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Proposed IRS Regulations on the New 20% Passthrough Deduction

SUMMARY
The new tax reform legislation passed at the end of 2017 created several new provisions favorably impacting US business owners. Perhaps one of the most beneficial provisions within the new tax reform is the 20% passthrough deduction under Section 199A (also known as the ‘QBI Deduction’). The expansive Section 199A calculations are quite complex and tax professionals along with business owners have studied the provision and identified several areas of concern regarding application of the new law. In response, on August 8th, the Internal Revenue Service issued long awaited guidance under Proposed Regulation (REG 107892-18). The purpose of the Proposed Regulations is to provide taxpayers with computational, definitional, and anti-avoidance guidance regarding the application of Section 199A. Although the regulations are in proposed form, taxpayers are permitted to rely on them until final regulations are issued.
OVERVIEW OF QBI DEDUCTION
For tax years ending in 2018 and thereafter, owners of various business entities are generally entitled to a deduction equal to 20% of qualified business income (QBI). Eligible entities include, among others, sole proprietors, domestic limited liability companies, partnerships, s-corporations, and trusts. The QBI deduction is claimed at the individual-level on the business owners’ individual tax returns.
QBI includes taxable income connected with the conduct of a US trade or business. The following income (loss) categories are excluded:
  • Capital gains and losses
  • 1231 gains and losses
  • Dividends and dividend equivalents
  • Interest income not connected with the trade or business
  • Various income from controlled foreign corporations
  • Guaranteed payment income received by the business owner
  • Wage and salary income received by the business owner
  • Other payments received by the business owner for services provided to the business
When calculating the 20% deduction, special rules and phase-out levels apply. The most significant rule depends on whether or the not the relevant business meets the definition of a specified service trade or business (SSTB). The original legislation defined an SSTB as follows:

A trade or business involving the performance of services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, or 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, or which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

The legislation specifies one income threshold for SSTBs and one threshold for non-SSTBs. The threshold for SSTBs is more restrictive and always results in a deduction equal or less than the non-SSTB deduction. The thresholds are as follows:

SSTB – Phased out of the deduction for business owner income between $157,500 to $207,500 for single taxpayers and $315,000 to $415,000 for married filing joint taxpayers.

NON-SSTB – These businesses are not subject to direct phase-out but are subject to a wage and capital limitation based on the owner’s proportionate share of the business’s total W2 wages and capital property (defined under IRC 167). This limitation is phased in between $157,500 to $207,500 for singles and $315,000 to $415,000 for married filing joint. For taxpayers over the income threshold and fully subject to the limitation the amount of the QBI deduction cannot exceed the greater of:

  • 50% of the owner’s share of W-2 wages; or
  • The sum of 25% of the owner’s share of W-2 wages plus the owner’s share of 2.5% of the unadjusted basis immediately after acquisition (UBIA) of all “qualified property” in the business
An additional limitation applies based on the taxable income of the business owner. The amount of the QBI deduction cannot exceed the business owner’s taxable income.
NEW GUIDANCE UNDER PROPOSED REGULATIONS
The IRS Proposed Regulations provide 183 pages of new guidance which reveals the complexity of Section 199A. Below are highlights from sections where the Proposed Regulation provides guidance:
Self-Employment and Net Investment Income Tax:
The 20% deduction only provides a deduction for purposes of the regular income tax. The deduction has no impact on self-employment tax or the net investment income tax.
 
Fiscal-Year Passthrough Entities:
The Proposed Regulations clarify that for purposes of determining QBI, W-2 wages, and UBIA of qualified property, if an individual receives any of these items from a passthrough entity having a fiscal year beginning in 2017 and ending in 2018, such items are treated as having been incurred by the individual during the individual’s 2018 taxable year and may be taken into account in determining the individual’s QBI Deduction. For example, if a partner owns an interest in a partnership with a year-ended 1/31/18 the partner can claim the QBI deduction on his 2018 calendar year tax return due 4/15/19.
 
Definition of a Specialized Service Trade or Business:
One of the most significant areas of the Proposed Regulation provides guidance addressing when a business meets the definition of an SSTB and when not.
In a move praised by taxpayers, the proposed regulation limits application of the term “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” to businesses that consist of the following (or any combination thereof):
  1. A trade or business in which a person receives fees, compensation, or other income for endorsing products or services,
  2. 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, or
  3. Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.

