Employee Payroll – 1099 Contractors – IRC Sec. 199A Pass-Thru Deductions

Employee Payroll – 1099 Contractors – IRC Sec. 199A Pass-Thru Deductions

Employee Payroll – 1099 Contractors – IRC Sec. 199A Pass-Thru Deductions for cannabis startups.

The cost of labor often represents the single most significant operating expense for many cannabis industry businesses. The proper classification of individuals as employees [paid on Form W-2] vs.Employee Payroll - 1099 Contractors - IRC Sec. 199A Pass-Thru Deductions independent contractors [paid on Form 1099-MISC] is often complicated. Decisions relating to worker classification and related issues that must be addressed include:

The mechanics of processing payroll for employees and remitting employment taxes, as well as employment-related filings with regulatory agencies, are complicated, mainly when some or all of these payments are cash payments.

Consideration of workman’s compensation insurance coverage for both employees and independent contractors must be addressed.

The amount of compensation paid, particularly to “owners” and related parties, must be evaluated in light of “reasonable compensation” rules.

The new pass-through deduction under IRC Sec. 199A analyzes worker classification and compensation issues far more complex.

Non-Employee Compensation

Cannabis businesses include, but are not limited to, cultivators, manufacturers, distributors, transporters, and dispensaries.  Employees include floor workers, managers, plant caretakers, budtenders, security guards, drivers, salespersons, and delivery persons.

Employee Payroll – 1099 Contractors – IRC Sec. 199A Pass-Thru Deductions

Who is an Employee?

As defined in the California Unemployment Insurance Code, an employee includes:

Any officer of a corporation.

Any worker who is an employee under the usual common law rules.

Any worker whose services are specifically covered by the law.

An employee may perform services on a less than full-time or temporary basis. The law does not exclude services from employment which are referred to as day labor, part-time help, casual labor, temporary help, probationary, or outside work.

Wages
Wages are all compensation for an employee’s services, whether paid by check or cash, or the reasonable cash value of noncash payments.
Wages include, but are not limited to:
Salaries, hourly pay, piece rate, or payments by the job.
Commissions and bonuses.
Overtime and vacation pay.
The reasonable cash value of compensation other than cash.
Wages are subject to all employment (payroll) taxes and are reportable as Personal Income Tax (PIT) wages unless otherwise stated.

Register as an Employer – If you operate a business and employ one or more individuals, you must register as an employer with the EDD when you pay wages more than $100 in a calendar quarter. Once an employer becomes subject to registration with the EDD, the employer must register within 15 days.

Employee Payroll – 1099 Contractors – IRC Sec. 199A Pass-Thru Deductions

Withhold, Report, and Pay

California businesses that hire employees to perform services are required by law to withhold, report, and pay payroll taxes to the EDD.

Note: If a cannabis business is unable to obtain a checking account, the business is still required to remit payroll taxes and should contact the local Employment Tax Office to make the appropriate arrangements with an EDD representative.

E-file and E-pay Mandate

In 2017 California state law required employers with 10 or more employees to electronically submit employment tax returns, wage reports, and payroll tax deposits to the EDD. Beginning January 1, 2018, all employers became subject to this mandate.

File and Pay Online with e-Services for Business

e-Services for Businesses is your fast, easy, and secure way to manage your employer payroll tax account online 24 hours a day, seven days a week.
Workman’s Compensation

All California employers must provide workers’ compensation benefits to their employees under the California Labor Code Section 3700. If a business employs one or more employees, the business must provide workers’ compensation benefits under California law.

Sometimes a business owner (sole proprietor) may desire to purchase workers’ compensation insurance to cover himself/herself only. The inclusion of a sole proprietor must be clearly stated in the workers’ compensation policy or must be added as a coverage endorsement to the policy. Since workers’ compensation insurance is a type of liability insurance where the employer assumes complete liability for all worker injuries, a workers’ compensation policy for a sole proprietor may not be the best choice.

Purchasing health, life, and disability income insurance can be a viable option for workers’ compensation for a sole proprietor. Contact a licensed commercial broker-agent or a casualty broker-agent for further information and consultation.

