Uncertainty, Perverse Incentives, and More

The 20 Percent Deduction and the Reasonable Compensation Standard

Can any independent contractor — making less than $315,000 for a married couple (and half that for a single individual)— take the new 20 percent deduction on income from their work under the new tax law? Can partners with relative ease do the same? If they can, then there will be a significant tax penalty to being an employee, since employees clearly don’t get the benefit of the deduction even if they provide very similar services.

These basic questions — to which there are not clear answers — have the potential to affect millions of people. These millions of workers are faced with both uncertainty as to their tax bills for the current year and potentially perverse incentives in their employment and business decisions as a result of the new law and its special write off for certain kinds of business income.

Lily Batchelder and I began to explain some of the uncertainty and perversity in our op-ed in the LA Times about this deduction. Noam Scheiber also described some of the potential consequences in the NYTimes for workers. And I want to say some more about it here, and specifically explore the legal question of whether service providers (i.e. workers) who are sole proprietors and partners get the deduction even as employees do not.

The answers to this question turns on the degree to which one of the law’s restrictions — a restriction that says that people do not get the 20 percent deduction on payments that represent reasonable compensation for services — applies broadly or not. The law itself is unclear. If it applies broadly, then there shouldn’t be as large a tax penalty on being an employee versus being an independent contractor or partner; if that restriction has a narrow scope (specifically, applying only to S-corporations), then that perverse penalty exists and sole proprietors and partners get a significant tax cut that employees do not — a tax cut that can be substantial especially for those with relatively high incomes.

As to what the IRS should do: They should issue guidance as soon as possible clarifying this matter. Further, I’d urge them to restrict this deduction for service providers, consistent with the legislative text — in order to avoid, to the extent they can, a tax penalty for being an employee. A number of people would still come off unfairly as winners here, especially some very high-income American like passive investors in a qualifying trade or businesses (say…a real estate business) who clearly qualify. But, better to narrow the scope of this deduction and not to mess up employment markets in the meantime. Then, Congress should repeal this entire mess as soon as it is able.[1]

Restrictions on Service Providers

Section 199A allows a 20 percent deduction from certain kinds of trade or business income. Service providers — i.e. people who work for a living as opposed to passive investors for instance — can only take advantage if they meet certain restrictions.

One set of restrictions for service providers applies only above the taxable income threshold of $315,000 for a married couple (and half that for a single individual).[2] For these high-income filers, certain lines of business don’t qualify for the deduction. The restricted lines of business include specific restricted services (law, health, etc.) and a business where the principal asset is the reputation or skill of the employees or owners. There are ways to get around these restrictions even for those in these specific service sectors — for example, be an in-house lawyer, working as a partner, at a business engaged in other kinds of services. Further, these restrictions do not apply at all to the vast majority of Americans, including many people with relatively high incomes, who make less than these thresholds.

A second set of restrictions applies to all service providers, irrespective of income:

First, a service provider cannot get the deduction if she is working as an employee. At any income level, an employee is ruled out.

Further, even if not working as an employee (i.e. as an independent contractor or as an owner in a partnership), there are three kinds of income particularly relevant to service providers that do not get the 20 percent deduction. These three prohibited categories of income are:

1. Reasonable compensation for services paid by to the taxpayer by the taxpayer’s trade or business.

2. A guaranteed payment to a partner in a partnership (under 707(c)).

3. A payment to a partner not acting in her capacity as a partner (under 707(a)).

I have pasted the legislative text in the appendix (from 199A(c)(4)) listing these restrictions.

The second two restrictions are specific to partnerships (entities with multiple owners like LLCs, LLPs, and so on); they don’t apply to businesses owned by a single person including independent contractors (technically called sole proprietors). Further, these restrictions are relatively easy to avoid even within a partnership. For a payment not to be “guaranteed,” it simply must be related to the income of the partnership. When it comes to acting in one’s capacity as a partner, there’s a multifactor test focusing on entrepreneurial risk, whether the service provider’s status in the partnership is temporary, and other factors. That test too has, so far, been relatively easy to escape.

And, that leaves us with the “reasonable compensation” standard. If that ends up having a narrow scope, then it’s off to the races if you’re not an employee — certainly below the $315,000 threshold and, for some service providers, above it. That’s because the other two restrictions do little to restrict deductibility.

Reasonable Compensation Restriction: Who Does It Apply To?

So, the crux of the question is whether the reasonable compensation standard and its restriction apply narrowly or broadly.

The legislative history suggests that it applies only very narrowly. According to the descriptions provided both in the conference report and the original Senate section-by-section, the restriction applies only to S-corporations. (I’m pasting at the back the description from the Senate section-by-section and then from the conference report.) This would connect with the existing “reasonable compensation” doctrine that has developed in the S-corporation context to determine whether owners are paying themselves reasonable salary or not. (They have been incentivized to underpay themselves in terms of salary and take more as firm profits to avoid the Medicare payroll tax — sometimes called the Gingrich/Edwards loophole for two people who notoriously took advantage of it.)

So, if that’s true, then there appear to be no restrictions at all on service providers organized as sole proprietorships and very limited restrictions on partners in partnerships — so long as they make less than the high-income threshold. And, for those above that threshold, they might still get the full benefit of the deduction if they meet the additional requirements (service providers in the industries that don’t fall under the high-income restrictions).

