Wouldn’t it be nice if the IRS said: “Hey, you don’t have to pay all your taxes anymore. 80% is good enough.”?
It’s absurd, but that’s exactly what the Tax Cuts & Jobs Act, which went into effect in 2018, did by introducing a new tax deduction under Section 199A.
199A created a huge new tax break for small business owners, partnerships, real estate investors, and contractors. But there was a lot of uncertainty initially due to seeming ambiguities and loopholes in 199A without clear guidance/regulations to address them.
Now, two years later, a lot has become clearer.
This week, I invited CPA Steve Nelson, whose tax blog I’ve followed for years, to chat with us about the details of how Section 199A works and the restrictions around it.
- Section 199A overview
- What counts as Qualified Business Income
- Key rules and restrictions of 199A
- Strategies for maximizing the 199A deduction
- How 199A might alter your retirement contribution strategy
- Special considerations for real estate investors (including why a 1031 exchange may no longer make sense with 199A)
- Special considerations for professional service partnerships (law, medicine, accounting, etc)
- Special considerations for freelancers and online business owners
- What happens to 199A after 2025
Are you currently able to avail Section 199A? If so, how has it changed your business operations and/or financial planning considerations, if at all? Let me know by leaving a comment.
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Links mentioned in this episode:
- Evergreen Small Business blog
- How the final Trump tax bill affects you: analysis for early retirees
- HYW private Facebook community
Read this episode as a post:
Andrew Chen 01:23
My guest today is Steve Nelson.
Steve is a Redmond, WA based CPA who writes about tax policy and tax strategies at his blog: Evergreen Small Business.
He is the best-selling author of “QuickBooks for Dummies” and also “Quicken for Dummies”
…and has written numerous other books about small business accounting and finance.
He’s also an Adjunct Tax Professor at Golden Gate University in San Francisco.
And he’s been featured as an expert on small business accounting and finance in the Wall Street Journal, CNN, and the Seattle Times, among other publications.
Super thrilled to have Steve on the podcast today. I’ve been a big fan of his blog for a long time and have learned a lot about tax from it.
I invited Steve today to talk about the Section 199A tax deduction, which was part of the Tax Cuts & Jobs Act that was passed and went into effect in 2018.
Now, this was a very consequential new tax provision that affects business owners, real estate investors, any type of contractor. And over the past couple of years, additional guiding regulations and a lot more clarity has emerged on how the deduction works.
So I invited Steve to come share some nuggets of wisdom on this with us today.
Steve, thanks so much for joining us to share insights and tips about Section 199A!
Steve Nelson 02:24
Thank you. I’m glad to be here.
Andrew Chen 02:26
I’d love to start just by learning a little bit more about your background.
How did you get into advising small businesses on tax and accounting matters?
Steve Nelson 02:34
I guess I got into my accounting undergraduate degree just because I was interested in business.
And one of the things that my accounting professors had told me, a secret, was that small business was exciting, profitable, a lot of really interesting things happening there. So I just got hooked.
After I finished my undergraduate degree, I went over to the University of Washington MBA program and, from there, started at a very large public accounting firm, but eventually pretty quickly moved back to serving small businesses and having my own firm.
Andrew Chen 03:07
You have one of the clearest, easiest to understand blogs that I’ve come across on tax updates and strategies.
I guess for fun, what is your secret for writing such easy-to-understand posts and communicating arguably dry but financially important topics in a simple, clear way, given the tax code itself can be really convoluted?
Steve Nelson 03:31
Thank you for saying that. That may be giving me too much credit.
But I think one of the things you want to do is really show a lot of respect for the reader, and make sure you really understand this stuff before you start writing about it.
Some of it is very hard for me to learn, and I can spend days or weeks trying to learn really how something works and then trying to figure out how to describe it in a way that makes sense to the taxpayer who is going to have to follow these accounting rules.
So mostly, I think it’s just taking the time and showing respect for the reader.
Andrew Chen 04:04
I would love to dive into 199A, but first let’s just start out with some basics.
The Tax Cuts and Jobs Act that went into effect in 2018 introduced this new tax deduction under 199A.
Before we get into some of the finer-grained details, just to orient folks, what is Section 199A and how does it work at a high level?
Steve Nelson 04:26
This almost doesn’t make any sense because it doesn’t follow any sort of logic.
But essentially, what Congress decided to do, because they were giving a break to big corporations, they decided that what they would do is, say, if you’re a small business or a real estate investor, that you got a break too.
And that break roughly goes like this: You just don’t have to pay income taxes on the last 20% you make in the business.
Just to make the math easy, if you make $100,000 in your business, they’re not going to tax you on $100,000. They’re only going to tax you on $80,000.
Andrew Chen 05:05
I definitely want to dive into some of the rules and constraints around this.
But first, the income that gets this tax break is, as you’ve written about on your blog, qualified business income.
What is considered qualified business income? What’s included and excluded?
Steve Nelson 05:32
That’s a key question and a little bit confusing, but the general rule goes like this:
It’s not income from a C corporation, a traditional big corporation. And it’s not investment income, interest on a bond, or dividends on a stock. But what it is is almost everything else.
The profit that a sole proprietor makes, that’s qualified business income. The rental income that a real estate investor earns, that’s qualified business income.
What’s called distributive share or the profit share that an S corporation or a partnership allocates to its owner, that’s qualified business income.
There also are the 199A deductions available for REITs and for publicly traded partnerships.
And there are even some special categories like agricultural and horticultural cooperatives that may generate 199A tax deductions for beneficiaries or for owners too.
Andrew Chen 06:42
So we’re not talking about W-2 income here, for sure.
Steve Nelson 06:45
No. And that’s a good point.
One of the mistakes you have is that there are things like W-2 income that an S corporation, a small business owner might pay to him or herself, but that’s not QBI.
Also, guaranteed payments that a partnership makes to a working partner, that’s not QBI.
One of the tricks here is to understand what QBI is and make sure that it’s as big a number as possible on your tax return.
Andrew Chen 07:17
On the partnership income, it sounds like salary-like partnership payments are not considered QBI.
But an equity-like partnership, like a profit share, for example, that would be considered. Is that accurate?
Steve Nelson 07:32
Yeah, exactly. If somebody is familiar with the way a K-1 works, the very first box on the K-1 that has a dollar amount in it, that is QBI. That’s qualified business income.
Andrew Chen 07:44
What are the most crucial restrictions or rules and constraints that folks should know about when it comes to claiming this deduction?
Steve Nelson 07:53
Maybe a place to start is that if you have an income that is below the phase-out thresholds, they give you a lot of flexibility and they don’t restrict you in any way.
What that means is that if you’re single and your taxable income is below $163,300 (this is in 2020) or married and your income is below $326,600, they just give it to you. They give you 20%.
But once you rise above that level, some rules start to click in.