In addition, the Proposed Regulations provide much-needed clarity around the meaning of the term SSTB, separately addressing each of the following listed services:

  • Health
  • Law
  • Accounting
  • Actuarial Service
  • Performing Arts
  • Consulting
  • Athletics
  • Financial Services
  • Brokerage
  • Investment Banking
  • Trading
  • Dealing in Securities, Commodities, and Partnership Interests

A specific discussion of each of these definitions is beyond the scope of this article but here are a couple industry samples:

 

Health: Medical services provided 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 (service recipient). The performance of services in the field of health does not include the provision of services not directly related to a medical services field, even though the services provided may purportedly relate to the health of the service recipient. For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or the research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.

 

Consulting: The provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems. Consulting includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such. The performance of services in the field of consulting does not include sales or economically similar services or the provision of training and educational courses. The determination of whether a person’s services are sales or economically similar services is based on all the facts and circumstances of that person’s business which may include, for example, the manner in which the taxpayer is compensated for the services provided. Performance of services in the field of consulting does not include 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 (such as typical services provided by a building contractor) if there is no separate payment for the consulting services.

 

Brokerage: Services in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee. This includes services provided by stock brokers and other similar professionals, but does not include services provided by real estate agents and brokers, or insurance agents and brokers.

The proposed regulation has added a new de-minimis rule for trades and businesses with only a small portion of activities that are SSTB related. A trade or business (determined before the application of the aggregation rules) 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 percent 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 percent of the gross receipts of the trade or business are attributable to the performance of services in an SSTB.

How to Handle Negative QBI:
Special computational rules apply in situations where a taxpayer has negative QBI from one or more qualified trades or businesses and that individual is below the phase-out range.

 

Under these rules, if an individual has only one qualified trade or business and the business has negative QBI the individual’s Section 199A deduction is zero for the taxable year. The negative total QBI amount is treated as negative QBI from a separate trade or business in the succeeding taxable year of the individual for purposes of Section 199A. This carryover rule does not affect the deductibility of the loss for other purposes.
 
If the individual has two or more qualified trades or businesses and one of the businesses has negative QBI the individual must offset the QBI attributable to each trade or business that produced net positive QBI with the QBI from each trade or business that produced net negative QBI in proportion to the relative amounts of net QBI in the trades or businesses with positive QBI. The W-2 wages and UBIA of qualified property from the trades or businesses which produced net negative QBI are not taken into account and are not carried over to the subsequent year.  For individuals who are within the phase-out range, a more complex calculation must be completed to address negative QBI.
 
Definition of Limitation Amounts – Wages and Qualified Property:
Wages – The Proposed Regulations generally follow the W-2 wage rules under former Section 199. As a result, in order for wages to be included in the W-2 wages of a taxpayer for purposes of the QBI Deduction, wages must be reported on a Form W-2 and must be for employment by the taxpayer. Additionally, taxpayers may take into account wages reported on Forms W-2 issued by other parties provided that the wages reported on the Forms W-2 were paid to employees of the taxpayer for employment by the taxpayer.

The proposed regulations provide that, in determining W-2 wages, a person may take into account any W-2 wages paid by another person and reported by the other person on Forms W-2 with the other person as the employer listed in Box c of the Forms W-2, provided that the W-2 wages were paid to common law employees or officers of the person for employment by the person. Persons that pay and report W-2 wages on behalf of, or with respect to, others can include certified professional employer organizations, statutory employers, and agents

 
Qualified Property – In general, qualified property means, with respect to any trade or business of an individual for a taxable year, tangible property of a character subject to the allowance for deprecation under Section 167(a), which is held by, and available for use in, the trade or business at the close of the taxable year, which is used at any point during the taxable year in the trade or business’ production of QBI, and the depreciable period for which has not ended before the close of the individual’s taxable year. The amount used for calculating the limitation is referred to as the unadjusted basis immediately after acquisition (UBIA) of all qualified property. For purchased or produced qualified property, UBIA generally will be its cost basis as of the date the property is placed in service. Other rules apply for contributed, inherited, and basis adjustment property.
 
Definition of Qualified Business Income (QBI):
The Proposed Regulations provide clarity around the inclusion of certain income (loss) items within QBI. Among others, the following income (loss) items are addressed:

Section 751 ordinary income is taken into account for purposes of computing QBI.