Executive officers and directors of corporations must be included in workers’ compensation coverage unless the directors and officers fully own the corporation. If the directors and officers fully own the corporation, then they may elect to be excluded from workers’ compensation benefits. Wholly owned corporations may want to discuss the option to include or exclude their officers and directors with a licensed commercial broker-agent.

California Labor Code Section 3351 defines who an employee is, and therefore who can be covered under a workers’ compensation policy. Whether a business is a sole proprietorship, a partnership, or a corporation, it is beneficial to develop a working relationship with a reliable, competent broker-agent who can explain coverage eligibility issues and present options based on the organization model of a business.

Employee Payroll – 1099 Contractors – IRC Sec. 199A Pass-Thru Deductions

Employers must purchase workers’ compensation insurance from either a licensed insurance company or through the State Compensation Insurance Fund (State Fund). Employers may also have the option to self-insure for workers’ compensation.

A commercial broker-agent can assist a business with purchasing workers’ compensation insurance from a licensed insurance company and can assist with information on State Fund and self-insurance. Also, information on insurance companies licensed to sell workers’ compensation insurance and an online rate comparison of the top 50 workers’ compensation insurers can be accessed on the California Department of Insurance (CDI) Web site at www.insurance.ca.gov.

State Fund is a state-operated entity that exists to transact workers’ compensation on a non-profit basis. State Fund competes with private workers’ compensation insurance companies for business and also operates as the insurer of last resort if private companies are not willing to offer workers’ compensation insurance.

Self-insurance requires state approval, a net worth of at least $5 million, net income of $500,000 per year and posting of a security deposit. While historically only huge companies could self-insure because of legal requirements, in recent years group self-insurance, in which several small employers in the same homogenous industry pool their workers’ compensation liabilities, has increased in popularity as an alternative to traditional coverage.

A self-insured employer has the option of administering its own workers’ compensation claims or contracting with a third-party administrator (TPA) to provide these services.

The state does not regulate Workers’ compensation insurance premium rates. While the Workers’ Compensation Insurance Rating Bureau – the licensed statistical agent for the state insurance commissioner – issues recommended rates and carriers must file their rates with the California Department of Insurance, prices can vary from carrier to carrier. Like any reasonable consumer, you should shop around for a carrier that best meets your needs. Cost is one consideration, but there are other factors to look at services provided, ease of access to the claims adjusters, their familiarity with your industry, the doctors in their network, etc. If you have a broker or agent, he or she should be able to give you expert guidance.

You must post the “notice to employees” poster in a conspicuous place at the work site. This poster provides employees with information on your workers’ compensation coverage and where to get medical care for work injuries. Specific requirements are contained in sections 3550-3553 of the California Labor Code. Failure to post this notice is a misdemeanor that can result in a civil penalty of up to $7,000 per violation. Contact your insurer to get the posting notice and the required information that must be included on it.

You must also provide newly hired employees with a workers’ compensation pamphlet explaining their rights and responsibilities.

Reasonable Compensation

An ongoing area of focus for the IRS is whether the compensation paid to a shareholder-employee of an S corporation is reasonable. A recent district court decision highlights the employment tax risks to S corporations that are found to have paid unreasonably low compensation to shareholder-employees while making distributions to the same individuals.

The considerations for an S corporation are much different from those of a C corporation. In the case of a closely held C corporation, the IRS is often concerned with whether the compensation paid for personal services rendered by an employee-shareholder is excessive and is being used to avoid the second level of tax in the form of a dividend distribution. In the case of an S corporation, the IRS believes that employee-shareholders, particularly those who provide professional services, have an incentive to draw a minimum salary to reduce their payroll tax liability.

