligations by moving out of the country – even if you plan to renounce your citizenship. Under current law, U.S. citizens and long-term residents (defined as lawful permanent residents in eight out of the last 15 taxable years) who expatriated on or after June 17, 2008, may have specific filing requirements or tax obligations. The IRS will address noncompliance through outreach, soft letters, and examination.

High Income Non-filer. Under current law, U.S. citizens and resident aliens are subject to tax on worldwide income. This is true whether or not taxpayers receive a form W-2, forms 1099 or foreign equivalents. Taxpayers are not exempt from reporting requirements simply because they don’t receive an information form. The IRS will address noncompliance through examinations.

U.S. Territories – Erroneous Refundable Credits. Some bona fide residents of U.S. territories are erroneously claiming refundable tax credits on their individual tax returns. A refundable credit means that you can take advantage of the credit even if you do not owe any tax. Unlike with a nonrefundable credit, if you don’t have any tax liability, the “extra” credit is not lost but is instead refunded to you. The IRS will address noncompliance through outreach and traditional examinations.

Section 457A Deferred Compensation Attributable to Services Performed before January 1, 2009. Section 457 plans are non-qualified, unfunded deferred compensation plans established by state and local government and tax-exempt employers. Under rules passed in 2009, deferred compensation under a non-qualified deferred compensation plan is includible in gross income when there is no substantial risk of forfeiture of the right to receive such compensation. Most commonly, you must report when it vests. The IRS will address noncompliance through issue-based examinations.

If you feel your blood pressure rising as you read this, or have questions or concerns about your filing obligations or compliance status, check with your tax professional.

As part of the Tax Cuts and Jobs Act (TCJA), there have been changes to the treatment of certain business-related expenses, including travel, business meals, and entertainment. As I wrote earlier this year, some tax professionals believe that the language in the TCJA created confusion, asking the Internal Revenue Service (IRS) for clarification on this issue. At the time, I advised, “Don’t order the lobster just yet” since the rules were still unclear. Now, you can finally order the lobster: The IRS has issued transitional guidance on business meals and entertainment.

Under prior law, the rule was that you could deduct 50% of entertainment, amusement, or recreation expenses directly related to your trade or business. Under the TCJA, there is no deduction for any item generally considered to constitute entertainment, amusement, or recreation.

Under Section 1.274-2(b)(1)(i) of Regs, the term “entertainment” includes activities like entertaining at nightclubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation, and similar trips, including such activity relating solely to the taxpayer or the taxpayer’s family. The term can also include certain business expenses which could be considered personal, such as a hotel suite or a car for a business customer or the customer’s family.

The Regs make clear that “entertainment” should not be interpreted to mean only the entertainment of others, or that an item of expenditure for entertainment should be characterized as advertising or public relations to circumvent the test. The Regs also make clear that the taxpayer’s trade or business matters. For example, my attending a baseball game would be considered entertainment, but it would not be considered entertainment for a scout to attend a game in a professional capacity.

The TCJA did not change the definition of entertainment. Where things get tricky, though, is whether providing food and beverages might constitute entertainment, especially if food and beverages were tied to an activity considered to be entertainment.

Under the prior law, expenses for meals were generally deductible at 50% so long as they were connected to business and otherwise met the deductibility criteria. But the loss of the entertainment deduction left some taxpayers confused. What happens, for example, if meals are tied to nondeductible entertainment like dinner at a show or lunch during a ballgame? The IRS intends to publish proposed regulations clarifying when business meal expenses are nondeductible entertainment expenses and when they are 50% deductible expenses. Until those regulations are published, however, taxpayers can rely on guidance issued in Notice 2018-76 (downloads as a PDF).

That guidance allows taxpayers to continue to deduct 50% of meals so long as the expense is ordinary and necessary to carry on a trade or business. Just as before, the costs can’t be lavish or extravagant under the circumstances (context matters). Further, the taxpayer or an employee of the taxpayer must be present when the food or beverages are served (you can’t just offer up a smorgasbord and walk away).

