It’s been more than seven months since President Donald Trump signed the Tax Cuts and Jobs Act (TCJA) into law. In that time, the IRS and U.S. Department of the Treasury (Treasury) have been working on guidance to implement the new tax law, while taxpayers and their advisors have been working to understand how it applies to their specific tax situations. While we don’t have answers to all our questions, the guidance received thus far does shed light on several issues.
On August 8, 2018, the IRS and Treasury released proposed regulations under Internal Revenue Code (IRC) Section 199A, i.e., the qualified business income (QBI) deduction. Section 199A is arguably one of the most significant provisions within the TCJA for individuals, partnerships, S corporations, trusts and estates engaged in domestic trades or businesses. See this chart for a closer look at the new deduction. In its 2017–2018 Priority Guidance Plan, Treasury noted “computational, definitional, and anti-avoidance guidance under new §199A” as one of its projects for the 2017–2018 plan year. The guidance received through Proposed Regulations §§1.199A-1 through 1.199A-6 covers each of these areas, as well as other general items of guidance. This guidance doesn’t apply for purposes of calculating the pass-through deduction for specified agricultural and horticultural cooperatives.
The proposed regulations provide clarification on the meaning of several terms of art for purposes of §199A. A notable term addressed in the guidance is “trade or business.” The IRS and Treasury have determined the use of the term in §162(a) is most appropriate for this purpose. Section 162(a) provides a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” However, the term “trade or business” in this context isn’t defined in the IRC, regulations or IRS guidance. The courts have interpreted a trade or business to mean an activity conducted with “continuity and regularity” and a primarily profit-based motive.i For purposes of §199A and the regulations thereunder, the §162 definition of trade or business is modified to exclude the trade or business of performing services as an employee and to include the rental or licensing of tangible or intangible property to a commonly controlled, related trade or business, even if the rental activity wouldn’t normally rise to the level of a §162 trade or business. The determination of whether a rental activity rises to the level of a trade or business for purposes of §162 is challenging and uncertainty will remain absent future guidance.
Another key term tackled in the proposed guidance is the definition of a specified service trade or business (SSTB). QBI, W-2 wages and qualified property from an SSTB aren’t taken into account by taxpayers if their taxable income exceeds the phase-in range ($207,500 for single taxpayers or $415,000 for married taxpayers filing jointly in 2018). A pass-through entity is required to determine whether it conducts an SSTB and disclose the information to its owners. The proposed regulations provide a safe harbor rule stating a trade or business isn’t an SSTB if it has gross receipts of $25 million or less, and less than 10 percent of those gross receipts are attributable to the performance of services in an SSTB. This threshold decreases to 5 percent for businesses with gross receipts exceeding $25 million.
The proposed regulations provide several specific examples of services that are and are not considered SSTB activities. For example, performance of services in the health field doesn’t include the operation of health clubs or spas, and the field of accounting doesn’t include payment processing and billing analysis. Included in the list of SSTBs in the statute is “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.”ii The guidance from Treasury and the IRS clarifies the meaning of “reputation or skill” for this purpose and limits its interpretation to fact patterns in which the taxpayer is engaged in the trade or business of one or more of the following:
Receiving income for endorsing products or services
Licensing or receiving income for the use of an individual’s image, likeness, name or other symbols associated with the individual’s identity
Receiving appearance fees or income
A notable computational issue addressed in the proposed regulations is the application of the various limitations when a taxpayer has multiple trades or businesses, some with net income and others with net losses. In that case, the limitations based on W-2 wages and the unadjusted basis immediately after acquisition of qualified property would apply to each trade or business after the taxpayer apportions the net losses to each business with positive QBI.
While the proposed regulations don’t follow the passive activity loss grouping rules under IRC §469, they do provide an alternative method by which taxpayers may aggregate businesses that are operated across multiple entities. The IRS and Treasury concede that allowing taxpayers to aggregate trades or businesses for purposes of applying the W-2 wage and qualified property basis limitation would allow them to potentially inflate their deduction under §199A. With certain exceptions, taxpayers must report the aggregated group in the same manner in subsequent tax years.
