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199A – 2 Wage Allocation by a Third Party – Primarily RE Mgmt / Owners

RETaxAcctBrk
Level 3

Sorry for the length: The issue seemed to require a lot of details:

Question:

When must / can a business allocate W2 wages to another business for the purpose of calculating the QBI limitations? Does the analysis change if the W2 employer is a C Corp?

Situation:

Though particularly in Real Estate, I have identified other examples of where one business (W2 Payor) hires people primarily if not exclusively for work done at another business (Client), sometimes several Clients. The agreement includes the W2 Payor billing Client for all related costs plus an overhead charge.

This arrangement does not have a profit motive, but rather accommodates the Client’s desire to insulate operations or assets from compliance challenges and legal issues (Client is generally an LLC owing high value assets). Thus the W2 Payor is acting as a centralized management company, and in most cases are all related parties (at least one owner has an interest in all the entities and is generally the executive in charge and/or managing member).

Common Law Rule for Reference:

Per the IRS (https://www.irs.gov/businesses/small-businesses-self-employed/employee-common-law-employee😞 “Under common-law rules, anyone who performs services for you is your employee if you can control what will be done and how it will be done. [deleted] What matters is that you have the right to control the details of how the services are performed.”

 

But when this applies to two businesses related to a single employee, what then? I was not able to find any relevant material on this topic, and conclude the issue is strictly about ensuring people are classified as an Employee vs Contractor, not who actually reports the W2 wages in such circumstances (centralized management companies, employee loan outs, etc).

 

Specific Example:

Client has 4 real estate properties each in their own 51%+ owned LLC’s. Client also has a management business that exclusively services these 4 real estate entities by hiring W2 managers, bookkeepers and maintenance people (becoming the W2 Payor). The owner is involved with both the W2 Payor and Client’s businesses in a substantial manner. The W2 Payor can demonstrate there is no profit made on providing these employees for the Client’s use (though there is a separate management fee based on a % of rents). In this case, as with most Real Estate Operations, the Client Owner exerts significant direct control over the onsite work (extremely common in real estate operations) and can prevent any individual person / employee of the mgmt co from continuing to do work at the property (and being an owner of both the W2 Payor and Client, in such circumstance the employee would thus be fired). The W2 Payor also can exert significant direct control. In regard to the manager, a similar relationship exists. In regard to the bookkeeper who does no onsite work, the relationship does not exist (the lack of onsite work generally precludes direct Client interface and is generally behind the scenes work).

Based on the Common Law definition, it seems the onsite and manger employee are eligible Common Law employee of either the W2 Payor or Client. Thinking about standard business relationships, is seems this Substance over Form issue commonly exists, but that employment law is focused on someone claiming people an employee (vs an independent contractor), rather than determining if or who needs to claim a person when both entities have Common Law control (I could not find any such cases). This concept is what gives rise to the 199A terminology that allows allocation of W2 wage attributes, specifically as it relates to Real Estate (though poorly written).

I submit that the “W2 Attributes” for the purpose of calculating the QBI limitations must be allocated from the W2 Payor to the Clients in the sample above.

Alternatively, if in the above scenario the entities were not related parties, the W2 Attributes can or may be allocated if a written agreement of Non-Duplication was entered into by the W2 Payor and Client.

Tax Law Analysis:

Per the 199A Final Regulations, page 180, 199A-2(b)(2)(ii): I summarize this as stating: A Taxpayer may include W2 wages paid by another person (W2 Payor) and reported on that other persons W2/W3 provided that the W2 wages are related to an individual’s labor that otherwise are the Taxpayers (Client) common law employe(es). IE: the Taxpayer (Client) has the right to control the details of how the services are performed. This is supported by:

The Final 199A-2(b)(2)(ii) states that the entity paying the actual wages that allocates W2 wages can include, but are not limited to, [CPO Sec7705, statutory employers Sec3401, and agents Sec3504]”. In the proposed 199A-2(b)(2)(ii) language, it stated W2 wages can include [CPO Sec7705, statutory employers Sec3401, and agents Sec3504]”. The preamble to the proposed regs further defined third party payors as being “such as [PEO, CPE or Agents]” (see 1) Line 5 below). The use of “such as” and “can include” to “can include, but are not limited to” clearly suggests / indicates the intent was to broaden the definition of a third party payor (not restrict it) and that any similar structure would be eligible to implement W2 attribute sharing. Otherwise why not clearly limit the definition of the third party payor, especially when the IRS recognizes so few types of formal third party payor types (see https://www.irs.gov/businesses/small-businesses-self-employed/third-party-arrangement-chart ).