One of the rules is that if you’re earning this income in what’s called a specified service, trade, or business, which should be a doctor, a lawyer, an accountant, a consultant, an investment advisor, a professional athlete, a celebrity, then they’re not going to let you use it.
There’s a phase-out range, but eventually you lose the ability.
The other thing is if you make over those thresholds I mentioned, what Congress wanted to do is they’re okay with people using that deduction, but they expect something in return.
What they expect in return is you provide employment to workers earning a living in the U.S.
They have a requirement that if they’re going to give you a $20,000 qualified business income deduction, they want you to have paid at least $40,000 to American workers.
So those are the two things. And actually, those two restrictions, one based on wages and one based on somebody not being in a specified service, trade, or business, operate together.
The other thing I would say is, unfortunately, it’s even a little more complicated than that because real estate investors don’t need wages. With real estate investors, it will actually look at wages and also the investment you’ve made in the property.
Andrew Chen 09:50
I want to double-click on some of those things.
Specified service, trade, or business. Is this an explicitly enumerated list, or is there a test?
Steve Nelson 10:02
No. That’s a good point. There is a list.
And I would say that if you think you might be in a category where you’re a specified service, trade, or business, this is foreign, but I think you want to go into the final regulations and read the small paragraph that describes whether the field you’re in counts as a specified service, trade, or business.
And there are a couple of things that are worthwhile noting about that.
One is that tax law uses definitions of specified service, trade, or businesses that are not the same as you might use if you’re in the business.
One example there would be you might be a physician and you might think that what you do in your clinical practice or your surgical practice counts as medical services and so is therefore a specified service, trade, or business. But it may actually not be a specified service, trade, or business.
You might, if you’re a physician doing physician things, think that 199A doesn’t work for you. But in fact, it may work for you.
Another category that is really misused by taxpayers is consultants. A consultant is, in the final regulations language, something very specific. It’s someone who provides advice or counsel or someone who does political lobbying.
And a lot of people who are contract programmers or developers call themselves consultants. But tax law uses a very precise definition.
So that’s something really to be cautious of. And we see a lot of mistakes that taxpayers and, I’m sorry to say, that some tax accountants make where they don’t really map what somebody’s role is to what the final regulations say counts as a specified service, trade, or business.
Andrew Chen 11:47
So it sounds like, for somebody who is unsure, they would have to read the relevant part of the regulation.
And it’s pretty clear, almost in a binary way, whether you fit. It’s not like an evaluative test that you would ask yourself a series of questions to determine whether you’re an SSTB. Is that right?
Steve Nelson 12:06
Yeah. I think in most cases, that will be true.
Just to use another example, a celebrity or a performing artist is considered a specified service, trade, or business. But it’s very clear what sort of fees count as or trigger specified service, trade, or business.
The one thing I would say is that in some categories, and physicians are one of these categories, what the final regulations say is you’re a specified service, trade, or business if you provide medical services.
But what you need to do is, if you’re going to read that and you’re a physician, you need to know what tax law considers medical services because it’s different than what you as a physician will consider medical services.
The classical example is cosmetic surgery is not a medical service. Somebody who does cosmetic surgery may not be a specified service, trade, or business, even though clearly they would think of themselves as providing medical services.
Andrew Chen 13:09
And would therefore, in that case, potentially be able to avail deduction. Is that correct?
Steve Nelson 13:15
Yeah, I think so. That would be a tax position that a tax accountant and a taxpayer would want to take carefully. And I think it’s something that they would want to disclose on a return and document the rationale.
But I think that’s the case.
The rule for medical services is that medical services are things that lead to valid medical deductions on Schedule A.
But it turns out that by terms of the statute, cosmetic surgery is not a medical deduction. Therefore, circularity there is that it’s probably not a medical service if you’re providing certain kinds of cosmetic surgery.
It depends. You have to look at the rules. But those can be some big numbers and some big errors if people aren’t on top of that.
Andrew Chen 14:05
In terms of the phase-out, as I was both reading posts you’ve written about this as well as hearing your explanation, it sounds like there’s three discrete buckets that a taxpayer may fall into for purposes of 199A.
One is they’re entirely under the threshold where the phase-out even begins. The second is they’re in the middle, between where the phase-out begins and the phase-out ends. And then the third is when they’re above where the phase-out even ends.
I think some of those are clear. If you’re below the starting point, you basically can take the deduction without much restriction.
My question was, you mentioned for business owners and for real estate investors, once you start exceeding these numbers, Congress wants something in return, like job creation, etc.
Does that kick in in the middle bucket or only after you bust above the end of the phase-out?
Steve Nelson 15:00
That’s a great question.
If we look at the phase-out range for just a single person, these are indexed for inflation, as noted earlier, but in 2020, once you start moving above a taxable income of $163,300 (and let’s assume it’s not a specified service, trade, or business), Congress has a rule.
And the rule is “We care about the wages your business pays.”
At $163,300, they don’t care if you have wages. But at $213,300, they’re going to say, “You get the lesser of either 20% of your qualified business income or 50% of your wages.”
And then what they do is you move from $163,300 to $213,300. They phase in that requirement to have wages.
Here’s what I think about it. If you happen to find yourself at the exact midpoint between those two endpoints of the range and you had no wages, you would lose half of your 199A deduction.
You wouldn’t get 20%. You would only get 10%.
Andrew Chen 16:17
What would it be if you were in the dead center of that range but you were fortunate enough to be able to fully max out your 199A deduction just on the strength of the wages alone?
Would that mean that you would get the full deduction?
Steve Nelson 16:37
Yeah, you will get the full deduction.
If you’re not constrained by your wages or limited by your wages and you’re sitting at $25,000 into that $50,000 range, you’re going to get your full deduction.
Andrew Chen 17:02
And then once you’re above the upper end of that threshold, then it’s no longer about your QBI, it sounds like. It’s really just about the 50% of wages or…
Steve Nelson 17:16
No. I’m sorry, I didn’t do a good job there.
Once you’re above the limit, what happens is, say you make a million dollars, just to make the math easy. Your QBI deduction is going to be 20% of a million dollars, $200,000.
But there’s a little check on the formula that says, “But to get that $200,000, your business needs to have paid at least $400,000 in wages.”
Andrew Chen 17:43
Gotcha. So even above the second threshold after the phase-out, you could still get the full deduction but subject to that check.
Steve Nelson 17:55
So what happens is that as you move through that phase range, the wages become more and more essential. And finally, at the top and beyond, your deduction will be the lesser of 20% of your QBI or 50% of your wages.
Andrew Chen 18:20
I understand that there’s an additional rule around you get the lower of 199A or 20% of your taxable ordinary income. I was wondering if you could talk a little bit about how that works.
Steve Nelson 18:37
That’s an important thing to keep an eye on.
Just to make the math easy, you might have $150,000 of qualified business income, but if you have $50,000 of deductions, your taxable income might be only $100,000.
So your QBI deduction is going to be the lesser of 20% of the $150,000 of business income you have or 20% of the $100,000 of taxable income that you have, which should be less. One number is $30,000 and one number is $20,000.