But what about food and drinks provided during or at an activity considered to be entertainment? In that case, if food and drinks are purchased or stated separately from the entertainment, the cost of the food and drinks would remain deductible. In other words, food and drinks provided during entertainment events will not be considered entertainment so long as they are kept separate.

In my earlier article, I raised the example of whether a business lunch during a ballgame would remain deductible. Under the IRS guidance, the cost of tickets to the game would be considered entertainment and would not be deductible. However, the cost of lunch, so long as it is purchased separately from the tickets, is not considered entertainment and would be subject to the 50% deductibility rule.

But what if the tickets to the game included access to a suite with food and beverages – a package deal? As before, the cost of the tickets would be considered an entertainment expense and would not be deductible. But in this case, the cost of the food and beverages, which are not purchased separately from the game tickets and not stated separately on the invoice (remember, it’s a package deal) would also be considered an entertainment expense and would be disallowed.

Those are pretty easy examples to sort out, but there are bound to be situations where the lines are blurred. The IRS has announced its intent to release future guidance on the issue and is seeking public comment.
In the meantime, my advice from before still stands:

  • Pay attention. Last-minute changes and guidance may have significant consequences on Tax Day. You don’t want to be taken by surprise.
  • Get a good tax professional. I know that you don’t have time to read every piece of guidance from IRS or to analyze the language in the TCJA over late-night cocktails. You’re busy running a business, right? Leave that to the folks who like doing this for a living.
  • Keep excellent records. This piece is more important than ever. In addition to filing or scanning receipts, annotate where appropriate. You should include the date of the event, the type of expense and who was with you. It’s also a good idea to write down the purpose of the meal, including the general topic of discussion. If there’s an entertainment piece, be sure that it gets carved out–separate checks are even better.

(But Watch Out For Tax Law Changes)

Wondering about those updated per diem rates? The new per-diem numbers are now out, effective October 1, 2018. These numbers are to be used for per-diem allowances paid to any employee on or after October 1, 2018, for travel away from home on or after that date. The new rates include those for the transportation industry; the rate for the incidental expenses; and the rates and list of high-cost localities for purposes of the high-low substantiation method.

I know: That sounds complicated. But it’s intended to keep things simple. The Internal Revenue Service (IRS) allows the use of per diem (that’s Latin meaning “for each day” – remember, lawyers love Latin) rates to make reimbursements easier for employers and employees. Per diem rates are a fixed amount paid to employees to compensate for lodging, meals, and incidental expenses incurred when traveling on business rather than using actual expenses.

Here’s how it typically works: A per diem rate can be used by an employer to reimburse employees for combined lodging and meal costs, or for meal costs alone. Per diem payments are not considered part of the employee’s wages for tax purposes so long as the payments are equal to or less than the federal per diem rate and the employee provides an expense report. If the employee doesn’t provide a complete expense report, the payments will be taxable to the employee. Similarly, any payments which are more than the per diem rate will also be taxable.

The reimbursement piece is huge because there is a big change this year in the way that employees may report their expenses. For the 2017 tax year, unreimbursed job expenses were deductible on Schedule A as miscellaneous deductions subject to the 2% floor. That means that they were deductible to the extent that they exceeded 2% of your adjusted gross income (AGI). Here’s an example: Let’s say that your AGI in 2017 was $50,000 and your job-related expenses totaled $3,000 for that year. For the 2017 tax year, you could have deducted $2,000 of those expenses. That’s because 2% of $50,000 is $1,000, and expenses over that amount ($3,000 less $1,000 = $2,000) would have been deductible.

However, the Tax Cuts and Jobs Act (TCJA) eliminated unreimbursed job expenses and miscellaneous itemized deductions subject to the 2% floor for the tax years 2018 through 2025. Those expenses include unreimbursed travel and mileage.

