Proposed Regulations Released on IRC Section 199A Pass-Through Deduction
Gibbons Corporate & Finance News - Legislative Tax Alert
August 15, 2018
Among the most highly anticipated releases explaining the 2017 Tax Reform Act, on Wednesday, August 8, the Treasury Department issued Proposed Regulations providing guidance on the 20% pass-through deduction for qualified business income (“QBI”) under new Internal Revenue Code Section 199A. The IRS also issued Notice 2018-64, which contains a proposed revenue procedure providing guidance on methods for calculating W-2 wages for purposes of Section 199A. While the proposed rules are not final, Treasury officials have stated that taxpayers may rely on them for planning purposes.
Overview of the Proposed Regulations
Among other items addressed by the new Proposed Regulations, they include:
- Anti-abuse rules to prevent specified service trades or businesses (“SSTBs”) from maximizing deductions under Code Section 199A by splitting off qualifying activities from service-type activities;
- Rules providing guidance and examples of what types of work do and do not qualify as QBI within various fields of employment;
- New clarifying text that significantly limits the application of a catch-all definition (“any trade or business where the principal asset is the reputation or skill” of at least one employee) which had threatened to greatly expand the scope of SSTBs;
- A couple of new de minimis rules allowing business owners to claim that all of their income qualifies as QBI even if a small portion of their income is derived from an SSTB; and
- Elective aggregation rules to allow individual filers with pass-through income from multiple sources to group them together under certain circumstance to increase their Section 199A deductions.
Background on Section 199A
Section 199A was implemented as part of the 2017 Tax Reform, and provides a deduction of up to 20% of QBI for owners of pass-through businesses, including sole proprietorships, which effectively lowers the top tax rate from 37% to 29.6%. For taxpayers whose taxable income exceeds a $315,000 threshold for joint filers ($157,500 for all others), the deduction is phased out over the next $100,000 ($50,000) of income for taxpayers who are SSTB owners (such as high-earning partners of law or accounting firms).
For non-SSTBs, the deduction is limited for taxpayers with income over the threshold, to the greater of their allocable share of: (i) 50% of the W-2 wages with respect to the qualified trade or business, or (ii) the sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. The deduction is then subject to a second limitation equal to 20% of the excess of: (i) the taxable income for the year, over (ii) the sum of net capital gain. The second limitation is intended to minimize the extent to which the 20% deduction can be used to offset long-term capital gain income.
Critical Provisions of the Proposed Regulations
Among the notable provisions of the proposed regulations are anti-abuse rules to prevent “crack and pack,” a strategy in which SSTBs which would otherwise be ineligible for the deduction spin off their administrative and other non-professional services functions into separate entities which might otherwise qualify for the deduction. Under the proposed rules, if an SSTB owns 50% or more of another business, the controlled business would be considered a part of that SSTB.
An SSTB includes the activities of law, accounting, consulting, performing arts, athletics, financial services, investment management, securities and commodities trading, actuarial science, health, and brokerage services, as well as “any trade or business where the principal asset is the reputation or skill” of at least one employee. The Proposed Regulations provide numerous examples of what types of work do and do not qualify as QBI within various fields of employment. Real estate and insurance brokers are not SSTBs.
To the relief of many taxpayers, the regulations narrowly define the final SSTB catch-all (“any trade or business where the principal asset is the reputation or skill” of at least one employee) to include primarily activities generating endorsement, licensing, appearance fees and similar payments tied directly to the reputation of a taxpayer.
The Proposed Regulations also include a couple of new de minimis rules allowing business owners to claim that all of their income qualifies as QBI even if a small portion of their income is derived from an SSTB. Business owners with gross receipts of $25 million or less can claim the full deduction if less than 10% of receipts are from an SSTB, while those with more than $25 million of gross receipts are limited to 5% from an SSTB.
The Proposed Regulations include new elective aggregation rules for individual filers who have pass-through income from multiple sources. If a taxpayer elects to aggregate, then their allocable shares of QBI, W-2 wages, and property basis for the businesses are aggregated and determined before computing the deduction. Aggregation is done at the owner level, meaning that one owner of a business could choose to aggregate interests in certain businesses for Section 199A purposes while another owner does not. The requirements to obtain the right to elect to aggregate under the new rules are as follows:
- The same person or group of persons, directly or indirectly, must own 50% or more of each business (the electing owner does not need to be the 50% owner, it is sufficient that there is a common 50% owner (or ownership group) of all of the entities to be aggregated);
- The control test must be met for the majority of the tax year;
- The businesses must all share the same taxable year;
- None of the businesses may be an SSTB; and
- The businesses must share two of the following three factors:
- they must provide the same products or services or those that are typically offered together;
- they must share facilities or significant centralized business elements; or
- they are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group.
Section 199A provides an opportunity for many businesses that operate via pass-through structures to benefit from a potentially significant tax reduction. While the IRS’s new proposed regulations may have preemptively blocked the “crack and pack” strategy, the elective aggregation provisions present a potentially very advantageous planning opportunity, and the de minimis rules offer some helpful protection. If you have any questions or concerns with how these provisions will impact you or your business, please do not hesitate to contact the authors.