Regarding the preamble to the proposed regulations, Par. A. W-2 wages attributable to a trade or business, page 18 - Excerpts (as found in order written) suggest 4 key requirement to meet:

  1. Line 5 “…amounts paid to workers who receive Forms W-2 from third party payors (such as professional employer organizations, certified professional employer organizations, or agents under section 3504) that pay wages to workers on behalf of their clients [omitted], may be included in the W-2 wages of the clients of third party payors.”
  2. Line 11 “, …the Form W-2 must be for employment by the taxpayer [or client].”
  3. Line 14 “…since employees of the taxpayer are defined in the regulations as including only common law employees of the taxpayer…”
  4. Line 20 “…a person may take into account any W-2 wages paid by another person and reported by the other person on Forms W-2 [omitted], providing that the W-2 wages were paid to common law employees…”

All 4 of these requirements are met in the above example. The third party payor is acting such as, but not limited to a PEO, CPE or Agent; the employment is for the benefit of the Client, the common law definition is met, and the W2 wages are simply paid by another person.

Finally, 199A-2(b)(3) (page 184 – Allocation of wages) the regulations talk about a structure that directly conducts more than one business MUST allocate wages among the various businesses. Using the example above it seems where the W2 Payor and Client are either an individual or separate entities, all owned by the same person, this paragraph is attempting to simply state that when there is more than one trade or business being controlled by related parties, W2 wage allocation is required. This is easy to assume the goal is to best match employee W2 effort / attributes to the actual business benefited (otherwise entities could easily manipulate where the W2 wages are counted by simply moving the payroll function between the business entities and charging the other for the work as a service).

CAN allocate vs MUST allocate further explored

199A2(b)3 which states “each individual…that directly conducts more than one trade or business MUST allocate those wages amount to its various trade or businesses.  W2 wages must be allocated to the trade or business that generated those wages.”  This seems very clear and I cannot find evidence to the contrary in the preamble.

The IRS acknowledges that 199A is intended to be broadly defined (and thus subject to abuse), so both the proposed and final regulations put a clarifying statement found in 199A-2(b)(5): Non-duplication rule “an amount cannot be treated as W-2 wages by more than one trade or business”. I suggest here the IRS is stating any allocation of W2 wage attributes must be supported by agreement or supporting documents that indicates how W2 wages are being allocated which can be tied back to the W2 Payor W3, which for consistency must be followed each year after.  Thus the W2 Payor must agree to allocate the W2 attributes.

These sections again lead back to the conclusion: 199A must be contemplating the allocation of W2 wage attributes to best represent a businesses use of employee labor, supporting the reality of a centralized management relationship (vs where the employees are provided and billed at a rate where there is a profit motive).

General Thoughts on 199A Background:

199A was designed to provide business owners (including certain real estate owners) tax relief (just as Corporations were given a tax rate decrease). The lengthy preamble of 199A suggests the regulations allow a taxpayer great flexibility in certain application of the regulations to most accurately report the character of revenue and expenses and tax attributes in a manner that best represents an Individual’s or RPE’s separate trade or business. In many areas, the IRS refused to issue more exacting guidelines.

 

Concluding:

As tax preparers we have the obligation to identify tax positions supported by authority. 199A uses very specific words and avoided specifically limiting the definition of a third party payor for the purpose of allocating W2 wage attributes.  We know these laws are poorly written, and this major tax item was not given the time or input needed to arrive at clarity on many points.  As such, relying upon the evolution from the proposed regulations to the final regulations, clearly the ability to allocate wages from other than a CPO Sec7705, Statutory Employers Sec3401, Agents Sec 3504 was intended, and it is simply up to the taxpayer to properly support that the other 4 requirements noted above have been met.

So unless my analysis is flawed somewhere, should we not rally behind the law and provide this tool to our clients?

Thank you.

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