Source: https://www.rosenbergmartin-tax.com/news/section-199a-how-reasonable-compensation-will-be-defined-and-how-it-may-impact-the-qbi-deduction/
Timestamp: 2019-04-19 10:34:21+00:00

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From its inception, Section 199A made it fairly clear that the deduction for qualified business income (“QBI”) would not apply to all income in respect of pass-through businesses. Aside from limitations dependent on the nature of the industry (i.e., the “specified service trade or business” provisions of I.R.C. § 199A(d)(2)), the total wages paid to employees and capital used in the business (I.R.C. § 199A(b)(2)(B)), and the nature of the income itself (I.R.C. § 199A(c)(3)(B)), the statute indicated that payments in the nature of wages to business owners were not included within the definition of QBI. For instance, I.R.C. § 199A(d)(1)(B) excludes the “trade or business of performing services as an employee” from the definition of a “qualified trade or business.” More important to most business owners, however, I.R.C. § 199A(c)(4) provided that QBI shall not include “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,” certain guaranteed payments made to partners, and certain payments to partners for services rendered.
For the past year, many had hoped that regulations would curtail the impact of “reasonable compensation” in the context of Section 199A or, at least, be interpreted to keep different entity types on the same footing. Unfortunately, the unveiling of the final regulations under Section 199A did little, if anything, to address these issues. In light of final regulations issued in the past few weeks, business owners should familiarize themselves with existing guidance on “reasonable compensation,” how those interpretations may affect their ability to claim the QBI deduction, and consider steps that can be taken to maximize the QBI deduction going forward.
To understand the potentially different treatment amongst different entities, some background is needed. The QBI deduction was intended as a benefit only with respect to the profits interests of business owners – not payments made by businesses in the form of wages. Accordingly, I.R.C. § 199A(c)(4) carved out items paid to business owners that were less like profits and more like wages (i.e., not predicated on income of the business). The separate exclusions for S corporations, partnerships, and sole proprietorships were needed due to the way in which payments to business owners were classified. The “reasonable compensation” provisions of Section 199A only apply to those businesses structured as S corporations for tax purposes. In the case of partnerships and sole proprietorships, “reasonable compensation” is irrelevant as all net income from the business is considered net business income or a guaranteed payment. Further, the Service previously indicated that a partner of a partnership may not be an employee of that partnership. Rev. Rul. 69-184, 1969-1 C.B. 256.
“[R]easonable compensation” is a well-known standard in the context of S corporations. Under Rev. Rul. 74-44, 1974-1 C.B. 287, S corporations must pay shareholder-employees “reasonable compensation for services performed” prior to making “dividend” distributions with respect to shareholder-employees’ stock in the S corporation under section 1368. See also David E. Watson, P.C. v. United States, 668 F.3d 1008, 1017 (8th Cir. 2012). The legislative history of section 199A confirms that the reasonable compensation rule was intended to apply to S corporations…The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevent from including an amount equal to reasonable compensation in QBI.
Section VII.C. (Reasonable Compensation), 83 FR 40884 (August 16, 2018). From this alone, it can be inferred that the Service will likely impute reasonable compensation for shareholder-employees if it is not otherwise reported on their tax return.
Moreover, the Service will likely look to court precedent in the self-employment tax context to determine if reasonable compensation is appropriate in a given case under Section 199A. For small business owners, they should expect reasonable compensation to be subject to close scrutiny. See, e.g., Spicer Accounting v. United States, 918 F.2d 90 (9th Cir. 1990)(“salary arrangements between closely held corporations and its shareholders warrant close scrutiny”). Classification as an independent contractor, in order to avoid deemed “reasonable compensation,” is not likely withstand scrutiny. Joseph M. Grey Public Accountant, P.C. v. Commissioner, 119 T.C. 121 (2002). The Service has, in essence, documented its litigation position on the factors to be used to determine reasonable compensation. See IRS Fact Sheet 2008-25 (factors include training and experience, duties and responsibilities, time and effort, dividend history, comparison to other businesses, formulas, etc.). Business owners should pay attention to these factors in determining how best to structure a business and compensation in light of Section 199A.
With the addition of Section 199A, business owners have yet another item to consider when selecting a business structure that minimizes taxes. No longer will small businesses, without significant property, need to solely consider how entity selection may impact self-employment taxes. Now, business owners will need to consider this issue in tandem with the impact of entity selection on Section 199A calculations (e.g., QBI base and W-2 limitation). It may be that the old structure will not result in the lowest overall tax liability in light of the Tax Cuts and Jobs Act. Further, business owners may want to consider re-drafting compensation/employment agreements, rethinking their duties and responsibilities with respect to the business, or perform an analysis of market rate salaries. Either or all of these steps may be necessary to bolster a claim of “reasonable compensation” in the future should one seek to maximize their QBI deduction or be forced to defend it in the context of an audit.

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