The provision of the Tax Cuts and Jobs Act that right now is giving the most stress to tax preparers is probably Section 199A also knows as the pass-through deduction. Sitting in an RV in a state park in Georgia, I once again am grateful that I retired from doing compliance work. Not having any current returns to crank out gives me time to think about the effect that 199A might have on deal structuring.
What To Think About
My conclusion is that 199A considerations are unlikely to make or break a deal and in many contexts, they will not be significant enough to risk screwing up the deal – Reilly’s Second Law of Tax Planning – Sometimes it is better to just pay the taxes. On the other hand, it would be wise to incorporate 199A considerations and there will probably be times when a small tweak might preserve 199A deductions as a business is being disposed of.
I’m going to use a couple of unrealistic examples to make the math easy. There are two companies in the widget business – LovePeople and HatePeople. LovePeople makes very high-end custom widgets using skilled craftspeople. HatePeople makes all sorts of widgets and only uses robots. Each company makes a million dollars a year. LovePeople is owned by a descendant of George Bailey and HatePeople is owned by a great-nephew of Mr.Potter.
Things have been going along swimmingly for each business and both Bailey and Potter get a $200,000 199A deduction. They qualify in different ways though. LovePeople pays $500,000 in wages. That gives Bailey a comfortable $250,000 limitation. HatePeople manages its robot workforce with a team in Bangalore over the internet. No wages. The robots cost $10,000,000. So HatePeople also has a $250,000 limitation. (The limitation (oversimplified) is the greater of 50% of W-2 wage paid or 25% of W-2 wages plus 2.5% of gross depreciable assets.
LovePeople has fixed assets of negligible value. HatePeople, of course, has all those robots. They are worth about $2,000,000 and have a negligible basis. Despite the strong profitability of the companies, storm clouds are on the horizon for the widget industry, so both the Baileys and the Potters are bailing – selling their businesses to WidgetWorld for $5,000,000 each.
The Problem With A Sale
The Baileys get a capital gain of $5,000,000 and everything else being equal no particular problems with 199A. Capital gains are not included in the 199A deduction. And whatever profit they have for the year of the sale, which would depend largely on when the sale took place should have a proportional amount of W-2 wages attached, even accrued wages and deferred compensation assumed by WidgetWorld. Here is the rule on that.
W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity, regardless of which permissible method is used for reporting predecessor and successor wages on Form W-2, “Wage and Tax Statement.”
In other words, it is about who the people were working for when they earned the W-2 wages, not which company cut the check and issued the W-2. That’s my reading anyway.
The Potters have a problem, though. A couple of problems actually. They have $3,000,000 in capital gain and $2,000,000 in ordinary income from recapture. The latter is subject to 199A. Then there is whatever they earned for the year. So if the deal is near the end of the year, they could have a tentative 199A deduction of $600,000. What is their limit? Unless there is some fancy footwork, the limit is zero, since at the close of the fiscal year they don’t own any depreciable property.
Mr. Vlahos proposes a possible solution:
When this property is sold, then, by definition, the selling entity will not hold it at the end of its tax year. That being said, should it make a difference in the application of the rule where the sale of the business and the immediate liquidation of the seller (actual or deemed) occur on the same date, with the liquidation marking the end of the tax year; should the seller be treated as having held the property on such date for purposes of the rule? The IRS has not addressed this point.
In this scenario, the entity does own depreciable property on the last day of its fiscal year. At the beginning of the day. Not at the end of the day. I’ve got some other schemes, but they are on the complicated side like forming a partnership between the seller and the buyer or some sort of temporary leasing arrangement. Another idea, pretty simple, is a big bonus to the principal – but not too big.
Actually, the main lesson in thinking about this is Reilly’s Sixth Law of Tax Planning–Don’t do the math in your head. In other words, when doing the planning for the effect of the deal on the individuals, you walk through everything including the full 199A computation including the limitations.
On Laws Of Tax Planning
Mr. Vlahos in his piece leads with a much more comprehensive background on 199A and of course you can find a lot more detail in other places on this platform. This piece is focused on a very narrow issue and is a sort of heads up.
I’m pleased to see that I am not the only writer making up laws. Here is Mr. Vlahos on something similar to my Second Law – Sometimes it is is better to just pay the taxes. He has.
Thou shalt not pursue any undertaking solely for tax purposes , but thou shalt first consider the business purpose for such undertaking and, if thou findeth such purpose worthy of attainment, then, and only then, shalt thou contemplate the tax benefit, but never shalt thou lose sight of your primary business purpose.
I attribute the difference in the manner of expression to a difference in education. Mr. Vlahos is a graduate of Harvard Law School. I am a graduate of having the late Herb Cohan as my first managing partner. One of the great ways he trained us was by forcing us to talk to him like he was a client rather than a fellow accountant – and an impatient client at that. So you could never use a couple of long sentences when a short one would do.