That suggests that, in some cases, what you want to do is, paradoxically, you want to think about letting your taxable income creep up because it will allow you to take a bigger QBI deduction.
Some investment advisors, and I think Jeffrey Levine, who is a well-known CPA and investment advisor and writer, has pointed out that a person might want to think about not using their 401(k) and instead use a Roth 401(k) because that will mean they have a higher taxable income, and that might mean they get a bigger QBI deduction.
Andrew Chen 19:54
That does make sense.
Effectively, you get the benefits of the Roth because it’s tax-free thereafter, but you might still get some deductions. You get a little bit of the benefits of a traditional 401(k), but you’re just doing it through the 199A vehicle.
Steve Nelson 20:10
Andrew Chen 20:14
Let’s say I have a W-2 job but I also have a side hustle, and that side hustle is doing pretty well. And that side hustle is actually a legit small business that I could take a QBI deduction.
Does that mean that I as a taxpayer am now having to do two analyses? I have to do an analysis on my side hustle QBI, and then I have to do an analysis on my job W-2 income to figure out which is the lower (my taxable income from the job or my QBI) before I know the number I can take?
Steve Nelson 20:42
No, because in that situation, if you have someone who has a $100,000 W-2 and a $100,000 side hustle, what’s going to happen is they’re going to get a QBI deduction tentatively equal to 20% of the $100,000 they make in their side hustle. That’s the way it will work.
And then the question is if their side hustle business has no wages and they’re above the threshold, they may lose part of their deduction because they don’t have wages in their side hustle.
That’s the situation where if that was a married couple, $200,000 is going to be below the threshold where they begin to lose the deduction. But if you were a single person, you would have lost a lot of your QBI deduction because you’d be so close to the top of the phase-out range, that middle bucket you were talking about.
Andrew Chen 21:41
Well, let’s say they were married. To set aside for the moment the complexity of the phase-out range, if that didn’t apply, then am I doing two analyses: one on my W-2 and another on my side business?
Steve Nelson 21:55
No. It will be easy.
In that case, what will happen is, say you’ve got $100,000 W-2 income and $100,000 side hustle income, you’re just going to get 20% of the side hustle income, so you’re going to get a $20,000 QBI deduction.
And you’re not going to have to worry about W-2 wages there.
Andrew Chen 22:16
So what does it mean, then, the constraint that says you would get the lower of the two? Where exactly does it kick in?
Steve Nelson 22:24
Good question. Just to make this easy, the wages become important once you begin, as a single person, to have a taxable income of more than about $163,000, or once you’re a married couple and you have a taxable income of more than $326,000.
As you raise above that, you quickly ramp up to a level where (sorry to give you these numbers out here) at $213,000 or at $426,000, you get the lesser of 20% of your QBI or 50% of your wages.
Andrew Chen 23:04
I see. I could have sworn there was some rule that there’s almost like a third check, which is that you’d get the lower of your 199A deduction or 20% of your taxable ordinary income.
Steve Nelson 23:19
You do. Your QBI deduction is going to be 20% of your QBI but not greater than 50% of your wages. And you also can’t take a QBI deduction that’s more than 20% of your taxable income.
Andrew Chen 23:39
Back to my example of the $100,000 side hustle and the $100,000 W-2 income, married couple. They’re below the married joint filing phase-out range where the phase-out range even begins.
Does that mean that they’re having to compare 20% of their taxable income against whatever their 199A deduction ended up being and taking the lower of the two numbers?
Steve Nelson 24:03
Yes, but it turns out probably not to be much of a problem.
Let’s think about this and just keep really round numbers.
Say we’ve got a couple, and one person has a W-2 with $100,000 on it, and the other person has a side hustle or their principal hustle and they make $100,000.
What they would get is they would get 20% of the $100,000 or 20% of their taxable income.
But what might be a common scenario is they’ve got $50,000 of deductions, so they would get the lesser of 20%.
Again, we’ve got $100,000 W-2, $100,000 side hustle, and $50,000 deductions. Their taxable income is $150,000.
So they’re going to get the lesser of 20% of $150,000 or 20% of $100,000.
I think the thing that shows up is that if you have a W-2 in a couple or in a household on a tax return, the W-2 is going to mean that your taxable income is above your QBI.
Another way to say the same thing. Your tax deductions are probably not going to be bigger than your W-2.
Andrew Chen 25:17
Makes sense. Great.
So 199A really applies to small business owners, partners in a partnership, contractors. But most people work in jobs as W-2 employees.
Why don’t employees just call themselves contractors or sole proprietors to take advantage of this?
What provision or what part of 199A prevents them from claiming the QBI deduction if they just went ahead and did that?
Steve Nelson 25:52
Good question. In fact, I think the early version of the law led people to believe that you might be able to get QBI deduction on your wages, and they fixed that in the regulations.
The other thing they’ve said is that if you have been an employee and then somebody waves a magic wand and now you’re a “partner” or you’re a “contractor,” that’s got to be a real deal.
And in the case of a former employee becoming a partner, it’s got to be something that’s pretty standard in your industry. You can’t just misclassify people.
If you were an employee and now you’re an independent contractor, the presumption is that’s not QBI income. You’ve just misclassified the employee.
The regulations should prevent you from doing that.
Andrew Chen 26:50
Are there are any general rules of thumb or heuristics or tips or strategies that you would advise taxpayers to keep in mind in order to, other things being equal, maximize their potential 199A deduction?
Steve Nelson 27:07
Yeah. First of all, and we hit on this at the very start of our conversation, you really want to do things to maximize your qualified business income.
And there are a lot of partnership returns that mistakenly classify distributions to partners as guaranteed payments when really they’re just distributions. And those partnership returns that have been prepared incorrectly, it used to not matter.
But with 199A, those incorrectly prepared partnership returns destroy the 199A deduction. So you’ve got to make sure the returns are done well and that you’re not doing things to damage or understate your QBI.
And then the other thing to remember is that these phase-out rules kick in based on your taxable income essentially.
People have assumed something like a doctor or a lawyer, an investment banker, or whatever making $500,000 a year, she or he doesn’t get the QBI deduction. And that’s potentially true.
But if that person is married to a spouse who is a real estate professional and who, on paper, loses $200,000, it doesn’t matter that they make $500,000 in their specified service, trade, or business. Once the spouse, on paper, loses money, it pushes them below the threshold.
In that case, there’s an example where they won’t get 20% of the $500,000 of QBI, but they’ll get 20% of maybe the $300,000 of taxable income.
So those opportunities need to be carefully watched because it’s easy to miss this and operate with some ignorance. That means you lose out on huge tax savings.
Andrew Chen 28:47
Those are good tips.
Are there any other things that folks should keep in mind?
Steve Nelson 28:52
We talked about the one that you really want to make sure that you’re not unfairly labeling yourself a specified service, trade, or business.
