Welcome to the Bryn Mawr Trust Wealth Management Podcast, providing commentary on what’s moving the financial markets, financial planning, and other timely business and monetary topics. Please welcome your host, Jennifer Fox, President of BMT Wealth Management.
[JENNIFER FOX] Welcome, everyone. Welcome to our podcast. A few weeks ago at Bryn Mawr Trust, we hosted an educational seminar for our clients on the 2017 Tax Cuts and Jobs Act, the new 199A section of the tax code. And that’s where I met today’s guest, Tony Lopes, an attorney with Riley Riper Hollin & Colagreco attorneys at law.
So Tony counsels business owners and entrepreneurs on federal and state tax matters, which is the topic of our conversation today. And Tony was our guest presenter at the seminar that we had, and did a fantastic job. Really excited to have him with us because we got some of the best feedback ever on that presentation.
[TONY LOPES] Oh, thank you so much for saying that.
[JENNIFER FOX] And we’ve been doing these for 10 years, so–
[TONY LOPES] Wow.
[JENNIFER FOX] –no pressure today, Tony.
[TONY LOPES] [LAUGHS]
[JENNIFER FOX] No pressure whatsoever. So welcome, and looking forward to our conversation.
[TONY LOPES] Yeah. Thank you so much for having me. And I hope that all your listeners are strapped in because we are in for a bumpy ride. Section 119A can be a little complex to deal with. So initially, the first thing to say is make sure, despite this podcast, to come to BMT, talk to Jen, talk to your financial advisors, and then also bring in your accountants and attorneys to help you out with this very complex provision of the tax code.
[JENNIFER FOX] Yeah. And thank you for touching on that because it is complex. I’ve had the opportunity to be at your presentation, read through, in detail, a lot of the deck, and I will be candid. There is so much information, and, depending on your specific fact pattern, and can really take you down a different avenue of this section. So why don’t we start here, and start with the nuts and bolts and the basics? So what is 199A, other than just a number in the tax code?
[TONY LOPES] Right. So the headline is that, essentially, it’s a 20% qualified business income deduction for pass-through business owners or entities. So essentially, what that means is that if you own a pass-through business of some sort– and that’s regardless if you’re a self-proprietor, a partnership, an LLC, or an S corp, and also some trusts in the states– you can get a 20% qualified business income deduction above the line on your taxable income. That’s great for pass-through business entities. It’s essentially 20% off, right?
[TONY LOPES] So fantastic.
[JENNIFER FOX] Well, that’s quite a coupon.
[TONY LOPES] Yeah.
I’ll take it. But there are certain limitations.
[JENNIFER FOX] Mm-hm.
[TONY LOPES] First and foremost, there are income cap limitations. So first, we’ll start with the single filers, which will encompass, essentially, any form tax-filer– or taxpayer– that isn’t filing married, filing jointly, because those are going to be separate. So single filers, which will include married filing separately are capped for 2018 at $157,500 in taxable income– not qualified business income, taxable income.
[JENNIFER FOX] So total taxable income.
[TONY LOPES] Total taxable income. So that’s one of the first nuances that we have to– or pitfalls, if you will– that we have to watch out for. Secondarily to that, if you’re married filing jointly, then the cap limit for 2018 is going to be $315,000, OK? So we’re in 2019 now. We’re looking back at the tax year for 2018. Those are the numbers that you’re looking at. That number is adjusted. It’s inflation-adjusted pursuant to a provision that we won’t need to mention here for your listeners. We won’t bore them.
But essentially, it’s inflation adjusted on a year-by-year basis. So for 2019, those numbers have jumped up for single filers to $160,725, or, for married filing jointly, $321,400. So those are your initial cap limits for section 199A.
[JENNIFER FOX] But right now, the tax season that we’re in today, and the tax returns that folks are working on right now, are really for the 2018 tax year. So this is our first time really seeing the full impact of 199A, correct?
[TONY LOPES] Yes. Exactly. And the IRS and the treasury have basically said, flat out, that we are in for a very bumpy ride. There are lots and lots of taxpayers that are going to be affected by this, and we’re talking millions of planning and review hours to cover just this one provision of the Tax Cuts and Jobs Act. So it’s huge for everyone.
[JENNIFER FOX] Yeah. And my understanding is that they didn’t even really give a lot of guidance until pretty late in the tax year. So that is why people are kind of scrambling to get the fact pattern and understanding of how to use this deduction.