These shareholder-employees would prefer to take a tax-free distribution of funds from the S corporation instead of withdrawing the funds in the form of additional salary. The employee-shareholder is already paying tax based on his or her marginal ordinary income tax rates, whether or not the S corporation distributes the income to the shareholder. In many cases, the actual distribution does not result in additional federal income tax because the shareholder will have sufficient tax basis in the stock to absorb the distribution. Thus, by seeking to recast compensation as a tax-free distribution from the S corporation, the employee’s wages are reduced, income goes down, but a comparable amount increases taxable income from the S corporation. The net effect on the shareholder’s income is zero or negligible. However, even though taxable income remains the same, there will be less payroll tax liability to the S corporation as well as to the employee-shareholder.

The IRS can re-characterize distributions to the S corporation employee-shareholder as wages for employment tax purposes. In Rev. Rul. 74-44, the IRS ruled that distributions that two employee-shareholders arranged to receive instead of compensation for services they performed be deemed wages and were therefore subject to FICA, FUTA, and federal income tax withholding. The revenue ruling described a situation in which there was a clear avoidance motive, as distributions were made to compensate the shareholder-employees who received minimal salaries in that year. Several courts have confirmed the IRS’s ability to increase the employment tax obligations of S corporations under this theory. A recent case that decided this issue in favor of the IRS is David E. Watson, P.C., No. 4:08-cv-442 (S.D. Iowa 12/23/10).

The issue, in this case, was whether David Watson’s salary paid by the taxpayer, a professional corporation that elected to be taxed as an S corporation, for 2002 and 2003 was reasonable. Watson was the sole shareholder and employee of the professional corporation, and the professional corporation was a member of an accounting firm. Watson was a CPA with more than 20 years of experience who specialized in partnership taxation. During the 2002 and 2003 tax years, he provided accounting services to the related accounting firm through the professional corporation. Watson received only $24,000 in salary subject to the required employment taxes, while he received larger distributions of profits totaling $200,000 and $175,000 in those years.

The district court found that his regular salary of $24,000 for 2002 and 2003 was not reasonable. Based on the specific facts and circumstances, the court found that an annual salary of $91,044 was reasonable, and it, therefore, reclassified $67,044 in distributions to wages and required the taxpayer to pay employment taxes on the additional salary amounts each year, as well as interest and penalties.

The court based its decision in substantial part on an analysis of what other businesses paid for similar services performed by employees comparable to Watson in training and experience as a tax professional. The fact that a professional with 20 years of experience was being paid entry-level compensation seemed to influence the court particularly. It concluded that an employee of Watson’s stature, experience, and earning power is worth more than the $24,000 salary paid, as seen by the significant profit distributions he took instead of salary.

Employee Payroll – 1099 Contractors – IRC Sec. 199A Pass-Thru Deductions

In advising clients, tax practitioners often seek to provide more specific guidance to determine how much compensation an S corporation should pay an employee-shareholder to reduce or eliminate the risk of recharacterization of distributions as wages. The IRS has provided some guidance in Fact Sheet 2008-25 (August 2008). In that document, the IRS states that there are no specific guidelines for reasonable compensation within the Code or regulations and that each case is different based on the independent factors as well as the particular nature of the situation. However, FS-2008-25 explicitly states that S corporations should treat payments for services to officers as wages and not as distributions of cash and property unless they perform no or minimal functions. Although there is no specific guidance to determine whether compensation is reasonable, the fact sheet lays out the following factors that the courts have addressed:

  • Training and experience;
  • Duties and responsibilities;
  • Time and effort devoted to the business;
  • Dividend history;
  • Payments to non-shareholder employees;
  • Timing and manner of paying bonuses to key people;
  • Payment by comparable companies for similar services;
  • Compensation agreements; and
  • The use of a formula to determine compensation.

The Watson decision serves as a reminder that it is essential to consider a variety of factors in establishing reasonable compensation levels for shareholder-employees of an S corporation and why it is so important to closely monitor specific facts and circumstances when determining whether a compensation level is reasonable.

The IRS assumes all corporate officers are performing services for the S Corp and should be paid Reasonable Compensation. If your client is a corporate officer in name only and not performing any services for the S Corp, there is an exception in the IRS code for officers who perform only minor services. (Treas. Reg. § 31.3121(d)-(1)(b)) If you are filing Form 1125-E, make sure time devoted to the business is 0% and make a notation in the corporate minutes.