You want to be sure that if you have a very successful sole proprietorship and you’re making an income that would mean you need wages, even a one-person business should often operate as an S corporation just purely to get wages.
Now, just to make the math crazy, if you were some high-powered real estate broker and you’re making a million dollars a year (I’m just being crazy there), you’re not going to get a Section 199A deduction.
But if you reform your business as an S corporation and pay yourself (the right number would be $280,000), you’re going to get $140,000 QBI deduction.
So even though you’ve only really just bifurcated your million dollars of profit into wages and distributive share and it’s playing a shell game, you’re able to, by creating somewhat imaginary wages, get yourself a 199A deduction.
Andrew Chen 30:00
In that case, you would get it because you’re actually getting the 50% of wages.
Steve Nelson 30:07
Yeah. Instead of paying yourself a million-dollar sole proprietorship profit, if you reform that as an S corporation, pay yourself $280,000 of wages and $720,000 of distributive share of qualified business income, you would get 20% of $720,000, which would be $144,000, or 50% of $280,000, which would be $140,000.
So that would be the optimal number.
Andrew Chen 30:30
Sounds like you’ve used this example before.
Steve Nelson 30:35
Andrew Chen 30:38
I’d love to talk a little bit about how 199A interacts with retirement planning.
I know you’ve written some posts in the past about how 199A can alter the cost benefit analysis for retirement planning (you even alluded to this a few moments ago) when it comes to contributing pre-tax money to a 401(k) or an IRA or doing it to a Roth 401(k) or doing a Roth conversion.
Can you talk a little bit about how 199A can change retirement planning considerations?
What type of taxpayers should be thinking carefully about the interaction between these two things? What are the markers of that taxpayer?
Steve Nelson 31:16
That’s a good question. I would point people to consider three issues as they think about 199A in the context of retirement planning.
One is that if your 199A deduction is limited because of your taxable income, as noted earlier, you may want to think about not doing a traditional IRA or not doing a traditional 401(k) and instead doing a Roth version, because that will bump up your taxable income and that will bump up your QBI deduction.
That would be one thing to think about.
Another thing to think about (and this is the same thing but a little bit different) is that if you’re somebody who has got a $40,000 tax deduction on your return due to QBI, you can just put that deduction on your return and you can save $10,000 or $15,000 in tax.
That’s good. You can use that money to do whatever you want to do with it.
But one of the things I’ve suggested to people, we’ve got historically low tax rates. Maybe what you should do, if you’ve got a $40,000 bonus deduction on your return, maybe you should, in essence, do the mental accounting and use that to shelter a $40,000 Roth conversion.
You’re going to use your deduction strategically to move money from a tax-deferred account to a Roth account. I think that’s worth people thinking about.
The other thing I think that’s a little bit thought-provoking is to think about whether this changes your asset location decision.
If you have taxable money, qualified dividends and long term capital gains are the most favorably treated taxable income. But if you’re only paying tax on 80% of the REIT dividends or 80% of your rental property, that’s pretty attractive too.
So I think if somebody did have an interest in real estate or wanted to have an allocation to their REIT, it’s not crazy to think about doing that in a taxable account.
It’s not clear. It’s not like you should put it in a taxable account. But it’s less crazy than it used to be given that you’re only going to pay tax on 80% of that real estate income.
Andrew Chen 33:45
So what’s the best course of action that somebody who is contemplating their asset location decision for them to get further clarity on that without becoming a CPA themselves?
Steve Nelson 34:04
I would say that I’m not a hardcore Roth fanatic. I think that they’re often overused.
But I think your first money should be in your tax-deferred account. And I think your bonds should be in your tax-deferred account.
And then if you are going to have a taxable component, I think you should have, in my philosophy or the thing I ascribe to, stock equity index funds in my taxable account.
And then if I still had more money that I needed to invest, I would consider doing real estate.
I would definitely do direct real estate in a taxable account, but I would consider doing REITs in a taxable account too if I had more space in my taxable area and I hadn’t filled it up with stock equity index funds.
Andrew Chen 35:03
Wonderful. I’d love to talk a little bit about real estate investors in particular.
What are some of the 199A issues and considerations that rental property owners and investors should know about? In particular, I wonder if you could speak to two different personas.
The first one being the casual real estate investor who may own multiple properties, but they still have a full time day job. And they’re not like real estate professionals in the IRS.
Steve Nelson 35:33
The first thing I would say, and I know you’ve been alert to the safe harbor issue with the 199A, but let me back up and say this. In order to use 199A, the activity needs to rise to the level of a trade or business.
One of the questions is if you’ve got a rental or two or three, does that rise to the level of a trade or business? It needs to to allow you to escape tax on that last 20% of the income you make.
So that’s the question. Lots and lots of confusion about that from taxpayers. And those of us who are trying to figure this out were scratching our heads what they meant.
What they came up with was a couple of rules. One of the rules is that it was a safe harbor that if you could accumulate or people working on your property accumulated 250 hours, then that was going to be enough.
I think those of us who are grizzled tax practitioners thought that was nonsense.
What most of us would say is forget about the safe harbor. What you want to do is qualify under what’s called the Section 162 standard, which is, does your activity rise to your level of a trade or business?
And that has three requirements.
One is that you’re motivated by profit. Clearly, if you’re out buying rentals to build your wealth and prepare for retirement, of course you’re motivated by profit.
If you accidentally were renting a bedroom to your nephew or something like that, that’s not profit-motivated. But if you’re seriously out buying rentals, it’s profit-motivated.
And then you need to be involved in the activity with continuity and with regularity.
I did an analysis of this probably a couple of years ago where we looked at the court cases that the IRS and tax court and federal courts had said rose to the level of a trade or business. And it was very easy to qualify.
If you’re doing something a dozen times a year, if you’re engaging in it year in and year out, there are a lot of cases where just because you’re small doesn’t mean you’re not serious about it.
I think you get 199A on those small real estate portfolios. That’s very clear. So that’s one thing to think about.
The other thing that’s a little bit of a wrinkle here is those phase-out levels that we’ve unfortunately had to discuss a couple of times here, they apply to real estate investors too.
But the real estate investor rule works a little differently. There, what it says is that the QBI deduction either equals the lesser of 20% of your QBI or 25% of your wages plus 2.5% of the purchase price of the building.
So you have to be a little bit alert that if you get your income real high, it’s not a completely wage-based thing, but they’re going to look at the value of the building.
Just to make this easy, if you have no wages and you have a million-dollar apartment, your maximum QBI deduction is going to be $25,000, 2.5% of a million dollars.
Andrew Chen 38:41
So it sounds like you don’t need the 250 hours if you have that continuity and regularity and profit motivation.
That is enough to claim QBI even if you only have a handful of properties. You’re a casual real estate investor.
Is that accurate?
Steve Nelson 38:58
Yeah. I think that is absolutely clear.
