Published: 4/8/2023 1:00:18 PM
By John Cunningham
For the Monitor
Most business owners who read this column must submit their completed federal tax returns for 2022 to the IRS this year by April 18. In these returns, they will obviously want to claim to the fullest extent possible every federal income tax deduction that is available to them. In this column, I’ll provide two tax tips regarding federal tax planning techniques that may be useful to them and their tax preparers in preparing their 2022 tax returns—techniques of which even a significant number of tax preparers may be unaware.
Section 199A. Internal Revenue Code (IRC) Section 199A provides most individuals who are business owners and who own interests in “pass-through entities” with an annual federal income tax deduction of 20% of their shares of the net income of these entities (called “qualified business income” under Section 199A). Pass-through entities include state-law sole proprietorships, virtually all single-member LLCs taxable as sole proprietorships for federal tax purposes, and state-law business corporations and LLCs that are taxable as S corporations.
If you are one of the above individuals, your key goal under Section 199A should be to arrange your business structure to maximize your Section 199A deduction by maximizing your net business income. In the case of multi-member LLCs taxable as partnerships or S corporations and the case of state-law business corporations taxable as S corporations, this means that under your operating agreement if your business is an LLC or under your shareholder agreement if it is a corporation, you should minimize any income you derive from your company as a salary or bonus (called a “guaranteed payment” in partnership tax terms). This will maximize your net business income and thus will maximize your Section 199A deduction. Salaries, bonuses and guaranteed payments reduce your net business income; distributions of net income do not.
If your business is a multi-member LLC taxable as a partnership, IRC Section 761(c) may facilitate your effort to maximize your 2022 net business income. Section 761(c) provides, in essence, that as long as you have a valid business purpose for doing so, you can retroactively amend your operating agreement to change any income you have received from your LLC as a guaranteed payment during the relevant taxable year to income you have received as a distribution of your share of LLC income.
The Self-Employment Tax (the “SET”). The SET is a major federal tax; it applies at a rate of 15.3 percent to the first $147,000 of the income of individuals who are liable for it—a tax of $22,491 on this $147,000. However, a little-known IRS proposed regulation designated Prop. Reg. § 1.1402(a)-2 (the “Prop. Reg.”) provides a powerful means to reduce this liability. Under the Prop. Reg., the capital structure of your LLC operating agreement must provide for two classes of members—a management class and an investor class—and it must provide that at least 20% of the income that your operating agreement allocates to LLC members must be allocated to members who are passive. This may include, for example, the spouses of active members of the LLC if these passive spouses work for the LLC for fewer than 500 hours per year. But if your LLC has this structure, then even if you yourself are active in your business, not only the above passive members but also you yourself will be able to avoid the SET on allocations to you and the passive member as members of the investor class.
It is true that the Prop. Reg. is merely a proposed regulation. However, the IRS itself in at least two public forums has stated that the Prop. Reg. is its audit guideline for determining the SET liability of members of entities taxable as partnerships.