[TONY LOPES] Exactly. So in 2018, the IRS and the treasury released proposed regulations, which kind of gave us an early– and if I recall correctly, that was in August of 2018. That kind of gave us an idea of what we were going to be in for. They took comments, took questions from trusted advisors and professionals in the tax world, and then finally released the final regs in January of 2019. So the final regs are out. We know sort of what we’re in store for.
There are a lot of examples, and they’ve been pretty good, the IRS and the treasury, about trying to draw some gray, but thick gray, black lines– for lack of a better term– for us to look at to see, OK, is my example going to be– let’s say you’re a restaurateur, right? If you’re a restaurateur, you need to go and look at the provisions that apply to restaurateurs because there are some other exclusions that could apply– for example, being a specified service, trade, or business.
[JENNIFER FOX] OK.
So a specified service, trade, or business– there are a lot of terms I apologize to the listeners in advance– essentially means that it’s a trade or business where the principal asset of that trade or business is the reputation or skill of the business as a whole. So if it’s a restaurateur and he’s selling his likeness like Tony Luke’s, for example– this Philadelphia guy– if he’s selling his likeness and doing endorsements, that’s going to fall in within reputation, skill, or likeness, which falls as a subset in there.
Now, if he’s just running the restaurant, and it’s just a regular restaurant that he’s running– he’s doing his cheesesteak and the pork sandwiches– then he’s going to be able to qualify for this deduction, presuming that he’s not above the cap limits, and he would not be an SSTB.
[JENNIFER FOX] So let me ask you this question because that’s an interesting one of what part of the business is for your reputation and what part of the business is for that operation. So is that something that you have to track– that revenue and what source it’s coming from?
[TONY LOPES] Yes, that’s correct. And so there are two ways to look at that actually. One, if you have separate entities. So if Tony Lukes has split his entities and he has an umbrella entity that has sub-entities– and, let’s say, the restaurant is one LLC, for example, and then he’s got another LLC for his personal appearances, and one he’s using his, again, reputation, skill, or likeness– what you have to do is you have to look at the qualified business income of those two separately, but then aggregate the two. So if you have a loss in one business, that’s not going to be able to be offset from the other–
[JENNIFER FOX] Income.
[TONY LOPES] –business. Yes, the other income that you have coming from other businesses. That’s one way to look at it. The other way to look at it is that there are special provisions in the regulations in the final regs that list out what qualifies where is that benchmark of what qualifies an SSTB or not. And that’s– you look at a facts and circumstances. So if, let’s say, for example, 50% or more of the business is an SSTB business– for example, a law firm, an accounting firm– those individuals are all using their reputation or skill– legal skill in the example of a law firm– to sell services to their clients. So that’s going to be an SSTB.
[JENNIFER FOX] So for those that are not the Tony Lukes, who are not selling reputation, but reputation as a critical part of the business like you said I’m thinking of the architects who were buying services for a new building–
[TONY LOPES] Exactly.
[JENNIFER FOX] –or looking at, as you mentioned– if I hire you as our legal and tax counsel– so that is still in the SSTB because it’s consulting income?
[TONY LOPES] Presumably.
[JENNIFER FOX] Presumably.
[TONY LOPES] Yeah, consulting income would generally fall within an SSTB, but, again, look at your specific set of circumstances. And the IRS, again, and the Treasury have been pretty good in the regulations about listing out these major SSTB areas. So if we look at it, you’re looking at health, law, accounting, actuaries, financial management and planning. And then you can even go as far down the line as sports figures and celebrities. So Bryce Harper is a pretty relevant topic in Philadelphia these days.
[TONY LOPES] Go Phillies.
[JENNIFER FOX] Go Phillies. So Bryce Harper, for example, is an athlete and uses his reputation and skill to earn his income. So even if he were to set up a separate entity, he would be using that as the main source for revenue for that business, so that would be an SSTB. The good news is even if you’re an SSTB– so even if you’re one of these professional organizations that’s selling the reputation or skill, you can still qualify for the 20% QBI deduction as long as you’re below those income thresholds that we talked about at the beginning of the episode.
[JENNIFER FOX] So in this case, as we were joking, the high school Bryce Harper, not the newly signed Bryce Harper.
[TONY LOPES] Exactly, right, yeah, he’s earning way too much to qualify for this, unfortunately.
[JENNIFER FOX] And good for him.
