The Tax Cuts and Jobs Act (TCJA) created a new 20% deduction for qualified business income to reduce the tax burden on sole proprietors, the owners of S Corporations and partnerships and certain trusts and estates and their beneficiaries. On August 8, 2018, the Department of the Treasury (Treasury) issued proposed regulations interpreting the new provision. Taxpayers should take careful note of the new regulations as the pass-through deduction is effective for tax years beginning after December 31, 2017.
The proposed regulations provide computational and definitional guidance regarding the availability of the pass-through deduction. The regulations are voluminous and detailed. For an overview of the basic mechanics of the pass-through deduction, please see our tax alert “Utilizing the New 20% Pass-Through Tax Deduction.”
Qualified Trade or Business
Only a qualified trade or business is eligible for the pass-through deduction.
- The regulations adopt Section 162’s definition of a trade or business for purposes of the pass-through deduction (with very limited exceptions, such as certain rental activities).
- Entities are responsible for determining the specific trades or businesses in which they are engaged. They must also determine whether any such trades or businesses constitute a specified service trade or business (discussed below).
- Both individuals and entities that conduct multiple trades or businesses must allocate all relevant items (wages, basis, income, etc.) amongst the multiple trades or businesses using a “reasonable method based on all the facts and circumstances.”
- Treasury is still considering how to apply rules concerning the reasonable allocation of items and is requesting comments on a method to allocate items that are not clearly attributable to a single trade or business and on any safe harbors that may be appropriate.
- Any entity that is engaged in multiple trades or businesses must report, on Schedules K-1 issued to its owners, amounts of income, wages, basis in qualified property, etc. for each trade or business to its owners.
The proposed regulations permit (although do not require) individuals to aggregate multiple separate trades or businesses. This will help some taxpayers maximize the available pass-through deduction by combining the available W-2 wages and basis in qualified property, thereby allowing the wages and basis of one business to increase the available deduction of a separate aggregated business.
- In order to aggregate trades and businesses the following requirements must be met:
- The same person or group (directly or indirectly) must own a majority interest in each aggregated trade or business.
- All items attributable to each trade or business must be reported on returns with the same taxable year (excluding short years).
- None of the aggregated trades or businesses is a specified service trade or business.
- The taxpayer must establish two of the following three factors demonstrating the existence of a larger integrated business:
- The businesses provide products and services that are the same or customarily offered together;
- The businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources; and/or
- The businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies).
- Individuals may elect to aggregate trades or businesses owned both directly and through an entity.
- Multiple owners of a business do not need to elect to aggregate in the same manner.
- Aggregation must be disclosed on the individual’s tax return identifying each aggregated business.
- Treasury is still examining, and has requested comments on, the aggregation of trades or businesses by entities and tiered structures.
The Treasury Department and the IRS considered using aggregation methods consistent with those used for purposes of the passive activity rules. However, for various reasons, they felt the passive activity aggregation rules were not appropriate for section 199A. As a result, taxpayers now face added complexity and, potentially, additional compliance costs since they may have to track different aggregated businesses under the passive activity rules and the pass-through deduction rules.
Specified Service Trade or Business (SSTB)
The law provides that certain enumerated SSTBs are not eligible for the pass-through deduction (unless the individual owners’ taxable income is below a threshold amount).
- The proposed regulations provide additional guidance on each type of SSTB. Please see the chart of SSTB Guidance Under Proposed Regulations at the end of this Tax Alert for a summary of this guidance.
- Treasury has also interpreted the law’s catchall provision that defines SSTB to include any trade or business where the principal asset is the reputation or skill of one or more employees or owners. This vague provision has been interpreted relatively narrowly, identifying three types of businesses to which it applies:
- A trade or business in which a person receives fees, compensation, or other income for endorsing products or services;
- 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 other symbols; or
- Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.
- The regulations provide a de minimis rule that allows trades or businesses to perform certain minimal amounts of SSTB activities without being treated as a SSTB. If less than 10% of gross receipts of the trade or business are attributable to SSTB activities, then the trade or business will not be treated as a SSTB. For businesses with gross receipts greater than $25 million, the de minimis rule threshold is lowered to 5%.
- The regulations also provide rules to prevent taxpayers from segregating certain back-office and administrative functions from a SSTB or shifting income via rental or other expenses. These rules will limit the feasibility of various strategies that have been proposed as a way for taxpayers to circumvent the SSTB limitations. The following rules apply where a trade or business has 50% (direct or indirect) or more common ownership with a SSTB:
- A trade or business will be treated as a SSTB if it provides 80% or more of its property or services to a commonly controlled SSTB.
- If a trade or business provides less than 80% of its property or services to a commonly controlled SSTB, then that portion of the trade or business providing property or services to the commonly controlled SSTB will be treated as part of the SSTB.
- If a trade or business has common ownership with a SSTB and has shared expenses with the SSTB, including wage or overhead expenses, then the business will be treated as a SSTB if the gross receipts of the trade or business do not exceed 5% of the total combined gross receipts of the trade or business and the SSTB in the tax year.
The preamble to the proposed regulations discusses the rationale behind how the various SSTBs were defined and provides insight into the existing authorities that were used as guidelines. Even with the guidance provided by the proposed regulations, many taxpayers will continue to face substantial uncertainty about whether certain trades or businesses constitute SSTBs. Treasury is requesting comments on its proposed rules and the clarity of the definitions it has provided.
Determination of W-2 Wages
The total amount of “W-2 wages” paid by a business during the year can serve to limit the amount of pass-through deduction available to the business’s owners. Treasury provided the following guidance on calculating the wage limitation:
- The definition of wages generally follows the rules under repealed code section 199, with some modifications.
- Wages paid by third parties, on behalf of a business, can qualify as eligible “W-2 wages” eligible for the pass-through deduction. This clarifies that businesses will not be penalized for utilizing the services of a professional employer organization (PEO). However, Treasury has indicated that taxpayers would be expected to treat PEOs consistently for all areas of taxation. This could impact the treatment of such employees with respect to items such as profits interests.
- The wage limitation applies separately for each trade or business of a taxpayer (unless the trades or businesses are aggregated by an individual taxpayer). The regulations provide that the wages should be allocated to each trade or business in the same proportion as deductions associated with the wages are allocated amongst the trades or businesses.
- In an acquisition or disposition of a trade or business, where employees are employed by multiple taxpayers during the year, the total W-2 wages for the year of the acquisition/disposition are allocated between each taxpayer based on the period during which the employees were employed by such taxpayer.
- In a simultaneously released proposed revenue procedure, the IRS has provided three methods for calculating W-2 wages.
Determination of Basis in Qualified Property
A taxpayer’s “unadjusted basis immediately after acquisition” (UBIA) of certain qualified property used in a trade or business can also limit the amount of pass-through deduction available to a business’s owner. The amount is generally equal to the cost basis of purchased qualified property used by the business that is either (i) still depreciable under the property’s applicable recovery period, or (ii) was placed into service within the prior 10 years.
The proposed regulations provided the following additional guidance on the UBIA of qualified property:
- A taxpayer who takes 100% bonus depreciation or expenses property under Sec. 179 will still be able to utilize the cost basis of the asset for purposes of the UBIA limitation.
- For property contributed to a partnership or S Corporation, the UBIA will generally be the carry-over basis.
- For property acquired in a like-kind exchange, the date the exchanged basis in the property was placed into service will generally have the same placed in service date as the relinquished property. Any excess basis in the replacement property will be treated as placed in service on the date the replacement property is placed in service by the business.
- Partnership special basis adjustments under 734(b) and 743(b) are not treated as separate qualified property and therefore will not increase a business’s UBIA.
- An improvement to pre-existing qualified property is treated as separate qualified property with a placed in service date based on the date the improvement (not the underlying property) was placed in service.
- The depreciable period of any improvement of qualified property is determined by treating the improvement as separate qualified property that is first placed in service on the date the improvement is made.
- Treasury is implementing anti-abuse rules to prevent taxpayers from acquiring property specifically to increase UBIA. Property will not be deemed qualified property if it is acquired within 60 days of the end of a tax year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer can demonstrate that the principal purpose of the acquisition and disposition was something other than increasing the pass-through deduction.
- The proposed regulations clarified that the pass-through deduction will not affect a partner’s or S Corporation shareholder’s outside basis.
- Previously disallowed losses (for example suspended passive activity losses, at-risk loss carryovers, and losses suspended due to a lack of outside basis) are factored in when determining a taxpayer’s qualified business income and thus the amount of the pass-through deduction in the year allowed. This rule only applies to losses disallowed after 2017.