That means that the business standard mileage rate (you’ll find the 2018 rate here) cannot be used to deduct unreimbursed employee travel expenses for the form 2018 through 2025 tax years. The IRS has clarified, however, that members of a reserve component of the Armed Forces of the United States, state or local government officials paid on a fee basis, and certain performing artists may still deduct unreimbursed employee travel expenses as an adjustment to income on the front page of the form 1040. In other words, those folks can continue to use the business standard mileage rate. For details, you can check out Notice 2018-42 (downloads as a PDF).

What about self-employed taxpayers? The good news is that they can still deduct business-related expenses. However, the per diem rates aren’t as useful for self-employed taxpayers because they can only use the per diem rates for meal costs. Realistically, that means that self-employed taxpayers must continue to keep excellent records and use exact numbers.

As of October 1, 2018, the special meals and incidental expenses (M&IE) per diem rates for taxpayers in the transportation industry are $66 for any locality of travel in the continental United States and $71 for any locality of travel outside the continental United States; those rates are slightly more than they were last year. The per diem rate for meals & incidental expenses (M&IE) includes all meals, room service, laundry, dry cleaning, and pressing of clothing, and fees and tips for persons who provide services, such as food servers and luggage handlers.

The rate for incidental expenses only is $5 per day. Incidental expenses include fees and tips paid at lodging, including porters and hotel staff. It’s worth noting that transportation between where you sleep or work and where you eat, as well as the mailing cost of filing travel vouchers and paying employer-sponsored charge card billings, are no longer included in incidental expenses. If you want to snag a break for those, and you use the per diem rates, you may request that your employer reimburse you.
That’s good advice across the board: If you previously deducted those unreimbursed job expenses and can no longer do so under the TCJA, ask your employer about potential reimbursements. Companies might not have considered the need for certain reimbursement policies before the new tax law, but would likely not want to lose a good employee over a few dollars – especially when those dollars are important to the employee.

Of course, since the cost of travel can vary depending on where – and when – you’re going, there are special rates for certain destinations. For purposes of the high-low substantiation method, the per diem rates are $287 for travel to any high-cost locality and $195 for travel to any other locality within the continental United States. The meals & incidental expenses only per diem for travel to those destinations is $70 for travel to a high-cost locality and $60 for travel to any other locality within the continental United States.

You can find the list of high-cost localities for all or part of the calendar year in the most recent IRS notice. As you can imagine, high cost of living areas like San Francisco, Boston, New York City, and the District of Columbia continue to make the list. There are, however, a few noteworthy changes, including:

  • The following localities have been added to the list of high-cost localities: Sedona, Arizona; Los Angeles, California; San Diego, California; Vero Beach, Florida; Jekyll Island/Brunswick, Georgia; Duluth, Minnesota; Pecos, Texas; Moab, Utah; and Cody, Wyoming.
  • The following localities have been removed from the list of high-cost localities: Mill Valley/San Rafael/ Novato, California; Steamboat Springs, Colorado; Petoskey, Michigan; and Saratoga Springs/Schenectady, New York.
  • The following localities have changed the portion of the year in which they are high-cost localities (meaning that seasonal rates apply): Oakland, California; Aspen, Colorado; Boca Raton/Delray Beach/Jupiter, Florida; Naples, Florida; Bar Harbor/Rockport, Maine; Boston/Cambridge, Massachusetts; Jamestown/Middletown/Newport, Rhode Island; Charleston, South Carolina; Vancouver, Washington; and Jackson/Pinedale, Wyoming.
  • The following localities have been redefined: Traverse City, Michigan no longer includes Leland and Bar Harbor, Maine now includes Rockport.

You can find the entire high-cost localities list, together with other per diem information, here (downloads as a PDF). To find the federal government per diem rates by locality name or zip code, head over to the General Services Administration (GSA) website.

Most of the time, figuring the timing of income and expenses is fairly straightforward: Income is income when received, expenses are expenses when paid. When income and expenses straddle tax years, things can get muddled. And when income and expenses straddle tax years when big changes are happening, it’s even more confusing. Taxpayers got a bit of a break this week when the Internal Revenue Service (IRS) offered guidance for taxpayers who moved in 2017, but expenses weren’t reimbursed or paid until 2018.

