The deduction provided in Section 199A of the Internal Revenue Code (the "Code") is a major part of Tax Cuts and Jobs Act (P.L. 115-97) because it levels the playing field for certain taxpayers who do not conduct their businesses through C corporations, which saw their tax rate cut to 21%. Section 199A generally provides a deduction of (1) up to 20% of an individual's income from a domestic business operated as a sole proprietorship or through a partnership or S corporation and (2) 20% of the aggregate amount of an individual's dividends from real estate investment trusts ("Qualified REIT Dividends") and "qualified publicly traded partnership income" ("PTP Income"). As a result, the Section 199A deduction can reduce the highest ordinary rate on such income from 37% to an effective rate of 29.6% (i.e., 80% of 37%). As discussed below, however, the determination of the Section 199A deduction is complicated because numerous terms, multiple limitations, and onerous calculations apply.
On August 8, 2018, the Treasury Department and Internal Revenue Service (the "IRS") released proposed regulations (available here) that generally provide taxpayers with computational, definitional, and anti-avoidance guidance regarding the application of Section 199A. Although Section 199A applies to trusts and estates as well, the summary below focuses on the impact of the proposed regulations to individuals who operate domestic businesses as a sole proprietorship (including through disregarded entities), through a partnership or an S corporation and/or have Qualified REIT Dividends or PTP Income.
Highlights of Proposed Regulations
A few of the notable "take aways" from the proposed regulations are the following:
- aggregating trades or businesses in multiple entities is not required (but is permitted in certain cases), which should significantly reduce compliance issues;
- negative "qualified business income" (referred to as QBI below) from one trade or business is required to be netted against positive QBI from another trade or business, which may have the effect of reducing the Section 199A deduction;
- if the net QBI from all trades or businesses is less than zero, such amount is treated as a loss from a trade or business in the succeeding taxable year or years, which may reduce the Section 199A deduction in future years;
- wages paid to workers who receive Forms W-2 from professional employer organizations and certified professional employer organizations are generally treated as W-2 wages paid by the client for purposes of the W-2/Basis Limitation (defined and discussed below), meaning current payroll arrangements do not need to be restructured to obtain the benefits of the Section 199A deduction;
- special basis adjustments under Section 734 and Section 743 are not treated as separate qualified property, meaning the W-2/Basis Limitation is not affected by, and, thus, the Section 199A deduction cannot be increased as a result of, any special basis adjustment to qualified property held by the partnership;
- the basis of qualified property contributed to a partnership or an S corporation in a tax-free exchange is the "adjusted basis" of the property at the time of the exchange, rather than the "unadjusted basis" in the hands of the transferor, meaning an individual's Section 199A deduction attributable to such property may, for example, be reduced if such individual were to incorporate a sole proprietorship as an S corporation;
- the "reputation or skill" catchall for defining a "specified service trade or business" (e.g., lawyers, doctors, and accountants) (referred to as an SSTB below) is narrowly defined, meaning fewer businesses will be excluded from the Section 199A deduction;
- a trade or business is not treated as an SSTB if less than 5% of the business' gross receipts are attributable to an SSTB (10% if gross receipts are $25 million or less for the year), meaning a de minimis amount of income from an SSTB will not taint the entire trade or business; and
- banks are excluded from being treated as an SSTB.
In general, an individual who files a joint return with taxable income (before computing the Section 199A deduction) at or below $315,000 ($157,500 for others) (the "Threshold Amount") is entitled to a deduction under Section 199A equal to 20% of the individual's "qualified business income" ("QBI"). However, an individual's Section 199A deduction can never exceed 20% of the excess of the individual's taxable income over the individual' net capital gain (the "Overall Limitation").
If the taxable income of an individual who files a joint return equals or exceeds $415,000 ($207,500 for others) (the "Cap Amount"), the individual's Section 199A deduction is generally equal to the lowest of:
- 20% of the individual's QBI,
- the greater of (the "W-2/Basis Limitation"):
- 50% of the individual's share of W-2 wages paid with respect to the "qualified trade or business" ("W-2 Wages"), and
- the sum of (i) 25% of W-2 Wages, plus (ii) 2.5% of the "unadjusted basis immediately after acquisition of all qualified property" ("UBIA"), and
- the individual's Overall Limitation.
If the individual's taxable income exceeds the Threshold Amount but is less than the Cap Amount, the individual's Section 199A deduction is generally equal to the lesser of (1) 20% of the taxpayer's QBI, reduced in cases where the W-2/Basis Limitation applies by a "reduction amount" (the effect of which is to partially, rather than completely, reflect the impact of the W-2/Basis Limitation with respect to individuals whose taxable income is less than the Cap Amount but greater than the Threshold Amount) (the "Phase-In Range") or (2) the individual's Overall Limitation.
