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By John Wolf and Tom Collen CPA
Qualified Trade Or Business
A taxpayer can claim a §199A deduction for most types of businesses, but not
for any businesses:
(1) that involves the performance of services in accounting, actuarial science, athletics, brokerage services, consulting, financial services, health,
law, or the performing arts; or
(2) that involves the performance of services in investing and investment
management, trading, or dealing in securities, partnership interests, or
commodities; or
(3) whose principal asset is the reputation or skill of one or more of its
employees or owners (§199A(d)(2)).
However, a taxpayer carrying on such a business can claim a modified quali-
fied business deduction, if his or her taxable income for the tax year is less
than:
(1) $415,000 ($315,000 + $100,000) for taxpayers filing a joint return; or
(2) $207,500 ($157,500 + $50,000) for all others (§199A(d)(3)(A)).
The modified qualified business deduction is based on a percentage of qualified items allocable to the specified service equal to 100% reduced by the ratio of:
(1) the taxpayer’s taxable income for the tax year above the $157,500
threshold amount ($315,000 if married filing jointly), over
(2) $50,000 ($100,000 if married filing jointly) (§199A(d)(3)(B)).
Tax Cuts and Jobs Act, Provision 11011 Section 199A Qualified Business Income Deduction FAQs
Corporate Tax Rate Reduced to 21%
A corporation’s regular income tax liability generally was determined by applying the following tax rate schedule to its taxable income:
Taxable Income Tax Rate
Less than $50,000 15%
$50,001 to $75,000 25%
$75,001 to $10,000,000 34%
Over $10,000,000 35%
The 15% and 25% rates were phased out for corporations with taxable income
between $100,000 and $335,000. As a result, a corporation with taxable income
between $335,000 and $10,000,000 effectively was subject to a flat tax rate of
34%. Similarly, the 34% rate was gradually phased out for corporations with tax-
able income between $15,000,000 and $18,333,333, such that a corporation with
a taxable income of $18,333,333 or more effectively was subject to a flat rate of
35% (§11). Thus, the detailed rate chart was:
Taxable Income Tax Rate
Less than $50,000 15%
$50,001 to $75,000 25%
$75,001 to $100,000 34%
$100,001 to $335,000 39%
$335,001 to $10,000,000 34%
$10,000,001 to $15,000,000 35%
$15,000,001 to $18,333,333 38%
$18,333,334 to Infinity 35%
Personal service corporations are not entitled to use the graduated corporate rates below the 35% rate. A personal service corporation is a corporation the principal activity of which is the performance of personal services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and such services are substantially performed by the employee-owners.
Corporations are allowed a deduction concerning dividends received from other taxable domestic corporations. The amount of the deduction was generally equal to 70% of the profit gained. In the case of any dividend received from a 20% owned corporation, the amount of the deduction was equivalent to 80% of the dividend received. A bonus received from a corporation that is a member of
the same affiliated group is generally allowed a deduction equal to 100% (§243).
For 2018 and later, the corporate tax rate is reduced to a flat 21% rate but, no special rate for personal service corporations is provided. Also, 70%
dividends received deduction is reduced to 50%, and the 80% dividends received deduction is reduced to 65%.
Alternative Minimum Tax for Corporations
Corporations had to compute their income for purposes of both the regular in-
come tax and the alternative minimum tax (AMT), and their tax liability was
equal to the greater of their standard income tax liability or AMT liability. In
computing the AMT, only alternative minimum taxable income (AMTI) above
an AMT exemption amount was taken into account, but AMTI represents a broader base of income than regular taxable income.
For 2018 and later, the alternative minimum tax is repealed for corporations. As a result, the AMT only applies to individuals, estates, and trusts after 2017.
Small Business Accounting Methods Expanded
Best Accounting Methods for Small Business
An accounting method is a set of rules used to determine when and how income and expenses are reported. A business chooses an accounting method when it files its first income tax return. There are two basic accounting methods.
1. Cash method: Under the cash method, income is reported in the tax year in which it is received. Expenses are usually deducted or capitalized in the tax year for which they are paid.
Businesses structured as sole proprietorships, partnerships (without a corporate partner), and S corporations generally may use the cash method of ac-
counting. Businesses structured as corporations and companies with a corporate partner may only use the cash method of accounting if its average gross receipts do not exceed $5 million for all prior years (including the previous taxable years of any predecessor of the entity).
2. Accrual method: Under an accrual method, income is generally reported in the tax year in which it is earned, even though payments may be received in a
later year. Expenses are deducted or capitalized in the tax year in which they are incurred, whether or not the business pays them that year.