[TONY LOPES] Yeah, good for him. Right, but, yeah, presumably if you’re married filing jointly and your combined income is– your combined taxable income is below $315,000, then you can still qualify for this Section 199A deduction regardless of whether or not you’re an SSTB. So that’s actually a pretty easy situation to look at. And later on we’ll talk about some more specific examples and what you can do if you’re close to that line. So if you’re below that income threshold, what are some of the things that you can do to maximize the deduction. And if you’re above that income threshold, what are some of the strategies that you can apply to get yourself below it.
[JENNIFER FOX] So– but let me ask you this question. So whenever I hear the maximum of the deduction or the maximum income that you have, there’s usually phase-outs at a certain level. So how– are there phase-outs for this and how does that work?
[TONY LOPES] That’s absolutely correct. And thank you for bringing that up. So the phase-out provisions work this way. If you’re not an SSTB– so if you’re an SSTB, your cap limit is the cap limits that we’ve already discussed. However, if you have a business that’s not a specified service, trade, or business, essentially what you have is an additional phase-out amount above those cap limits that we talked about. So we’ll stick to 2018, so that we don’t get too complicated with numbers.
So if you’re a single filer again that’s essentially any filer that is not married filing jointly, your cap limit is 157.5, $157,500, and then the threshold amount above that the phase-out amount is 50,000 more dollars. So, essentially, your new limit becomes $207,500.
[JENNIFER FOX] Got it. A nice round number.
[TONY LOPES] Yes, exactly.
[JENNIFER FOX] A nice round remember.
[TONY LOPES] Pretty easy to remember. And so the way that that works though is if you are within that phase-out range, then you really need to go talk to your financial planners, your accountant, and, perhaps, your attorney because that calculation for that phase-out amount of $50,000 for the single filers is very complex. Because you have to look at the QBI deduction being limited to the greater of 50% of your W-2 wages or 25% of your W-2 wages plus 2.5% of unadjusted basis immediately after acquisition of qualified property. I know. I can imagine the listeners, all ready your heads are spinning, so I apologize. I didn’t come up with this.
[JENNIFER FOX] Well– and no one can see me rolling my eyes at the complications that this definitely entails as I’m thinking even through the math formula that you would need to go through to figure this out. But the reality is that there’s an opportunity in there for tax savings, but there’s an opportunity also to lose tax savings if you’re not planning properly.
[TONY LOPES] That’s correct. And I’ll actually just jump in here and give a quick bit of advice to our planner friends out there or other trusted advisors who are maybe helping the clients that are listening. You need to be very careful if you’re in this phase-out range and you have to do these calculations, the malpractice risk is huge. So what can happen is you actually have to do both of these calculations for your client and figure out which one is the limit– the new limitation amount, and how it applies, and how it’s recalculated, and how it all breaks down. If you missed something in that calculation, you’re subjecting yourself to malpractice risk. So be careful if you’re a planner or a trusted advisor and you’re working in Section 199A, be very cautious.
[JENNIFER FOX] And I think that that goes to, from a client perspective, is that really being confident and comfortable with your advisors is really critical, especially in this situation of making sure that folks are up to speed on a complex matter like this.
[TONY LOPES] Exactly. And so just going back to what we were talking about– so the phase-out amount for married filing jointly, because we didn’t cover that, is an additional $100,000. So if you’re starting at the $315,000 original cap, you add $100,000 to that, you now have a maximum of $415,000 that you can do. And, again, that $100,000 range is subject to those limitations. We won’t go back through those terms again, but it’s subject to those limitations as we discussed.
So, Tony, let’s stay on that theme of the SSTBs because that’s clearly where a lot of the confusion is– is what is consulting versus, quote unquote, trade or business? Are there other things that clients should focus on if they’re in that SSTB definition for considering the deductions or calculation of income?
[TONY LOPES] It’s pretty straightforward, honestly, for SSTBs because, essentially, you do have to consider the scope of the term consulting, as we talked– as we spoke about before– mainly it’s, essentially, whether or not you’re providing professional advice and counsel to clients. So think of it this way. If you’re using your brain as your key source for providing a service to your clients, you’re most likely an SSTB.
Now, each field has different benchmarks. So if we look at the health industry, for example, health clubs or spas, payment processing for health care, research, testing facilities, or the manufacture and/or sales of pharmaceuticals or medical devices are not going to be SSTBs, but doctors, medical service providers will be. Now, if you’re looking at sales of pharmaceuticals and medical devices by a retail pharmacy, that’s not by itself an SSTB. However, some of the services that are in the, quote unquote, field of health provided by the pharmacist would be. So it gets even more complex.
