Take-Away:  An overlooked change in the 2017 Tax Act is a change to the understatement of income tax penalty. The normal threshold for a taxpayer to become exposed to the understatement penalty is when the tax on the 1040 return is understated by greater than  10% of the reported tax. However, if the taxpayer claims the IRC 199A deduction on his or her income tax return, then assessment of the understatement penalty drops to 5% (from 10%) of the reported tax liability. This reduction in the threshold to assess the penalty could pose a trap for taxpayers who claim the IRC 199A deduction and expose all of their reported income on their income tax return to the imposition of the penalty.

Background: IRC 6662 imposes an accuracy related penalty when a taxpayer understates their income tax liability. A taxpayer is exposed to this accuracy related penalty if they understate their income tax liability by more than 10% of  the tax that  is reported on their filed  income tax return. The penalty imposed is 20% of the portion of any underpayment of tax that is due to the taxpayer’s negligence or disregard of rules or regulations.

Change: IRC 6662 was amended as part of the  2017 Tax Act. It imposes an understatement accuracy related penalty if an IRC 199A 20% tax deduction is claimed by a taxpayer when the ‘final’ income tax liability exceeds 5% of the reported tax liability that was reported on the return. In short, if a taxpayer claims an IRC 199A 20% deduction for any part of their tax return, they will become more easily exposed to the 20% understatement accuracy related penalty as their threshold of exposure to the penalty assessment goes from 10% to 5% of their reported income tax liability.

Example: A financially successful taxpayer with a large taxable salary, bonuses, and other sources of income,  also owns a diversified investment brokerage portfolio which includes a REIT investment. The taxpayer reports $10,000 Real Estate Investment Trust (REIT) dividend income on his Form 1040. The REIT dividend qualifies for the 20% IRC 199A deduction, so the taxpayer claims a 199A tax deduction of $2,000 on the same Form 1040. But now the taxpayer’s entire return has been ‘tainted’ since the IRC 6662 understatement penalty kicks in with a 5% difference from the reported income tax due. A small $2,000 deduction increases the taxpayer’s exposure to the understatement penalty for his entire tax return’s reported income, not just the $10,000 REIT dividend income that was reported. Think of the client who prepares his own income tax returns sitting at his kitchen table. He gets his 1099-DIV from his broker that reports the $10,000 REIT dividend income and he plugs the number into the tax calculator program, and he files his 1040 return claiming the $2,000 IRC 199A deduction. Does he have any idea that he just changed his threshold accuracy related penalty for his entire income based solely on his claim a $2,000 deduction. Will the software that he uses ‘catch and alert’ him to the consequence of claiming that IRC 199A deduction?

Think about all of the planning strategies now being kicked around to re-position clients and their businesses to be able to claim an IRC 199A deduction. Consider the common practice of self-charging rent or self-charged interest that is ‘stripped out’ of a business as an expense in order to reduce self-employment taxes, and also avoid the net investment income tax (the taxpayer materially participating in that passive business activity.) If more income is ‘stripped’ from a business by converting wages to passive income in order to expose that passive income to the IRC 199A 20% deduction, will taxpayers who follow that advice understand that they are also increasing their risk of exposure to under-reporting penalties, which can range from the 20% to 40% depending upon the magnitude of the under-reported tax liability. [If any part of an underpayment of tax required to be shown on a return is due to fraud, a separate penalty equal to 75% of the portion of the underpayment is also imposed. IRC 6663.]

We do not have any Regulations that interpret and implement the 2017 Tax Act, and it could be upwards of 18 months before any proposed Regulations are published to give taxpayers any guidance on how to report the income and deductions under the Act.  I’m sure that there are a lot of creative ways to create passive income (or profit) or to spread income among multiple taxpayers or entities (like trusts) to keep reportable income low in order to qualify to claim the IRC 199A deduction, like transferring some S corporate stock to multiple QSST and EBST trusts to keep reported income low enough to qualify to claim the IRC 199A deduction, but those strategies will all be implemented in a vacuum without much certainty that they will ‘fly.’ Even if the strategies  do ‘fly’ the taxpayer will have corresponding greater exposure to the 20% under-reporting tax penalty. In short, there is a trade-off between the 199A deduction and heightened exposure to a penalty. It is something to think about as clients start to jump on the IRC 199A deduction bandwagon.