By Adam Sweet
August 15, 2018
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New Proposed Regulations Under Section 199A Provide Much Needed Guidance
As part of the Tax Cuts and Jobs Act passed by Congress at the end of 2017, new section 199A was enacted to provide a 20 percent deduction for owners of pass-through businesses (generally partnerships, S corporations, and sole proprietors, including LLCs classified for tax purposes as any of the former) generating qualified business income (QBI). This deduction is available to individuals regardless of whether they itemize deductions or take the standard deduction. However, the deduction does not reduce self-employment income or net investment income for purposes of computing the separate taxes on these amounts. Our Insight The New 20 Percent Deduction for Pass-Through Businesses, provides a general overview of this new deduction. Since inception, practitioners have been patiently waiting for further guidance from Treasury and the IRS on the new section 199A deduction.
On August 8, 2018, that guidance was provided when the long-awaited regulations were released in proposed form. The proposed regulations provide important information on the application of new section 199A, including key definitional terms, rules for identifying and aggregating trades or businesses, the parameters of the various limitations, and classification rules for specified service trades or businesses (SSTB) that are generally not eligible for the new section 199A deduction. Even though the regulations are “proposed,” taxpayers can rely on them pending the issuance of final regulations.
In this Insight, we will outline the key provisions of the proposed regulations and highlight considerations and concerns. We will issue further Insights in coming weeks focusing on specific provisions of these proposed regulations and how they affect particular industries.
What Is Qualified Business Income?
Rather than directly defining QBI, the new statute instead defines it by exclusion. For example, section 199A provides that QBI is not wage income or guaranteed payments. Anticipating that some employers may attempt to re-classify employees as independent contractors (payments to independent contractors generally are not wages and ordinarily could be treated as QBI), the proposed regulations state that an employee, reclassified as an independent contractor in anticipation of generating section 199A benefits, still will be treated as an employee not eligible for the section 199A deduction. The proposed regulations further provide that the reasonable compensation rules for S corporations control for purposes of section 199A, meaning payments to a shareholder, considered part of reasonable compensation, whether termed wages or not by the S corporation, are not treated as QBI. However, for partnerships, the S corporation reasonable compensation rules do not apply under the proposed regulations in the context of guaranteed payments. For more information on planning opportunities related to guaranteed payments, please see our Insight Guaranteed Payments vs. Net Income Allocations Under the New Section 199A 20 Percent Deduction.
QBI does not include certain types of investment income and income from a SSTB. In defining QBI, the proposed regulations look to the traditional definition of a trade or business under section 162, stating that the definition “is derived from a large body of existing case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries.” The courts have generally held that the determination of a trade or business requires an examination of the facts of each situation and “regular and continuous” involvement by the owner.
Using this common definition may provide a degree of certainty to many businesses. However, for rental income from real property trades or businesses, the existing case law and guidance under section 162 can best be described as muddled. Given that rental income can qualify as QBI if it stems from a trade or business, many commentators hoped that the proposed regulations would provide further guidance on what it means to have a real property trade or business. The absence of this further guidance could result in more disputes between taxpayers and the IRS over whether rental income is derived from a trade or business (and thus classified as QBI) or whether the income is derived from an investment activity (classified as non-QBI). Key factual elements may include the type of property, the number of properties rented, the owner’s day-to-day involvement and the type of rental (short-term versus long-term and net lease versus traditional lease). We anticipate this to be an area of comment for scheduled hearings on these proposed regulations.
The proposed regulations provide one helpful rule for situations where an operating business rents real estate from a related entity (so called “self-rentals”). So long as the operating business and real estate entity are under common control and the real estate is used in the operating trade or business, the real estate entity is treated as part of the operating business, resulting in the rental income qualifying as QBI.
Wage and Basis Limitations
Once income is determined to be QBI, several limits can apply resulting in a reduced or disallowed deduction. One limit relates to the amount of wages paid by the trade or business generating the QBI. When 50 percent of the total wages paid is less than the section 199A deduction, the deduction is limited. A potential issue raised by this limitation is the use of related entities to conduct payroll and other back office functions. For instance, a group of dealerships under common control could use a single payroll entity to pay wages for all employees. Each of those dealerships technically has no direct employees and so some commentators wondered whether the income from those dealerships would be limited by the W-2 wage limitation.