S Corp officers are not required to take Reasonable Compensation if they are not making a distribution. If an S Corp owner can delay taking distributions for one or more years, when she does make the distribution (depending on the amount) she may be able to avoid some employment taxes. This happens when the Reasonable Compensation figure for multiple years exceeds the Social Security maximum. Be aware that when a multiple-year distribution is taken, the Reasonable Compensation should match the distribution’s time frame.
If you own your S corporation and provide services to your S corporation, the law says:

You are an employee of your S corporation.

Your corporation must pay you reasonable compensation as wages for the services that you perform.

If you fail to pay yourself reasonable compensation, then the IRS can recharacterize your S corporation distributions as wages, making you and your S corporation liable for all payroll taxes during the statute of limitations period.

Your reasonable compensation is what you’d pay a third party to perform the services that you deliver.

Moreover, now, thanks to tax reform, IRC Sec. 199A is an essential factor in your reasonable compensation decisions.

Reduced Salary

If you reduce your salary, you increase your S corporation’s pass-through income, and that can improve your Section 199A deduction if you have the correct taxable income and the right business. However, such a decision comes with significant risks:

The IRS can recharacterize your S corporation distributions into wages, hitting you with retroactive payroll taxes, penalties, and interest.

IRS recharacterization would also reduce your pass-through income as well as your Section 199A deduction.

IRS recharacterization of your S corporation distributions as wages prevents these wages from counting toward the Section 199A wage limitations because you didn’t report these wages on a timely Form W-2.

You pay less into Social Security, reducing your monthly benefit in retirement.

Increased Salary
If you grow your salary, then you’ll have a larger wage base for the Section 199A limitation, thus growing your Section 199A deduction if you are above the applicable taxable income threshold. However, that comes at a significant cost:
You’ll overpay payroll taxes.

You reduce your pass-through income, thus decreasing your Section 199A deduction.

Zero Salary
There’s one limited circumstance where you can legally pay yourself zero reasonable compensation as an S corporation owner.
If you don’t provide any services to your S corporation (or only minimal services) and you neither receive nor are entitled to receive any remuneration from your S corporation, then you aren’t an employee of your S corporation—and you don’t have to pay yourself reasonable compensation.

By arranging your S corporation operations to meet the zero-salary requirement, you can

eliminate FICA taxes on your salary,
maximize your S corporation pass-through income (and your Section 199A deduction), and

use the wage income you pay your employees to run the company for Section 199A limitation purposes
Sole Proprietors
Reasonable compensation doesn’t apply to your sole proprietorship business—you can’t be an employee of yourself.

Employee Payroll – 1099 Contractors – IRC Sec. 199A Pass-Thru Deductions

Some commentators have opined the IRS will come up with a process to impute reasonable compensation for your sole proprietorship and limit your Section 199A deduction.

We don’t agree for two reasons:

The conference committee report unequivocally states the reasonable compensation provision applies only to S corporations.

The conference committee report has examples that compute the Section 199A deduction for sole proprietors as merely the net business income multiplied by 20 percent.

Planning and Follow Up

Determine an Accurate Reasonable Compensation figure in every instance. Without an accurate, reasonable compensation figure, the rest of tax planning is just a guess.

Research and documentation are a best practice. If you don’t have a simple, economical and efficient solution for determining a reasonable compensation figure, there are tools available to do so.

Clients who would like to transfer money out of their S Corp as loan repayment should have that loan adequately documented and treated as if it were an arm’s length agreement. The IRS requires S Corps to pay Reasonable Compensation before taking a distribution, but an S Corp can re-pay loans before paying reasonable compensation to its shareholder-employees as long as the IRS deems the loan as valid.
IRC Sec. 199A Pass-Thru Deduction

 

In December 2017, Congress passed the Tax Cuts and Jobs Act, quickly making the most significant changes to both individual and corporate taxes in more than 30 years. As part of those changes, Congress created a new section of the tax code, IRC Section 199A, which provides a brand new 20% deduction on “qualified business income” for the owners of various “pass-through business entities” (or really, any business entity that is not a C corporation), including both S corporations, limited liability companies, and partnerships, as well as sole proprietorships.