Additionally, if the individual's taxable income exceeds the Threshold Amount, additional limitations apply in the event the individual's otherwise qualifying QBI is from any "specified service trade or business" (an "SSTB"). If the individual's taxable income is within the Phase-In Range, QBI, W-2 Wages, and UBIA attributable to an SSTB can only be taken into account in an amount equal to the "applicable percentage" of such item, which equals 100%, less the percentage equal to the ratio that the individual's taxable income in excess of the applicable Threshold Amount bears to the excess of the applicable Cap Amount over the applicable Threshold Amount, and if the individual's taxable income exceeds the Cap Amount, no portion of the QBI, W-2 Wages, or UBIA attributable to an SSTB can be taken into account (together, the "SSTB Limitation").
In addition, Section 199A generally provides a deduction equal to 20% of the aggregate amount of the individual's Qualified REIT Dividends and PTP Income. Neither the Phase-In Range limitation nor the SSTB Limitation applies to the 20% deduction for Qualified REIT Dividends and PTP Income, but such deduction is subject to the Overall Limitation. If an individual has QBI, Qualified REIT Dividends, and PTP Income, the Overall Limitation applies to the aggregate deduction otherwise determined under Section 199A.
As the above discussion demonstrates, the calculation of the Section 199A deduction takes into account numerous defined terms, is subject to several limitations, and requires onerous calculations. The significant computational, definitional, and anti-avoidance guidance provided in the proposed regulations is discussed below.
Guidance Provided in the Proposed Regulations
Trade or Business
Section 199A uses the term "qualified trade or business" extensively and defines such term as any "trade or business" other than an SSTB or the trade or business of performing services as an employee. However, neither the statutory text of Section 199A nor the legislative history provides a definition of "trade or business" for purposes of Section 199A. The proposed regulations define "trade or business" to have the same meaning as provided in Section 162 other than providing services as an employee. The proposed regulations also provide that the rental or licensing of tangible or intangible property to a commonly-controlled business in cases where such leasing or licensing does not rise to the level of a "trade or business" under Section 162 is nevertheless a "trade or business" for purposes of Section 199A.
A taxpayer can have more than one trade or business. The preamble to the proposed regulations explains that, in most cases, a trade or business cannot be conducted through more than one entity. However, the Treasury Department and the IRS acknowledged in the preamble that for various legal, economic, or other non-tax reasons a trade or business may be operated across multiple entities. As a result, the proposed regulations permit aggregation of separate trades or businesses if the requirements described below are met, but significantly, do not require aggregation, which should ease compliance for taxpayers.
Aggregation is permitted if the following requirements are met:
- each trade or business must itself be a trade or business as defined above;
- the same person, or group of persons, must directly or indirectly own a majority interest in each of the businesses to be aggregated for the majority of the taxable year in which the items attributable to each trade or business are included in income;
- none of the aggregated trades or businesses can be an SSTB; and
- at least 2 of the following 3 factors must be established: (1) the businesses provide products and services that are the same or they provide products and services that are customarily provided together; (2) the businesses share facilities or share significant centralized business elements; or (3) the businesses are operated in coordination with, or reliance on, other businesses in the aggregated group.
Individual owners of the same partnership or S corporation are not required to aggregate in the same manner. The proposed regulations also provide that, once multiple trades or businesses are aggregated into a single aggregated trade or business, individuals must consistently report the aggregated group in subsequent tax years.
QBI is generally defined as the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business of the taxpayer. QBI does not include Qualified REIT Dividends, PTP Income, reasonable compensation (in the case of compensation to S corporation shareholder-employees but the rule is not extended to partnerships), guaranteed payments (including to upper-tier partnerships or S corporation that are partners), or capital gains or losses. The proposed regulations also:
- clarify that ordinary income under Section 751 is generally treated as QBI if other requirements of Section 199A are met;
- treat losses suspended under other provisions of the Code (e.g., Sections 465, 469, 704(d), and 1366(d)), to the extent suspended for the 2018 taxable year and thereafter, as items attributable to the applicable trade or business in the year allowed;
- generally do not treat net operating losses (other than the portion thereof consisting of excess business losses disallowed under Section 461(l)) as losses in subsequent years because such losses are taken into account in computing QBI in the year incurred;
- do not treat a gain or loss that is treated as a capital gain or loss under Section 1231 as QBI, but do treat gain or loss that is not treated as a capital gain or loss under Section 1231 as QBI (provided all other requirements are met); and
- do not treat interest income received on working capital, reserves, and similar accounts as QBI, but do treat interest income received on accounts or notes receivable for services or goods as QBI.