[JENNIFER FOX] Got it. So there’s– and I see your explanation of if you’re using your mind versus you need a tool, or you need a business, or you need some manufacturing or assembly–
[TONY LOPES] Right.
[JENNIFER FOX] –being the definite– or difference in that definition.
[TONY LOPES] From a consulting perspective, yes. But, also, if you’re looking at, for example, athletics or celebrities– so it’s, essentially, if you’re using your brain, face, body, or voice to earn a living that would be my– in the back of my mind– qualifier. If you’re using those things, you’re going to be an SSTB. So, again, health, lawyers, accountants– engineers, oddly enough, were able to sidestep this and are not considered an SSTB. So engineers and architects are exempt from this. They had a better lobby than we did, I guess. But, yeah, so they’re not subject to the SSTB. However, anyone else using their brain, face, body, or voice is most likely going to be an SSTB.
[JENNIFER FOX] Interesting, interesting. So I’m going back and I’m even thinking of when I said the architect for the building that we’ve been working on– they’ve gotten an exemption from the SSTB–
[TONY LOPES] Correct.
–so they would be in more of the trader business category.
[TONY LOPES] Yeah, I don’t know how they pulled that off, but they did.
[JENNIFER FOX] Again, good for them.
[TONY LOPES] Yeah, exactly. Yeah, so you can actually go to the regs, and you can look at each of the SSTB qualifications, and you can look and see for your specific industry where are these bright line designations. And the IRS, again, and the treasury, in all fairness, have done a fairly good job of saying here’s the line, here’s what is an SSTB, here’s what isn’t an SSTB, and then here are some examples where you’ll have to wait and see. So–
[JENNIFER FOX] Got it. Got it. So now thinking of the qualified business deduction– we’ve talked about the SSTB, which is a special carve out for that calculation, why don’t we spend some time talking about the true trader– and I’m calling it true trader business, aside from our SSTB definition–
[TONY LOPES] Sure.
[JENNIFER FOX] How does this qualified business deduction work for those type of businesses?
[TONY LOPES] So, again, up to the cap amount you’re definitely getting the deduction. If you’re above that cap amount, those figures that we talked about earlier, then you have to work with a professional or at least you should. I guess you don’t have to, but you should. Call BMT, talk to your wealth advisors, and get some help, and get some guidance here. Because this is very complex.
So then you have to look at that phase-out portion and see where you fit within that, what you’re limited to. And then if, let’s say, your– if we want to look at some planning strategies for the individuals out there– and, again, this isn’t financial or planning advice, you still should work with your trusted advisors– but this is, hopefully, going to make the people that are listening a little bit more sophisticated when they have those meetings with their trusted advisor, and that way they can go down the list together, and follow along a little bit better.
But one strategy is if you’re above those threshold amounts, you need to reduce your overall taxable income. So a couple of different ways– or a few different ways that you can do that is looking at your tax– getting some tax-free bond, life insurance and annuities, real estate investments, oil and gas investments, you can recognize some losses, you could avoid recognizing gains, you can make some charitable contributions, you can make some pension plan or retirement plan contributions to reduce your taxable income.
You could increase your payroll, but, there, you have to be cautious. Because, again, if you’re within that threshold amount, you’re going to have to look at your W-2 wages anyways. So you need to be cautious there. But you can also accelerate some business expenses, maybe now is the time to buy some new equipment– reduce some of that taxable income that you have– or you can broaden your ownership group. So if you were thinking about maybe offering some skin in the game to one of your key employees, now might be a good time.
[JENNIFER FOX] So let’s use an example.
[TONY LOPES] Sure.
[JENNIFER FOX] So– because I know that there’s a lot of situations out there and we could probably go for hours in some specifics, but when I think about it– and I think you’re in the same situation– so I had the W-2 income, but I’m married to an entrepreneur who has the business income. How does that work when you’re starting to plan for that? So is it the total income? Is it– is there different planning that you can do in that situation where you’ve got multiple income streams?
[TONY LOPES] Yes, that’s correct. So if you have– if you’re in a– like your situation– where you’re married to an entrepreneur, you really need to look at what’s the overall cost/benefit analysis of married filing separately or married filing jointly. Married filing separately, the entrepreneur is going to be subject to that limitation of $157,500 with only a $50,000 phase-out above that. So is that entrepreneur’s income below $157,500 on their own? And, if not, looking at those W-2 calculations.