The good news for advisors is that this deduction, known both as the 199A deduction, or the qualified business income (QBI) deduction, is a huge tax break for many of their business-owning clients. The bad news is that the QBI deduction is, without a doubt, one of the most complicated provisions of the new law, and it may be some time before we get some meaningful additional guidance from the IRS.

That being said, even with today’s “limited” information, practitioners have been drooling over planning opportunities around the QBI deduction, dreaming up ways to allow business owners to secure the most significant possible deductions. Those planning strategies are the primary focus of this article, but to plan productively, it’s important to recognize that given the QBI rules as written, business owners will generally fall within one of three categories when it comes to the QBI deduction:

Business owners below their applicable threshold amount – which is $157,500 of taxable income for all filers except joint filers, and $315,000 for those filing jointly – can enjoy a QBI deduction for the lesser of 20% of their qualified business income or 20% of their taxable income. It does not matter what type of business is generating the revenue, nor is there a need to analyze W-2 wages paid by the company or depreciable assets owned by the market. The QBI deduction is what it is.

Business owners over their applicable threshold who derive their income from a “specified service” business (i.e., some specialized trade or service business) – which includes doctors, lawyers, CPAs, financial advisors, athletes, musicians and any company in which the principal asset of the business is the skill or reputation of one or more of its employees– will have their QBI deduction phased out. The phase-out range is $50,000 for all filers except joint filers and $100,000 for those filing jointly.

Once a business owner’s taxable income exceeds the upper range of their phase-out threshold ($207,500 for individuals, and $415,000 for married filing jointly), they cannot claim a QBI deduction for income generated from a specialized trade or service business. Period. End of story. “Do not pass go, do not collect $200.”

Business owners over their applicable threshold who derive their income from a business that is not a specialized trade or service business may also have their QBI deduction at least partially phased out, but the full deduction may be “saved” based on how much they pay in W-2 wages and/or how much depreciable property they have in the business. Business owners with qualified business income from non-specified- service businesses whose taxable income exceeds the upper range of their phase-out threshold can still take a QBI deduction equal to or less than the greater of:

50% of the W-2 wages paid by the business generating the qualified business income, OR
25% of the W-2 wages paid by the company making the qualified business income, plus 2.5% of the unadjusted basis of depreciable property owned by the business.

A careful analysis of the rules above will lead one to realize that, when it comes to maximizing a business owner’s opportunity for a QBI deduction, strategies will fall into one of three main buckets:

Income reduction strategies, such as trying to lower taxable income by increasing deductions or spreading out the income over multiple taxpayers, to stay below the income threshold where the specified service business or wage-and-property tests kick in.

“Income alchemy” strategies where we try to transform income derived from a specified service business into income derived from a company that is not specific service business to avoid the phaseout (for those over the income threshold).

Business strategies, such as changing an entity, revisiting compensation models, and revisiting business assets, to more favorably characterize business income in the first place.

Employee Payroll – 1099 Contractors – IRC Sec. 199A Pass-Thru Deductions

 

 

Author: abizcannabis

Managing Director & CEO of integrated transactional financial advisory, tax, and technology consulting firm - aBIZinaBOX Inc New York, Chicago, and OaklandCPA.CITP.CISM.CGEIT.CGMAExpertise with: Alt. Investments/Private Equity, Real Estate, Professional Services, CA Cannabis, Tech Start-Ups and Distressed Assets/DebtTechnology Certifications including:Advanced & High Complexity Cloud Integrator AICPA PCPS, CAQ,, IMTA, CITP ISACA CGEIT, CISMState CPA Societies in California, Florida, Illinois, New York and TexasExpertise with Regulatory Compliance - US - HIPAA, FINRA, SEC Rule 17(a)(3)/(4), eDiscovery, FINCEN - EU- EBA, ESMA, EIOPA UK - BoE, PRA, FCA