Before the 2017 Tax Cuts and Jobs Act (TCJA), certain moving expenses were either excluded from income (so, a tax-free perk) or treated as an above-the-line deduction. With an above-the-line deduction, you can claim some tax breaks even if you don’t itemize your deductions; sometimes called adjustments to income, they are found on page 1 of your form 1040.

For the 2017 tax year, they included moving expenses. However, in 2018, moving expenses were excluded both as a tax-free perk from employers and as an above-the-line deduction.

(Exceptions exist for active-duty members of the U.S. Armed Forces whose moves relate to a military-ordered permanent change of station.)

That presented a dilemma for some employers and taxpayers: What if the moving expenses occurred in 2017 but weren’t paid or reimbursed by the employer until 2018. Would you lose the tax break that you would have been entitled to if the employer moved a little faster?

Typically, you’d be quick to cry foul on the employer. Keep in mind, however, that the TCJA wasn’t signed into law until December 22, 2017 – just days before the holidays and year-end. Many companies had already run payroll and expenses and were looking forward to sipping eggnog, not delving through pages of new tax laws.

To resolve the issue, the IRS has issued Notice 2018-75 (downloads as a PDF). In the Notice, the IRS makes clear that the exclusion from income applies for moving expenses paid or incurred in 2017 and payments or reimbursements received in 2018. In other words, employer payments or reimbursements in 2018 for employees’ moving expenses in 2017 are excluded from the employee’s wages and are not subject to federal income or employment taxes. The IRS also clarified that the same result follows if the employer pays a moving company in 2018 for moving services provided to an employee in 2017.

Of course, the regular rules apply. The most important? The expenses must be work-related moving expenses that would have been deductible by the employee if the employee had directly paid them in 2017. And no double-dipping: The employee must not have deducted them in 2017.

(You can read more about the old rules governing moving expenses here.)

But, since it’s September of 2018 and we’re just now receiving this guidance, there’s a chance that some employers might have already treated reimbursements or payments as taxable. No worries: Almost all tax-related snafus can be fixed, and this is no exception. Employers should follow the normal employment tax adjustment and refund procedures.

It feels like TCJA guidance is coming fast and furious now, which is great since there are just a few more months in the tax year. Keep watching this space for more.

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 amount 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.

It’s been nearly a month since President Trump signed the new tax reform bill into law and taxpayers are still trying to determine how it might affect them. In particular, figuring out how the new deduction for pass-through businesses will work has challenged taxpayers and tax preparers alike.

Pass-through tax law has never been simple, but now there’s a twist: Business income that passes through to an individual from a pass-through entity and income attributable to a sole proprietorship will be taxed at individual tax rates less a deduction of up to 20% (under the rules, it’s possible that you could have no deduction). The rules for calculating the deduction can be complicated, depending on your situation.

A number of articles have been written about the pass-through deduction, including this one from me (as well as this one from Forbes contributor Tony Nitti and this one from Forbes contributor Peter J. Reilly).

However, as much as reading about the new law can be helpful, sometimes it helps to see it as an illustration. Rob and Joe Hassett thought the same thing – and came up with one of their own.

Rob Hassett, an attorney with Hassett Law Group in Atlanta, and Joe Hassett, a consultant with Accenture in San Francisco, used SimpleMind mind mapping software to create a flowchart to express the deduction. Their purpose was to provide a visual representation of the new rules to make them easier to understand and apply.

Here’s the chart:

passthrough deduction chart
To see the chart in full size, click here.