I think the sort of person who is going to have trouble as a rental investor (I’m just making this up now, but cloning previous court cases) somebody who was a college professor and went to Europe to do a sabbatical or teach a course in the summer, and for three months, they rented their house.
That’s not a trade or business.
Or somebody who, for some reason, they had a spouse transferred, so they’re going to leave town for six months, and they find themselves an accidental landlord for nine months.
That’s not a trade or business.
But if you’ve got a rental property that’s part of your retirement plan, or two of them, that absolutely is going to rise to Section 162 trade or business. You do not need to show very much regularity or continuity.
But it’s got to be a real business. But I think a lot of people are going to qualify for it.
Andrew Chen 40:03
I think what I’m interpreting from that is that even a single property owner, as long as they intended it to be for retirement purposes, etc., even that would qualify. Is that accurate?
Steve Nelson 40:14
Yeah, I think so. And you said them just a minute ago.
Are they profit-motivated? Clearly, they are.
Is there continuity there? If they’re renting it year in and year out, absolutely.
Is there regularity in their activity? They’re collecting a rent check every month and they’re regularly getting over there to check on the property. And as much as they don’t like it, they’re occasionally over there doing repairs.
They’re profit-motivated. They have continuity. They show regularity.
They meet the Section 162 standard.
Andrew Chen 40:46
And that would be true even if there might be a period of months that go by when they’re not engaged in the business because, actually, the rental is operating smoothly, there are no problems with the tenants, etc.?
Steve Nelson 40:56
The thing I would say is if you had a small consulting business where you were just doing a little bit of consulting and you made $5000 a year, you’re going to qualify for Section 162 even though your profit is $5000, even though it’s just a couple of weeks of 1099 contract work to do, or whatever.
So this is going to work the same way. This was designed to be something for small businesses and for small real estate investors, so I think you’re going to get there with very low threshold.
Andrew Chen 41:35
I think I know the answer to this, but I’d just love to hear you say it.
If I’m house hacking, I live in a multifamily property, living in one unit and renting out the others, that also should qualify. Just because I live there doesn’t take away from the fact that I’m treating the other units as profit-motivated and continuous and regular.
Steve Nelson 41:52
Absolutely. If you had a duplex, and one is your house and one is your rental, clearly, the fact that you’re living next door is going to show continuity because you’re not just doing this on the willy-nilly.
If you had a fourplex and you’re living in one and renting three, or triplex, absolutely.
Andrew Chen 42:10
As a taxpayer, how do I document this?
Because I don’t recall ever filling out a form that’s saying “Yes, continuous and regular. Yes, profit motivation.”
But I could get audited. And if I’m doing my taxes myself with TurboTax, how does TurboTax know this?
Steve Nelson 42:33
The safe harbor rules, which I’m encouraging people to discard as useless, they have some record keeping requirements. You probably want to keep some sort of near-contemporaneous log.
Which is awkward because you needed to have a log from before they even required the safe harbor, so they have some rules about that that you don’t need a contemporaneous log before the safe harbor rule existed.
But I think your profit motive, continuity, and regularity thing, I don’t think you need to have much documentation for that, as long as you can pass the giggle test.
Again, if this is some deal where you were renting an extra bedroom to your nephew, or you were an accidental landlord for a few months, those things are not going to work.
But if you’re buying rental properties and working on them and it’s part of your wealth plan, I think just the essential facts of the situation are going to support you taking the QBI deduction.
You meet that Section 162 standard of your activity rises to the level of a trade or business.
Andrew Chen 43:39
If I was doing my own taxes, though, how would I convey that to TurboTax?
Because I don’t think TurboTax asks, “Are you a 162 trade or business?” They try to infer that based on a questionnaire that they walk you through, right?
Steve Nelson 43:51
Yeah. I don’t know TurboTax because I don’t see it very often because we’re using industrial strength software for this.
But in the professional software, what you do is you mark your rentals as being qualified business income. And there must be a box you can check to indicate that it’s qualified business income. So I would look for that.
Andrew Chen 44:16
Got it. If you are looking to the safe harbor because you qualify, like if you have more than half a dozen properties, it’s very conceivable you might be spending 250 hours a year through you and your agents, contractors, etc.
In terms of record keeping requirements, it sounds like there is some. You mentioned these contemporaneous logs.
What format does that take? Is that just me putting lines in Excel?
Steve Nelson 44:43
I think that’s what you’d want to do.
Because I’m militantly anti-safe harbor, I’m probably not the best person to review the details, and I’m sorry about that.
But I would read the safe harbor. I think it’s a notice that has the safe harbor rules. And they start up when they issue the safe harbor rules because we were already well into 2018.
But you should keep track of that.
By the way, I don’t mean to grouse about the safe harbor rule, but that 250-hour limit includes hours spent by your contractors. I don’t know where in the world you’re going to get that information if you’re going to expect the repair guy or the kid who mows your lawn to track those, but I guess you will.
Andrew Chen 45:29
Why are you so anti-safe harbor? I’m just curious.
Steve Nelson 45:35
First of all, I think, like many of these safe harbors, it is way beyond what Congress required and what the Treasury regulation writers required, which is, you can hit the trade or business level probably with 10 hours a year or 20 hours a year or 30 hours a year.
Again, profitability, continuity, regularity.
So the fact that they created a safe harbor that was 250 hours might be 10 times the hours. That seems just like dirty pool to me.
The other problem I have is (maybe I shouldn’t say this, but) if I have an auditor come out and she or he is thinking safe harbor, and they’ve got in their mind they’ve now anchored their assessment on 250 hours, I may have difficulty convincing them that somebody that only spends 50 or 100 hours meets the 162 standard.
And yet clearly, I can point to a list of a dozen court cases where the court is accepting those lower hour levels. You don’t need to have 250 hours to be a trade or business.
By the way, there’s no 250-hour limit when they say you’re subject to self-employment tax on consulting income. There, they say you’re in a trade or business if you make more than $400.
So I think the 250-hour safe harbor rule was bad rulemaking.
Andrew Chen 47:03
The second persona I’d love to get your thoughts on is what 199A considerations should a real estate investor be aware of and know about if they’re a fulltime professional real estate investor who doesn’t have another day job besides real estate investing?
This might be somebody who has many rental properties, maybe a strip mall or two, etc. And their rental income is that is their business.
Steve Nelson 47:33
That’s a good question.
Those folks are not going to have any problem calling their thing a qualified business and their income qualified business income. So they’re going to get the deduction.
The one actionable insight I have for those people is we don’t know how long this 199A thing is going to be around. It’s scheduled to sunset in 2025.
Who knows what’s going to happen? But the democratic candidate for president has talked about extending 199A for people that make less than $400,000, so maybe it will be around.
But because you don’t know whether it’s going to be around or not, and because tax rates are at really pretty low levels, I think if you’re a real estate investor, you allow your income to be higher these years and you don’t do things that pull depreciation into these low tax rate years.
