Highlights of IRS Guidance On Section 199A for Sole Proprietorships, S Corps, Partnerships and Trusts
The IRS finally issued its long awaited proposed regulations for the qualified business income deduction, also known as the Section 199A deduction for qualified business income of pass-through entities.
Whew, what a mouthful! If your head is already spinning, I encourage you to keep reading, as business owners stand to benefit from this deduction.
The Section 199A deduction allows owners of sole proprietorships, S corporations and partnerships to deduct up to 20% of income earned by the business.
We got excited when the IRS released its guidance on the QBI deduction, because taxpayers and CPAs alike have struggled to fully understand this complex aspect of the Tax Cuts and Jobs Act.
There’s good news and bad news, however.
The bad news is that there are more than 100 pages of proposed regulations to wade through and understand. The regulations are complex.
The good news is that we’ve done the reading for you, and break down the highlights of what business owners need to know.
Before we dive in, let’s take a quick look back at the basics of Internal Revenue Code Section 199A, which was enacted under The Tax Cuts and Jobs Act (TCJA) at the end of 2017.
A Refresher On the Section 199A Deduction
Section 199A generally allows owners of pass-through businesses such as sole proprietorships, S corporations, or partnerships to deduct up to 20% of income earned by the business. Our blog post, Qualified Business Income Deduction: A Primer On the New Section 199A, covers the basics of Section 199A.
The qualified business income deduction (QBID) is available to eligible taxpayers whose taxable income is less than $315,000 if married filing jointly ($157,500 for all other taxpayers). The deduction is generally limited to 20% of the taxpayer’s qualified business income (QBI), or 20% of taxable income minus net capital gains.
The proposed regulations address many of the questions raised by the new law, clarify a number of details left unclear by the tax code, and are quite extensive at 184 pages in length. The regulations are broken down in to six sections. We’ll cover the more pertinent areas below.
9 Key Take-Aways From the Proposed Regulations
The complexity of Section 199A leaves many taxpayers with more questions than answers.
The proposed regulations attempt to offer guidance on some of these questions, defining terms used Section 199A and offering computational guidance, including the impact of losses on Section 199A calculations.
Let’s dive into the highlights of the proposed regulations.
1. Definition of “Trade or Business” for Purposes of the Qualified Business Income Deduction
A taxpayer must determine the amount of QBI for each of his or her trades or businesses.
The proposed regulations generally define the term “trade or business” to mean “a Section 162 trade or business other than the trade or business of performing services as an employee.”
Under the proposed regulations, the term “trade or business” also includes the rental or licensing of tangible or intangible property that does not rise to the level of a Section 162 trade or business, provided that the property is rented or licensed to a trade or business that is commonly controlled, meaning the business has at least 50% common ownership.
This proposed regulation permits most “self-rental” real estate to qualify for the deduction even if it doesn’t otherwise rise to the level of a Section 162 trade or business. Though this proposed regulation provides some relief, there are situations that still may result in unfavorable treatment under this standard, such as:
- A real estate business that leases property to unrelated parties will still need to meet the Section 162 standard.
- For business activities conducted through multiple entities, each entity must qualify as a trade or business on its own and an activity that does not rise to the level of a trade or business cannot be aggregated with another activity that is a trade or business. This can be problematic for businesses that have rental real estate in a separate entity, a common practice for both legal and other non-tax reasons.
2. General Computational Guidance
The proposed regulations address a number of computational matters at the pass-through business and individual level.
Netting of QBI
The code section is written to force the netting of positive and negative QBI, as Example 1 illustrates. The proposed regulations clarify that the negative QBI is netted against the positive QBI in proportion to the relative amounts of positive QBI from the trades or businesses with positive QBI, as seen in Example 2.
An individual with $100 of positive QBI from Herman’s Shoe Supply, $100 of positive QBI from Socks by Sam, and $100 of negative QBI from Hannah’s Distribution Co. has a net $200 of QBI.
Continuing with the example above, Herman’s Shoe Supply produced one-half of all positive QBI ($100 out of $200), so one-half of the negative QBI (or $50) is applied to reduce Herman’s Shoe Supply’s QBI. Similarly, the QBI of Socks by Sam is reduced by $50 to a net $50.
The adjusted QBI of each business with positive QBI is then compared to W-2 wage and asset basis limitations for that particular business to determine the tentative QBID for that business. The W-2 wages and asset basis of the trade or business that produced negative QBI are not taken into account by the trades or businesses with net positive QBI.
