Will the 70/30 Rule Come Into Play

Published on: 22:00PM Feb 14, 2018

The new Section 199A 20% deduction is allowed against qualified business income, however it is not allowed on compensation paid to owners of S corporations or guaranteed payments paid to partners of a partnership.  Therefore, there may be an extra incentive for taxpayers to "artificially" reduce their S corporation wages or partnership guaranteed payments.

Congress knew there would be attempts regarding this, so they added language that allows the IRS to issue Regulations to determine what is reasonable compensation for all taxpayers.

Dana Trier who is a Treasury deputy assistant secretary for tax policy recently spoke at an American Bar Association meeting.  He indicated that there is no effort by the IRS to "redo the law of reasonable compensation" beyond what already applies to S corporations.  The IRS continues to try to make sure that S corporation's pay reasonable compensation, however, little has ever been done regarding reasonable guaranteed payments for partners.

This sounds great, however, he did indicate that the new law is "written as it's written", therefore, if someone above him at Treasury feels that taxpayers are abusing reasonable compensation (by reducing current S corporation wages or guaranteed payments), then new Regulations may be issued to address this.  If so, could we see the House proposal of 70/30 come into play.  Under that proposal, all business income would be placed into one of two buckets as follows:

  • Compensation (typically 70% of all business income) not allowed for Section 199A, and
  • A return on investment (the remaining 30%) allowed for Section 199A.

This could drastically reduce the value of the new Section 199A.  Let's look at some examples:

Farmer Smith farms as an S corporation.  During 2017, he paid himself $100,000 of wages and netted $300,000.  To try to maximize his Section 199A deduction in 2018, he reduces his wages to $30,000 and reports S corporation business income of $370,000.  This results in a Section 199A deduction of $74,000.  If he had continue to pay wages of $100,000, the deduction would only be $60,000.

Now let's assume Farmer Smith is a partner in the ABC partnership.  Each partner gets a guaranteed payment of $100,000 and the partnership makes $900,000.  For 2018, they each reduce their guaranteed payment to $10,000 and report $390,000 of partnership income on their tax return instead of $300,000.  This increases their Section 199A deduction from $60,000 each to $78,000.

Now let's assume Farmer Smith is a Schedule F farmer who earns $400,000.  Under Section 199A, he is entitled to a 80,000 deduction.

However, now let's assume the IRS incorporates a new 70/30 rule.  In all three examples, Farmer Smith would now have qualified income reduced from $370,000 to $400,000 down to $120,000 that would qualify for the Section 199A deduction ($400,000 of gross income times 30%).  This would reduce his Section 199A deduction all the way down to $24,000.

Will this happen?  Likely not.  Can it happen? Yes.  It all depends on how "successful" tax advisors are in converting "compensation" to "business income".  We will keep you posted.