The IRS is true to their word when they said they’d issue regulations on the Qualified Business Income Deduction, otherwise known as QBI, by the end of summer. In the past week proposed regulations were published, coming in at 184 pages. Remember these are “proposed” regulations. Final regulations come after guys like me pick it apart. Most of what you see probably survives so it is a good time to start the planning process.
Accountants who wanted to get a jump-start advising clients on ways to maximize the deduction are in for a rude surprise. Most schemes are out. At the end of this post I will outline what can be done to maximize the deduction.
The 184 pages of proposed regs cover more than just QBI. We will discuss the most relevant here. Consider consulting with a tax professional to review how your personal situation is affected by these proposed regulations.
If I find any other juicy tidbits, I’ll publish. If not, I’ll wait until the final regs are issued.
First, let’s clarify what the QBI deduction is. The QBI deduction is a 20% non-cash deduction for qualified business income (generally profits) for small businesses (sole proprietors, LLCs, S corporations, partnerships and some trusts) and income property investors.
The IRS confirmed what I suspected when they said QBI applies to self-employed persons, along with pass-through entities (S corps, partnerships, LLCs) and certain trusts. I think there is room for debate of the sole proprietor issues, but if the IRS gives the green light I’m happy to oblige. QBI is also available for income property owners with somewhat different rules.
Some issues the IRS clarified are pretty straight forward from H.R. 1. Phase out of the deduction starts at $315,000 for joint returns and $157,500 for the rest of the crowd if the business is in a listed field. The deduction is reduced to zero for that business once income exceeds $415,000 for joint returns; $207,500 for other returns.
The fields restricted by the above phase out are:
- Performing Arts
- Actuarial Science
- Financial/Brokerage/Investment Management/Securities Trading/Securities Dealers
One issue worth pointing out is the phase out is applied per business! This opens a potential planning opportunity where you break a larger company into parts to fall under the limits. Except the IRS knows this trick already and nixed it.
This doesn’t mean you can’t have multiple businesses. QBI is calculated separately for each business, but if the same owner/s has two or more similar businesses they are combined in many cases! The “bust the company into a bunch of littler companies” idea doesn’t work.
And talking about wages: enterprising tax professionals may have advised you to fire employees and hire them back as independent contractors. This way the old employees are really business owners and get a 20% deduction on their wages. The IRS has made clear this will NOT be allowed. This and similar schemes will be pursued and denied by Revenue. Penalties and interest will apply. You’ve been warned.
Investors in Real Estate Investment Trusts (REITs) have clarity with the proposed regs when claiming QBI. I’ll discuss this in a future post closer to tax season as the planning opportunities are limited for most taxpayers.
S corporations exclude reasonable compensation to owners when calculating QBI. The same applies to guaranteed payments to partners. Every idea I’ve seen to game the system involving owner’s compensation is clarified in the proposed regs and not allowed. But there are legal ways to maximize QBI.
Legal Ways to Increase QBI
Fancy footwork may seem the way to go when dealing with the new tax rules, but the old reliable methods of reducing income have a better chance having stood the test of time.
Lowering your income if you are already below the phase out has less benefit than in the past as business deductions are technically only worth 80 cents on the dollar. (You get a 20% deduction anyway if you don’t invest in the expense.) Below the phase out you need to consider the long-term effects on your tax situation. Additional equipment purchases or promotional expenses may not be the best choice when you consider the reduced profits mean a reduced QBI deduction. Example: You elect to spend an additional $10,000 on advertising. The additional deduction is only $8,000 since you would have received a $2,000 QBI deduction anyway.
The phase out is where things really get interesting. If you’re reasonably close to the phase out threshold, a modest amount of planning could make the difference between the full QBI deduction and no deduction at all. Remember, you can’t just increase your paycheck (assuming you are an owner receiving reasonable compensation) to reduce the company profits since reasonable compensation isn’t considered when calculating QBI. Let’s start with some small things and work up to large deductions you can take to qualify for the QBI deduction.
Office in the home: Sole proprietors can deduction a regular and exclusive office in the home using actual expenses or the safe harbor of $5 per square foot, up to 300 square feet. This is more valuable than in the part with the standard deduction much higher and state and local taxes (SALT) deductions limited on Schedule A.
Missing deductions: It might sound strange, but many business owners forget to take all their deductions. Business miles are deductible. Keep a log book in your vehicle so every mile is counted. Small cash payments for business expenses add up. Track them all. Any expense related to the business should be included. The IRS used “ordinary and necessary” as their term for what is allowed as a business expense. This is a wide road.