Fortunately, the proposed regulations allow businesses under common control to aggregate W-2 wages if the wage expense is allocated to each of the businesses. In our example above, this means that each of the dealerships would be allocated a portion of the wage expense paid by the payroll entity for purposes of the W-2 wage limitation. Additionally, the proposed regulations allow wages paid by certain third-party payors (such as professional employer organizations) to count towards the W-2 wage limitation so long as the wages are paid on behalf of the business generating QBI.
Section 199A provides an alternative limitations test for businesses if those businesses do not pay enough W-2 wages to satisfy the W-2 wage limitation test. This alternative test looks to the unadjusted basis immediately after acquisition (UBIA) of certain qualified property. A taxpayer can multiply its UBIA by 2.5 percent, and increase this amount by 25 percent of total wages paid. So long as the resulting amount exceeds the section 199A deduction, the deduction will not be limited by either the W-2 wage limitation or the UBIA limitation. The proposed regulations provide rules for tracking the UBIA and apportioning it across multiple businesses.
Taxpayers with taxable income under certain threshold amounts (generally $157,500 for single filers and $315,000 for married filing joint) are generally not affected by the wage limitation or UBIA test, but this rule phases out when taxable income exceeds $207,500 for single filers and $415,000 for married filing joint filers.
Specified Service Trades or Businesses
Congress enacted section 199A to provide a broad-based tax cut to businesses operating in the pass-through form. However, income from a SSTB is generally not treated as QBI. The primary exception is for SSTB income earned by taxpayers with taxable income under certain threshold amounts (generally $157,500 for single filers and $315,000 for married filing joint). These taxpayers can treat the SSTB income as QBI and take the section 199A deduction. This benefit phases out once single filers have taxable income of $207,500 and married filing joint filers have taxable income of $415,000.
Section 199A provides a list of SSTB, including trades or businesses performing services in the fields of health, law, accounting, financial services, and consulting (there are other listed businesses). Certain investing and investment management businesses, along with trading businesses and dealer businesses (relating to securities, partnership interests, and commodities) are also treated as SSTB.
For the definition of these enumerated service businesses, the proposed regulations state the Treasury and IRS looked to what they consider the “ordinary meaning” of the service business. For example, performing legal services includes the provision of services by lawyers, paralegals, arbitrators and mediators. Further, performing accounting services means the provision of services by accountants, return preparers, financial auditors, and similar professionals. Generally, these definitions are broadly defined and do not focus exclusively on any one factor. Providing accounting services, for instance, includes tax return and bookkeeping services, even though the provision of such services may not require a CPA license.
Notable exclusions from the definition of SSTB (meaning these businesses are generally eligible for the section 199A deduction) include banking, real estate brokers, insurance agent brokers, engineers, and architects. The Treasury and IRS state that Congress intended for these professions not to be included in the definition of financial services for purposes of section 199A.
In addition to the listed SSTB professions, Congress included a catch-all category that deems a business a SSTB if the “principal asset” of the trade or business is the reputation or skill of its employees or owners. This ill-defined and seemingly all-encompassing category raised concerns that many businesses could be swept up into the definition of SSTB. For instance, could it be argued that a lawn mowing company named after its owner, say “Adam’s Landscape Services,” depends on the reputation or skill of its owner and thus is a SSTB not eligible for the section 199A deduction?
Fortunately for Adam in the above example, and for many other businesses, the Treasury and IRS interpreted the catch-all category narrowly. Recognizing that “Congress enacted section 199A to provide a deduction” for businesses in the non-C corporation form, the Treasury and IRS stated only the following categories will be treated as SSTB under the catch-all category:
This narrow definition hopefully results in many businesses, including Adam’s Landscape Services, not being labeled SSTB.
The proposed regulations adopt several helpful rules for otherwise qualifying businesses that generate a small portion of revenue from a SSTB. A business with gross receipts of $25 million or less will not be treated as a SSTB if less than 10 percent of its revenue comes from a SSTB. If gross receipts are above $25 million, that percentage drops to 5 percent. Also, if a business involves the selling or manufacturing of goods, and imbedded in its products are certain ancillary consulting services (for example, demonstrating the use of the products), the business will not be deemed a consulting SSTB.
