Section 199A: What do the proposed regulations mean?

Looking at a few points that amplify complexity.

A Brief Primer

Section 199A, enacted in December 2017 as part of the Tax Cuts and Jobs Act (“TCJA”), allows individuals and certain other non-corporate taxpayers to deduct up to 20 percent of qualified business income (QBI) beginning in 2018. QBI includes certain income from a partnership, S corporation or sole proprietorship, as well as qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income. QBI generally is taxable income generated by an active domestic trade or business. Passive investment income, such as capital gains, dividends and interest income, does not qualify as QBI (with an exception for interest received in connection with a lending business).

Taxpayers with income that exceeds certain amounts are not eligible for the QBI deduction if the income is generated by a specified service trade or business (“SSTB.”) The SSTB exclusion phases in for (a) individuals filing joint returns with taxable income in excess of $315,000 and (b) for other taxpayers with taxable income in excess of $157,500. These amounts are indexed for inflation.

In addition to the QBI eligibility limitation noted above, the Section 199A deduction, otherwise allowable, cannot exceed the greater of (a) 50 percent of the W-2 wages paid with respect to the qualified trade or business, or (b) the sum of 25 percent of the W-2 wages paid with respect to the qualified trade or business plus 2.5 percent of the tax basis of certain tangible depreciable property used in the qualified trade or business.

Under Section 199A, 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, 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.” Section 199A provides that an SSTB also includes the “performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.”

Some Interesting Rules Under the Proposed Regulations

Treasury and the IRS released proposed regulations under Section 199A on August 8, 2018. The regulations will not officially apply until they are adopted as final; however, the preamble to the proposed regulations states that taxpayers can rely on the proposed regulations until final rules are adopted.

It’s only 25 million hours of reading.

According to the preamble to the proposed regulations, the estimated total annual reporting burden for the proposed regulations is 25 million hours. After those 25 million hours, just about the time the most difficult provisions of Section 199A get clarified through further IRS guidance or court rulings, Section 199A will expire under the sunset provisions of the TCJA.

Trade or Business
The proposed regulations define “trade or business” as a Section 162 trade or business (other than the trade or business of performing services as an employee). (Proposed Reg. § 1.199A-1). Section 199A requires that qualified business income eligible for the 199A deduction must come from a “qualified trade or business.” The proposed regulations state that for purposes of 199A, Section 162(a) provides the most appropriate definition of “trade or business,” as that definition is “derived from a large body of existing case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries.” The proposed regulations state further that: “Defining trade or business as a section 162 trade or business will reduce compliance costs, burden, and administrative complexity.”

Self-rentals
The proposed regulations deem most self-rentals to be “trades or businesses.” The rental of property to a related trade or business is automatically treated as a trade or business if the rental and the other trade or business are commonly controlled (regardless of whether the rental activity and the trade or business are otherwise eligible to be aggregated under Proposed Regulation § 1.199A-4(b)(1)).

Aggregation
Section 199A requires each trade and business to calculate its own QBI deduction. The proposed regulations, however, provide a way by which taxpayers can aggregate trades and businesses for purposes of applying the W-2 wages/tax basis limitation to potentially maximize their 199A deduction.
The proposed regulations allow aggregation where:

• Each trade or business is a trade or business (with the special exception for self-rentals)
• The same person or group directly or indirectly owns a majority interest in each of the businesses to be aggregated for a majority of the year. For purposes of determining ownership, an individual is considered as owning the interest owner directly or indirectly by his or her spouse, children, grandchildren, and parents.
• None of the trades and businesses are SSTBs.

Individuals and trusts must show that the trades or businesses meet two of the following three factors:

1. The businesses provide products and services that are the same or that are customarily provided together (example: a gas station and a car wash).
2. The businesses share facilities and significant centralized business elements such as personnel, accounting, or human resources.
3. The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group.

Fiscal Year
Under the proposed regulations, S corporation shareholders and partners can take the 199A deduction in 2018 for QBI generated by an entity with a fiscal year ending in 2018. The proposed regulations state that if an individual receives QBI, W-2 wages, or unadjusted tax basis of qualified property from a pass-through entity with a taxable year that begins before January 1, 2018, and ends after December 31, 2017, such items are treated as having been incurred by the individual during the individual’s tax year during which the entity’s taxable year ends.

Scope of SSTB
As noted above, taxpayers in a specified service trade or business (SSTB) are ineligible for the deduction for income from their SSTB if their taxable income exceeds the statutory threshold and phase-out ranges ($157,500 for singles and $315,000 for married filing jointly). Section 199A provides that specific fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or investment management are automatically deemed SSTBs, as is “any trade or business where the principal asset of such trade or business is the reputation or skill of the owner or 1 or more of its employees.”

Interpreted broadly, the last quoted phrase could cover all service businesses. In the proposed regulations, however, the IRS significantly limits the meaning of that phrase to a list of specific situations where the income received is based directly on the skill and/or reputation of the employees or owners:

1. Receiving income from endorsing products or services
2. Licensing or receiving income from one’s image, likeness, name, etc., or
3. Receiving appearance fees or income

Divide and conquer? No.

Nice try, but SSTBs cannot spin-off non-SSTB parts of their business to qualify for the deduction. The preamble to the proposed regulations states that it is “inconsistent with the purpose of section 199A” for taxpayers to separate out parts, such as the administrative functions, of what otherwise would be an integrated SSTB, to qualify a portion of the business for the deduction. Prop. Regulation Section 1.199A-5(c)(2) provides that an SSTB includes any trade or business with 50 percent or more common ownership (directly or indirectly) that provides 80 percent or more of its property or services to an SSTB. And, if a trade or business has 50 percent or more common ownership with an SSTB, any portion of the property or services provided to the SSTB will be treated as an SSTB. For example, a dentist’s self-rental income from renting his office building to his practice is SSTB income, not entitled to the deduction.

Nice try, part two

Employees who become independent contractors to take advantage of the QBI deduction will be disappointed. Proposed Regulation Section 1.199A-5(d)(3) provides that for purposes of Section 199A, if an employer improperly treats an employee as an independent contractor, the improperly classified employee will be treated as an employee and ineligible for the 199A deduction. Specifically, an employee who becomes an independent contractor providing services for his or her former employer is presumed to be an employee.

Section 1231

Gains or losses from the sale of property used in a trade or business are not QBI. The proposed regulations clarify that IRC Section 1231 gain or loss is excluded from the definition of QBI to the extent that it is treated as a capital gain or loss. QBI does not include any item taken into account in determining net long-term capital gain or net long-term capital loss.

Compensation
“Reasonable compensation,” which is excluded from the definition of QBI, is limited to the context from which it derives: compensation of S corporation shareholders-employers. The proposed regulations state that this rule is not extended to partnerships. Proposed Regulation Section 1.199A-3.

Consolidating Income and Loss

What happens under Section 199A if one trade or business of a taxpayer has a QBI loss, but other trades or businesses have positive QBI, and the net QBI for all trades and businesses of the taxpayer is positive. The proposed regulations authorize a netting approach. Proposed Reg. Section 199A-3. The QBI loss is allocated among the trades or businesses with income before the W2 wages/tax basis limitation for each trade or business is applied. The allocation is proportionate to the respective QBI of each trade or business.

Winners and Losers Under the SSTB Regulations

If you have any questions concerning the Qualified Business Income Deduction or any other tax questions, please contact a member of the Woods Rogers’ Tax Practice.