On December 22, 2017, President Trump signed a historic tax reform bill into law. Of the many changes that the law enacted, perhaps one of the most radical changes was the creation of the new section 199A which gives a deduction to pass-through entity owners in the amount of 20% of qualified business income. Finally, after a winter, spring, and most of the summer where taxpayers wondered about the nuances of this deduction, the Internal Revenue Service (“I.R.S.”) issued guidance on how the new deduction will be applied to taxpayers. Below are our top 10 takeaways from the proposed regulations and what questions remain even after the promulgation of these regulations.
- Aggregation of Businesses. One of the main areas of guidance needed was how to apply the deduction in the case of multiple trades or businesses. First, the regulations make clear that separate trades or business will generally remain separate for tax purposes unless aggregated by the taxpayer. Taxpayers may then aggregate their businesses if certain requirements are met: the same person/group of people directly or indirectly owns a majority interest in each trade or business, none of the businesses are specified service trades or businesses, and the businesses are related (e.g., provide complementary products/services, share facilities or significant centralized business elements, or are operated in coordination with one another). If aggregated, then the separate trade or businesses will be deemed one business for the purpose of calculation of QBI, the unadjusted basis limitation, and the W-2 limitation.
- Qualified Business Income (QBI). Instead of defining QBI specifically for section 199A purposes, the regulations indicate that business income is income from a trade or business as defined under existing I.R.C. § 162. While this may seem an easy cross reference, there is no concrete definition of a trade or business under I.R.C. § 162. Rather, the determinations are made on the facts and circumstances of each case. Thus, in tying the definition of business income in I.R.C. § 199A to the trade or business definition under I.R.C. § 162, the I.R.S. has invited more, rather than less, uncertainty into the interpretation of the deduction in the recently released regulations.
- Specified Service Trade or Business (SSTB). One of the main components of the I.R.C. § 199A deduction was that it did not universally apply to all service businesses. While the text of the statute did provide categories of businesses that constituted “specified service trade or businesses,” there were still many questions about which businesses would qualify. The new regulations clarified many of these questions and did so largely in taxpayer-friendly ways. For example, the final definition of brokerage services specifically excludes insurance agents and brokers and real estate agents and brokers. In addition, the catch-all category – which provided that specified service businesses included any business where the principle asset of the trade or business is the reputation or skill of its employees or owners – was defined very narrowly to include only businesses where the business is earning fees from personal endorsements or for the use of an individual’s image, likeness, name, or voice.
- Required Aggregation. Unlike the permissive aggregation generally allowed for most businesses, specified service trade or businesses may be required to be aggregated with other businesses. For example, a specified service trade or business includes any trade or business that provides 80% or more of its property or services to such service business if there is more than 50% common ownership. This rule will foreclose service businesses from segregating their business operations to qualify for the deduction.
- What about real estate? While eligible taxpayers may also be entitled to a deduction of up to 20 percent of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, personal real estate holdings may not qualify. As noted above, the drafters of the regulation had an opportunity to address the over-arching trade or business question as it relates to rental real estate business, but chose to defer to the existing, muddled guidance about such businesses currently available under I.R.C. § 162.
- What qualifies as W-2 wages? W-2 wages are total wages subject to wage withholding, elective deferrals, and deferred compensation paid during the tax year that are attributable to QBI. There are several methods that can be used to figure out wages that are properly allocable to QBI. As described above, you may be able to group multiple entities together if the trade or businesses meet certain requirements.
- Treatment of Certain Employees. The new regulations indicated that any former employee who continues to perform the same services in a non-employee capacity will be presumed to be an employee. This will foreclose the possibility of employees of pass-through entities contractually rearranging their employment to qualify for the pass-through deduction, as merely acting as an employee is not a qualified trade or business for the purposes of the 199A deduction.
- Losses. Taxpayers with multiple business that qualify for the deduction will have to net business losses against business income to determine QBI, whether or not those businesses qualify for aggregation and whether or not the taxpayer actually chooses to aggregate them. Losses carry forward until they are used, so generating a large loss may not be as beneficial. When losses are suspended for either at-risk rules or passive activity rules, they are also suspended for QBI purposes.
- Reporting. One of the operational problems that remains unresolved is how all of this information will be ultimately reported to pass-through entity owners who will need the information for their own personal tax return. Tax practitioners expect that this information will be passed to the owner on the information reporting form K-1 issued to each owner; however, it is likely that significant changes to that form will be required before it can satisfy all of the required reporting for the 199A deduction.
- Help is available for all your 199A questions and needs. For further information, contact your P&N tax advisor.
Tax Managers Stephen Blitz and Heidi Mabile contributed to this article.