And some key definitions to help you navigate the chart:

  • EXCESS TAXABLE INCOME means TP taxable income  THRESHOLD
  • PHASE-IN RANGE means $100k for married taxpayers filing jointly & $50k for all other taxpayers
  • QBI means qualified business income, which means the taxpayer’s share of income from a pass-through entity
  • QBIF means qualified business income factor which means 20% x QBI
  • SPECIFIED SERVICE BUSINESS means, in general terms, a business with respect to which the services of one or more individuals is the main source of income, such as lawyers, doctors, accountants & consultants (architects & engineers are expressly excluded). For the full definition see page 553 of the Conference Report (downloads as a pdf).
  • THRESHOLD means $315k for married taxpayers filing jointly & $157.5k for all other taxpayers
  • TP means TAXPAYER
  • WAGE-CAPITAL FACTOR means TP’s share of the greater of 50% x W-2 Wages OR (25% x W-2 Wages) + (2.5% x Capital Investment).

Of course, Rob being a lawyer, had a few caveats, notably:

In order to determine how best to structure a business for tax purposes, it will be necessary to take into account additional factors other than just what is in the Flowchart. For example, owners of S Corporations may be able to avoid a substantial amount of Social Security and Medicare/Self-Employment taxes which can add as much as (.9235) x (15.3%) or 14.129% of income. Actions that lower your amount of Self-Employment tax may decrease your pass-through deduction. Also, with the additional change of the corporate rate to a flat rate of 21%, without knowing all the rules and crunching numbers, it is not possible to determine whether taxation as a proprietorship, partnership, S- Corporation or C-Corporation will be optimal.

Rob also notes that the flowchart is not meant to constitute legal or tax advice and is, instead, provided solely for educational and discussion purposes. Feel free to test the formulas, which were crafted to make it as easy to follow as possible – and not to incorporate every possibility – and reach out to him directly with feedback (click here for email). Changes may be required.

I would also stress that this is meant to be a visual representation to help you sort through some pretty complicated rules, and isn’t meant to be a substitute for finding out more, including consulting with your tax professional.

One of the most significant changes under tax reform is the tax treatment of businesses. Unlike changes to the individual tax scheme, which are temporary and somewhat piecemeal, the changes to the business tax scheme are permanent and fairly comprehensive. It would be impossible to address all of the changes so I’m focusing on what I’ve been asked about most: how the new rules will affect pass-through entities and small businesses.

First, a quick reminder. Currently, you can structure your business in a few ways, including:

  • A sole proprietorship is the most simple form of business entity. Taxpayers do not file a separate tax return and instead, business income and expenses are reported on a federal form 1040, Schedule C.
  • A partnership is an association of two or more persons to carry on a business and can take different forms (like limited or general partnerships). A partnership files a separate return, a federal form 1065, and passes income and losses to the individual partners who are responsible for reporting that information on their individual tax returns.
  • A Limited Liability Company (LLC) is a hybrid entity that offers the option to be taxed as a partnership or a corporation.
  • A Single Member Limited Liability Company is an LLC with a single member, typically treated as a “disregarded entity” for federal tax purposes. That means there’s no separate tax form and income and expenses are reported on a Schedule C, just as with a sole proprietorship.
  • A C corporation is what most people think of when it comes to business. A C corporation files a federal form 1120 and pays any tax due. Shareholders also pay tax at their individual income tax rates for dividends or other distributions from the company (this is where the term “double tax” comes from).
  • A Professional or Personal Service Corporation is a corporation for certain occupations – typically service professions like lawyers, doctors, and architects.
  • An S Corporation is a corporation with tax treatment similar to a partnership. An S corporation files a federal form 1120-S which passes most items of income or loss to shareholders who are responsible for reporting that information on their individual tax returns.

(For more on business entities, check out this post.)

Corporate tax rates, like individual tax rates, are progressive. For 2017, corporate rates range from 15% to 39% (except for personal service corporations which are taxed at 35%) while individual tax rates range from 10% to 39.6%. While the brackets vary, the rates for individuals and corporations are pretty closely aligned.

The new tax law now provides for a flat 21% tax rate for corporations (the new tax rates for individuals are here). You can imagine how that could have been problematic without more changes: If companies were taxed at a lower rate than individuals, the pass-through scheme doesn’t work. But creating a new tax rate for the entities would take away the pass-through nature of the entity. Congress’ solution? Business income that passes through to an individual from a pass-through entity and income attributable to a sole proprietorship will be taxed at individual tax rates less a deduction of up to 20% to bring the rate lower.