You keep your taxable income and you keep your QBI income big. That gives you a big QBI deduction. And then you save things like depreciation deductions for the future.
If you can use QBI deductions, I would not be inclined to do cost segregation and put giant depreciation deductions on these years’ returns because I figure, “Well, I can take the depreciation and save taxes later probably when rates are higher.”
Right now, the opportunity is to have a big QBI deduction.
Andrew Chen 49:02
You wouldn’t be able to decelerate depreciation beyond linearly, right? That would be the default, if you didn’t take advantage of any accelerated methods?
Steve Nelson 49:11
Yeah. What we see some real estate investors do, and this is a hack, is that you can use cost segregation to pull a bunch of stuff onto the first year. You place something into service.
If you bought a condo or a single-family home and the building was $275,000, normally what you’d do is you’d depreciate that $275,000 over 27 and a half years and it would be at the rate of $10,000 a year depreciation. So that would be slow.
But if you use cost segregation, you may be able to desegregate that $275,000 into $75,000 of furniture and fixtures, and then $200,000 of property.
In that case, what you’ll be able to do is you may be able to write off that $75,000 in year one. So I would not do that kind of stuff now.
Another related comment, and not to chat around too much about this, but I would be cautious about doing like kind exchanges now.
There’s a part of me that would consider recognizing income now, paying tax on it now, bumping up the bases, having lots of bases, and having more depreciation for later on.
Andrew Chen 50:32
Yeah, that makes sense. I want to come back to the 1031 thing here in a moment.
But just to close out on the depreciation point, it sounds like the basic philosophy is a bird in hand is worth more than two in the bush, because you know that the deduction is available now.
If you don’t do cost segregation, I can’t push my depreciation lower than it would be just with regular depreciation, which is just linear depreciation. There’s no technique that I have that can push that potentially to zero.
Basically pick and choose which years I want to take the depreciation. I can’t do that, right?
Steve Nelson 51:12
No, you can’t. People do do that in error, but you’re not supposed to do that.
That would be incorrect. I’m not going to say that, and you’re not going to say that.
But you’re right. That $275,000 house, there’s no way.
The lowest number you can do is $10,000 a year. You can’t get any lower than that.
Andrew Chen 51:31
If I start with linear depreciation, can I later choose to move to cost segregation? Or is that a one-time thing upfront? I have to make that choice right away?
Steve Nelson 51:39
You can probably do that. You basically have a cost segregation study done at some point down the road, and you do an accounting method change and fix your depreciation error. People do that.
And that might mean that in five years, you realize that you’re going to stop using just the $10,000 a year on the $275,000 condo or whatever.
Andrew Chen 52:06
And then in terms of like kind exchanges, because real estate investors’ interaction with 199A is throttled by this 50% of wages plus 2.5% of depreciable basis constraint that you mentioned earlier when you start to bump up against those phase-out thresholds…
If I was an investor at the verge of selling property and I had the choice to do a 1031 exchange or just sell it, pay the capital gains taxes, and rebuy another property, if I do the 1031 method, is that 2.5% being deducted from this lower, transferred basis?
Because that’s all I can depreciate going forward if I did a like kind exchange, right? So is my 2.5% restricted to that, or is it on the whole purchase price?
Steve Nelson 53:01
First of all, let me say that the way the wage-based limitation works is that you actually get a choice, just to make a typo correction here.
Tentatively, your QBI deduction is the lesser of one of these three numbers: 20% of your QBI or 50% of your wages or 25% of your wages plus 2.5% of the unadjusted basis of the property.
When you look at the property, that calculation is 25% of wages plus 2.5%.
When I think about this, I think there is a way to wriggle into or weasel into a higher basis.
Number one, you do like kind exchanges.
But I think that’s right. You may find yourself doing things where you don’t get the QBI deduction that you wanted to get because your QBI deduction is limited by your adjusted basis.
Here’s the way to think about it. Like kind exchange doesn’t reduce your taxes. It just delays your taxes.
If a like kind exchange means you lose QBI deduction, you have lost tax savings. And whether the loss of tax savings is compensated for by the deferral benefit would be a question.
But I would think, in many cases, those savings are true savings from QBI. You don’t want to be losing QBI deductions probably.
Andrew Chen 54:49
I see. So it sounds like if you are in the bucket that is considering the 2.5% depreciable basis, the textbook way to do it would be using your adjusted transfer basis, but there might be some wiggly things that you can do to raise it.
But then you might find yourself in tax court where you’re having to defend this. Is that correct?
Steve Nelson 55:11
I don’t think you’d be in tax court. But I think there is.
I had a colleague point out to me that he read the regs and he thought you could weasel your way into a higher basis. I’m sorry, I don’t remember the details.
It’s a 248-page set of recipes for how to do this. There is some language in there about like kind exchanges.
Andrew Chen 55:38
And when you’re evaluating whether to make the selection, you were saying 1031 only lets you defer. It doesn’t exempt you from taxes.
So if I was a real estate investor (I just want to run this by you as a temperature check), I would analyze it. I would try to model it out both ways.
I would model out the scenario where I just sell the property outright, consider what capital gains I’m paying (that’s cash outflow) versus the QBI I get (that’s the cash inflow), and what is the net of that, what is the offset of that, versus where I do the 1031 exchange and I don’t have to pay taxes right away.
I have to think about some time value of money considerations when I might actually liquidate that. Or if I don’t ever plan to, and maybe at my death, I get a step up in basis.
But then that’s going to be a lower QBI, and that’s forever, at least through 2025 which is the known time period, and then I’d take a probabilistic assessment about the likelihood it’s going to survive past 2025.
Is that, high level, the way you would evaluate these two sides?
Steve Nelson 56:49
Andrew, I think that’s exactly right. I think that’s exactly what you try and do.
And just to underscore something that you referenced, I think you want to think about it’s not for sure, so you have to think about it probabilistically. “How do I want to weigh these things?”
And then one thing I know you know, but I’ll just mention it because I have an obsessive-compulsive personality, is it might be that rates are higher. We may be avoiding low capital gain rates today and we may be paying them later on.
I’m not someone who can predict tax law changes. I don’t know anybody who can really, but there’s also the question about whether they eliminate the step-up in basis, the Section 1014 rule.
So there’s a lot of uncertainty once you start trying to push out very far, which is why I go back to the idea that I wouldn’t want to thoughtlessly give out QBI deductions today when it’s real money, real savings.
Andrew Chen 57:49
Frankly, I don’t know anybody who could really do the analysis between these two options in a really rigorous way because there’s so many variables around whether you think the deduction is going to survive or not, what you think tax rates are going to be in the future.
Or your point about is there going to be a step-up in basis? Is that going to continue unaffected?
What is one to do in that scenario?
Because you don’t want to make it randomly. It does have real consequences. But it’s almost an unknowable answer.
Steve Nelson 58:24
Yeah. And that’s why I would probably err on simplicity and not doing the like kind exchange and take the QBI deduction and enjoy the QBI savings.