Carryover of net QBI losses
If an individual has net negative QBI from all trades or businesses, then there will be no QBID for that tax year and the net negative amount will carryover. In the subsequent tax year, that negative QBI is treated as an amount from a separate trade or business, which will then follow the loss reallocation rules discussed above in later years. The W-2 wages and asset basis of the trades or businesses producing the net negative QBI do not carryover to the subsequent year.
Fiscal-year pass-through entities
The proposed regulations provide that QBI reported to individuals on K-1s in 2018 from fiscal-year pass-through entities does qualify for QBID, provided all other requirements are met.
For example, an individual who receives a K-1 from an S corporation with a tax year ending June 30, 2018, will be able to claim QBID on its 2018 individual tax return with respect to all income on the K-1 even though a portion of it was generated during the 2017 calendar year.
This is a very taxpayer-friendly clause and a welcome clarification for all fiscal-year pass-through business owners.
3. W-2 Wages and Unadjusted Basis Immediately After Acquisition (UBIA)
As we discussed in our earlier article about Section 199A, for higher income taxpayers, the amount eligible for the 20% deduction with respect to a qualified trade or business (QTB) is limited to the greater of:
- 50% of the W-2 wages paid with respect to the QTB and
- The sum of 25% of the W-2 wages with respect to the QTB plus 2.5% of the UBIA of all qualified property with respect to the QTB.
In general, the proposed regulations provide that the term “W-2 wages” means amounts
reported for federal employment tax purposes, including certain deferred compensation. This definition includes amounts paid by another entity as long as the trade or business claiming the wages is the common law employer of the employees. Thus, businesses that lease employees may still be able to claim those W-2 wages as their own.
Additionally, any entity with multiple trades or businesses must allocate its W-2 wages between those businesses. W-2 wages must be allocated to the owners of pass-through businesses in the same manner as wage expense is allocated.
Unadjusted basis of qualified property (UBIA)
For purposes of the asset limitation, qualified property means tangible, depreciable property that is held by and used in the trade or business for the production of QBI, and for which the depreciable period has not ended.
The depreciable period is the normal tax recovery period but can never be shorter than 10 years. The cost basis of qualified property means the tax basis on the date placed in service, and is determined without regard to any depreciation or other expensing (e.g., Section 179). UBIA is allocated to the owners of pass-through businesses in the same manner as tax depreciation expense is allocated. Special rules exist for assets placed in service near year end. We’ll address anti-abuse rules later.
4. Qualified Business Income
Section 199A provides a list of items that are not treated as qualified items of income, gain, deduction or loss for QBI purposes. Clarifying the meaning of the terms listed in the code section, the proposed regulations provide specific rules with respect to the inclusion/exclusion of the certain items, including the following.
Capital gains and losses
The code section excludes capital gains and losses from QBI. Under the proposed regulations, capital gains and losses would be excluded from QBI, including gains and losses that are treated as capital gains or losses.
The code section provides that QBI does not include any interest income other than interest income that is properly allocable to a trade or business. The proposed regulations clarify that interest income received on working capital, reserves and similar accounts are not properly allocable to a trade or business.
5. Aggregation Rules
The Section 199A deduction is claimed by individuals, trusts and estates, though the deduction is based on the QBI, W-2 wages and assets of each individual trade or business.
It is common for a business to be conducted through multiple legal entities. For existing business structures, wages may be paid by one entity while the income is generated in another. As such, applying the W-2 wage or asset tests separately for entities that are under common control could result in unfavorable computations.
The proposed regulations permit taxpayers to aggregate related businesses. Note that these aggregation rules are unique to QBID, and do not rely on any other existing aggregation rules, such as passive activity grouping or at-risk grouping rules.
In order to aggregate for QBID purposes, each of five requirements must be met:
- Each trade or business must be under common ownership, either directly or indirectly, with the same person or group of persons owning 50% or more of each trade or business that will be aggregated.
- The common ownership must exist for the majority of the tax year.
- The businesses must have the same taxable year. An exception to this requirement exists for short periods.
- None of the aggregated businesses can be a specified service trade or business (SSTB).
- The aggregated trades or businesses must satisfy at least two of the following factors:
- They provide products and services that are the same or customarily offered together.
- They share facilities or significant centralized business elements (personnel, accounting, legal, manufacturing, purchasing, HR or IT).
- They are operated in coordination with one or more of the businesses in the aggregated group (e.g., supply chain interdependency).