Section 481 adjustments (whether positive or negative) are generally included in QBI but only if the adjustment arises in taxable years ending after December 31, 2017.

Previously disallowed losses or deductions allowed in the taxable year are taken into account for purposes of computing QBI unless the losses or deductions were from taxable years ending before January 1, 2018.

A deduction for a net operating loss is not taken into account in computing QBI. However, to the extent that the net operating loss is disallowed under Section 461(l), the net operating loss is taken into account for purposes of computing QBI.

QBI does not include any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss, including any item treated as one of such items, such as gains or losses under Section 1231 which are treated as capital gains or losses.

QBI does not include any interest income other than interest income which is properly allocable to a trade or business. However, interest income attributable to an investment of working capital, reserves, or similar accounts is not properly allocable to a trade or business.

Aggregation of Trades and Businesses:
An individual or passthrough entity may be engaged in more than one trade or business. Under the general rules, each trade or business is treated as a separate trade or business for purposes of determining the QBI Deduction, including application of the Wages & Capital Limitation and SSTB Exclusion. The Proposed Regulations provide that, under certain circumstances, individuals may, for purposes of the Wages & Capital Limitation, aggregate trades or businesses. Aggregation of multiple trades or businesses is allowed only if:
  1. Each activity to be aggregated must be considered a trade or business and reported on returns with the same taxable year.
  2. The same person, or group of persons, directly or indirectly, owns 50 percent or more of each of the trades or 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.
  3. None of the aggregated trades or businesses are an SSTB.
  4. The trades or businesses meet at least two of three factors, which demonstrate that the businesses are in fact part of a larger, integrated trade or business:
    1. The trades or businesses provide products and services that are the same (for example, a restaurant and a food truck) or they provide products and services that are customarily provided together (for example, a gas station and a car wash).
    2. The trades or businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources).
    3. The trades or businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).
Once an individual chooses to aggregate two or more trades or businesses, the individual must consistently report the aggregated trades or businesses in all subsequent taxable years. However, an individual may add newly created or newly acquired trades or businesses to an existing aggregated trade or business if the requirements described above are satisfied. In a subsequent year, if there is a change in facts and circumstances such that an individual’s prior aggregation of trades or businesses no longer qualifies for aggregation under the rules of this section, then the trades or businesses will no longer be aggregated and the individual must determine a new permissible aggregation (if any).

For each taxable year, individuals must attach a statement to their returns identifying each aggregated trade or business. The statement must contain (A) a description of each trade or business; (B) the name and EIN of each entity in which a trade or business is operated; (C) information identifying any trade or business that was formed, ceased operations, was acquired, or was disposed of during the taxable year; and (D) such other information as the Commissioner may require in forms, instructions, or other published guidance. If an individual fails to attach the required statement, the Commissioner may disaggregate the individual’s trades or businesses.

 

Reporting Requirements for Passthrough Entities:
Relevant Passthrough Entities (RPEs) must report on Schedule K-1 to each owner the information necessary to calculate the QBI deduction. This information includes the following:
  1. Each owner’s allocable share of QBI, W-2 wages, and UBIA of qualified property attributable to each such trade or business.
  2. Whether any of the trades or businesses is an SSTB.
  3. Any QBI, W-2 wages, UBIA of qualified property, or SSTB determinations, reported to it by any RPE in which the RPE owns a direct or indirect interest.
If an RPE fails to separately identify or report on the Schedule K-1 (or any attachments thereto) issued to an owner the required items described above, the owner’s share (and the share of any upper-tier indirect owner) of positive QBI, W-2 wages, and UBIA of qualified property attributable to trades or businesses engaged in by that passthrough entity will be presumed to be zero.

 

CONCLUSION
The Proposed Regulations provide clarity in a variety of areas and will assist business owners and professionals to better integrate the impact of the deduction for year-end planning purposes. Within Section 199A and other sections of Tax Reform, areas still exist where additional guidance from the IRS is necessary. In evaluating choice of entity for existing and new businesses, understanding the 199A rules is especially important. With all the new regulations under Tax Reform, tax planning for 2018 will be especially beneficial for many taxpayers.
Please contact Newburg & Company, LLP if you have questions regarding your current tax situation, new tax reform and the newly issued Proposed Regulations.

 

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