The U.S. Treasury Department and the Internal Revenue Service (IRS) recently released proposed regulations and guidance for applying the new Code Section 199A created by the Tax Cuts and Jobs Act.
Miryam Wisnicki, CPA
Marsha W. Fisher, CPA
The U.S. Treasury Department and the Internal Revenue Service (IRS) recently released proposed regulations and guidance for applying the new Code Section 199A created by the Tax Cuts and Jobs Act. The new §199A allows noncorporate owners of pass-through entities (i.e., sole proprietorships, partnerships and S Corporations) to deduct 20% of their qualified business income (subject to certain limitations) effective for tax years beginning after December 31, 2017. As currently enacted, the deduction is technically a temporary benefit, and is set to expire December 31, 2025.
The new 20% deduction has generated a significant amount of attention and debate among lawmakers, tax professionals and taxpayers due to the ambiguous language and widespread impact. The IRS and Treasury released the much-anticipated guidance on the new deduction in early August; in general, the proposed regulations as a whole are taxpayer favorable. Unfortunately, there are some harsh anti-abuse provisions, as well as remaining uncertainty in many areas. Here is a look at some of the highlights.
The proposed rules clarify that taxpayers with taxable income below the threshold ($315,000 for married couples filing jointly and $157,500 for single filers) will generally be able to deduct 20% of their qualified business income from all qualified trades or businesses. For taxpayers with taxable income over the threshold, the proposed regulations provide additional guidance as to how the deduction and applicable limitations should be calculated.
To claim the 20% qualified business income deduction, taxpayers must generate the qualified business income from a qualified trade or business. Treasury instructs taxpayers to rely on the large body of existing case law and administrative guidance in interpreting the meaning of a trade or business under IRC §162. In general, an activity rises to the level of a trade or business if the taxpayer’s primary purpose for engaging in the activity is for income or profit, and the activity is conducted with “continuity and regularity.” However, the determination of a trade or business under §162 is extremely fact-specific and courts have reached different results with respect to activities constituting a trade or business.
This uncertainty is especially true for taxpayers who derive income from rental real estate properties.
As an example, a lessor who derives income from a property under a net lease is generally deemed not to be engaged in a trade or business. Other courts have found that managing property and collecting rent can constitute a trade or business.
Fortunately, in the proposed guidance, Treasury did extend the definition of a trade or business, for purposes of the qualified business income deduction only, to certain rental real estate businesses even if they generally would not rise to the level or a “trade or business.” Solely for purposes of the qualified business income deduction, the rental of property to a related trade or business is treated as a trade or business if the rental activity and the other trade or business are commonly controlled. This is good news for many businesses who hold their real estate in a separate but commonly controlled entity from the operating businesses. However, outside of this context, the definition of a trade or business for purposes of §199A (especially as it relates to rental real estate) remains murky.
For purposes of the 20% qualified business income deduction, the trade or business of providing services as an employee is never considered to be a qualified trade or business.
For taxpayers with taxable income above the threshold, in order to be eligible for the 20% deduction, the business income cannot be generated from a “specified service trade or business (SSTB).” Included in the list of specified service trades or business not eligible for the deduction are trades or business in Health, Law, Accounting, Actuarial Science, Performing Arts, Consulting, Athletics, Financial Services, Brokerage Services, Investing and Investment Management, Trading, Dealing in Securities or any trade or business where the principal asset of such trade or business is reputation or skill of one or more of its employees or owners (the “catch all”). Addressing the concerns of many tax professionals and taxpayers, the treasury fortunately provided relatively narrow definitions, within the Proposed Regulations, for the enumerated professions and services. Essentially, the Proposed Regulations limit the reputation and skill provision to apply only to people whose skill and reputation is such that it makes them famous and marketable.
In addition, Treasury established a de minimis rule for situations where a trade or business will not be considered a specified service trade or business merely because it provides a small amount of services in a specified service activity.
In general, the calculation of the qualified business income deduction is initially done separately for each of the taxpayer’s trades or businesses. For taxpayers with taxable income above the threshold, the 20% deduction is limited to the greater of
In an effort to prevent costly legal restructuring, the Proposed Regulations permit (but do not require) individuals to aggregate separate trades or businesses for purposes of the 20% deduction, if the requirements provided in the Regulations are met. The criteria involve both common control as well as fact-specific requirements that indicate that the businesses should be viewed as a single trade or business. Once an individual elects to aggregate multiple entities into a single aggregated trade or business, individuals must consistently report the aggregated group in subsequent tax years.
In the proposed guidance, Treasury has clarified that an individual can take a deduction in 2018 for the income received from a fiscal year pass-through entity, which could include income earned by the pass-through entity in 2017 (no cutoff or proration).
The proposed regulations contain several anti-abuse provisions, including provisions to prevent a “crack and pack” technique, where a specified service business (i.e., law firms) could spin off their non-professional services functions (i.e., administrative staff, real estate) into a separate entity to take advantage of the 20% deduction in the non-specified service entity. They also include an anti-abuse provision aimed at preventing employees from recasting themselves as owners or independent contractors (i.e., so as not to be in the “trade or business of providing services as an employee”).
While Treasury addressed many of the ambiguous areas of §199A, there are still many unanswered questions where additional guidance would be helpful—a public hearing on the proposed rules is scheduled for October 16, 2018. The hope is that Treasury and the IRS will address some of the remaining ambiguity and public comments in the Final Regulations or through other administrative guidance.