On August 8, the Internal Revenue Service (IRS) and the Department of the Treasury released proposed regulations on new section 199A, the 20 percent deduction for qualified business income, added to the Internal Revenue Code of 1986, as amended, by the 2017 Tax Act. Taxpayers and practitioners have eagerly awaited guidance on significant issues that arose with the recent enactment of the new 20 percent deduction. While the proposed regulations answer many questions regarding section 199A, they leave many significant issues unaddressed.
The proposed regulations under section 199A provide definitional, computational, and anti-avoidance guidance helpful in determining the appropriate deductible amount. Additionally, the IRS and Treasury proposed regulations under section 643(f) that contain anti-avoidance provisions with respect to the use of multiple nongrantor trusts to circumvent the purpose of section 199A. The section 199A proposed regulations contain six sections, each briefly summarized below.
Background
Section 199A provides generally that taxpayers other than corporations may claim a deduction for 20 percent of their qualified business income from a partnership, S corporation, or sole proprietorship. “Qualified business income” for purposes of section 199A is defined generally as the net amount of income, gain, deduction, and loss with respect to the qualified trade or business, excluding certain investment-related income and guaranteed payments to partners in a partnership. A “qualified trade or business” is defined generally as any trade or business except the trade or business of performing services as an employee and any specified service trade or business (SSTB).
The deduction under section 199A is limited generally to the greater of: (1) 50 percent of the W-2 wages of the trade or business for the taxable year, or (2) the sum of 25 percent of such wages and 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property for the taxable year (referred to awkwardly in the proposed regulations as “UBIA of qualified property”). The W-2 wage and UBIA of qualified property limitations do not apply to taxpayers with a taxable income of less than $157,500 ($315,000 for married couples filing jointly) and is phased in for taxpayers with taxable income above that threshold amount. Finally, the section 199A deduction cannot exceed the taxpayer’s taxable income over net capital gain for the tax year.
Operational Rules
The first section of the proposed regulations under section 199A provides guidance on the determination of the section 199A deduction generally. The proposed regulations clarify that, for purposes of section 199A, the term “trade or business” should be interpreted in a manner consistent with the guidance under section 162, which provides a deduction for ordinary and necessary business expenses. The proposed regulations under section 199A, however, expand the traditional definition under section 162 to include certain rental or licensing of property to related parties under common control.
This first section also provides guidance on computing the deduction for a taxpayer that has taxable income above, at, or below the threshold amount for applying the W-2 wage and UBIA of qualified property limitations. In doing so, the IRS and Treasury prescribe computational rules, including rules for determining carryover losses and for the treatment of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
Finally, the first section of the proposed regulations provides that the section 199A deduction is applied at the partner or shareholder level. The deduction does not affect the adjusted basis of a partner’s interest in a partnership, the adjusted basis of a shareholder’s stock in an S corporation, or an S corporation’s accumulated adjustments account.
Determination of W-2 Wages and the UBIA of Qualified Property
The second section of the proposed regulations prescribes rules for determining W-2 wages and the UBIA of qualified property. The proposed regulations provide that W-2 wages of a qualified trade or business are determined generally using the rules that applied under former section 199 with respect to the domestic production activities deduction. The IRS and Treasury state in the preamble of the proposed section 199A regulations that Notice 2018-64, issued concurrently with the proposed regulations, provides three methods for calculating the W-2 wages of a qualified trade or business.
Additionally, the second section of the proposed regulations addresses many issues concerning the UBIA of qualified property, including its allocation among relevant passthrough entities, subsequent improvements to the qualified property, and the effect of certain nonrecognition transactions (for example, like-kind exchanges). The regulations put in place guardrails to prevent taxpayers from gaming the system. For example, the proposed regulations indicate that property is not qualified property if a taxpayer acquires and disposes of the property in a short period unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was not to increase the section 199A deduction.
Qualified REIT Dividends and Qualified Publicly Traded Partnership Income
The third section of the proposed regulations restates the definition of qualified business income (QBI) and provides additional guidance on the determination of QBI, qualified REIT dividends, and qualified PTP income. The regulations describe in further detail the exclusions from QBI, including capital gains, interest income, reasonable compensation, and guaranteed payments. With respect to qualified REIT dividends, the proposed regulations contain an anti-abuse rule to prevent dividend-stripping and similar transactions aimed at increasing the qualified REIT dividends without having a corresponding economic exposure.
Aggregation Rules
The fourth section of the proposed regulations addresses rules for aggregating multiple trades or businesses for the purposes of applying the computational rules of section 199A. Commentators urged the IRS to apply the grouping rules for determining passive activity loss and credit limitation rules under section 469. The IRS concluded that the rules under section 469 were inappropriate for purposes of section 199A, but did agree with commentators that aggregation should be permitted.
The proposed regulations create a four-part test for aggregation. First, each trade or business a taxpayer proposes to aggregate must itself be a trade or business as defined by the proposed regulations. Second, the same person, or group of persons, must own, directly or indirectly, a majority interest in each of the businesses for the majority of the taxable year. The proposed regulations provide rules allowing for family attribution for this purpose. Third, none of the trades or businesses can be an SSTB. Finally, the trade or business must meet at least two of the three following characteristics:
(1) The businesses provide products and services that are the same or typically provided together.