Accounting for Inventories: Businesses are required to use an inventory method
if the production, purchase, or sale of merchandise is a material income-
producing factors for the business. Businesses that are required to use an inventory method must also use the accrual method of accounting for tax purposes. An exception from the accrual method of accounting is provided for:
(1) individual small businesses with average gross receipts of not more than $1
million, and
(2) companies in specific industries whose annual gross receipts do not exceed
$10 million.
UNICAP Rules: The uniform capitalization (UNICAP) rules generally require
individual direct and indirect costs associated with real or tangible personal proper-
ty manufactured by a business to be included in either inventory or capitalized
into the basis of such property, as applicable.
Note: A business with $10 million or less of average annual gross receipts is
not subject to the UNICAP rules concerning personal property acquired
for resale.
Accounting for Long-term Contracts: The taxable income from a long-term con-
tract generally is determined under the percentage-of-completion method, which
allows for deductions and income recognition based on the percentage of the contract that is completed each taxable year. A taxpayer determines the percent-
age of the contract completed during the year by comparing the contract costs
that were incurred during the year with the estimated total contract costs.
Note: An exception from the requirement to use the percentage-of-
completion method is provided for certain businesses with average annual gross receipts of $10 million or less in the preceding three years. Such a business may use the completed contract method under which a business is permitted to deduct costs associated with the construction when they are paid and recognize income when the contract is completed.
For 2018 and later, the $5 million thresholds for corporations and partnerships with a corporate partner are increased to $25 million, and the requirement that such businesses satisfy the need for all prior years is repealed. The increased $25 million thresholds are extended to farm corporations and farm partnerships with a corporate partner, as well as family farm corporations. Also, the average gross receipts test is indexed to inflation.
Businesses with average gross receipts of $25 million or less are also permitted to use the cash method of accounting, even if the company has inventories. Under the cash method of accounting, a business may account for inventory as nonincidental materials and supplies. A business with inventories that qualifies for and uses the cash method can account for its inventories using its method of accounting reflected on its financial statements or its books and records.
In addition, businesses with average gross receipts of $25 million or less are fully exempt from the UNICAP rules. This exemption applies to real and personal
property acquired or manufactured by such business.
Finally, the $10 million average gross receipts exception to the percentage-of-
completion method is increased to $25 million. Businesses that meet the in-creased average gross receipts test are permitted to use the completed-contract
method.
Comments: these changes allow businesses greater access to cash meth-
od of accounting, other simplifying accounting method rules, and the exemption from complex UNICAP rules. Additionally, they align the eligibility to benefits of each of these rules to a single average gross receipts test, which further simplifies these rules for businesses.
Excessive Employee Remuneration Limitation Modified
A corporation generally may deduct compensation expenses as an ordinary and
necessary business expenses. The deduction for compensation paid or accrued concerning a covered employee of a publicly traded corporation, however, is limited to no more than $1 million per year (§162). The deduction limitation applies to all remuneration paid to a covered employee for services, including cash and the cash value of all compensation (including benefits) paid in a medium other than money, subject to several significant exceptions:
(1) commissions;
(2) performance-based remuneration, including stock options;
(3) payments to a tax-qualified retirement plan; and
(4) excludable amounts from the executive’s gross income.
A covered employee is the chief executive officer (CEO) and the next four highest compensated officers based on the Securities and Exchange Commission
(SEC) disclosure rules. Due to changes in the applicable SEC disclosure rules,
IRS guidance has interpreted “covered employee” to mean the principal executive officer and the three highest compensated officers as of the close of the tax year.
For 2018 and thereafter (subject to a transition rule), the exceptions to the $1
million deduction limitation for commissions and performance-based compensation are repealed. The definition of “covered employee” is revised to include the CEO, the chief financial officer, and the three other highest-paid employees, realigning the definition with current SEC disclosure rules. Under the modified definition, once an employee qualifies as a covered person, the deduction limitation applies for Federal tax purposes to that person so long as the corporation pays remuneration to such person (or to any beneficiaries).
After 2018, compensation (remuneration) includes any cash and noncash benefits paid for services.
IRS Guidance on Section 162(m) Tax Reform
Comments: The significant exceptions to the current limit on the deductible executive compensation by publicly traded corporations have resulted in a
shift away from cash compensation paid to senior executives in favor of stock options and other forms of performance pay. This shift has led to perverse consequences, as some executives focus on. Could, in rare cases, manipulate – quarterly results (off of which their compensation is determined), rather than on the long-term success of the company.
Qualified Equity Grants
Employers may grant various forms of stock compensation to employees, including nonstatutory and statutory stock options, restricted stock, restricted stock units, and stock appreciation rights. The tax treatment of these various forms of stock compensation depends on the specific terms and conditions of the arrangement and applicable rules
In the case of an employer’s transfer of stock to an employee, specific rules govern the amount and timing of the income employee’s inclusion and the employer’s compensation deduction (§§83, 3401 & 6051). An employee generally must recognize income (equal to the fair market value of the stock as of the date of transfer) in the taxable year in which the employee’s right to the stock is transferable or is not subject to a substantial risk of forfeiture. The employer is allowed a deduction equal to the amount included in the employee’s income.
