By Gary G. Wallace, CPA | Tax Partner
As part of the 2017 Tax Cuts and Jobs Act, Congress initiated a new tax deduction for qualifying pass through businesses. Section 199A introduced the Qualified Business Income Deduction (QBID), which for tax years after 2017 and before 2026, provides qualifying taxpayers with qualifying pass through business income (QBI) a 20 percent tax deduction of the amount of the QBI, subject to various limitations. The intent for this provision was to more closely align federal income tax rates for pass through businesses with the 21 percent C corporation tax rate.
New Section 199A Explained
New Section 199A provides a complex regime that taxpayers must work through to determine if they qualify for the deduction. The provision, as drafted, also left many unanswered questions as to how the new rules would be applied in practice.
On August 8, 2018, The IRS and Treasury issued proposed regulations in an attempt to address some of these questions. The IRS also released Notice 2018-64 which proposes a revenue procedure for calculating W-2 wages associated with the QBID. Finally, the IRS released Frequently Asked Questions pertaining to 199A. The pronouncements address various matters related to the Section 199A calculations.
The proposed regulations attempt to define the term “trade or business” by indicating that the term should be interpreted in a manner consistent with Code Section 162, other than the trade of business of performing services as an employee. In addition, the regulations provide that the rental of tangible or intangible property that does not meet the Section 162 definition of a trade or business may be treated as qualified trade or business if the property is rented to another commonly controlled trade or business as defined in the regulations. This provision could be applicable to real estate that is leased under a “net lease” agreement.
The proposed regulations clarify that the deduction is applied at the partner or S corporation shareholder level and that the deduction does not affect the adjusted basis of the owners’ interest in the entity. In addition, if an individual has more than one qualifying trades or businesses, losses from one or more qualifying businesses will offset income from other businesses for purposes of calculation the deduction. If the net QBI from all qualifying businesses results in a net loss, the net loss is carried over to the succeeding tax year and reduces QBI for purposes of the calculation of the deduction in the succeeding year.
The QBID is limited to the greater of 50 percent of the W-2 wages paid by the qualified trade or business or the sum of 25 percent of the W-2 wages paid by the business plus 2.5 percent of the unadjusted basis of “qualified property” used in the qualified trade or business. The proposed regulations provide clarifications that W-2 wages are determined using the rules of former Section 199, the domestic production activities deduction. The Notice prescribes three methods for calculating W-2 wages. Rules are provided in the regulations for allocating wages paid by a pass through entity to the owners of the entity for purpose of computing their individual limitations.
Section 199A Business Impact
The proposed regulations address the definition and computation of the unadjusted basis of qualified property. Also addressed by the regulations are other issues related to “qualified property” including allocations among pass-through entities and the owners of the entities, subsequent improvements or additions to qualified property made during a taxable year, and the effects of non-recognition transactions, such as like-kind exchanges.
In cases where taxpayers have multiple pass through trades or businesses, the proposed regulations provide rules for the aggregation of those trades or businesses. However, the proposed regulations do not follow the aggregation rules related to passive activity losses under Section 469. Instead, a new complex four-part test is utilized for aggregation, which in some cases may be more limiting than the Section 469 rules.
Specified Service Trades or Businesses
Under the statutory language of Section 199A, the deduction does not apply to Specified Service Trades or Businesses (SSTB) and to trades or businesses that involve the performance of consulting services or services that consist of investment/financial service type activities. Some of the biggest unanswered questions related to Section 199A were how the definition of a SSTB and other non-qualified business was going to be defined by the IRS and Treasury. The proposed regulations provide some helpful guidance related to these definition, but more guidance is needed.
According to the proposed regulations, a taxpayer who participates in a SSTB is treated as engaging in a SSTB regardless of level of participation, active or inactive. The proposed regulations also provide rules that a SSTB includes a trade or business with 50 percent or more common ownership that provides 80 percent or more of its services to a related SSTB.
Under the rules related to SSTB’s, the proposed regulations provide for a de minimis rule for small businesses that may engage in more than one business with one business meeting the definition of a SSTB. Under the de minimas rules, businesses with gross receipts of 25 million dollars or less will not be engaged in a SSTB as long as less than 10 percent of total receipts are attributable to services in one of the disqualified fields. For businesses with gross receipts in excess of 25 million dollars, the de minimis is reduced to 5 percent.This is welcome news for many taxpayers, and the regulations provide that taxpayers that meet these tests do not have to keep a separate sets of books for each business in order to calculate the QBID. These rules are applied at the entity level and not the partner/shareholder level.
The SSTB rules and the W-2 wage limitations do not apply to certain individual taxpayers with taxable income below threshold amounts. These amounts are 315,000 dollars for married, joint filing taxpayers, and 157,500 dollars for other individuals.
The proposed regulations provide additional guidance on the types of businesses that are SSTB, referencing guidance under Sections 448 and 1202. Under Code Section 199A, the performance of service in the fields of health is a SSTB not eligible for the QBID. The regulations provide that the SSTB related to performance of services in the field of health means the performance of service by healthcare professionals providing medical service directly to a patient. Under the regulations, performance of services in the field of health does not include the provision of services not directly related to providing patient care such as medical device sales, payment processing, and other ancillary services in the healthcare industry.
The trade or business of providing financial service is also a SSTB under Section 199A and is not eligible for the deduction. The proposed regulation clarifies which type of financial services will be considered a SSTB under Section 199A. The regulations state that the definition of financial services does not include services provided by real estate brokers and agent, and insurance agents and brokers.
Under the SSTB definitions, the regulations provide a caveat that a SSTB includes “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees….in which a person receives fees, compensation or other income for endorsing products or services, licenses or receives fees for use of an individual’s image, likeness, name, signature, voice, trademark or any other symbols associated with the individuals identity or for appearing at an event or on radio, television or other media.”
Now that the proposed regulations have been issued, taxpayers should review their revenue streams as compared to the SSTB guidance, especially the de minimis rules, in order to make the case that their trade or business will qualify for the QBID.
As a final note, the recent pronouncements provide much needed additional guidance but there are still many questions that are unanswered. The Treasury is soliciting comments until October 1, 2018, with a public hearing on October 16, 2018. At that time, we may have a better understanding of whether these will be enacted or further modified.
Additional Section 199A Resources: