An Interesting Way to Allocate SE Tax Deduction
Feb 13, 2019
It has been brought to our attention that the final regulations dealing with deducting SE tax deduction and retirement plan contributions might be considered a little "interesting" by most tax professionals.
The final regulations are quoted as follows:
1.199A-3(b)(1)(vi) Other Deductions.
Generally, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of section 199A and this section are otherwise satisfied. For purposes of section 199A only, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual's gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.
Self-employment tax and retirement plan contributions are solely based upon the amount of net earned income generated by the business. Allocating these deductions using gross income (or receipts) will be completely distorted based by using this allocation and not net income. Businesses with high gross income and low net income will have a substantially higher deductions allocated to it than high net income with low gross revenues. SE tax deduction and retirement plan contributions should be allocated based upon net income generated by the business, not gross receipts. The deduction for self-employed health insurance should be OK since that is allocated directly to one business.
Let's look at some examples to see how this method of allocation works:
Sue, has a Schedule F that has gross income of $2 million and generates a net profit of $100,000. She also has an accounting business that has gross sales of $150,000 and generates net income of $100,000. The total amount of SE tax is rounded to $25,000 is based on net income of $200,000. All tax professionals would agree that we should allocate SE tax $12,500 to the farm and $12,500 to the accounting business. However, the final regulations states that Sue will allocate $23,256 to the farm and $1,744 to the accounting business. Now the final QBI deduction could be the same if Sue is under the threshold. Final QBI would be $200,000 minus $12,500 (50% of SE tax) or $187,500 times 20% equals $37,500.
Now, lets assume that Sue if fully over the threshold. Therefore, none of the accounting QBI of $99,128 ($100,000 minus $872 (1/2 of $1,744)) is allowed as QBI. Instead of having QBI from farming of $93,750 ($100,000 minus $6,250 ($12,500 X 50%), it is now reduced all the way to $88,372 ($100,000 minus $11,628 ($23,256 / 2)).
Now I must admit that this will likely never be a huge adjustment, but if a farmer or other taxpayer has large income that fully qualifies for QBI and has other income that does not qualify (SSTB), the distortion of the correct deduction could easily approach $50,000 or more.
There could be a chance that the IRS really means "gross income" equals net income from the business. If so, we hope they will provide guidance on this matter quickly since this could affect a substantial number of tax returns this year. Also, we will need to make sure to provide gross receipts for all of our partnerships that have self-employment income.
Will the IRS change this? They have already "fixed" the final regulations once already for other minor technical issues. They may feel this is the correct way to doing this calculation, but it will be tough to find anyone else that agrees (assuming gross income means gross receipts). This may be the law that we are stuck with. We will keep you posted.