A little-noticed consequence of the proposed regulations on the 20% qualified business income (QBI) deduction introduced by the legislation known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, is that so-called statutory employees may be able to claim the deduction.
One of the requirements of being a qualified trade or business for purposes of claiming the QBI deduction is that the taxpayer must not be in the trade or business of performing services as an employee (Sec. 199A(d)(1)(B)). Prop. Regs. Sec. 1.199A-5(d)(1) further specifies that "income from the trade or business of performing services as an employee refers to all wages ... and other income earned in a capacity as an employee, including payments described in [Regs. Sec.] 1.6041-2(a)(1) (other than payments to individuals described in Sec. 3121(d)(3)) and [Regs. Sec.] 1.6041-2(b)(1)" (emphasis added).
Payments described in Regs. Sec. 1.6041-2(a)(1) are generally those required to be reported on Form W-2, Wage and Tax Statement. Payments described in Regs. Sec. 1.6041-2(b)(1) are those distributed or made available to beneficiaries of certain employee trusts or annuity plans.
Individuals described in Sec. 3121(d)(3) are statutory employees. Since payments to them are not included in income from the trade or business of performing services as an employee, it appears that these payments may be includible in QBI and that statutory employees are eligible to claim the deduction if they meet all other requirements. Payments to statutory employees also are not considered W-2 wages for purposes of the W-2 wage limitation on the deduction, which further suggests the payments are QBI (see Prop. Regs. Sec. 1.199A-2(b)(2) and Notice 2018-64, §3).
Statutory employees are defined as those in four specific vocations:
- Drivers who earn commissions by distributing meats, produce, or bakery items, beverages other than milk, or laundry or dry-cleaning services;
- Full-time life insurance salespeople;
- Home workers performing services on materials owned by their employer; and
- Traveling salespeople soliciting orders of merchandise for resale or use in business operations.
Statutory employees are unique in that they are often considered self-employed, although their income is reported on Form W-2. A consequence of this income-reporting requirement is that statutory employees have Social Security and Medicare contributions made on their behalf by an employer and are not subject to self-employment taxes. However, they are involved in a trade or business that reports income on Schedule C, Profit or Loss From Business (Sole Proprietorship), and are not employees for purposes of claiming deductions against that income under Sec. 62 or Sec. 67. Thus, ordinary and necessary business expenses can be directly deducted on Schedule C before arriving at adjusted gross income.
While less prevalent than they once were, some of these occupations are hardly obsolete, and a significant number of life insurance salespersons, for example, may benefit from a QBI deduction. However, a claim for the deduction may be rife with complications. It is fairly common for a life insurance salesperson to have multiple sources of income, some of which may be reported on Form 1099-MISC, Miscellaneous Income, in addition to the income reported on Form W-2. A good example is a financial adviser who sells life insurance policies primarily from one insurance company, with occasional commissions from other insurance companies, and who also provides investment, brokerage, and wealth management services.
The income from some of these sources, moreover, might not be QBI under Sec. 199A(d)(2), which provides that specified service trades or businesses (SSTBs) are not qualified trades or businesses. These SSTBs include investing and investment management. Prop. Regs. Sec. 1.199A-5(b)(2) further clarifies that SSTBs include the management of wealth and advising clients with respect to finances but also specifically excludes services provided by insurance agents and brokers.
The SSTB definition is important, as Sec. 199A(b)(3) provides for a phaseout of the QBI deduction for income from SSTBs once taxable income exceeds the threshold in Sec. 199A(e)(2) of $315,000 when married filing jointly ($157,500 for all others). The deduction is completely phased out for SSTBs once taxable income exceeds $415,000 when married filing jointly ($207,500 for all others).
In the case of the financial adviser above, assuming the taxpayer is over the upper income threshold for SSTBs, there may be multiple activities that differ in treatment for self-employment tax and the QBI deduction. Income earned as a statutory employee would not be subject to self-employment tax but could qualify as QBI. Income reported on Form 1099-MISC as an insurance agent would be subject to self-employment tax but possibly be eligible for the QBI deduction. Income reported on Form 1099-MISC from services as an investment adviser would be subject to self-employment tax but is also income derived from an SSTB that would not be taken into account in determining the QBI deduction.
This scenario raises the question of how expenses should be attributed to different sources of income. The taxpayer might think of all revenue streams as coming from one integrated practice as a financial adviser, but expenses may be clearly allocated to a segment of that practice. Investment licenses and subscriptions are two common examples. If these expenses can be directly identified, for a taxpayer with high earnings, deductions may be properly claimed against income from an activity subject to a tax rate of almost 40% (the top tax bracket of 37% plus self-employment and additional Medicare taxes) rather than an activity subject to a 29.6% rate (the top tax bracket of 37% reduced by the 20% QBI deduction). Thus, in many cases, it is favorable for the taxpayer to identify expenses as directly associated with an SSTB rather than a qualified trade or business.
However, if those direct expenses are salaries, direct allocation may prove costly. Sec. 199A provides a limit on the QBI deduction of 50% of W-2 wages paid with respect to the qualified business (or 25% of W-2 wages paid with respect to the qualified business plus 2.5% of the unadjusted basis of qualified property). For a taxpayer over the threshold amount of taxable income, the rules of Prop. Regs. Sec. 1.199A-1(d)(2)(iv) require a determination of W-2 wages attributable to each trade or business to determine the QBI component for each trade or business.
Returning to the example of the financial adviser, consider in addition an employee of the practice who assists solely with clients' investment questions rather than questions about insurance policies. If that expense were directly allocated, it would lower the SSTB income but would also lower the wages allowable in determining the limitation on the QBI deduction.
Guidance on the allocation of expenses is somewhat scarce. However, the IRS advised in Field Service Advice 39 that expenses of an insurance salesman who was a statutory employee but also carried on a separate trade or business should be divided between Schedules C according to which activity they pertained to, but if they could not be so divided, they should be allocated according to the percentage of earnings attributable to each type of work. Thus, it is important to interview statutory employees — or, for that matter, any taxpayer with multiple businesses that may or may not be SSTBs or producing QBI — and get a real understanding of their expenses and to which segment of their business those expenses relate.
On a more procedural note, that field service advice states that taxpayers may use one Schedule C to report all earnings in such instances, but it is often more practical to prepare separate Schedules C to report the different categories of income. It may be all the more necessary to determine correct treatment when factoring in a QBI deduction.
Brian M. Dingman, CPA, is an associate partner at London Witte & Company LLP in Indianapolis.
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