It sounds easy but it quickly can become tricky since the deduction is subject to limits and restrictions. To understand those, you need some definitions:

  • Qualified business income (QBI). QBI is generally net income from your business without regard for any amount paid by an S corporation that is treated as reasonable compensation, any guaranteed payment for services in business, or any amount paid or incurred to a partner for services outside his or her capacity as a partner. You’ll use the “normal” rules when figuring QBI, so capitalize and amortize expenditures accordingly. One last note: QBI is determined on a per business, not a per taxpayer,  basis.
  • Qualified property. Qualified property is tangible property (typically, things you can touch) subject to depreciation and available for use in your business at the end of the tax year. You must use the property to produce qualified business income (as defined above).
  • Specified service trade or business. A specified service trade or business is any business involving the performance of services in the fields of health, law, 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 one or more of its employees or owners.” I like to think of it this way: if the success of your business depends on you and not on something that you sell, you’re pretty much included (except for engineering and architecture services, which were specifically excluded). The definition also includes a business where the performance of services consists of investing and investment management trading, or dealing in securities, partnership interests, or commodities.
  • Threshold amount. The threshold amount is the amount above which both the limitation on specified service businesses and the wage limit apply. The threshold amount is $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly. Phase-ins apply: that means that the benefit decreases as income increases.

Now that we’ve got those definitions down, here’s how to figure the deduction:

If your taxable income is below the threshold amount, the deductible amount for each of your businesses is simply 20% of your QBI with respect to each business.

  • So, if your income is $50,000 and your QBI is $40,000, then your deduction is $8,000, or 20% of your QBI. You’re under the threshold amount so no need to do any more math.

Easy, right?

If you are above the threshold amount, you are subject to limitations and exceptions which are determined by your occupation and a wage (and capital) limit.

Let’s look at specified service trade or businesses first. To figure QBI for a specified service trade or business, you take into account the applicable percentage of qualified items of income, gain, deduction, or loss, and allocable W-2 wages. When figuring the wage (and capital) limit, you’ll include total wages paid to employees during the tax year but not those which are properly allocable to QBI (in other words, don’t double count).

Here’s how it works: Figure 20% of your QBI (a) and compare that to an additional formula (b): the greater of 50% of W-2 wages with respect to your trade or business or the sum of 25% of W-2 wages + 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property. Don’t forget to take into account the applicable percentage rate – 100% less the excess of the taxable income over the threshold amount divided by the range amount or in more simple terms, it’s pro-rated for the amount you’re over the threshold.

  • So let’s say that you are a single taxpayer with taxable income of $200,000. Let’s also say that included in that amount is $100,000 in income from your law firm with applicable W-2 wages of $90,000.
  • For purposes of figuring the deduction, calculate the applicable percentage. The applicable percentage is 15%, or 100% less 85% [($200,000 – threshold amount of $157,500)/$50,000 = 85%].
  • Apply the applicable percentage to QBI (15% of $100,000 = $15,000) and W-2 wages (15% of $90,000 = $13,500).
  • After applying the applicable percentage, your deduction is the lesser 20% of includible QBI (20% of $15,000 = $3,000) or 50% of W-2 wages (50%  x $13,500 = $6,750), or $3,000.

If you are a specified service business and your taxable income exceed the threshold amount plus the phase-in range ($207,500 for individual taxpayers and $415,000 for married taxpayers filing jointly), then you lose the deduction completely. In that case, the old pass-through rules apply meaning you pay tax using your individual tax rate.

For all other businesses, if your taxable income exceeds the threshold amount, the wage (and capital) limits begin to kick in. The wage (and capital) limit applies fully for a taxpayer (other than a specified service business) when taxable income exceeds the threshold amount plus the phase-in range ($207,500 for individual taxpayers and $415,000 for married taxpayers filing jointly).