As discussed above, the proposed regulations look to existing law to define a trade or business. However, the proposed regulations provide a newly introduced aggregation rule to allow taxpayers to group various related businesses together for purposes of the section 199A deduction. Under this new rule, aggregation of multiple businesses is allowed, but not required, if the following requirements are met:
The businesses share facilities or significant centralized business elements (for instance, common accounting and or HR functions)
The businesses operate in coordination with each other (for example, supply chain interdependencies)
Taxpayers may find it beneficial to aggregate businesses for several reasons, including: administrative efficiencies, allowing related businesses to share W-2 wages and UBIA for purposes of the various limitation tests, and the ability to net together income and loss for purposes of the overall section 199A deduction.
For example, if a person owns three related businesses (business X, Y, and Z) and each business generates $200,000 of QBI, but only business Y pays wages and has UBIA, non-aggregation results in the taxpayer not being able to claim the section 199A deduction for the QBI from business X and Z (because of the W-2 wage and UBIA limitation). However, if the businesses are appropriately aggregated, the taxpayer can use the wages and UBIA from business Y when applying the various limiting tests for the income from business X and Z because the total income from all the businesses is treated as from a single trade or business.
Aggregation is generally made at the individual level. Therefore, partnerships and S corporations will need to provide the necessary information on the respective schedules K-1 to allow partners and shareholders to aggregate.
Once made, the choice to aggregate is generally binding for all future tax years.
After the enactment of section 199A, some commentators suggested that a SSTB could split apart the component parts of its business to generate QBI using a so called “crack and pack” strategy. For example, could a law firm “crack” open its business by isolating certain administrative functions and then “pack” those functions into a separate business, potentially generating QBI when the law firm pays the newly formed administrative business for the use of the administrative functions formerly housed inside the law firm? Not surprisingly, the proposed regulations shut this planning idea down by providing that when a SSTB has common ownership with a related business, the income generated by that related business for services or property provided to the SSTB will be treated as income from a SSTB. In the above example, this results in the newly formed administrative business being treated as part of the law firm and not eligible for the section 199A deduction after the “crack and pack” transaction.
Another planning idea floated in commentary involved using multiple trusts to circumvent the various section 199A limitations. The proposed regulations provide that in these types of situations, the various trusts will be treated as a single trust for purposes of applying the various section 199A limitations unless there are significant non-tax (or non-income tax) purposes for using multiple trusts.
Tracking and Reporting
The proposed regulations introduce new tracking and reporting requirements for taxpayers and businesses. Partnerships and S corporations, termed relevant passthrough entities (RPE), are required to determine whether the income generated by the entity stems from a SSTB to be reported to the partners and shareholders. The RPE will also have to compute and report each partner’s and shareholder’s allocable share of QBI, wages and UBIA so each partner and shareholder can apply the various limitations at the individual level.
Individuals directly conducting a business as a sole proprietorship (or through a LLC disregarded for tax purposes) will make the SSTB determination at the individual level along with the computation of the various section 199A limitations.
This type of tracking and reporting has not previously been required, so taxpayers and businesses need to start designing and implementing accounting and tracking systems now to help with the various reporting requirements when tax returns are filed.
Fiscal Year Entities
The proposed regulations allow a taxpayer receiving a K-1 from a fiscal year RPE with a tax year straddling December 31, 2017, to make full use of the section 199A deduction, provided all other requirements are met. For example, QBI reported on a K-1 from a partnership with a tax year beginning on May 1, 2017, and ending on April 30, 2018, would be fully eligible for the section 199A deduction (assuming all other requirements are met) when the recipient partner files its 2018 tax return. Some commentators worried that only the income earned in 2018 (or possibly none of the income) would qualify as QBI because section 199A is generally effective for tax years beginning after December 31, 2017.
The proposed regulations provide welcomed and helpful guidance on a variety of open questions raised with the passage of section 199A. The proposed rules in many instances can be considered taxpayer-friendly. Given all the additional definitions and rules, any business or taxpayer possibly eligible for the section 199A deduction should consult with their tax adviser to consider eligibility, the various limitations, and whether any steps can be taken to maximize the deduction.
And, while these proposed regulations provide guidance, there are still hearings to be held that could modify the final version of these regulations.
If you would like to provide comments or concerns to be presented to the Treasury and IRS for consideration, or if you have questions concerning the proposed regulations under section 199A or other aspects of the Tax Cuts and Jobs Act, contact your Eide Bailly professional.