IRS Issues Guidance on 20 Percent Pass-Through Deduction
It took a little over eight months, but the IRS has issued much-anticipated proposed regulations regarding the 20 percent pass-through deduction provided under Section 199A. The 184 pages of proposed regulations provide answers to some, but not all, of the questions considered since the Tax Cuts and Jobs Act (TCJA) was signed into law on Dec. 22, 2017. Since TCJA was enacted, tax advisors have counseled clients to ‘stand your ground’ and refrain from any radical structure modifications in response to the new provision. Those that heeded this advice will likely be thankful they did. Outlined below is a rundown of the top takeaways from the proposed regulations. But first, an exceptionally brief Section 199A refresher.
For taxable years beginning after Dec. 31, 2017, owners of sole proprietorships, S corporations, partnerships, and trusts are permitted to deduct up to 20 percent (the deduction) of qualified business income (QBI). For owners above of an income threshold ($315,000 MFJ), the deduction may be limited or denied entirely. The deduction will be limited if the business does not have adequate W-2 wages/fixed asset investment; denied entirely where the business is a specified service trade or business (SSTB). Conversely, owners below the income threshold are generally entitled to the full 20 percent deduction without limitation, provided the business generates QBI.
In a win for taxpayers, the IRS narrowly interprets the definition of an SSTB.
For eight months, taxpayers have asked whether or not they qualify for the deduction. We have known that for owners above the income threshold, certain enumerated businesses would not be entitled to the deduction as an SSTB (health, law, financial services, and others). However, under Section 199A an SSTB includes any business where “the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees.” This wide-reaching language had the potential to encompass a vast array of seemingly otherwise qualifying businesses. As a result, tax advisors repeatedly answered the “do I qualify” question with a “qualified yes,” instructing clients that while they might otherwise operate a qualifying business, the “unequivocal yes” is illusive due to this catch-all phrasing.
For example, John is a famous chef and owns several restaurants. Patrons frequent his restaurants because of his culinary skill and reputation. Prior to the issuance of the proposed regulations, there was concern that his otherwise qualifying business might be an SSTB due to John’s exceptional culinary “skill and reputation.”
In welcome relief, the IRS made it clear that the catch-all only applies to the following:
- The receipt of endorsements,
- Licensing for the use of an individual’s image, likeness, name, voice, etc., or
- Receiving appearance fees (i.e., fee to appear on TV or radio).
The net result is that few businesses will fall into this catch-all, opening the door for tax advisors to muster an “unequivocal yes.”
IRS provides de minimis rule for specified services.
A trade or business will not be considered an SSTB simply because it provides a small amount of specified services. The de minimis levels are based on a gross receipts analysis. For businesses with less than $25 million gross receipts, up to 10 percent of gross receipts can be specified service receipts. For businesses in excess of $25 million gross receipts, the applicable de minimis percentage decreases to five percent.
Ancillary consulting services exempt from definition of consulting.
Consulting services constitute an SSTB. However, where a business sells or manufactures goods, and the business provides ancillary consulting services that are not separately purchased or billed, the business is not in the trade or business of consulting. Therefore, where a company sells computers but provides consulting with respect to setup and operation, such service will not constitute an SSTB provided the consulting service is not separately purchased or billed. Conversely, services which constitute professional advice and counsel to assist clients with achieving goals and solving problems would not be considered ancillary.
Brokerage services only include a broker that arranges a transaction with respect to “securities.”
Brokerage services constitute an SSTB. However, the proposed regulations limit the scope to those that broker “securities.” As a result, real estate agents and brokers, insurance agents and brokers, and trucking brokers would be exempt from the definition of brokerage services.
Potential taxpayer-favorable rule for a business with two trades or businesses, only one of which is an SSTB.