Aggregation is only done by individuals, estates or trusts, and it is elective. This is done by including aggregation disclosures with the tax return. Once a decision has been made to aggregate certain trades or businesses, they are treated as one trade or business for QBID and must be consistently reported as such by the electing owner in future years. Aggregation decisions can only change when new trades or businesses are acquired or created, or where certain businesses no longer qualify for aggregation. Each owner of a business is able to make their own aggregation decisions irrespective of the aggregation decisions of other owners.
This new aggregation rule provides welcome relief for many closely-held business structures.
In essence, this allows the owners of existing, interrelated businesses to maintain their structures while treating the overall enterprise as a single business for QBID. However, because pass-through businesses cannot aggregate at the entity level, this will require those entities to report all information for each trade or business to their owners as if there will be no aggregation. As a result, aggregation could be favorable for taxpayers, but it will come with increased reporting requirements.
6. Specified Service Trades or Businesses
One of the more hotly debated topics of the Section 199A deduction involves the definition of specified service trade or businesses (SSTB). This is because the owners of SSTBs are not eligible for QBID if their income exceeds the thresholds discussed earlier.
The code section provides a list of fields and a catch-all “skill or reputation” clause but provides no detailed definitions. The proposed regulations include detailed definitions for the list of SSTBs and also narrows the scope of the “skill or reputation” clause.
The expanded definitions are as follows:
Meaning of services performed in the field of health – The provision of medical services by individuals such as physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists and other similar healthcare professionals performing services in their capacity as such who provide medical services directly to a patient. It excludes services not directly related to a medical services field even though the services provided may purportedly relate to the health of the service recipient such as health clubs or health spas, payment processing services, medical research, or the manufacture or sale of pharmaceuticals or medical devices.
Meaning of services performed in the field of law – The performance of services by individuals such as lawyers, paralegals, legal arbitrators, mediators and similar professionals performing services in their capacity as such. It does not include the provision of services by printers, delivery services or stenography services.
Meaning of services performed in the field of accounting – The provision of services by individuals such as accountants, enrolled agents, return preparers, financial auditors and similar professionals performing services in their capacity as such.
Meaning of services performed in the field of actuarial science – The provision of services by individuals such as actuaries and similar professionals performing services in their capacity as such.
Meaning of services performed in the field of performing arts – The performance of services by individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors and similar professionals performing services in their capacity as such. It does not include services that are not unique to the creation of performing arts, such as facility maintenance and operation, and audio or video broadcast.
Meaning of services performed in the field of consulting – The provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems, and includes advice and counsel regarding advocacy provided with the intention of influencing decisions of government and legislators. Consulting does not include services where advice and counsel is not provided, such as sales or the provision of training and educational courses. Moreover, this does not include consulting services that are embedded in, or ancillary to, the sale of goods or performance of non-SSTB services where there is no separate payment for the consulting services.
Meaning of services performed in the field of athletics – The performance of services by individuals who participate in athletic competitions such as athletes, coaches and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards and racing. It does not include services that are not unique to the athletic competition, such as facility maintenance and operation, and audio or video broadcast.
Meaning of services performed in the field of financial services – The provision of financial services to clients including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings (including in Title 11 or similar cases) and raising financial capital by underwriting, or acting as a client’s agent in the issuance of securities and similar services. This specifically includes services provided by financial advisors, investment bankers, wealth planners and retirement advisors.
Meaning of services performed in the field of brokerage services – The provision of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee. This does not include services provided by real estate agents and brokers, or insurance agents and brokers.
Meaning of the provision of services in investing and investment management – The provision of services involving the receipt of fees for providing investing, asset management or investment management services, including providing advice with respect to buying and selling investments. This does not include the direct management of real property.
Meaning of the provision of services in trading – This includes the trading in securities, commodities or partnership interests. However, this does not include hedging transactions that are undertaken by a business, such as a manufacturer or farmer, who is not otherwise considered a trader.
Meaning of the provision of services in dealing – This involves regularly purchasing securities, commodities, or partnership interests from and selling those assets to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign or otherwise terminate positions in those assets with customers in the ordinary course of a trade or business. This does not include a business that regularly originates loans but only engages in negligible sales of those loans.
Meaning of trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owners – This includes a trade or business that consists of any of the following activities:
- 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
- Receiving fees, compensation or other income for appearing at an event or on radio, television or another media format
The code section provides that engineers and architects are not SSTBs. The proposed regulations do not directly define these exempted fields.
