Because the 199A tax deduction is complex, there are many nuances and side issues that can arise for business owners. Details about -- and solutions to -- numerous situations you may encounter can be found below.

The deduction is not allowed in computing AGI, but rather is allowed as a deduction reducing taxable income. (Code Sec. 62(a), as added by Act Sec. 11011(b)). Thus, it will have no impact on AGI limitations. Form 1040, line 13 (2020 through 2024) accommodates the 199A deduction.

The deduction is only used to offset taxable income, so it does not reduce the net earnings for self-employment used to compute self-employment (SE) tax. Thus, it will not be used to reduce SE tax.

With the advent of the Sec 199A deduction the issue of “reasonable compensation” takes on a whole new meaning for S corporation shareholders. This has been an issue of contention in the past, with shareholders that are actually working in the business and not just being investors taking minimum or no salary and having all the income pass through via the K-1 as investment income, thus avoiding payroll taxes on the income that should have been treated as W-2 compensation.

As an advisor to your clients, it is you who will normally provide guidance to them to minimize their tax liability. However, you also have to be concerned about the client’s IRS jeopardy for not paying themselves an adequate amount for the services provided and instead treating all remuneration as return on investment.

For S corporations, the Sec 199A deduction only applies to the K-1 pass-through income, not wages paid to the shareholder. The lure of this 20% deduction will only tempt more employee-shareholders to ignore the reasonable compensation requirements.

So, what is reasonable compensation? There currently is no bright line definition, but courts have consistently imposed reasonable compensation based on facts and circumstances. However, IRS Publication 536 provides the following factors to be considered when determining reasonableness:

In the early stages of 2017's tax reform (TCJA) the bill included a safe harbor definition of reasonable compensation of 70% compensation and 30% flow-through income. It also allowed a larger (more taxpayer favorable) allocation to flow- through income where a taxpayer could prove investment in the business justified a larger allocation. Unfortunately, that provision did not make the cut.

As a result, this places an increased burden on tax practitioners, who will find themselves between a rock and a hard place (client and IRS) in determining what is reasonable compensation. Further guidance is needed from IRS; hopefully they will come up with safe harbor guidelines (but given the way they side-stepped the “trade or business” definition in the proposed and final 199A regulations, don’t bank on it). Otherwise, practitioners are exposed to potential preparer penalties and client litigation. 

Partnerships and S corporations will have to provide, in addition to the usual information included on a K-1, the partner’s or shareholder’s share of qualified business income (QBI), qualified W-2 income paid by the entity and the partner’s/shareholder’s share of qualified business property. The partnership or S corporation is required to indicate if the trade or business is a specified service trade or business; this is done on a separate statement.

At first impression one would think partners and shareholders of entities with large incomes would not qualify for the Sec 199A deduction. But that may not be true because the deduction is based on each partner’s or shareholder’s allocation of qualified income, wages and qualified property from the entity and each partner’s or shareholder’s individual taxable income.