I’m sure the 1031 aficionados will, if they find a way, share with me their displeasure of me saying that.
Anyway, that would be the way I would think about it too.
Andrew Chen 58:51
Let me ask a little bit about partnerships.
What are some of the key issues and considerations that owners of professional services, partnerships, and practices, like law firms, accounting firms, medical practices, should know about?
I know we talked a little bit about this before. They’re SSTBs.
I’m just curious. Is there any strategy or technique or scenario where they can avail the 199A deduction even after they exceed the phase-out thresholds? Or are they pretty much out of luck?
Steve Nelson 59:17
No, they’re not out of luck. In fact, it’s really good to raise this point because there are a couple of things to realize.
First of all, many professional service firms destroy any possibility of getting a QBI deduction.
You’ve got a guy, man or woman, making $500,000 a year as a physician or a partner in a big law firm. What they do is they extract that money as a guaranteed payment.
Some of it is health insurance. And then they have a little bit of box one, what’s called distributive share.
By the way, I’m intentionally using a big number because that’s when the SSTB stuff would kick in.
You make $500,000 a year. You might think that potentially you have $500,000 a year of possible QBI. But if you pay out $400,000 of that as a guaranteed payment, that guaranteed payment is not a QBI.
I said this early on and some people thought I was being really aggressive. And then I think everybody else or many other people who had been critical thought it worked.
I said partnership agreements should have been written in early 2018 to eliminate guaranteed payments, and what they should have been replaced with was special allocations and distributions.
So you would still pay the $400,000 out to the woman who is the doctor or the man who is the attorney, but it wouldn’t be a guaranteed payment. It would be a special allocation and a distribution.
So that’s critical.
And here’s the other thing about this. As I know from personal experience serving these categories of taxpayers, you’ll have partners say something like “Well, nobody here is going to get QBI deduction because everybody is making way over that $426,000.”
“It’s not relevant to us. We’re not going to worry about it.”
But the problem is (and all CPAs know this) there are a number of power couples where you have one spouse who, for example, makes $500,000, and if the other spouse, because they’re a real estate investor, on paper, “loses” $200,000, then suddenly they’ve pushed their income down below the threshold where SSTB status matters.
If the partnership agreement is written correctly, they’ll get a $60,000 deduction on their return.
That’s something else to realize as you’re doing this. You can push your income down to the level where being a specified service, trade, or business doesn’t matter.
One other thing I’ll just mention is that a lot of these firms, what they’re doing is a specified service, trade, or business. But there are also situations where you may think of yourself as a lawyer, but it may be that you practice law but you also do continuing legal education.
If you’re doing continuing legal education and that’s a thing you do, that’s probably QBI even if you practicing law isn’t qualified business income activity.
So you need to have your accounting system sophisticated enough that it will segregate what they call “separable books.”
If you can break your accounting into the QBI part of the business and the non-QBI part of the business, you can find yourself with a QBI deduction even if you think of yourself as a lawyer or a doctor or some specified service, trade, or business.
Andrew Chen 1:02:43
And that’s because the analysis the IRS is doing compartmentalizes the continuing legal education service that you’re providing. It’s not considering you SSTB for that purpose. Is that correct?
Steve Nelson 1:02:59
Yeah. There’s some complicated rules.
If you only have a little bit of non-SSTB activity, you ignore it. And if you only have a little bit of SSTB activity, you ignore it.
Then if it’s more significant, what they let you do is, as long as you can separate this, you should be able to break it apart.
Another example would be an eyeglass doctor. If you’re an optometrist or what the eye doctors are called, you’re going to be a specified service, trade, or business. But if you can break out the sale of prescription lenses, that’s not an SSTB.
Andrew Chen 1:03:38
I see. I think the takeaway I’m hearing (and please correct me if I’m wrong) is that if you’re in one of the professions that would otherwise be an SSTB, your primary strategy is to try to structure your payments in such a way that you are pushed below the phase-out thresholds.
But in the most optimal case, you’re exactly right at the phase-out threshold, so you’ll get the full extent but don’t suffer any from being an SSTB. Is that correct?
Steve Nelson 1:04:06
Yeah, that’s true. And to summarize it or say it more briefly, you want to maximize your qualified business income. You don’t want to do things that destroy that.
And then what you’d like to do is just have your income be dropping right down to that level that it just starts to matter that you’re an SSTB.
Andrew Chen 1:04:27
If you’re part of a partnership, like a law partnership, is the analysis done at the partnership level or at the individual partner level?
Steve Nelson 1:04:34
That’s a great question. It will be done at the entity level, and then it will reported on a partner’s K-1 whether it’s a specified service, trade, or business.
Andrew Chen 1:04:45
So it is the individual partner who would take the deduction rather than the partnership trying to do it for all the partners. Is that right?
Steve Nelson 1:04:53
And just to flag this, that’s something to take special note of because what you don’t know, if you’re the partnership or the partnership controller or the partnership tax accountant, is you may be thinking that “I don’t think any of the guys are going to be able to take this,” but you don’t know that unless you see her or his or their tax returns.
They may be able to take it even though the K-1 from the partnership has a big number on it.
Andrew Chen 1:05:21
If I move to the last category of taxpayer that I’d love to get your thoughts on, what are the key issues in consideration that a location-independent freelancer, an online/digital business owner should know about when it comes to 199A?
Steve Nelson 1:05:38
I don’t think there’s going to be anything particularly challenging about those guys. An online retailer, that’s clearly a qualified business there.
The thing that those folks want to do is S corporations make a lot of sense. And that’s another subject.
But if they have a sole proprietorship and they’re making under $163,000 if single or under $326,000 if married, they don’t need to worry about anything and they’re just going to get QBI deduction equal to 20% of their business profit.
And then if they start to rise above that, they need to be alert that they may need wages. That will be the thing that will trip them up, if they have their business explode.
My one tip to people in online businesses is they can explode very quickly that you can be going along not making anything for a few months and then things can just absolutely go crazy.
So I don’t think it’s a bad idea to run your business as an LLC, which means it’s treated as a sole proprietorship by default. But then you always have the option, even at the last minute, of making it into an S corporation, which might be necessary if suddenly profits explode.
That’s one thing to keep in mind.
And then I would say for the independent contractor, I would be really careful about how I describe my business. And don’t default to describing yourself as a consultant. A consultant is an SSTB potentially.
If you’re a trainer, call yourself a trainer. If you’re a programmer, call yourself a programmer. If you’re an engineer, call yourself an engineer.
And for goodness’ sakes, don’t name your business a consultant if you want to try and take a QBI deduction because that’s going to flag your return as one that maybe isn’t entitled to QBI.
Andrew Chen 1:07:25
And I guess any synonyms of that, like advisory, for example?
Steve Nelson 1:07:28
Yeah, exactly. Consulting, basically, is providing advice and counsel or doing political lobbying.