Section 1.263(a)-1(f) de minimis election: The de minimis election allows you to deduct all items that would normally be depreciated under $2,500. This is per item! For businesses this doesn’t mean much as bonus depreciation (more on this later) allows much larger deductions. But income property owners benefit mightily! Most stoves and refrigerators are under $2,500. Expensing anything connected to real estate under Section 179 isn’t allowed, even stoves and refrigerators. For most taxpayers this is a moot point as bonus depreciation counts for all assets with a class life of 20 years or less. But, many states limit Section 179 depreciation or don’t exactly follow federal tax rules for bonus depreciation. To my knowledge, all states follow this de minimis election, thereby bypassing Section 179 and bonus depreciation issues. Note: you can clean your depreciation schedule, too. Previous items under $2,500 can be currently expensed if the election is made. This could be a sizable deduction if you have a lot of small items on your depreciation schedule from prior years.
Repair Regs: Section 1.263(a)-3(h) election: This election allows for a deduction of up to $10,000 for an improvement as a repair. Property improvements do not fall under the bonus depreciation rules. Example: a bathroom or kitchen in an office or income property is probably an improvement by most measures and therefore depreciated over 27.5 or 39 years. If the remodel is $10,000 or less (per remodel or improvement) you can elect to treat the improvement as a repair and expense the entire amount. This is important. You might have a deck on a property replaced for $3,000, a roof for $9,000 and a minor bathroom remodel for $6,000. Each is a separate event. Each is under $10,000. You can elect for each improvement (you make multiple elections for multiple improvements) to deduct the amount as a repair expense. In this case the total repair expense deducted is $18,000.
Bonus depreciation: Bonus depreciation is back at 100% for assets with a class life of 20 years or less. This is by far the easiest way to chew huge chunks of reportable profit from a business. The decision for a machine shop to purchase a new piece of equipment this year or next for $200,000 will require a review of the current circumstances. If this year’s profits are too high for the QBI deduction, it might be advantageous to purchase the equipment this year. If not, you can save the purchase for next year. Facts and circumstances will prevail. If there is one area to get creative, it’s here. One caveat: restaurant, retail and leasehold improvements (qualified improvement property) acquired and placed in service between September 28, 2017 and December 31, 2017 get the 100% bonus depreciation, but not afterwards unless the tax law glitch is fixed. Don’t hold your breath.
I don’t want to get any longer on such a technical post. I just want you to understand there are many ways to take advantage of the current tax environment. The proposed regulations cover a wide variety of material. When the regs finalize I’ll publish more.
Until then, feel free to leave questions in the comments. I’ll answer the best I can with the limited information you provide me and as time permits. As previously noted, the proposed regs run 184 pages. I focused on the issues affecting my clients most. There are lesser issues that also affect clients I didn’t touch on. For example, I didn’t touch on the “reputation or skill” clause as it relates to QBI.
To keep this blog readable I’ll break up the technical tax posts with plenty of entertaining and useful wealth building, early retirement, side hustle and frugal living posts. It’s always good to have a family friendly blog.
More Wealth Building Resources
Personal Capital is an incredible tool to manage all your investments in one place. You can watch your net worth grow as you reach toward financial independence and beyond. Did I mention Personal Capital is free?
Side Hustle Selling tradelines yields a high return compared to time invested, as much as $1,000 per hour. The tradeline company I use is Tradeline Supply Company. Let Darren know you are from The Wealthy Accountant. Call 888-844-8910, email Darren@TradelineSupply.com or read my review.
Medi-Share is a low cost way to manage health care costs. As health insurance premiums continue to sky rocket, there is an alternative preserving the wealth of families all over America. Here is my review of Medi-Share and additional resources to bring health care under control in your household.
QuickBooks is a daily part of life in my office. Managing a business requires accurate books without wasting time. QuickBooks is an excellent tool for managing your business, rental properties, side hustle and personal finances.
A cost segregation study can save $100,000 for income property owners. Here is my review of how cost segregations studies work and how to get one yourself.
A major tax bill late in the year followed by a bill of extenders February 9th and we have the perfect recipe for problems.
My initial reaction to the tax bill in December was that most of my clients would see some benefit since my clients tend towards the upper end of the income scale. I also have lower income and older clients who are not benefiting as I expected. Certain taxpayers are even seeing a tax increase, most notably, those with large unreimbursed employee business expenses like on-the-road sales people and rock band members.
The tax software used in my office estimates what the new tax rules will mean for clients if the rules applied to their 2017 return. This has been a powerful planning tool early in the tax season. But as an accountant I always look under the hood and when I did found a disturbing problem.