- Losses carried forward to offset against qualified business income in future years will not affect the deductibility of such losses under any other area of the code.
- Net operating losses deducted in the current year are not relevant for determining qualified business income.
- The pass-through deduction is only allowable with respect to income effectively connected to a US trade or business. The pass-through deduction will not be allowed in instances were a taxpayer elects to treat certain income as effectively connected. For example, a foreign taxpayer may not take advantage of the pass-through deduction by making an election to treat certain income from US real property as income effectively connected with a US trade or business.
- Treasury is concerned about employees changing their status to non-employees and continuing to provide the same services to their former employer to take advantage of the pass-through deduction. In order to stop this practice, the proposed regulations provide that any such person will be presumed to be in the trade or business of performing services as an employee and therefore ineligible to take advantage of the pass-through deduction. The presumption is rebuttable upon a showing of non-employee status.
- Treasury is also concerned with individuals creating multiple taxable trusts to reduce total income below the threshold amounts for limitations. The proposed regulations provide a rule that will treat multiple trusts as a single trust for purposes of section 199A if a significant purpose of the trusts is to receive a deduction under section 199A. Regulations were also proposed under section 643 that treat two or more trusts as a single trust if such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and if a principal purpose for establishing such trusts is the avoidance of Federal income tax.
The proposed regulations provide a significant amount of guidance with respect to different aspects of section 199A. They also attempt to curtail or eliminate some of the planning strategies that have been discussed since the passage of the TCJA. A public hearing on these proposed regulations is currently scheduled for October 16, 2018.
We will continue to monitor the development of administrative guidance concerning the pass-through deduction and report accordingly.
Please contact your Mazars USA LLP professional for additional information.
SSTB Guidance Under Proposed Regulations
|Business Field||Fields Considered SSTBs||Fields Not Considered SSTBs|
|Health||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.||Non-medical services such as the operation of health clubs (gyms) or health spas or businesses that provide payment processing or the research, testing and manufacture or sales of pharmaceuticals or medical devices.|
|Law||Services by lawyers, paralegals, legal arbitrators, and mediators in their capacity as such.||Services that do not require skills unique to the field of law such as printers, delivery services, or stenographers.|
|Accounting||Accountants, enrolled agents, return preparers, financial auditors and similar professionals.|
|Actuarial Science||Actuaries and similar individuals.||The preamble to the regulations notes that it does not include services by analysts, economists, mathematicians and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events.|
|Performing Arts||Individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors and similar professionals.||Services that do not require skills unique to the creation of performing arts, such as the maintenance and operation of equipment or facilities for use in the performing arts or services by persons who broadcast or disseminate video or audio of performing arts.|
|Consulting||Provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems. It includes lobbying (i.e., influencing government, government agencies, legislators, or government officials).||Performance of other services such as sales or the provision of training and educational courses. Furthermore, consulting does not include the performance of consulting services that are embedded in, or ancillary to, the sale of goods or the performance of non-SSTB services if there is not a separate payment for consulting services.|
|Athletics||Performance of services by individuals who participate in athletic competition such as athletes, coaches and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards and racing.||Services that do not require skills unique to athletic competition, such as the maintenance and operation of equipment or facilities for use in athletic events or services by persons who broadcast or disseminate video or audio of athletic events to the public.|
|Financial Services||Managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings, bankruptcy restructurings and raising financial capital by underwriting, or acting as a client’s agent in the issuance of securities. The regulations specifically mention financial advisors, investment bankers, wealth planners and retirement advisors.|
|Brokerage Services||Services by stock brokers in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee.||Services provided by real estate agents and brokers, or insurance agents and brokers.|
|Investing and Investment Management||The receipt of fees for providing investing, asset management, or investment management services, including providing advice with respect to buying and selling investments.||Directly managing real property.|
|Trading||Trading in securities, commodities, or partnership interests which is determined by taking into account all relevant facts and circumstances including the source and type of profit associated with the activity.||Taxpayers, such as manufacturers or farmers, who engage in hedging transactions as part of their business.|
|Dealing in Securities||Regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.||Taxpayers engaged in the business of originating loans that engage in no more than negligible sales of the loans.|