Allocation of QBI
The proposed regulations provide that, if an individual (directly or through a partnership or S corporation) conducts multiple trades or businesses, and has items of QBI that are properly attributable to more than one trade or business, the individual (or the partnership or S corporation) must allocate those items among the several trades or businesses to which they are attributable using a reasonable method that is consistent with the purposes of section 199A. The chosen reasonable method for each item must be consistently applied from one taxable year to another and must clearly reflect the income of each trade or business.
Netting Positive and Negative QBI
If an individual has multiple trades or businesses, the individual must calculate the QBI from each trade or business and then net the amounts. If an individual has QBI of less than zero from one trade or business, but has overall QBI greater than zero when all of the individual's trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the W-2/Basis Limitation for each such trade or business. The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the W-2/Basis Limitation, the net gain or income with respect to each trade or business (as offset by the apportioned losses) is the individual's QBI with respect to that trade or business.
Carryover of Net Negative QBI
If the net QBI with respect to qualified trades or businesses of the individual for any taxable year is less than zero, such amount is to be treated as a loss from a qualified trade or business in the succeeding taxable year. The proposed regulations clarify that Section 199A carryover rules do not affect the deductibility of the losses for purposes of other provisions of the Code.
W-2/Basis Limitation Calculations
To calculate the W-2/Basis Limitation, the proposed regulations provide that the individual must determine the W-2 Wages and UBIA attributable to each trade or business contributing to the individual's combined QBI. Those W-2 Wages and UBIA amounts are then used to determine whether the W-2/Basis Limitation exceeds 20% of the QBI for each such trade or business. If so, the amount taken into account for such trade or business for purposes of determining the Section 199A deduction is limited to 20% of QBI for that trade or business. If not, the amount taken into account for such trade or business for purposes of determining the Section 199A deduction equals the amount determined using the W-2/Basis Limitation for that trade or business. Similar, but more complicated, rules apply if the individual's taxable income is within the Phase-In Range.
The proposed regulations clarify that wages paid to workers who receive Forms W-2 from third-party payors (such as professional employer organizations, certified professional employer organizations, or agents under Section 3504) are W-2 Wages of the clients of the third-party payors as long as such wages are paid to common law employees or officers of the clients for services provided to the clients.
For purposes of calculating the W-2 Basis Limitation, the proposed regulations provide that, in the case of W-2 Wages that are allocable to more than one trade or business, the portion of the W-2 Wages allocable to each trade or business is determined to be in the same proportion to total W-2 Wages as the deductions associated with those W-2 Wages are allocated among the particular trades or businesses.
In the case of a trade or business conducted by a partnership or an S corporation, a partner's or shareholder's allocable share of W-2 Wages is determined in the same manner as the partner's allocable share or a shareholder's pro rata share of the wage expenses.
UBIA and Qualified Property
For purposes of the W-2/Basis Limitation, "qualified property" means tangible property of a character subject to depreciation that is held by, and available for use in, a trade or business at the close of the taxable year, and which is used in the production of QBI, and for which the "depreciable period" has not ended before the close of the taxable year. For this purpose, "depreciable period" means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (1) the date ten years after that date, or (2) the last day of the last full year in the applicable recovery period that would apply to the property. Although Section 199A uses the phrase "immediately after acquisition," the proposed regulations interpret this phrase to mean the date the property is placed in service. Special rules apply in the case of non-recognition transfers of property that treat the "first placed in service" date of part or all of the property transferred as the date such property was first placed in service by the transferor.
For purchased or produced qualified property, UBIA generally will be its cost as of the date the property is placed in service (i.e., unadjusted basis is used throughout depreciable period). For qualified property contributed to a partnership or an S corporation in a tax-free exchange, however, UBIA generally will be its "adjusted basis" at the time of the exchange (rather than the "unadjusted basis" that would apply sans an exchange), which means qualified property generally has a lower basis for purposes of calculating the W-2/Basis Limitation in the hands of the transferee partnership or S corporation than in the hands of the transferor partner or S corporation.
The proposed regulations provide that partnership special basis adjustments under Section 734 and Section 743 are not treated as separate qualified property. Therefore, the basis for purposes of determining the W-2/Basis Limitation is not increased by (and, thus, the Section 199A deduction is not increased as a result of) any such special basis adjustments to qualified property held by the partnership.