If you describe yourself in that manner, you’re going to look like an SSTB, and that will start to matter if your income gets high.
Andrew Chen 1:07:43
And just to clarify this point around once you start to bust the thresholds, if you are in this scenario, you’re an online or digital business owner or a location-independent freelancer and you are having to evaluate the 50% of wages because you’re above the phase-out thresholds, it has to be an employee wage, right?
If I hire a VA or I have subcontractors working for me, that doesn’t count. Those payments don’t count. Those are business expenses, right?
Steve Nelson 1:08:12
Yeah, that’s a good point.
Actually, Andrew, one thing that pops into my head, which you’re thinking of and I didn’t spot or think about originally, is it’s not just wages.
First of all, the wages are wages paid to U.S. employees, includes employees in Puerto Rico. So it’s got to be domestic wages.
And then the other part of this is location-independent. It needs to be income earned in the U.S.
So if you’re a travel blogger and you’re really living in Europe, you’re not going to get a 199A deduction. You could if you moved back to the U.S., but you’d need to have U.S. income and U.S. wages.
That’s the other part of this. What Congress did, and you can see their logic in this even if you don’t agree, is they’re going to reward people who are operating businesses in the U.S. and who are paying wages to U.S. workers. That’s what they want to do and set to happen.
Andrew Chen 1:09:08
But why does it matter where my domicile is as a principle?
Because the income may be generated in the U.S. For example, if I’m the travel blogger, most of my readers are in the U.S., and all of my affiliate link networks are in the U.S.
Steve Nelson 1:09:23
So then you’re earning the income in the U.S.
If you’re making it in the U.S., paying taxes on it in the U.S., that’s going to work fine. And if you’re paying W-2 employees in the U.S., that’s going to be fine.
But if you’re an American taxpayer but you give tours in France and you’re making money in France, that’s not going to be qualified business income.
Andrew Chen 1:10:03
On this point, two mini-scenarios I would love to get your thoughts on.
If I’m selling e-commerce, I can pretty clearly prove which sales went to a U.S.-based customer versus a non U.S.-based customer because I can see where I sent the product to, or maybe I can infer it based on their order details.
But if I’m running a travel blog, for example, and I make my money mostly by advertising, how do I prove which portion is U.S. income versus not?
Steve Nelson 1:10:35
In that case, I think it would be tricky. And we have real-life situations where this is an issue.
But I think if you’re operating in the U.S. and you’re selling stuff in the U.S. and you’re selling advertising in the U.S., it doesn’t really matter if some of the people who are buying your products are from France or from South America or whatever.
You’re still earning the money in the U.S. The income is going to be sourced where you do the work, not necessarily where the customer uses the product.
So you’re going to be okay there.
And I think you’d have the same thing happen with your selling advertising, selling affiliate type stuff off of a website.
And then clearly, if you’re doing tours, you’re literally the tour guide in Europe, that’s clearly European.
The problem would be you’re living in Europe, blogging, making money in the U.S. I think that’s going to be a little bit murky.
I suppose what you might end up doing is you might end up having to source some of your income to the U.S. and source some of it to France or the UK or Argentina, wherever you are.
And then you’d have the wages issue too. How would you have wages in the U.S.?
Andrew Chen 1:11:55
I’m just thinking about the scenario of the hypothetical travel blogger who is a U.S. citizen but living abroad in Sydney, Australia.
Their website is accessible all over the world. They have readers all over the world, a lot of whom are in the U.S. but not all of them.
It sounds like there is some segregation work that has to be done.
Steve Nelson 1:12:18
Yeah. I’m thinking about this, and I don’t have the details in my head, but there is language in the final regs that comes from the statutes, where it needs to be U.S. source income and the W-2 wage, and that employees are people whose wages appear on the W-2 or the Puerto Rican equivalent. That counts.
So I think they’re real problems.
I think we advise clients who were outside the U.S., if they really wanted to take the QBI deduction, to move back to the U.S. We have clients around the world, and I’m pretty sure we were advising people to do that.
Andrew Chen 1:12:59
One last question I wanted to ask before we wrap.
Around policy, unless Congress changes the current law, 199A is scheduled to sunset in 2025, which means it goes poof if no action is taken.
What do you reckon is the likelihood that it would get renewed or extended by Congress?
More broadly, do these kinds of tax provisions, which can materially impact how businesses organize and structure their operations, generally or often get extended? Or do they just as often get sunsetted into oblivion?
Steve Nelson 1:13:32
That’s a good question. I and every other tax accountant probably has a poor record predicting tax law changes.
But I think pre-COVID, I could have easily believed that because this is a crazy tax deduction, in a certain sense, just between us small businesspeople, why should small businesses not have to pay tax on the last 20% of their income, which is, by the way, the highest taxed income they earn? It doesn’t really make sense.
Pre-COVID, you could have thought, “Well, maybe if we get a new president, and depending on the balance of power in Congress, maybe they’d think about dumping this thing.”
I’m a total booster of small business, but there’s a part of this that doesn’t make any sense. So you think that way.
And then you also think, “Yeah, but how much fight is Congress going to want to have over this when this whole thing sunsets anyway at the end of 2025?”
That was the way I was thinking. And then I was surprised, but also, quite honestly, happy on behalf of my clients that candidate Biden had said that he didn’t like 199A for really high income people, but he was okay on it up to $400,000, which is actually most small businesspeople.
And I know people think that there are a lot of people whose income is regularly above $400,000, but there actually aren’t very many people. People have their income spike up, but to average above that level is unusual.
So I think there’s a possibility 199A could be around for a long time.
Subchapter S, which is similar, has been around since the Eisenhower administration. And it’s a similar small business loophole that is super attractive and super powerful.
Andrew Chen 1:15:23
All right. Great. Well, this has been really helpful.
By the time this episode airs, we may already know who the winner of the presidential election is, so this may become less theoretical at that point.
Steve Nelson 1:15:34
Andrew Chen 1:15:35
But we’ll see how that lands.
Steve, this has been super insightful and a lot of fun. Where can people find out more about you and your practice and services?
Steve Nelson 1:15:45
I’d say if they go to the blog, Evergreen Small Business, there’s lots of information about us and how to contact us. And then, as you mentioned, a whole bunch of information about 199A there.
Andrew Chen 1:15:55
All right. We’ll link to all that stuff in the show notes and look forward to sharing this with our audience. I think this will be a good one.
I really appreciate your taking the time to chat with me today.
Steve Nelson 1:16:04
Thank you, Andrew.
Andrew Chen 1:16:05
Cheers. Take care.
Regina Levy says
One MAJOR point that was not addressed, the 20% 199A deduction was created to equalize the tax effect of lowered tax rate on C Corps to 21%. Absent the 199A deduction it would have made sense for many S-Corps and others to become C-Corps.
Andrew C. says
Good callout, thanks!
PAUL E SCHOESSLER says
Enjoyed the conversation. Very informative.
Andrew C. says
Thanks, glad it was helpful!