The proposed regulations provide four requirements that must be met for taxpayers to aggregate their trades or businesses for purposes of determining their pass-through business deduction:
Each trade or business must actually be considered a trade or business, as defined under the proposed regulations
The same person or group must own a majority interest in each of the businesses for a majority of the year
An SSTB can’t be included in the aggregated group
The taxpayer must demonstrate at least two of the following:
The businesses provide products and services that are the same or customarily provided together
The businesses share facilities or significant centralized business elements
The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group
The proposed regulations struck down one of the planning strategies several taxpayers and their advisors were hoping to use to avoid the limitations imposed on SSTBs. Under what’s commonly referred to as the “crack and pack” strategy, taxpayers would split off portions of their business that fell under the SSTB umbrella in an effort to shield the remaining business from the limitation. Treasury and the IRS believe such a strategy is “inconsistent with the purpose of §199A” and the proposed regulations include an anti-avoidance rule that targets the strategy by providing that an SSTB includes any trade or business with 50 percent or more common ownership that provides 80 percent or more of its property or services to an SSTB.
The proposed regulations also address strategies to reduce or avoid the limitations on the 20 percent deduction by dividing up assets among multiple nongrantor trusts. Citing authority granted by IRC §643(f) to treat two or more trusts as one, the new guidance provides that trusts formed or funded with a significant purpose of receiving a deduction under §199A won’t be respected for this purpose.
Another anti-avoidance measure addressed in the guidance is the presumption that former employees may still be considered employees for purposes of determining their eligibility for the §199A deduction. The provision provides that the trade or business of providing services as an employee doesn’t meet the eligibility standards for the deduction. Individuals who become independent contractors or other nonemployees while continuing to provide substantially the same services will be considered employees for purposes of the deduction, unless they can provide evidence to properly substantiate their nonemployee status.
Beyond the definitional, computational and anti-avoidance guidance, the proposed regulations also include several “special rules” related to the new pass-through deduction. The proposed regulations provide that the §199A deduction has no effect on the adjusted basis of a partner’s interest in a partnership or a shareholder’s stock in an S corp.
The proposed regulations also emphasize the pass-through deduction doesn’t reduce net earnings from self-employment or net investment income and is deducted when calculating alternative minimum taxable income without any adjustments or preference items.
Another area of concern expressed by the tax community in recent months is whether taxpayers with arrangements with third-party payors (such as professional employer organizations) would be able to take into account wages reported on Forms W-2 issued by other parties, provided the wages were paid to employees of the taxpayer for employment by the taxpayer. The proposed regulations permit this arrangement and clarify that the employer listed on Form W-2 would, consequently, be precluded from including those same wages for purposes of determining its W-2 limitation.
Other guidance provided in the proposed regulations includes:
An individual, trust or estate’s share of QBI from a fiscal year-end pass-through entity is considered incurred in the taxable year in which the pass-through entity’s year ends
The loss carried over from a qualified trade or business doesn’t affect the deductibility of losses for other purposes under the IRC
Partnership special basis adjustments under IRC §§ 734(b) or 743(b) aren’t treated as separate qualified property for purposes of the qualified property basis limitation
To be considered qualified, property can’t be acquired within 60 days of the taxpayer’s year-end and disposed of within 120 days unless it’s used for at least 45 days prior to disposition or the taxpayer can demonstrate the principal purpose of the acquisition and disposition wasn’t to manipulate its deduction under §199A
Guaranteed payments for the use of capital aren’t considered QBI
Section 481 adjustments arising in a taxable year ending after December 31, 2017, and attributable to a trade or business are considered QBI
Section 1231 gains and losses that are ultimately treated as capital gain or loss aren’t considered QBI
Interest income received on working capital, reserves and similar accounts isn’t considered QBI
The reasonable compensation standard applicable to S corps doesn’t extend to partnerships
The IRS and Treasury are requesting comments on all aspects of these proposed rules and a public hearing is scheduled for October 16, 2018. For more information on the pass-through deduction, as well as other provisions included in the TCJA, visit BKD’s BKD’s Tax Reform Resource Center and stay tuned for our upcoming external webinar—an invitation will be coming soon to clients and BKD Thoughtware® subscribers.
i Groetzinger, 480 U.S. 23, 35 (1987)