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On August 8, 2018, the IRS issued Proposed Regulations under Section 199A as enacted by the Tax Cuts and Jobs Act, which generally provides a deduction of 20% of an owner’s allocable share of the “qualified business income” (“QBI”) from a pass-through entity (S corporation, partnership, LLC taxed as a partnership) or sole proprietorship. The Proposed Regulations address computational, definitional and anti-abuse guidance and are generally favorable to taxpayers.
The Proposed Regulations contain six substantive areas. The operational rules for application of Section 199A are set forth in Proposed Reg. § 1.199A-1, and provide guidance on the computation of the deduction for individuals with taxable income at, below, or above the threshold amount ($315,000 for married taxpayers filing jointly and $157,500 for other taxpayers), including application of Section 199A to taxpayers within the phase-in range above the threshold amount (between $315,000 and $415,000 for married taxpayers filing jointly and between $157,500 and $207,500 for other taxpayers). Once a taxpayer’s taxable income exceeds the fully phased-in amounts ($415,000 for married taxpayers filing jointly and $207,500 for other taxpayers), the wage and capital limitations fully apply to owners of qualified trades or businesses (“QTBs”), and owners of specified service trades or businesses (“SSTBs”) are not eligible for the Section 199A deduction at all.
In the event that an owner of a QTB is fully subject to the wage and capital limitations, those limitations provide that the 20% of QBI deduction shall be limited to the greater of (1) the taxpayer’s allocable share of 50% of the W-2 wages of the QTB; or (2) the taxpayer’s allocable share of 25% of the W-2 wages of the QTB plus 2.5% of the unadjusted basis immediately after acquisition of the “qualified property” used in such trade or business.
Rules on determining W-2 wages and the unadjusted basis of qualified property are set forth in Proposed Reg. § 1.199A-2. In conjunction with the release of the Proposed Regulations, the IRS also released Notice 2018-64, which provides for three methods for calculating W-2 wages (which are similar to the rules previously prescribed for determining W-2 wages under former Section 199 as set forth in Rev. Proc. 2006-22). Wages will generally be included in determining the wage and capital limitation of a QTB as long as the QTB is the common law employer of an employee, even if a different entity (such as a Professional Employer Organization) issues the W-2 to the employee. This is very welcome guidance as any other interpretation would have likely resulted in costly business restructurings.
Guidance on determining QBI, qualified real estate investment trust dividends, and qualified publicly traded partnership income is set forth in Proposed Reg. § 1.199A-3, and the IRS has requested comments on reasonable methods for allocation of items not clearly attributable to a single trade or business, and whether any safe harbors may be appropriate.
A new set of aggregation rules (not the aggregation rules under Section 469 for passive activity losses which many commentators had requested be applied) are provided under Proposed Reg. § 1.199A-4. Consequently, taxpayers will be permitted to aggregate separate trades or businesses (even if conducted in different legal entities), provided certain requirements are met. Generally, under Proposed Reg. § 1.199A-4(b)(1), trades or businesses may be aggregated only if an individual can demonstrate that (1) the same person or group of persons, directly or indirectly, owns 50% or more of each trade or business to be aggregated, meaning in the case of such trades or businesses owned by an S corporation, 50% or more of the issued and outstanding shares of the corporation, or, in the case of such trades or businesses owned by a partnership, 50% or more of the capital or profits in the partnership; (2) the ownership described in (1) above exists for a majority of the taxable year in which the items attributable to each trade or business to be aggregated are included in income; (3) all of the items attributable to each trade or business to be aggregated are reported on returns with the same taxable year, not taking into account short taxable years; (4) none of the trades or businesses to be aggregated are an SSTB; and (5) the trades or businesses to be aggregated satisfy at least two of the following factors based on all of the facts and circumstances: (a) the trades or businesses provide products and services that are the same or customarily offered together; (b) the trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources; or (c) the trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group.
On the critical question of whether a business constitutes a QTB or SSTB, Proposed Reg. § 1.199A-5 sets forth definitions for the following enumerated professions: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. Proposed Reg. § 1.199A-5 also defines what constitutes investing and investment management, trading, and dealing in securities, partnership interests or commodities. For the most part, the Proposed Regulations are taxpayer-friendly and side with the majority of commentators by narrowly defining what constitutes a SSTB. For example, although one of the enumerated professions includes “brokerage services,” the Proposed Regulations make it clear that this provision only applies to stock brokers and similar professionals dealing in securities, and not to real estate agents or brokers, nor insurance agents or brokers.
Additionally, the Proposed Regulations take a very narrow view as to what is included as a SSTB where the principal asset of the business is the reputation or skill of one or more of its employees or owners. The Proposed Regulations provide that the term “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners” means any trade or business that consists of the following (or any combination thereof): (1) a trade or business in which a person receives fees, compensation, or other income for endorsing products or services; (2) a trade or business in which a person licenses or receives fees, compensation, or other income for the use of an individual’s likeness, name, signature, voice, trademark, or any other symbol associated with the individual’s identity; or (3) receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format. Consequently, the fear of many commentators that this provision could result in a wide range of service businesses being classified as SSTBs has been allayed.
Relevant pass-through entities (“RPEs”), publicly traded partnerships, trusts and estates are addressed in Proposed Reg. § 1.199A-6. RPEs are a new term introduced by the Proposed Regulations.
Although as stated above, the Proposed Regulations are generally taxpayer-friendly, anti-abuse provisions largely prohibit the so-called “Crack-and-Pack” strategy, which involves spinning-off a portion of an SSTB to a separate entity so that the spun-off entity can claim the Section 199A deduction as a QTB. Additionally, Proposed Regulations under Section 643 crackdown on the multiple-trust strategy, where multiple trusts are formed or funded with a significant purpose of receiving a deduction under Section 199A (and could be applied in a variety of other situations).
The Proposed Regulations also address how to treat income received from a fiscal-year pass-through when part of the income received by an individual is received before January 1, 2018. The Proposed Regulations allow an individual to take a deduction for all of the income received from a fiscal-year filer, which could include money earned by the pass-through entity in 2017.
The rules under the Proposed Regulations generally apply to tax years ending after the date the Final Regulations are published, and the anti-abuse rules contained in the Proposed Regulations are proposed to apply to tax years ending after December 22, 2017. Additionally, the provisions of the Proposed Regulations under Section 643 to prevent abuse through the utilization of multiple trusts generally apply to tax years ending after the date the Proposed Regulations were published (August 8, 2018).
The Proposed Regulations offer welcome guidance and clarification on the new deduction available to pass-through entities and sole proprietorships under Section 199A, but will require considerable analysis given their length (184 pages, including the preamble, plus the 14-page Notice 2018-64 providing guidance on methods for calculating W-2 wages under Section 199A). There are still “gray” areas not addressed by the Proposed Regulations, and undoubtedly the Proposed Regulations will undergo some changes before becoming finalized based on comments by practitioners. A hearing on the Proposed Regulations is currently scheduled for October 16th.
If you have any questions regarding Section 199A and its application to your business, please contact one of the tax attorneys at Dean Mead.
About the Author:
Stephen R. Looney is the chair of the Tax and Corporate department at Dean Mead in Orlando. He represents clients in a variety of business and tax matters including entity formation (S and C corporations, partnerships, and LLCs), acquisitions, dispositions, redemptions, liquidations, reorganizations, tax-free exchanges of real estate and tax controversies. His clients include closely held businesses, with an emphasis on medical and other professional services practices. He is Board Certified in Tax Law by The Florida Bar, as well as being a Certified Public Accountant (CPA). He may be reached at firstname.lastname@example.org.