Again, that would be a fairly extensive and lengthy discussion with BMT Wealth Management, for sure. So you have to have those discussions and have to have a bit of openness also with your partner or spouse to discuss what’s the cost/benefit analysis of married filing separately versus married filing jointly. Now, you’re going to have higher cap amounts if you do married filing jointly. So from a strategic financial planning perspective, that might be beneficial, generally speaking. But you have to look at each situation separately.
[JENNIFER FOX] I think the interesting part about this is that it does introduce a different planning technique that has been in and out of applicability over the years that I’ve been working on tax returns of– that there’s sometimes we’re looking at the filing status matters, and there’s sometimes where it doesn’t, and clearly this is one where it matters in certain circumstances, like everything else. But it’s interesting that you mentioned of having that conversation with a spouse or partner because married filing separate just means you’re tax filing.
[TONY LOPES] That’s correct. Not separate beds, not separate houses, just a separate tax filing.
[JENNIFER FOX] But, again, communication is always important on that. But I think that it does bring in unique ways to look at this– is that you don’t have to look at the way that you’ve always filed in the past as well. Correct?
[TONY LOPES] Correct, absolutely. So it doesn’t really matter how you filed up to this point. The IRS and the Treasury are actually being kind to us there. Because, as we’ll see, when we talk about real estate in a little bit, they were much harsher about changing status of entities, or how entities are structured, or moving things around from year to year. In the real estate world, not going to be so straightforward. So from a perspective of a married couple, it’s as simple as looking at it year by year and seeing what makes the most sense for you.
[JENNIFER FOX] Got it. So– and before we move on to the real estate conversation, you mentioned something that is interesting to me– is the ownership structure could also have an impact on how you file for the qualified business interests. So that, again, opens up another realm of planning or considerations if you’re now thinking about giving employees business interest for that reason. So can you talk a little bit about that part of it and how that could make sense?
[TONY LOPES] Ah, the dreaded succession planning. Yes. So if you’re trying to reward your key employees, whoever those employees may be, by offering them some, quote unquote, skin in the game– so some interest in the business– that’s a good way to reduce your taxable income. Because you’re providing, essentially, an ownership interest that’s going to reduce automatically your taxable ownership interest in the business.
So that is a good way– now is the time to strike while we have this provision that’s going to enable you to do this from both a strategic perspective with your employees– in a softer way to reward them for their years of service– or, again, if this is part of your succession plan and your exit strategy that you were going to lift up some of your key employees into ownership, so that then you can transition of the business. Now is the time to do so.
[JENNIFER FOX] But as I’m hearing you explain that what comes to mind, though, is that this is absolutely one of those situations where the tax tail shouldn’t wag the dog of your overall strategy.
[TONY LOPES] That’s true.
[JENNIFER FOX] And that if you really didn’t want key employees or if you have a longer term concern, maybe not the right path to go to save short-term taxes. Because this would be more of a permanent transfer to employees, correct?
[TONY LOPES] Correct. I completely agree with you. You don’t want to, necessarily, go say, all right, it’s time to start rewarding every employee with ownership interest, but it’s– if that was in the back of your mind, now might be the time to do it. And, again, the concept here is always to go to BMT Wealth Management, talk to your financial planner, talk to your financial advisors. Get your team involved. They should be focused on what your goals and objectives are, which BMT is, as I know from working with you.
[TONY LOPES] No problem. So you need to work with those individuals, and have this discussion, and have your team involved in what the discussion is going to be.
[JENNIFER FOX] Yeah. Now– and I– first, thank you for that and I would agree. Because I think having the full team of advisors around the table with this and making sure that you’re keeping your core goals and objectives in mind is critical for this type of tax planning because it is a huge opportunity. I mean, it’s 20% potential tax savings, but there’s also long-term downstream implications that you need to talk to your advisors about and make sure that you’re thinking about, so you don’t end up five years from now saying, why did we do this–
[TONY LOPES] Exactly.
[JENNIFER FOX] –and making sure that that’s part of the plan.
[TONY LOPES] Right.
[JENNIFER FOX] Tony, great advice. Thank you so much for joining me today.
[TONY LOPES] Well, thank you for having me, this was fantastic.
[JENNIFER FOX] So– and I appreciate all of the insight on 199A. I definitely feel like I have another level of clarity around a very detailed tax regulation, so– but thank you.
[TONY LOPES] No problem. Thank you very much for having me, this was great.
[AUDIO CONCLUSION/CLOSE] This has been a production of Bryn Mawr Trust, copyright 2019. Visit us online at BMT.com/Wealth.
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