Under the Senate Plan, Millions of Americans Still Will Have to Calculate Their Taxes Twice

And they probably won’t know if they’ve done it right until they’re audited

The new “qualified business income” deduction in the Senate tax plan is a stimulus package for tax lawyers and accountants. As I noted in an earlier post, the definition of “qualified business income” is potentially so expansive that it includes plain-vanilla salary and wages, though as I explain at the end of the post (with an addendum and an h/t to Kirk Stark), it’s doubtful that the IRS is going to allow ordinary employees to claim the QBI writeoff. But beyond its potential breadth, the QBI deduction — advertised by Senate Republicans as “simple and easy-to-administer” — turns out to be anything but. Even taxpayers whose goal is to comply with the provision in good faith will find that doing so is difficult and risky.

Let’s start with one of the Senate Finance Committee’s example households: a single parent with one child earning $41,000 a year. Let’s assume that $11,000 comes from a bartending job and $30,000 comes from the taxpayer’s housepainting business. Let’s also say that the taxpayer is an employee of the bar but an independent contractor with respect to the homeowners whose houses he paints.

Under current law, the taxpayer’s tax calculation is pretty simple. Adjusted gross income is $41,000. The standard deduction for a head of household is $9,350, and the taxpayer can claim two personal exemptions (one for himself, one for his child) of $4,050 each. So the taxpayer’s taxable income is $41,000 — $9,350 — (2 x $4,050) = $23,550. Under the current tables for heads of household, the tax due is $1,865 + 15% x the amount over $18,650, or $1,865 + 15% x ($23,550 — $18,650) = $2,600.

Under the Senate plan, things get quite a bit more complicated. Some portion of the taxpayer’s income may be qualified business income (QBI). Assuming that the IRS successfully precludes taxpayers from claiming the QBI benefit for wages earned as an employee, the QBI amount might be $30,000 (though it might be less — more on this below).

Let’s go with the $30,000 figure for now. CNBC and other outlets are reporting that Senate Republicans have agreed to increase the QBI deduction from 17.4% to 20%. Does the taxpayer get to claim a deduction of 20% x $30,000 = $6,000?

Not so fast. The text of the new section 199A(a)(2) imposes a cap on the QBI deduction equal to 17.4% x (taxable income — net capital gain), which presumably will increase to 20% x (taxable income — net capital gain) under today’s amendment. Fortunately, our taxpayer doesn’t have any capital gain, so we don’t have to worry about that. But we do have to worry about the fact that “taxable income” for purposes of the QBI cap must be “computed without regard to the deduction allowable under [section 199A].” See §199A(e)(1).

And so we’ll have to calculate “taxable income” twice — first without QBI, in order to figure out the size of the QBI deduction, and then with QBI, to figure out how much the taxpayer actually owes. To illustrate:

— Adjusted gross income without the QBI deduction is $41,000.

— The taxpayer can claim a standard deduction of $18,000 as a head of household under the Senate plan.

— The Senate plan eliminates personal exemptions, so we don’t have to worry about those.

— Taxable income (not accounting for the QBI deduction) is $41,000 — $18,000 = $23,000.

We then use that $23,000 number to figure out the cap on the taxpayer’s QBI deduction: 20% x $23,000 = $4,600. And now we do it all again:

— Adjusted gross income with the QBI deduction is $41,000 — $4,600 = $36,400.

— The standard deduction is again $18,000, and there are no personal exemptions.

— Taxable income is $36,400 — $18,000 = $18,400.

— Tax liability under the Senate table for heads of household is $1,360 plus 12% x the amount over $13,600, or $1,360 + 12% x ($18,400 — $13,600) = $1,936.

Now, our taxpayer just saved a chunk of change: his tax liability went down by $664 before factoring in the expanded child tax credit (the size of which still seems to be in flux). The reduction in his AGI as a result of the QBI deduction also potentially makes him eligible for a (modest) earned income tax credit.

But recall that Senate Republicans are promoting the fact that their plan — by eliminating the alternative minimum tax — will “simplify the tax code and eliminate uncertainty for millions of Americans who are required to calculate their taxes twice each year.” Well, the new QBI provision will require millions of Americans to calculate their taxes twice each year. Lower-income households that draw most of their income from small enterprises or gig economy jobs will run into the 20%-x-taxable income cap on the QBI deduction, and they’ll have to calculate their taxable income once without the QBI deduction and then again with. Meanwhile, higher income folks will have to calculate taxable income twice in order to comply with provisions limiting QBI for households whose taxable income exceeds $250,000 a year ($500,000 for married couples filing jointly). Those thresholds, too, are based on taxable income calculated without QBI, so again, households will have to calculate their taxable income once without QBI and once with.

As a practical matter, software such as TurboTax will make this a lot easier. But the same can be said for the alternative minimum tax, which Republicans were dead-set on eliminating. If you’re going to advertise the fact that your bill saves taxpayers the hassle of calculating their taxes twice, then you should make sure that you actually save taxpayers the hassle of calculating their taxes twice.

The more significant compliance challenge comes in figuring out “reasonable compensation” for small business owners and independent contractors. The Senate bill seems to imply (see §199A(c)(4)(A) on p. 28) that anyone claiming the QBI deduction should pay herself a reasonable salary and exclude that amount from QBI. So if you’re an Uber driver, or a babysitter, or a freelance writer, or a shopkeeper, now you have to figure out how much is “reasonable compensation” you pay to yourself and how much is profit eligible for the QBI deduction.

This issue currently arises with respect to high-income S corporation shareholders seeking to reduce Medicare taxes via the Gingrich-Edwards loophole. The Senate bill means that millions more Americans will have to wrestle with this issue even if they’re trying to comply with the tax laws in good faith. And they probably won’t know until they’re audited whether they’ve done it right.

All of which is good news for tax lawyers and accountants, whose services will be in higher demand. And as someone who makes his living teaching future tax lawyers, perhaps I should be pleased about this outcome. But “postcard filing” this is not. And it certainly does not live up to the promises of simplification that Republican leaders have made to voters.