IRS Issues Proposed Regulations Under Section 199A
On August 8, 2018 the U.S. Treasury approved the release of proposed regulations under section 199A. While not yet final, these proposed regulations do address many of the questions raised by the new law. And although the regulations are in proposed form, taxpayers are permitted to rely on them until final regulations are issued.
This alert highlights many of the areas where the proposed regulations provide additional clarity.
For taxable years beginning after 2017 and before 2026, section 199A provides a deduction of up to 20% of income from a domestic business operated as a sole proprietorship; or through a partnership, S corporation, trust or estate (a Relevant Passthrough Entity or RPE). This deduction is available to individuals (and certain estates and trusts) and is limited to 20% of the taxpayer’s taxable income (excluding net capital gains). For taxpayers with taxable income in excess of a threshold amount (Threshold), the deduction is subject to additional limitations based the type of trade or business engaged in, the wages paid to employees and the basis of property held for use in the business. These additional limitations are also subject to a phase-in, based on the amount by which taxable income exceeds the Threshold.
Section 199A also allows such taxpayers a deduction of up to 20% of their combined qualified Real Estate Investment Trust (REIT) dividends and Publicly Traded Partnership (PTP) income.
The IRS estimates that the annual burden on taxpayers to comply with section 199A is between 30 minutes and 20 hours for each taxpayer claiming or reporting information to support the deduction, depending on the circumstances. Thus, the new deduction brings with it a significant increase in annual compliance costs, not only for preparing tax returns, but also in projecting the amount of the deduction for the purpose of making estimated payments.
W-2 wage limitation
For taxpayers with taxable income in excess of the Threshold, the section 199A deduction for each trade or business is subject to limitation based on wages paid to employees of the business (W-2 Wages).
In conjunction y with the issuance of the proposed regulations, the IRS issued Notice 2018-64, which in turn proposed a revenue procedure providing three allowable methods for calculating W-2 Wages. Each method references amounts reported on Forms W-2 filed with respect to employees, but each method makes different modification to those amounts. As with the proposed 199A regulations, taxpayers may also rely on the proposed revenue procedure until it is published in final form.
The proposed 199A regulations provide that W-2 Wages include not only wages paid by the individual, partnership or S corporation itself, but also wages paid by a third party to common-law employees of the individual, partnership or S corporation for employment by such person or entity. Third party payors to which this rule applies include certified professional employer organizations under section 7705, statutory employers under section 3401(d)(1) and agents under section 3504. However, such wages must be properly and timely reported on forms filed with the Social Security Administration to be included in the computation of the W-2 Wage limitation.
This rule appears to be intended f to apply to payroll processing services such as PEOs and not necessarily to management companies whose employees provide services to multiple related entities. Thus, it may be necessary to take other steps, such as aggregation, to include the wages paid to employees of a management company in the W-2 Wage base of the trades or businesses to which it provides services.
Unadjusted basis immediately after acquisition
For taxpayers with taxable income in excess of the Threshold, the section 199A deduction, with respect to any trade or business, may be subject to an alternative limitation based partly on W-2 wages and partly on the tax basis of property used in that trade or business. The basis component of the limitation is generally determined with reference to the tax basis of qualified property on the date it is placed in service, without reduction for depreciation, section 179 expenses or adjustments for tax credits claimed (Unadjusted Basis Immediately after Acquisition or UBIA). The UBIA of qualified property may be included in the threshold until the later of 10 years after the property was placed in service or the end of the applicable recovery period for the property under section 168.
The regulations also provide several clarifications in determining UBIA, including the treatment of property acquired in like-kind exchanges or involuntary conversions, property acquired in other nonrecognition transactions, and improvements to existing properties. Notably, the regulations provide that adjustments to the basis of property held by a partnership under sections 734(b) and 743(b) are not treated as qualified property.
Qualified business income
Only qualified business income (QBI) is eligible for the section 199A deduction. QBI includes only items that are connected with the conduct of a trade or business within the United States and allowed in determining taxable income during the year.