From Joy to Tears
Taxes cause pain in two ways. First, the actual tax dings the household budget. Second, if not properly prepared for the changes, the timing of when the remaining taxes are paid can cause exquisite pain.
Adding to the mess, the IRS didn’t have time to update withholding tables until the end of January. Most clients didn’t see a change in their paycheck reflecting the new tax law until their first paycheck in February.
Also problematic is the issue of exemptions. For this calendar year personal exemptions are eliminated while the standard deduction is increased. As expected, this change was a big yawn for most clients. A few were able to capitalize on this particular change.
Without exemptions it is harder for the IRS to estimate the tax liability of household size. Yes, the child tax credit has been increased and the phase-out level pushed higher, but the age of the child and if they attend college now plays a bigger role than in the past.
Late January and early February tax returns delivered in my office presented our estimate of how the tax change will affect the client. A few people saw a tax increase, but most had either a small change or a larger refund.
One thing bothered me as we shared the news. I worried how the updated withholding tables would affect my results. I warned clients my estimate assumed everything was exactly the same as their 2017 return when we know the updated withholding tables would mess with my estimate.
Now that we are on the backside of February and most clients picking up in the last week have seen a paycheck with the new withholding, I can ask an additional question: How much did your paycheck change with the new withholding?
I expected a modest adjustment to my software’s estimate. What I got made me light-headed.
Every single client I met in the last week or so with a new withholding amount is under withholding by a large margin! People expecting a $3,000 reduction in their tax bill are seeing a $4,000 or more reduction in withholding. Clients who already owe money or like to keep it close to breakeven are in for a rude surprise if I don’t intervene.
An Imperfect Solution
I have a solution to fix the problem, but it entails a lot of screwing around. You can either reduce your exemptions on your W-4 or fill in an extra amount to be withheld each pay period above the withholding table amounts.
Unfortunately, most people don’t have a clue what is about to hit them. If their accountant doesn’t figure this out fast they will be steamrolled next tax season when the miscalculation bites. DIYers are at greatest risk as they tend to believe what the computer tells them. Computers are great for grunt level computing in preparing a tax return, but ill equipped to fix this new problem.
Here is what I consider the only appropriate option. When tax season is over you need to speak with a tax professional that is willing to crunch the numbers by hand to adjust for the tax and withholding changes. There is no other way.
My guess is online programs will become available as the year goes on. It still requires taxpayers to understand they even have a problem.
A Busy Off Tax Season
Tax professionals will be busy this year. I can’t imagine 140 million people are going to show up at the tax office this summer. First, many tax offices close or have reduced staff over the summer, and second, tax offices will focus on their regular clients if they address the issue at all. About half of taxpayers prepare their own return. Next spring, after the mid-term elections, taxpayer will have a hangover from the antics of Congress and the IRS. The reduced refunds and increased balance dues could chill the economy. (At least the guys who created the mess got re-elected. Man, if they lost their cushy government jobs they’d be unemployable, except as lobbyists.)
Your favorite accountant already has a plan. Originally I planned on reviewing all returns in my office with a business or income property. If we find an issue we’d give the client call to set up a meeting. This has been expanded to all clients! I estimate I’ll communicate with 600-700 clients over the summer out of a book approaching 1,000.
Readers of this blog will also feel uneasy as my discovery is copied by other news outlets. (Note to news outlets: Let your readers know where you learned this nugget of information as a gift to a wayward accountant from Backwoods, Wisconsin.) My regular clients have preference. Openings in my schedule are available to non-clients. That means most of you, kind readers.
It’s nothing personal. I have to focus my time as it will be at a premium this year. The amount of tax planning necessary this year will trump (pun intended) anything I’ve experienced in my 36 year career. The business income deduction alone would be enough for a comfortably busy summer. All these extra issues will overwhelm any tax office brave enough to remain open after April 17th.
I’m not bailing on you guys! Normally I block one day per week for consulting. This year I will open two days per week with the option some weeks for a third day. Keep in mind consulting takes prep work before we speak. I need to see your 2017 return and any expected changes.
To make this work will require specialized training in my office so I’m not a lone soldier. As a lone wolf I’d never make it through my client list, not even considering even one non-client from my list of awesome readers.
Late April will be a recovery period as I train and take some time with family. Clients reading this can set a summer appointment already. Some have. Clients picking up from now to the end of tax season will be reviewed for a summer appointment.
From May 1st on it will be full speed forward with consulting and tax planning. Clients with a business and landlords really need to make it a priority to see me this summer or fall.
