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Robert Bloink and William H. Byrnes

Financial Planning > Tax Planning > Tax Deductions

This COVID Tax Credit Could Limit Business Deductions

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More than four years after the 2017 tax reform reshaped the tax rules for small businesses, we’ve reached a point where many small-business clients might think they’re out of the woods when it comes to navigating the complexities of the Section 199A deduction for qualified business income (QBI) that’s available for passthrough entities.

However, the new employee retention tax credit that was put into place to encourage employers to retain employees during the height of the COVID-19 pandemic could throw a wrench into past plans. It’s possible that claiming the ERTC could actually limit the Section 199A tax deduction for passthrough entities — which, without advance planning, could create an unpleasant tax hike surprise in future months.

Background on Claiming the 199A Deduction

As most passthrough entities now know, the 2017 tax reform legislation now allows passthrough entities (partnerships, S corporations and sole proprietorships) to deduct 20% of QBI to create a level of parity with C corporations, which are now subject to a reduced 21% tax rate. Service businesses are not entitled to the full benefit of the 20% deduction if the business owner’s taxable income exceeds certain threshold amounts.

Further, when the passthrough entity’s income exceeds the thresholds (regardless of business type), the 20% deduction is capped at the greater of (1) 50% of W-2 wage income or (2) the sum of 25% of the W-2 wages of the business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property” (basically, depreciable business property).

In 2021, the deduction begins to phase out for businesses with income in excess of $329,800 for joint returns and $164,900 for all other returns (in 2022, the thresholds increase to $340,100 for joint returns and $170,050 for all other returns). In 2021, the phaseout was complete when income exceeded $214,900 (single filers) or $429,800 (joint returns).

W-2 wages for purposes of the 199A QBI deduction include remuneration for all services provided by an employee for the business. The definition of “wages” is further limited by the fact that the wages must be properly allocated to qualified business income, which, in turn, includes the net amount of qualified income, gain, deduction and loss with respect to the taxpayer’s trade or business (to the extent those amounts are allowed in determining taxable income).

Employee Retention Tax Credit Impact

By way of background, the CARES Act created the employee retention tax credit as a refundable tax credit designed to help employers who retained employees during the COVID-19 crisis. The credit was taken against employment taxes and was originally equal to 50% of the first $10,000 of qualified wages paid to the employee between March 12, 2020 and Jan. 1, 2021 (limiting the ERTC to $5,000 per employee in 2020). The credit was later expanded to increase the amount of the ERTC for 2021.

However, claiming the employee retention tax credit could impact passthrough entities whose income exceeds the annual thresholds, especially if the business is a service business or has little qualified property.  Typically, the “W-2 wages” that are taken into account for purposes of the Section 199A deduction must be reduced by the amount of the employee retention tax credit.

Under the terms of the CARES Act, the rules of IRC Section 280C apply in interpreting the rules that apply to the employee retention tax credit. Under 280C(a), no deduction is allowed for the part of the wages paid that are equal to the sum of any credits taken.

So, the wages and salaries shouldn’t be counted when determining taxable income — meaning that they likely will not be deemed to be properly allocable to qualified business income for purposes of the W-2 wage limit of the QBI deduction.

Conclusion

The employee retention tax credit issue only becomes important if the employer both claimed the credit and had income in excess of the threshold amounts. However, small-business clients who claimed the employee retention credit in 2020 or 2021 may have overlooked the issue —and it’s still possible that the IRS could provide guidance to the contrary in order to offer continuing relief to those passthrough entities.

For previous coverage of Section 199A planning in Advisor’s Journal, see https://nationalunderwriteradvancedmarkets.com/articles/fc020719-a.aspx?action=16

For in-depth analysis of partnership tax planning, see Advisor’s Main Library: https://nationalunderwriteradvancedmarkets.com/articles/default.aspx?filename=f13_1_2_1910.htm&search=partnership%20tax&type=and

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