However, here’s the problem with that view as matter of statutory interpretation: The statute itself seems to apply the reasonable compensation standard much more broadly. Again, the text (from 199A(c)(4)) is pasted in the appendix.

Note that there’s no mention of an S-corporation in the text of the statute. The reasonable compensation restriction applies to “reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered.” (emphasis added)

So, then, how about a partner given a profit allocation from a partnership in exchange for providing services to the firm? How about a sole proprietor whose entire business is to provide services? Are they receiving reasonable compensation for services? Arguably, they receive payment from “any” trade or business for services rendered — and so should be covered by the restriction.

On the other hand, the “reasonable compensation” doctrine has developed in IRS guidance and court cases in the context of corporations. (See Revenue Ruling 74–44 for the start.) Further, it is not entirely clear what it means for a partnership or, even more so, a sole proprietorship to pay compensation to an owner. Does a sole proprietor pay compensation to herself for services provided to herself? When it comes to the sole proprietor, there’s not a separate entity; she is the trade or business. (As Noel Cunningham points out, this raises questions that were addressed in a conflicted set of cases in the partnership context before 1954 — whether partners could be treated separately from the partnership. Section 707 settled these issues for partnerships, at least until this new provision came along.)

Still, reasonable compensation restriction under 199A is not specific to S-corporations in the legislative text; the text itself is broad. A payment from any qualified trade or business that’s “reasonable compensation” doesn’t get the deduction according to the provision. If Congress had wanted to say “S-corporation,” it could’ve said “S-corporation.” As a result, it seems entirely possible to read the provision as covering payments to partners and maybe even business earnings of sole proprietors in exchange for their services.

And, we are thus left with a mess of Congress’s making. For millions of Americans, it’s not clear whether they get this deduction or not — and people will be making decisions in the next few months which depend on this (how much to pay in estimated tax for instance).

What Should the IRS Do?

First, the IRS should try to quickly issue guidance to resolve the mystery and the exact breadth of the restrictions here.

Second, in terms of what that guidance should say: I vote for applying the “reasonable compensation” standard as broadly as possible, including to partnerships and sole proprietorships. Either this law will create significant perverse incentives to provide services in certain forms — as an independent contractor, as a partner, and not as an owner of an S-corporation and certainly not as an employee — or that incentive could be reduced if the reasonable compensation standard is read broadly. I support reducing that incentive and trying, to the extent possible, to tax service provision more uniformly irrespective of form.

To put a fine point on it: There shouldn’t be a large tax penalty for being an employee. Firms shouldn’t be encouraged to try to make their employees independent contractors or misclassify them that way — hugely aggravating an existing compliance problem.

Given ambiguity as we seem to have here, the IRS is due deference on its interpretation of the statute especially if it ultimately proceeds through notice and comment rulemaking (though it should take an initial position sooner than that).

To be sure, the “reasonable compensation” standard isn’t anything close to the ideal solution to all of the problems generated by this deduction. That standard too has been abused over time (again, see the Edwards/Gingrich loophole). After all, what exactly is “reasonable compensation” for services? What represents compensation that is above and beyond what is reasonable? It is a hard standard to use.

There is also the fact that, if the IRS makes it more difficult for service providers to get access to the deduction, that will still leave passive investors in qualifying trade or businesses remaining as winners from the deduction. Their benefit too should be eliminated, but that can’t be done via statutory interpretation — that’ll require legislative reversal.

So, in my view, applying the reasonable compensation standard broadly is better than nothing, and, in any case, the IRS should end the mystery for millions of taxpayers. Then Congress should get rid of this entire mess of a provision — and its many haphazard, unfair, and inefficient lines separating the winners from everyone else.

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Appendix: Statutory Text and Descriptions

Text of 199A(c)(4)

“(4) TREATMENT OF REASONABLE COMPENSATION AND GUARANTEED PAYMENTS. — Qualified business income shall not include —

“(A) reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business,

“(B) any guaranteed payment described in section 707(c) paid to a partner for services rendered with respect to the trade or business, and

“© to the extent provided in regulations, any payment described in section 707(a) to a partner for services rendered with respect to the trade or business.

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Description of the Restrictions Under 199A(c)(4) in Conference Report

Reasonable compensation and guaranteed payments

Qualified business income does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer. Similarly, qualified business income does not include any guaranteed payment for services rendered with respect to the trade or business, and to the extent provided in regulations, does not include any amount paid or incurred by a partnership to a partner who is acting other than in his or her capacity as a partner for services. (Footnotes Omitted)

(This description was of the restrictions in the original Senate provision, but those restrictions were adopted in the finaal conference bill.)

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Description of the Restriction in the Senate Section-by-Section

QBI does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer (as determined under current law). QBI also does not include any amount paid by a partnership that is a guaranteed payment under section 707(c) or a section 707(a) payment for services.

(This description comes from the Senate Finance Committee’s section-by-section description of the Senate Finance Committed-adopted bill. The restriction was then adopted in the final conference bill.)

[1] My thoughts on the “reasonable compensation” standard have benefited tremendously from discussions with and insights from Lily Batchelder, Noel Cunningham, Ari Glogower, Daniel Hemel, David Miller, and Mike Schler. They may not all agree with one another (and may not agree with me!), but I have benefited from their debates. Of course, all errors here are my own.

[2] The restrictions phase in over a $100,000 span above the threshold — so the restriction is only fully in effect at $415,000 in taxable income for a married couple (and half that for a single individual).

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