The Newly Issued Proposed Regulations and Their Impact on the New 20% IRC Section 199A Deduction.
On August 8th, the Internal Revenue Service (“IRS”) issued the proposed regulations (REG-107892-18) (the “Proposed Regulations”) regarding Internal Revenue Code (“IRC”) section 199A, the 20% deduction available to flow through businesses. As expected, the Proposed Regulations highlighted issues raised previously by Dave Kautter, acting IRS Commissioner. Included in the Proposed Regulations is clarity on the general computation rules, the business aggregation rules, the anti-abuse rules, and a clearer definition of “specified service” businesses. While these Proposed Regulations will not take effect until after they have been finalized later this year, they still reveal the IRS’s interpretation of section 199A and can be relied upon in the interim.
The Proposed Regulations are broken up into six sections. Key highlights of the Proposed Regulations are provided below.
Basic Computational Rules.
The Proposed Regulations, in describing how the 20% 199A deduction is to be calculated, begin by providing a firm definition for qualified business income (“QBI”). For purposes of section 199A all items of income, loss, etc. earned in the conduct of a trade or business (as defined in section 162) qualify as QBI. Income earned by a foreign enterprise must constitute effectively connected income under section 864 to qualify as QBI.
Importantly, QBI does not include any item treated as capital gain or loss under the IRC. This includes section 1231 gains or losses which are treated as capital rather than ordinary. QBI also does not include most interest or dividend income. Additionally, reasonable compensation, guaranteed payments and W-2 wages paid to the owner do not constitute QBI; however, W-2 wages paid to an S corporation shareholder reduces the S corporation’s QBI.
In addition to determining QBI, the Proposed Regulations provide rules detailing how the 20% 199A deduction is computed, how the W-2 wage and unadjusted basis immediately after acquisition of qualified property (“UBIA”) limitations are calculated and applied, and how the various “phase in” and “phase out” provisions are determined. In addition to the rules, the Proposed Regulations provide numerous examples demonstrating how these concepts, as well as others, are applied.
Of particular note is the Proposed Regulations’ treatment of losses. If an individual’s combined qualified business income (“QBI”) is negative or combined qualified real estate investment trust dividends and publicly traded partnership income is less than zero, proposed §1.199A-1(c)(2) provides rules for the carryover of the losses.
- If an individual has multiple trades or businesses, the individual must calculate the QBI from each trade or business and then net the amounts unless it meets the aggregation requirements provided below.
- For purposes of section 199A, if the net QBI with respect to qualified trades or businesses of the taxpayer for any taxable year is less than zero, such amount shall be treated as a loss from a separate qualified trade or business in the succeeding taxable year.
- The section 199A carryover rules do not affect the deductibility of the losses for purposes of other provisions of the Code. This carryover rule is specific to this provision.
The Definition of a Specified Service Trade or Business
The Proposed Regulations provide additional guidance with regards to what constitutes a specified service trade or business (“SSTB”). An SSTB is any business related to the practice of law, healthcare, accounting, actuarial services consulting, athletics, financial services, brokerage services, investing, trading, dealing or any service where the business is based upon the reputation or skill of one or more of its employees or owners.
- The definition of “consulting” under the Proposed Regulations is “professional advice and counsel to clients to assist the client in achieving goals and solving problems.” Though the general guidance is now present, this still results in the need for further clarity in the future.
- The Proposed Regulations exclude real estate brokerage services from this SSTB definition, as well as services related to the management of real property.
- With respect to the language including 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 Proposed Regulations provide a narrow interpretation, limiting the application to instances in which the employee or owner endorses a product or service or licenses his or her likeness in endorsement of a product or service.
- The Proposed Regulations also aggregate activities to extend out the definition of a SSTB. The Proposed Regulations include an example in which the entity employing the athletes and selling tickets to the public is considered engaged in the field of athletics, which is a SSTB. As a result, the example concludes that the entities’ owners’ share of income, gain, loss, and deduction with respect to the entity are not eligible for a deduction under section 199A.
- The Proposed Regulations include de minimis rules which allow predominantly non -SSTB business to earn minor amounts income related to an SSTB activity without such income tainting the entire business as an SSTB.
- The section 199A Proposed Regulations also address several planning techniques that had been contemplated and proposed to the IRS as a means of separating SSTB income from non-SSTB income. In most cases, the IRS has determined that many of the planning techniques will not qualify; therefore, making it more difficult to plan for those who own an SSTB.
The basic tenet is that business interests are not aggregated but can qualify for aggregation if they meet the following requirements as set forth in proposed §1.199A-4(b)(1). It is important to note that these Proposed Regulations specifically excluded the use of the section 469 aggregation rules for section 199A purposes.
- Consistent with other provisions in the Proposed Regulations, each trade or business must itself be a trade or business as defined in proposed §1.199A-1(b)(13).
- 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 a SSTB.
- Individuals and trusts must establish that 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. These factors are:
- The 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);
- The businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources);
- The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).
- Once aggregation is taken (and disclosed on tax returns annually), it may not be broken absent a loss of qualification. Newly created or acquired trades or businesses can be added to the aggregated business.
A strategy identified by some planners was the use of non-grantor trusts to create “income tax entities” so as to spread QBI between trusts and avoid implicating the threshold limited phase out.
- The Proposed Regulations subject this strategy to section 643(f), whereby two or more trusts shall be treated as one trust if (1) such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and (2) a principal purpose of such trusts is the avoidance of the tax imposed by this chapter. For purposes of the preceding sentence, a husband and wife shall be treated as one person.
- The Proposed Regulations will also crack down on the strategy to re-characterize employees as independent contractors so as to gain the opportunity to take the deduction. Prior employees, as well as related parties, who provide functions typically done by an employee will be presumed to be de facto employees.
- Substantial penalties may be imposed upon violation any of the rules established under section 199A and the Proposed Regulations thereunder.
Since the Proposed Regulations consist of 184 pages of content, the information included herein is meant to be a brief introduction to them, rather than a comprehensive overview.
There will be a hearing that is set for October 16th to allow responses to these Proposed Regulations.
These Proposed Regulations would apply to taxable years ending after the date of publication of a Treasury decision adopting these rules as final regulations in the Federal Register. However, taxpayers may rely on the Proposed Regulations, in their entirety, until the date a Treasury decision adopting these regulations is published in the Federal Register.
Finally, please note that FGMK is sponsoring a web broadcast to better address these new Proposed Regulations as well as to highlight the planning afforded to both clients and their advisors going forward. The webinar will be on Thursday, August 23rd at 10:00am CST. We hope you will be able to attend online.
For any questions on section 199A please contact your tax advisor at FGMK.
Chuck Schultz Jeff Golds