Taxpayers filing returns with Section 199A deductions—more likely to incur accuracy-related penalties under Section 6662

November 6, 2020

In 2017 via the Tax and Jobs Act of 2017, Congress enacted a new section of the Internal Revenue Code that greatly benefits certain business owners. Internal Revenue Code Section 199A provides eligibility to certain taxpayers, to deduct up to 20% of qualified business income (“QBI”) from a domestic business operated as a sole proprietorship, partnership, S corporation, trust or estate for taxable years beginning after December 31, 2017.  While the deduction can be taken by individuals, estates, and trusts, it is not available for wage income or business income earned through a C corporation.  Section 199A’s termination date is December 31, 2025.

The new Internal Revenue Code Section 199A offers eligible taxpayers an opportunity to enjoy hefty tax savings in future years. Section 199A generally allows eligible taxpayers to deduct (1) 20 percent of their qualified business income, plus (2) 20 percent of real estate investment trust (“REIT”) dividends, and qualified publicly traded partnership (“PTP”) income. With respect to the QBI component of the deduction, it should be noted this deduction is subject to limitations that may include the type of trade or business, the amount of W-2 wages paid by the business, and the unadjusted basis immediately after acquisition (“UBIA”) of qualified property by the business. Similar to QBI, the PTP income may be limited depending on the PTP’s type of business, but neither the REIT or PTP income are limited by W-2 wages or UBIA of qualified property.  In all, the QBI deduction is limited to 20% of taxable income less capital gain and/or income.

This new law is still very unclear.  For example what type of businesses are included as specified service trade or businesses?  Despite the fact that the law and the methods involved with the Section 199A deduction are complex, the new law amends the accuracy-related penalty language to provide for a lower threshold and before an accuracy related penalty is applied. For returns that do not feature Section 199A deductions, substantial understatements of tax for which an accuracy related could apply, are considered the greater of 10% of the tax required to be shown on the return for the tax year or $5,000. On the contrary, for returns that feature Section 199 deductions, substantial understatements of tax, for which an accuracy-related could apply, are considered the greater of 5% of the tax required to be shown on the return for the tax year or $5,000.  In essence, the threshold for the Internal Revenue Service to assert accuracy-related penalties has decreased for returns utilizing the Section 199A deductions.  In addition, these changes to the accuracy-related penalty do not require the substantial understatement to be attributed to the Section 199A deduction.  Therefore, any taxpayer who claims the Section 199A deduction will be subject to the lower threshold, even if the understatement is unrelated to Section 199A.

Because federal audits are often very expensive for taxpayers, abatement of accuracy-related penalties, which could range from 20 to 40% of the tax deficiency being alleged, can save taxpayers a lot of money.  However, whether or not taxpayers can actually save money via penalty abatement, will come down to their ability to establish a reasonable basis for the positions stated on his or her return.

If you are being audited by the IRS, please contact our experienced and highly skilled lawyers at Law Offices of A. Lavar Taylor, as we can advise you in even the most complex tax scenarios.

Author: Rami M. Khoury, Attorney