Note: If the employee’s right to the stock is nonvested at the time the stock is
transferred to the employee, the employee may make a §83(b) election with-
in 30 days of transfer to currently recognize the income in the transfer year.
The above rules apply to nonqualified stock options when the employee exercises the option. However, no amounts are included in an employee’s income on the grant, vesting, or exercise of a statutory option (§§421-424). Likewise, no deduction is allowed to the employer with respect to the option or the stock transferred to an employee. If a holding requirement (2 years from grant, one year from exercise) is met, and the employee later sells the stock, the gain can be capital gain rather than ordinary income.
There are two types of statutory employer stock options:
(1) incentive stock options (ISOs), and
(2) those provided under an employee stock purchase plan (ESPP).
In the case of a nonqualified deferred compensation, unless the arrangement either is exempt from or meets the requirements of §409A, the amount of deferred compensation is first includible in income for the taxable year when not subject to a substantial risk of forfeiture, even if payment will not occur until a later year. The employer deduction is permitted when the amount is included in the employee’s income.
For 2018 and later, a qualified employee is allowed to make a deferral election similar to the 30 days §83(b) election for employer qualified stock transferred to an employee (or with restrictions, qualified stock attributable to a statutory option). Both “qualified employee” and “qualified stock” are specifically defined.
If a qualified employee uses this new election to defer income, the income must
later be included on the earliest of:
(1) the first date the qualified stock becomes transferable;
(2) the date the employee first becomes an excluded employee;
Note: An excluded employee is any individual who (1) was a 1% owner during the preceding ten years, (2) is or has been, the CEO or CFO of the corporation, (3) is a family member of an individual described in (1) or (2), or (4)
has been one of the four highest compensated officers during the ten preceding years.
(3) the first date on which the stock becomes readily tradable on an established securities market;
(4) the time five years after the first date the employee’s right to the share be-
comes substantially vested; or
(5) the date on which the employee revokes her inclusion deferral election.
A corporation transferring qualified stock to a qualified employee must provide
a notice at the time (or a reasonable period before) of the employee’s vesting in the adequate stock and that income attributable to the stock would be includible
absent an inclusion deferral election.
Entertainment Activities Or Facilities Deduction Repealed
No deduction has been allowed for expenses relating to entertainment, amusement or recreation activities, or facilities (including membership dues concerning such activities or facilities), unless the taxpayer established that the item was directly related to (or, in some instances, associated with) the active conduct of the taxpayer’s trade or business, in which case the taxpayer may deduct up to 50% of expenses relating to meals and entertainment (§274).
Publication 463 (2019), Travel, Gift, and Car Expenses
Note: An item was considered directly related if it is associated with a substantial and bona fide business discussion
A taxpayer also may deduct the cost of certain fringe benefits provided to employees (e.g., transportation fringe benefits), even though such benefits are excluded from the employee’s income under §132.
Note: A taxpayer may also deduct expenses for goods, services, and facilities
to the extent that the expenses are reported by the taxpayer as compensation and wages to an employee (or includible in the gross income of a recipient who
is not an employee).
For 2018 and later, no deduction is allowed with respect to:
(1) an activity generally considered to be entertainment, amusement or recreation,
(2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes, or
(3) a facility or portion thereof used in connection with any of the above
items.
The deduction for expenses (or any payment or reimbursement) associated with
providing any qualified transportation fringe (i.e., vanpools, transit passes, qualified parking, and bicycle commuting under §132(f)) to employees is also disallowed except if necessary for employee safety.
Note: Entertainment expenses remaining fully deductible include: (1) goods,
services, and facilities treated as employee or non-employee compensation
to an -recipient; and (2) expenses for recreational, social, or similar activities and related facilities primarily for the benefit of non-highly compensated employees.
Taxpayers may still deduct 50% of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel). For amounts incurred and paid after 2017 and before 2025, this
50% limitation is expanded to include expenses of the employer associated with providing food and beverages to employees through an eating facility that meets requirements for de minimis fringes and for the convenience of the employer.
However, such amounts incurred and paid after 2025 are not deductible.
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Disclaimer: John Wolf and paystubmakr.com are making a total effort to offer accurate, competent, ethical HR management, employer, and workplace advice. We do not use the words of an attorney, and the content on the site is not given as legal advice. The website has readers from all US states, which all have different laws on these topics. The reader should look for legal advice before taking any action. The information presented on this website is offered as a general guide only.