Some Technology Companies See Benefit in 20% Tax Reform Pass-Through Deduction
November 6, 2018
The owners of certain technology and software companies will soon see the benefits of the new 20% income deduction provision of tax reform.
Section 199A of the Tax Cuts and Jobs Act is meant to give pass-through entities such as limited liability companies, S corporations, sole proprietorships, partnerships and trusts a reduction in effective tax rates that would give them some relief while larger C corporations now enjoy a much lower corporate tax rate of 21%.
The 199A provision allows the owners of certain pass-through entities to deduct up to 20% of Qualified Business Income (QBI) earned by the business when they file their personal tax returns.
Coupled with a new lower tax rate on ordinary income for individuals, which is now 37% compared with 39.6% previously, IRS section 199A pass-through deduction can further reduce the effective rate on QBI to as low as 29.6%.
In August, the Internal Revenue Service issued a 184-page proposed regulationthat provides additional guidance about how to interpret and apply section 199A, and cleared up some confusion about how it impacts the technology and software industry.
Can You Take It?
Yes, if your company is profitable.
The owners of some technology and software pass-through entities will be able to take the full deduction, especially if their income is below $315,000 for joint filers and $157,500 for individual filers.
To calculate the 20% deduction, business owners must calculate QBI separately for each of the taxpayer’s businesses. QBI is the net amount of certain qualified items of income, gains, deductions and losses. It excludes salary, capital gains or losses, dividends, investment income, guaranteed payments and other items.
For taxpayers with income that exceeds those amounts, the new tax law limits the 199A deduction to 50% of W-2 wages paid, or the sum of 25% of W-2 wages plus 2.5% of tangible depreciable property – whichever is larger.
The proposed regulations say that all pass-through entities must provide detailed W-2 information on the 2018 tax return, even if all owners are below the income limits.
Is It Consulting?
Another wrinkle some technology and software companies may face is uncertainty over whether software implementations and project scope estimates will be treated as consulting services, which are subject to “specified service trade or business” (SSTB) limitations.
The IRS regulations defined “consulting” as: professional advice and counsel to clients to assist the client in achieving goals and solving problems.
For companies that are in the business of licensing software wherein the customer pays a flat fee for the software license, implementation-related advice does not taint the overall business as “consulting” under the SSTB rules.
Additionally, the IRS guidelines clarified that discussing and evaluating a customer’s software needs as part of a software licensing deal wherein the customer pays a flat fee for the advice of licensing that particular softwarewon’t be treated as consulting for SSTB purposes.
The IRS also affirmed that training and education on how to use a software product is not considered consulting.
A software company that charges its client on an hourly basis to customize the product related to a software purchase or implementation may potentially be performing SSTB activities.
If your company generates both SSTB and non-SSTB income, you must track those activities and all expenses and costs related to each of them. We will rely on case law and prior regulations to take action.
Companies should consider spinning out the SSTB revenue stream into a separate entity, moving employees, generating separate invoices, separating accounting, and a myriad of other factors. A CPA should give guidance on the proper way to do that, especially in light of the fact that the IRS has already indicated they will look for abuses in restructuring.
Technology companies that want to consider alternative billing methods to take advantage of this new benefit should also take into account the impact on sales tax and the new generally accepted accounting principles (GAAP) revenue recognition rules.
PEOs Are OK
One question many technology companies had was about professional employer organizations (PEOs), which are separate business entities that serve as the employer of record for tax purposes.
PEOs are very popular with technology companies as businesses often get better prices on benefits while also reducing human resources complexities.
In the proposed regulations, the IRS affirmed that a pass-through entity with employees paid through a PEO will be treated as if they were paid by the company directly.
Guaranteed Payments is a tax term that means payments made to partners or LLC members to compensate that individual regardless of the profitability of the company. For many tech company partners or LLC members, this is akin to a salary.
Even though a guaranteed payment is reported on the pass-through entity’s tax return, it is not eligible for the 199A deduction, the IRS said.
Partnership and LLC agreements should be reevaluated to determine whether the payment is in fact guaranteed, and whether it can be restructured to be made in the form of a distribution instead. However, these types of changes can result in unintended business consequences, especially with companies whose ownership can include both active and passive holders.
Many technology companies operate at a net loss in the early years, and they often continue having net losses as the company refines its products. As such, many pass-through owners don’t think the 199A pass-through deduction applies to them.
Taxpayers with negative QBI for the year mustcarryforward that loss and offset positive QBI in the future. That will create a larger compliance burden for companies and individuals as the negative QBI will need to be tracked over time.
When the LLC becomes profitable, this deduction can become valuable.
Many owners of pass-through technology businesses will be able to take a 20% deduction on qualified business income from pass-through entities under the new section 199A of the tax reform law.
Owners of unprofitable technology companies must carryforward negative QBI and apply it toward positive QBI in future years, and tech companies that make guaranteed payments should evaluate whether they can restructure those contracts to eliminate them.