Before we do a deeper dive on how the phase-in affects the final numbers, let’s look at the wage (and capital) limit: the greater of 50% of W-2 wages with respect to your trade or business or the sum of 25% of W-2 wages + 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property. The addition of qualified property to the formula accommodates businesses which rely on the acquisition of capital, like real estate businesses. In other words, the “W-2 rule” under the Senate plan has been expanded to include wages paid plus capital.

Here’s an example of how the wage (and capital) limit is intended to work:

  • Let’s assume you have $5,000 in W-2 wages, and you buy equipment worth $200,000 and place it in service during the year.
  • According to the formula, 50% of W-2 wages = $2,500
  • And, according to second part of the formula: 25% of W-2 wages + 2.5% of unadjusted basis of the machine = $6,250.
  • The greater of the two amounts is $6,250: use that amount to figure your deduction. Note in this example that we’re aren’t figuring the actual deduction since we don’t have enough information, like total income or QBI. This is just an illustration of how you use the formula to determine the wage (and capital) limit when you have capital and W-2 wages.

If you sell the qualified property before year-end, it’s no longer available for use and is not used in the formula. It’s not yet clear under the law what will happen in circumstances such as like-kind exchanges or involuntary conversions – expect guidance from the Internal Revenue Service (IRS).

If you put QBI together with the wage (and capital) limit, you can figure your deduction. Remember that this only applies if you are over the threshold amounts.

Here’s an example of how the whole formula works together:

  • Let’s say you and your spouse file a joint return reporting taxable income of $350,000. Your business (not a specified service business) income was $75,000 and your share of W-2 wages paid by your business was $20,000. There is no qualified property.
  • Under the formula, (a) is 20% of your qualified business income, or $15,000.
  • Under the formula, (b) is 50% of W-2 wages, or $10,000 (since 25% of W-2 wages + 0 = $5,000 and you use the bigger number under the wage (and capital) limit part of the formula).
  • Since (b) is less than (a), the wage (and capital) limit applies and your deduction is reduced according to the phase-in. The applicable percentage is ($350,000 – $315,000 threshold amount)/$100,000, or 35%.
  • You’ll reduce the tentative QBI deduction of $15,000 (a) by the difference between (a) and (b) (or $5,000) times the applicable percentage of 35% ($5,000 x 35% = $1,750).
  • Your deduction should be $13,250 (or $15,000 – $1,750).

You should be able to deduce that the higher the applicable percentage, the more that the wage limit applies. Let’s switch up the numbers in the above example to have income of just $1,000 less than the top of the range:

  • The applicable percentage is ($414,000 – $315,000 threshold amount)/$100,000, or 99%.
  • You’ll reduce the tentative QBI deduction of $15,000 (a) by the difference between (a) and (b) (or $5,000) times the applicable percentage of 99% ($5,000 x 35% = $4,950).
  • Your deduction should be $10,050 (or $15,000 – $4,950).

And if you’ve reached the top of the range? The wage limit applies in full.
No matter which variation of the formula applies, your deduction may not exceed your taxable income for the year (reduced by net capital gain). If the net amount of your QBI is a loss, you’ll carry it forward as a loss to the next tax year.

And remember, these deductions from income reduce your taxable income on your individual return. It does not change how you calculate your taxable income inside your business. Business expenses remain deductible.

Got all that? Admittedly, I am relying on “easy” rules and examples for purposes of explanation. Additional rules apply to qualified cooperative dividends, qualified REIT dividends, and qualified publicly traded partnership income. Also complicating matters? Losses. If those items affect you, consult with your tax professional. Although, who are we kidding? Even if they don’t apply to you, you should consult with your tax professional.

And yes, there are a million “what ifs?” to be considered. Remember, this is just an overview. With respect to questions about the value of incorporating and other planning issues, there is no one size fits all answer but I will be following up with some general planning tips shortly.

And if you catch a math or other error, my apologies in advance. This wasn’t easy to work through and without further guidance from Congress or IRS, I am, like many of my peers, just doing the best I can.

Remember when we thought this was going to be simple?