When PEOs Spell Trouble
Thursday, April 26, 2018
Posted by: Hilary Korabik
When PEOs Spell Trouble
by Rob Nowak of Baker Tilly Virchow Krause, LLP
When Congress passed the Tax Cuts and Jobs Act, (the Act or the TCJA), the legislation provided for a 20 percent deduction for domestic qualified business income from a partnership, S corporation or sole proprietorship, the Qualified Business Income (QBI) deduction under new code section 199A. . While Congress included a new provision in the code, it failed to address many questions or to define certain terms critical to this deduction.
For years beginning after December 31, 2017, contractors other than corporations are generally entitled to the 20 percent deduction for qualified business income. This deduction is reported on the individual tax return of the pass-thru owner and is limited to 50 percent of his/her share of W-2 wages paid with respect to the QBI, or to 25 percent of wages plus 2.5 percent of qualified depreciable property. The limitation is easy to define when considering a contractor that pays its employees directly.
But what if the contractor utilizes a PEO (professional employer organization) for benefits leverage and payroll efficiency? Did Congress intend for wages paid by a PEO, but attributable to the contractor, to count towards the 50 percent wage limitation for the QBI deduction?
A similar wage limitation applied under the “old” Section 199 rules governing DPAD. Treasury specifically addressed in the “old” regulations whether wages paid from a PEO counted towards the DPAD wage limitation. Treasury Regulation 1.199-2 stated “If the taxpayer is treated as an employer described in section 3401(d)(1) because of control of the payment of wages (that is, the taxpayer is not the common law employer of the payee of the wages), the payment of wages may not be included in determining W-2 wages of the taxpayer.” Simply stated, for purposes of DPAD, wages paid by a PEO counted toward the wage limitation in computing the DPAD limitation.
Can the PEO wages rules under the old Section 199 regulations be applied to Section 199A? The answer is a resounding no. Applying the DPAD regulations to QBI would be like mixing apples and avocados. The regulations under Section 1.199-2 apply for computing the limitation on DPAD, not QBI. The DPAD deduction under Section 199 has been repealed and the regulations thereunder contain no reference to Section 199A.
As of the date of this writing, there is no guidance from Treasury giving taxpayers any authority to include wages paid by a PEO towards the QBI wage limitation. In addressing other areas of the TCJA where clarity is lacking, the IRS has stated that the law as written is clear and should be applied based on current guidance.
Will guidance be forthcoming? The short answer is we don’t know. With mid-term elections this November, it is uncertain whether Congress will address this and provide clarification to the TCJA before 2019. Additionally, there are differing opinions as to whether Treasury will act to provide clarification before Congress does. It should be noted, that PEOs have been around for more than 30 years. Neither Congress, nor Treasury, has yet to address numerous issues regarding the treatment of employees “employed” by the PEO. It is unlikely this will change in the next few months.
Where does this leave contractors who use PEOs and would otherwise qualify for the QBI deduction? The only fail safe is to discontinue use of the PEO and employ workers directly or use a common paymaster structure. Given these alternatives may not be appropriate for your situation, contractors should work with their PEO and tax advisor to develop a strategy, if those discussions aren’t already in progress.
But do not wait! Every pay period may put a contractor further behind in the QBI wage limitation.
About the author:
Rob Nowak is a tax partner with member company Baker Tilly, specializing in work with construction companies. He has experience in the technical areas of partnership taxation, taxation of closely held corporations and mergers and acquisitions. Rob can be reached at firstname.lastname@example.org.