How Much of My Tax Savings are Going to You, Mister Accountant?
And then we get to fees. In my office I will charge a flat $50 for clients to have their withholding reviewed. Before you pay me a cent (or I do a stitch of work) I’ll pull up your file to determine if a review is warranted. If it makes sense for me to review your records I will. If it is obvious you don’t have a tax issue I’ll inform you so you can save fifty bucks. Retired persons and those with low income generally fall into this group.
Businesses and landlords all require a review this year no matter what! There are too many additional moving parts to abscond a detailed review. My hourly fee will apply. I doubt anyone will lose on the deal as the advantages this year will far exceed anything you pay me (or most other accountants).
All non-client reviews are based on my hourly rate of $275 per hour. Regular clients have an advantage since I already know their tax situation and have their return on file. I need more review time with non-clients to acquaint myself with their tax situation.
I encourage you to begin a dialog with a tax professional early this year due to higher demand on their services. Your withholding is almost certainly wrong and to the government’s benefit. If you never consulted with a tax pro this is the one year you might want to consider it anyway.
I can see all your hands up. Yes, I will handle as many as humanly possible. However, I have a strong feeling my larger public presence will crimp the percentage of non-clients I can accept compared to demand.
The forum on this blog and Mr. Money Mustache are a great resource if you don’t have a tax professional on speed dial. I also expect many local accounting firms to add hours to handle the extra consulting this year.
The IRS has a complex formula in determining who to audit so secret even the government doesn’t know what it is. This secret is the subject of much debate and some even claim to know the formula. (They also have the secret formula to Coca Cola.)
In my neighborhood if you have an S corporation and get audited, I apologize. The lady who handles S corporation audits at the IRS around here was once an employee of mine. I take full responsibility for my limited role in training her. I am ashamed of my behavior.
But an IRS audit is not really an issue for most people. IRS audits are at all-time lows and do not look to be expanded much in the future. Most audits are not the dreaded visit to the IRS office or the auditor showing up at your place. Most audits are of the correspondence type, where they send you a letter. Correspondence audits are generally narrow in focus and are the result of a misplaced number or a mismatch on the tax return with information the IRS has.
Since so few people get audited nowadays, there should be no worry among taxpayers of a visit from your friendly government revenue agent. Still, I audit proof every tax return I prepare and train my employees to do the same. This isn’t cheating either. I am talking about preparing a tax return in a manner that doesn’t encourage scrutiny.
Who I Would Audit
The IRS seems to take an erratic course when choosing who to audit. Areas I would consider fertile ground for audit are ignored and areas where the ground has more stones is gleaned for any additional revenue. It seems counterproductive to take such an approach.
Since so much income is now reported to the IRS, most returns are easy to eliminate from audit consideration, or so you would think. Business owners and landlords are prime audit candidates since they receive income not always reported to the IRS. But there are millions of small businesses and landlords. You can’t audit them all.
The IRS selects tax returns for audit using their DIF System (Discriminant Inventory Function System). Other methods are used to uncover unreported income (UI DIF: Unreported Income Discriminant Index Formula). Only a government could come up with such names and acronyms.
The higher your DIF score the greater the chance of audit. The system works pretty well and is constantly tweaked and updated to improve efficiency. It also misses by a mile more often than not.
When you have 30 plus years in the tax industry you start to get a feel for who is pulling a fast one on their tax return. I am wrong periodically, but usually I can sniff out malfeasance.
There are two types of tax returns I would focus on auditing if I were an IRS auditor. The first is S corporations showing a loss and the other is people deep in debt and still spending.
The S corporation seems a strange choice. It isn’t. Since debt by an S corporation does not increase basis unless the debt is from the shareholder, all kinds of nasty surprises show up if the corporation shows a loss above basis. This is a complex area of tax law we will not delve into today. All I will say is please, if you have an S corporation, never have the company borrow from anyone but you, the owner. Guaranteeing a loan doesn’t help. Talk to a tax professional if you have this issue.
What I do want to focus on today is the type of person incentivized to cheat on their taxes: those deep in debt and spenders. A better way to look at who I would audit is to look at who I would not audit.
Who I Would Not Audit
If I worked for the IRS there is a group of people I would avoid auditing except for the most extreme cases. People reading this blog are awful candidates for audit! Why? Because savers don’t have a reason to cheat on their taxes. The people reading this blog are more interested in investing every penny they can. Instead of cheating on their taxes so they can spend more or to fund a heavy burden of debt, they cut spending on stupid stuff to free capital for investments in index funds and real estate.