The proposed regulations direct businesses with more than one trade or business to allocate QBI factors (income, expense, W-2 wages, etc.) amongst the many trades or businesses. The taxpayer is permitted to use any reasonable method of allocation (although further guidance may limit allocation methods). For example, a veterinary practice that sells pharmaceuticals should be permitted to qualify for the deduction for pharmaceutical sales, even though the veterinary practice generally will not qualify as an SSTB. However, there is some speculation that the IRS will attempt to curtail this treatment, treating any business with SSTB income in excess of the de minimis threshold (discussed above) as entirely SSTB.
Aggregation of related businesses permitted, but with an entirely new set of aggregation rules.
The good news, taxpayers are permitted to aggregate certain commonly controlled businesses. Because Section 199A takes a business by business approach there was concern that owners would be required to restructure operations in order to maximize the deduction. The potential problem lied in a mismatch of QBI and W-2 wages/fixed asset investment.
For example (maintaining the restaurant theme), John has a food delivery business that services his restaurant. The food delivery business does not generate QBI but has substantial W-2 wages. Conversely, John’s restaurant generates substantial QBI but has limited W-2 wages. When the restaurant is treated as a separate business for Section 199A purposes, John’s deduction is limited because even though the restaurant generates QBI, it does not have enough W-2 wages to fully utilize the deduction. The regulations permit John to aggregate the food delivery business and the restaurant. Thus, John is able to utilize W-2 wages from the food delivery business to maximize the deduction.
The bad news. Instead of borrowing from other aggregation regimes found in the code, this one is all new. The finer detail will be saved for later publication, but below is the general framework.
In order to aggregate separate trades or businesses, two of the following three factors must be satisfied:
- The businesses provide products or services that are the same (restaurant and a food truck) or customarily provided together (gas station and car wash),
- The businesses share facilities or significant centralized business elements (personnel, accounting, legal, etc.), or
- The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group.
Self-rentals treated as a trade or business, pass-through deduction available.
There was concern that a self-rental would not rise to the level of a trade or business and thus would not be entitled to a QBI deduction, forcing owners to consider restructuring. The regulations make it clear that for purposes of Section 199A, a self-rental is treated as a trade or business (subject to the “stripping out” rules discussed below).
W-2 wages from Professional Employer Organizations (PEOs) can be allocated to operational businesses.
When Section 199A was passed, owners of PEO firms most likely had a few sleepless nights. It was not clear that wages paid by the PEO could be allocated to an operational business. Therefore, businesses that used PEOs were not quite sure if they would get the deduction (as the business does not issue any W-2s). Fortunately, the regulations permit a business to take into account W-2 wages paid by another as long as those W-2 wages were paid to common law employees of the business.
IRS prevents abuse of employee classification.
Under Section 199A, it is clear that an employee is not eligible for the deduction. The question was, however, how would the IRS prevent employees from recasting their employee/employer relationship as that of independent contractor? As expected, the regulations latch on to the traditional factors historically used to classify an individual as an employee or independent contractor, thereby rendering the employer classification inconsequential. Furthermore, the regulations contain a presumption that if an individual was an employee but abruptly becomes an independent contractor providing substantially the same services to the former employer, such individual is presumed to still be an employee for purposes of Section 199A.
IRS prevents businesses from “stripping out” income from SSTBs.
Prior to the issuance of the proposed regulations, one strategy was to “strip out” segments of an SSTB into another entity that would qualify for the deduction. For instance, a medical practice might consider purchasing equipment in a separate LLC and leasing the equipment to the practice. The thought was the equipment LLC might have QBI whereas the medical practice would not. The proposed regulations dismiss this strategy. Any trade or business that provides 80 percent or more of its property or services to an SSTB (provided the entities share at least 50 percent common ownership) will be treated as an SSTB itself. Where the business provides less than 80 percent of its property or services to a controlled SSTB, a portion of the business income will be treated as an SSTB.
The IRS is requesting comments on all of the proposed regulations. Although the rules will not be effective until published as final in the Federal Register, taxpayers may rely on them until then.
Be on the lookout for future articles which will address the various components of the proposed regulations in greater detail. For questions on how these proposed regulations apply to you, please contact your KSM advisor.
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