The proposed regulations also include a de minimis rule whereby a business with gross receipts of $25 million or less will not be considered an SSTB if less than 10% of its gross receipts are attributable to the performance of specified services. For businesses with more than $25 million of gross receipts, the threshold is lowered to 5%. Therefore, businesses involving multiple activities may be considered an SSTB if one part of the business is a specified service with gross receipts that exceed the de minimis threshold.
As we discussed above, an SSTB is not eligible for aggregation, so the relevant wage and asset limitations will need to be reviewed carefully.
7. Anti-abuse Rules
Since the TCJA was passed into law, various strategies for maximizing the potential QBID for particular businesses have been mentioned.
Three potential strategies are directly addressed in the proposed regulations:
Breaking apart SSTBs
This strategy takes an SSTB and break it into multiple businesses. For example, a law firm that conducts an SSTB could separate out its real estate into a separate partnership, which would then lease it back to the law firm.
The proposed regulations address this strategy as inconsistent with the intent of QBID. As a result, a new rule was created to provide that any business that’s under common ownership (50% or more common ownership, including direct and indirect ownership by related parties) will be treated as an SSTB with respect to the income from the services or property provided to the related SSTB.
If the business provides 80% or more of its property or services to a commonly controlled SSTB, then that entire business will be considered an SSTB.
In applying this rule to the law firm example described above, the real estate rental activity would be considered an SSTB if the law firm was the only tenant. However, income from any portion of the building rented to third parties could be eligible for QBID if those third parties occupied at least 20% of the building, assuming all other requirements are met.
Changing from employee to independent contractor
The definition of a qualified trade or business excludes the trade or business of performing services as an employee. Some taxpayers surely have considered converting from an employee to an independent contractor so that the amounts previously paid as wages would become eligible for QBID.
The proposed regulations address this by adopting a rebuttable presumption that an individual who was previously treated as an employee for federal employment tax purposes with respect to a business will still be treated as an employee of that business despite a change in federal employment tax classification. This presumption applies regardless of whether the individual provides services directly or indirectly through an entity or entities. However, the presumption can be rebutted by showing that the individual is properly classified as an independent contractor under federal tax law.
While it is certainly possible to change the classification from an employee to an independent contractor, we expect that the IRS will view this type of change with a great deal of skepticism and that sufficient documentation will be needed to substantiate the change.
Property acquired at end of year
The cost basis of qualified property is determined as of the end of the tax year for purposes of the 2.5% limitation discussed earlier. If a business needs more assets to support a full 20% QBID, one possible option is to acquire or contribute qualifying property just prior to year end and potentially sell or distribute that property shortly after year end.
The proposed regulations impose time and use restrictions on property that is acquired by a business in close proximity to its year end. Under the general rule, property that is acquired within 60 days of year end and is disposed within 120 days of acquisition will not be considered qualified property unless it has been used for at least 45 days in the business.
Property that does not meet the 45-day use standard can still be considered qualified property if the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing its QBID eligibility.
8. Reporting Rules
A pass-through entity must separately identify and report the following on the Schedule K-1 issued to its owners:
- Each owner’s allocable share of QBI
- W-2 wages
- UBIA of qualified property attributable to each trade or business
- Whether any of the trades or businesses is an SSTB
A pass-through entity must also report the following on an attachment to the Schedule K-1: any QBI, W-2 wages, UBIA of qualified property, or SSTB determinations, reported to it by a pass-through entity in which it owns a direct or indirect interest.
As previously described, the aggregation rules require annual filings or else the trades or businesses will not be permitted to be aggregated.
9. State Tax Considerations
It is uncertain what, if any, impact the proposed regulations will have for state income tax purposes. That’s because the Section 199A deduction does not provide for a deduction in computing federal adjusted gross income (AGI), but instead allows the Section 199A deduction in arriving at federal taxable income.
In nearly every state that imposes a personal income tax, the starting point for determining state taxable income is federal AGI. Since the Section 199A deduction is not part of the determination of AGI, it is generally not included in the state tax base unless the state legislature chooses to specifically conform and incorporate the provision into state law.
While the Section 199A deduction can offer a substantial benefit to owners of sole proprietorships, S corporations and partnerships, it is indeed complex.
Our tax department can help you determine whether you are eligible for the deduction, or if the structure of your business should be, or remain, a pass-through entity or a C corporation. Contact us online or call 800.899.4623 to discuss how your business can take advantage of the Section 199A deduction.