People with a lot of toys are perfect candidates for audit. Decades in the business has proven my theory correct. When I see a client with a lot of big-boy toys they always perform poorly in audit. It is so bad I am nervous just preparing their returns. You know they have some serious preparer penalties out there. Never paid one; don’t want to start now.
A couple of things always concern me. When a client drives up in Hummer I am certain they don’t want to pay my fee (or they can’t). In the interview process I may learn of a lifestyle filled with lots of stuff coupled with debt. The risks these clients present my firm and me is higher. If I know of income and/or expenses, they must go on the return. It’s the stuff I don’t know about that keeps me thinking. The IRS may not believe I didn’t know. And then those preparer penalties show up again.
Avoiding Audit and Winning if You Are Audited
There is no fool-proof, 100% guaranteed way to prevent an audit. There are things you can do to significantly reduce your chances of getting that letter from your uncle in Washington.
- Report all income as it appears on tax documents.
- Make adjustments on the tax return for incorrect tax documents.
- Disclose positions you are taking on the tax return if you are adjusting for a tax document and for issues that make the return look like it has an issue (large charitable contributions, large business expenses, et cetera).
Where tax documents do not report the transaction to the IRS you need to consider how the return looks. Cost of goods sold higher than normal or other business or rental expenses should be covered in a disclosure included with the return. Better yet, change the mechanics of the tax return without changing the final result.
To prevent the IRS computer from throwing a fit, I will change how I handle certain numbers. This usually applies to small business owners, side gigs, hobbies, and landlords. For example, let’s say you have a really large advertising expense for a program in your business that failed to generate expected revenue. First, I would add a disclosure to the return. I would also break it up if possible. I might list the Yellow Pages ad separately to bring down the out of place advertising number.
Before you ever file your tax return you should review the return with the eyes of an auditor. What would you question if you worked for the IRS? Be brutally honest. Many returns selected for audit never get called because the auditor reviews the return and knows there is not much to gain if they open the file. As long as her supervisor doesn’t demand the audit take place, the thing will eventually run out of stat. The best audit is the one you never have to fight. Even if you win on all counts in an audit you still have time and money invested defending yourself.
When you review your tax return for things that look off, consider changing how you report the item. Again, I am not talking cheating. What I suggest is breaking big number up so they don’t look so out of place. When in doubt, disclose. Too many tax professionals are afraid to disclose a position they are taking with the IRS. They think it alerts the IRS to something they should audit. I disagree.
When the IRS sees a disclosure attached to a tax return it means you took the time to research the issue. You already self-audited. The IRS might disagree, but collecting more tax revenue is more difficult when the taxpayer already went out of her way to prepare an accurate return. My experience shows the same. I have never had a client audited when there was a disclosure attached to the return. Ever! That doesn’t mean I will not have one waiting for me when I get to the office. Even if there is one waiting for me, the number of audits of returns with a disclosure is very small.
The IRS is Reading this Blog
IRS auditors probably read this blog. It doesn’t bother me. They want to know how I conduct business, fine. One of the local auditors worked for me for a short time and knows how I conduct business. Like any tax professional, I sometimes get things wrong. Shit happens. What I don’t allow is willful errors. Judgment calls are part of the trade. Some returns we are happier with than others.
Since this is a public blog written by the owner of an accounting firm and we can assume the IRS is watching, let me share a few additional tips. I cannot remember the last time I saw a tax return audited from someone who maxes out their retirement account. I can’t remember ever seeing one. I think the IRS knows what I know; savers rarely cheat on their taxes. What would their incentive be? These people think along the lines of spending less. Their attitude is: my taxes are what they are. I’ve done everything I can to reduce them.
And reduce them they have. How much cheating do you have to do to get the same benefit as filling every retirement account you can? If you sock away $20,000 into your 401(k) and IRAs, the IRS can easily see what you did. Drop an extra 20k into the contributions to charity line on Schedule A and the revenuers might just want to verify that.
So how do you reduce your risk of audit to near zero? Simple! Spend less, pay off debt and save/invest more. The IRS is defenseless against such intelligent financial planning. It’s all legal. Pay off a credit card and you now have tax-free income! All that interest was not deductible and is now free for you to use elsewhere. In effect, tax-free income.
You can double down on the benefits by pushing the interest saved on consumer debt into a retirement account to get additional tax advantages. And the IRS has nothing to talk to you about. Your life is simpler. The government has less interest in your money. And you can finally start living the life you dreamed.
That is something everyone should be happy doing. Even an IRS auditor.