Various items are specifically excluded from QBI, including:
- Capital gains and losses;
- Any section 1231 gains or losses that are treated as capital gains or losses;
- Dividends and dividend equivalents;
- Interest income not connected with a trade or business, including interest on the investment of working capital and reserves;
- Various income from controlled foreign corporations;
- Guaranteed payment income, whether received for services or for the use of capital (although a partnership’s deduction of such guaranteed payments may reduce the partnership’s QBI)
- Other payments received by partners or S corporation shareholders for services they provide to their partnership or S corporation.
In addition, income from the trade or business of performing services as an employee is not QBI.
Where a taxpayer, partnership or S corporation conducts multiple trades or businesses, the proposed regulations provide that it must allocate the items comprising QBI among the various trades or businesses based on a reasonable and consistently applied method that clearly reflects the income and expense of each business. No specific guidance is offered on what allocations may or may not be reasonable.
QBI, W-2 Wages and UBIA must be determined separately for each trade or business engaged in by the taxpayer. The resulting section 199A deduction can be substantially affected by the way a taxpayer defines each trade or business. For this purpose, the proposed regulations allow, but do not require, the aggregation of trades or businesses, but only if the following requirements are met
- The same persons own 50% or more or each trade or business to be aggregated;
- The required common ownership exists for a majority of the taxable year;
- All of the items to be aggregated are reported on returns for the same taxable year;
- None of the trades or businesses are Specified Service Trades or Businesses (SSTBs); and
- At least two of the following factors are satisfied:
- The trades or businesses provide products and services that are the same (for example, a restaurant and a food truck) or customarily offered together (for example, a gas station and a car wash);
- The trades or businesses share facilities or significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources);
- The trades or businesses are operated in coordination with, or reliance upon one or more of the businesses in the group (for example, supply chain interdependencies).
Once an individual chooses to aggregate two or more trades or businesses, that same taxpayer must continue to do so in subsequent taxable years unless there is a change in facts and circumstances such that the trades or businesses no longer qualify for aggregation. However, newly created or acquired businesses may be added to an existing group if the requirements for aggregation are met. Multiple owners of an RPE need not aggregate in the same manner.
If a taxpayer engages in multiple qualifying trades or businesses, but one or more of those trades or businesses has insufficient W-2 Wages or UBIA to maximize the section 199A deduction, aggregating those trades or businesses with others that have excess W-2 Wages or UBIA may significantly increase the taxpayer’s deduction. Thus, the potential benefit of aggregation should be considered in the year-end planning for any individual with more than one trade or business that might be eligible for aggregation under these rules.
Specified service trades or businesses
Taxpayers with taxable income in excess of the Threshold (subject to phase-in) may not claim a section 199A deduction with respect to income they receive from Specified Service Trades or Businesses (SSTBs). SSTBs are defined as any trade or business involving the performance of services in the fields of health; law; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; investing and investment management; trading; dealing in securities, partnership interests or commodities; and 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.
The proposed regulations provide definitions for each of the trades or businesses listed above. Several of those definitions place important limitations on their scope. For example:
- Services performed in the healthcare industry generally include only services that healthcare professionals provide directly to a patient. That includes the services of physicians, nurses, dentists, veterinarians, physical therapists, and psychologists, but not the operation of health clubs and spas, payment processing services, or the development, manufacture and sale of pharmaceuticals or medical devices.
- Services in the performing arts includes services of individuals participating in the creation of performing arts such as actors, other entertainers and directors, but not services that do not require skills unique to performing arts, such as the operation of equipment and facilities for use in the performing arts, or the broadcasting or dissemination of performing arts media to the public.
- Consulting services broadly include the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems, specifically including lobbying. The definition excludes sales or economically similar services or the performance of consulting services embedded in, or ancillary to, the sale of goods and services on behalf of a trade or business that is not an SSTB.