The proposed regulations provide special rules that apply to "qualified property" that is part of a like-kind exchange. The proposed regulations also provide that improvements to qualified property are generally treated as separate new property for purposes of (and, thus, the unadjusted basis of such improvements is taken into account as a basis increase in) the W-2/Basis Limitation calculation.
Share of UBIA
The proposed regulations provide that, in the case of qualified property held by a partner or an S corporation, each partner's or shareholder's share of the UBIA of qualified property is an amount that bears the same proportion to the total UBIA of qualified property as the partner's or shareholder's share of tax depreciation bears to the entity's total tax depreciation attributable to the property for the year. In the case of qualified property of a partnership that does not produce tax depreciation during the year (for example, property that has been held for less than 10 years but whose recovery period has ended), each partner's share of the UBIA of qualified property is based on how gain would be allocated to the partners pursuant to Sections 704(b) and 704(c) if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property. In the case of qualified property of an S corporation that does not produce tax depreciation during the year, each shareholder's share of the UBIA of the qualified property is a share of the UBIA proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.
Qualified REIT Dividends and PTP Income
Qualified REIT Dividends
Section 199A generally provides a 20% deduction for an individual's Qualified REIT Dividends. To prevent dividend stripping and similar transactions aimed at capturing Qualified REIT Dividends without having economic exposure to the REIT stock for a meaningful period of time, the proposed regulations generally incorporate Section 246(c) as an anti-abuse rule.
Section 199A generally provides a 20% deduction for an individual's PTP Income. The proposed regulations clarify that the other rules applicable to the determination of QBI apply to the determination of PTP Income, including that Section 751 income recognized upon a sale of an interest in a publicly traded partnership must meet the standards of QBI to qualify as PTP Income (e.g., attributable to a domestic trade or business).
Carryover of Loss
Overall losses attributable to Qualified REIT Dividends and PTP Income (i.e., allowable losses from publicly traded partnerships exceed Qualified REIT Dividends and PTP Income) are not netted against QBI. Instead, the proposed regulations provide that if an individual has an overall loss after Qualified REIT Dividends and PTP Income are combined, the portion of the individual's Section 199A deduction related thereto is zero for the taxable year, and such overall loss is carried forward and must be used to offset combined Qualified REIT Dividends and PTP Income in the succeeding taxable year or years for purposes of calculating the Section 199A deduction.
An SSTB is defined as any trade or business involving the performance of services:
- in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services,
- in 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 (the "Reputation and Skill Clause"), or
- that consist of investing and investment management, trading, or dealing in securities (as defined in Section 475(c)(2)), partnership interests, or commodities (as defined in Section 475(e)(2)).
The proposed regulations provide definitions with respect to each of the listed items.
With respect to the Reputation and Skill Clause, the Treasury Department and the IRS state in the preamble to the proposed regulations that they believe it was intended to describe a narrow set of trades or businesses, not otherwise covered by the enumerated specified services, in which income is received based directly on the skill and/or reputation of employees or owners. As such, the proposed regulations provide that the Reputation and Skill Clause only applies to fact patterns in which the individual is engaged in the trade or business of:
- receiving income for endorsing products or services;
- licensing or receiving income for the use of an individual's image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual's identity; or
- receiving appearance fees or income.
With respect to defining "consulting," the proposed regulations indicate that consulting is limited to the provision of advice and counsel to clients and specifically does not include (1) the provision of training or educational courses or (2) the performance of consulting services embedded in, or ancillary to, the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB if there is no separate payment for the consulting services.
With respect to defining "investing and investment management services," the proposed regulations indicate that such services include the provision of investing, asset management or investment management services, but specifically exclude directly managing real property.
With respect to defining "financial services," the proposed regulations do not include banks. As such, shareholders of S corporation banks are eligible for the Section 199A deduction regardless of their taxable income because the SSTB Limitation does not apply to banks.
De Minimis Exception
The proposed regulations provide that a trade or business is not an SSTB if the trade or business has gross receipts of $25 million or less (in a taxable year) and less than 10% of the gross receipts of the trade or business is attributable to the performance of services in an SSTB. For trades or business with gross receipts greater than $25 million (in a taxable year), a trade or business is not an SSTB if less than 5% of the gross receipts of the trade or business are attributable to the performance of services in an SSTB.
The proposed regulations also include rules to prevent strategies to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions (known as "crack and pack" plans), in an attempt to qualify those separated parts for the Section 199A deduction.
Should you have any questions or concerns about the impact the proposed regulations may have on your business, please contact any of the authors of this update.
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