The meaning of the phrase “a trade or business where the principal asset of such business is the reputation or skill of one or more employees or owners” has been of particular concern to us, due to its potential to capture a wide range of businesses. The proposed regulations narrowly defines this category as:
- A trade or business in which a person receives fees, compensation, or other income for endorsing products or services;
- A trade or business in which a person licenses or receives fees, compensation or other income for the use of an individual's image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual's identity; or
- A trade or business in which the person receives fees, compensation, or other income for appearing at an event or on radio, television, or another media format.
For a trade or business with gross receipts of $25 million dollars or less for the taxable year, a trade or business is not an SSTB if less than 10 percent of the gross receipts of the trade or business are attributable to the performance of services in a specified field.
A trade or business with gross receipts of greater than $25 million for the taxable year is not an SSTB if less than 5% of its gross receipts are attributable to the performance of services in a specified field.
No income, W-2 Wages, or UBIA of an SSTB may be taken into account by any individual whose taxable income exceeds the Threshold (subject to phase-in), even if the item is derived from an activity that is not itself an SSTB.
If the SSTB is conducted by an RPE, the limitation applies to each direct or indirect individual owner regardless of whether the owner is passive or participated in any SSTB activity.
The proposed 199A regulations also provide that an SSTB includes any trade or business that provides 80% or more of its property or services to an SSTB if there is 50% or more common ownership of the trades or businesses. If the other trade or business provides less than 80% of its property or services to the commonly owned SSTB, then a proportionate share of the other business is considered part of the SSTB. This rule limits the ability of taxpayers to maximize the 199A deduction by spinning off components of an SSTB’s business (such as its real property) into a separate entity that does not conduct an SSTB.
The proposed 199A regulations clarify a number of other details left unclear by the statute:
- The deduction is only available with respect to income from a trade or business, which does not include an investment activity. The proposed regulations clarify that for purposes of section 199A, the term “trade or business” is as defined in section 162(a) with one exception: if a rental or licensing activity does not rise to the level of a trade or business (e.g., due to lack of sufficient business activity) it is treated as a trade or business if the property is rented or licensed to a trade or business that is commonly controlled.
- Where a taxpayer has multiple trade or business activities eligible for the deduction, the 199A deduction for each activity must generally be computed separately. The proposed regulations provide rules for netting losses from one activity against the income from other activities in determining the current year deduction and any net loss that must be carried over. The regulations also clarify that any carryover loss is treated as a loss from a separate trade or business in the following year in computing the section 199A deduction, but that the carryover does not affect the deductibility of the loss under other provisions of the internal revenue code.
- In the case of a partnership or S corporation, the deduction is determined at the partner or shareholder level. The regulations therefore clarify that any section 199A deduction claimed by a partner or shareholder does not affect the taxpayer’s basis in the partnership interest, the basis of their S corporation stock, or the shareholder’s accumulated adjustments account.
- The regulations clarify that the section 199A deduction does not affect the base for determining self-employment tax under section 1402 or the tax on net investment income under section 1411.
The proposed regulations require Partnerships, S corporations, PTPs, trusts and estates to provide their owners and beneficiaries with the information necessary to compute the section 199A deduction.
Specifically, each RPE must separately identify and report the following information on the Schedule K-1 issued to the owners for any trade or business engaged in directly by the RPE:
- Each owner’s allocable share of QBI, W-2 Wages and UBIA of qualified property attributable to each such trade or business;
- Whether any of those trades or businesses are SSTBs;
- Each owner’s allocated share of any qualified REIT dividends or qualified PTP income or loss; and
- Any such items reported to the RPE by any other RPE in which it owns a direct or indirect interest.
If an RPE fails to separately identify or report any such item, the owner's share (and the share of any upper-tier indirect owner) of positive QBI, W-2 wages, and UBIA of qualified property attributable to trades or businesses engaged in by that RPE will be presumed to be zero.
Special reporting rules are also provided for PTPs, trusts and estates.
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