(2) The businesses share facilities or significant centralized elements.
(3) The businesses are operated in coordination with each other.
Under the proposed regulations, an individual taxpayer may aggregate trades or businesses operated through multiple passthrough entities; however, the taxpayer must determine the QBI, W-2 wages, and UBIA of qualified property for each trade or business separately before applying the aggregation rules. The proposed regulations prohibit vertical aggregation of trades or businesses conducted through tiered partnerships.
Specified Service Trade or Business and the Trade or Business of Performing Services as an Employee
The fifth section of the proposed regulations contains substantial guidance on the definition of an SSTB. Under section 199A, if a trade or business is an SSTB, none of its items are taken into account for determining a taxpayer’s QBI. A taxpayer who owns an SSTB conducted through an entity, such as an S corporation or partnership, is treated as engaged in an SSTB for purposes of section 199A, regardless of the taxpayer’s actual level of participation in the trade or business.
Notwithstanding the general rule, taxpayers with taxable income of less than $157,500 ($315,000 for married couples filing jointly) may claim a deduction under section 199A for QBI received from an SSTB. The section 199A deduction phases out for taxpayers with taxable incomes over this threshold amount. If a trade or business is conducted by a passthrough entity, the phase-out threshold is determined at the individual, trust, or estate level, not at the level of the passthrough entity. Accordingly, a passthrough entity conducting an SSTB could have taxable income below the threshold amount but have no owners eligible for a section 199A deduction because each of them has taxable income above the threshold amount (plus $50,000 or $100,000 in the case of a married couple filing jointly).
The proposed regulations also attempt to combat what commentators have called the “crack and pack” strategy. Under this strategy, a business that would otherwise be an SSTB separates all its administrative functions into a separate entity to qualify that separate entity for the section 199A deduction. To minimize the potential for this abuse, the proposed regulations provide that an SSTB includes any trade or business with 50 percent or more common ownership that provides 80 percent or more of its services to an SSTB.
The proposed regulations contain a lengthy and detailed definition of an SSTB. Generally, the proposed regulations state that the existing guidance defining a “qualified personal service corporation” under sections 448 and 1202 informs the definition of an SSTB under section 199A. Pursuant to section 199A(d)(2)(A), which incorporates the rules of section 1202(e)(3)(A), an SSTB is any trade or business in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, or trading or dealing in securities, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. The proposed regulations limit “reputation or skill” to trades or businesses involving the receipt of income for endorsing products or services, licensing or receiving income for the use of an individual’s publicity rights, or receiving appearance fees.
The common law and statutory rules used to determine whether an individual is an employee for federal employment tax purposes apply to determining whether an individual is engaged in the trade or business of performing services as an employee for purposes of section 199A. The proposed regulations also create a presumption that an individual who was treated as an employee for federal income tax purposes but is subsequently treated as other than an employee with respect to the same services is still engaged in the trade or business of performing services as an employee for purposes of section 199A. The presumption attempts to prevent taxpayers from reclassifying employees as independent contractors in order to claim a section 199A deduction.
Special Rules for Passthrough Entities, Publicly Traded Partnerships, Trusts, and Estates
The sixth section of the proposed regulations contains special rules for passthrough entities, PTPs, nongrantor trusts, and estates. Passthrough entities, including S corporations and entities taxable as partnerships for federal income tax purposes, cannot claim a deduction under section 199A. Any passthrough entity conducting a trade or business, along with any PTP conducting a trade or business, must report all relevant information — including QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income — to its owners so they may determine the amount of their respective section 199A deductions.
The proposed regulations require that a nongrantor trust or estate conducting a trade or business allocate QBI, expenses properly allocable to the trade or business, W-2 wages, and UBIA of qualified property among the trust or estate and its beneficiaries. The allocation is based on the ratio that the distributable net income (DNI) distributed or deemed distributed to each beneficiary bears to the trust’s or estate’s total DNI for the taxable year. Any DNI not distributed is allocated to the nongrantor trust or estate itself. UBIA of qualified property is allocated without taking into account how depreciation deductions are allocated among the beneficiaries under section 643(c). When calculating the threshold amount for purposes of applying the W-2 wage and UBIA limitations, taxable income is computed at the trust or estate level without taking into account any distributions of DNI.
For purposes of the proposed section 199A regulations, a qualified subchapter S trust (QSST) is treated as a grantor trust. The individual treated as the owner of the QSST is treated as having received QBI directly from the trade or business and not through the QSST. The IRS and Treasury are requesting comments regarding whether a taxable recipient of an annuity or unitrust interest in a charitable remainder trust (CRT) should be eligible for a section 199A deduction to the extent the taxpayer receives QBI from the CRT.
Anti-avoidance Guidance for Multiple Nongrantor Trusts
In addition to proposing regulations under section 199A, the IRS and Treasury proposed regulations under section 643(f) designed to prevent taxpayers from manipulating the section 199A deduction using multiple nongrantor trusts. Section 643(f) allows Treasury to prescribe regulations to prevent taxpayers from establishing multiple nongrantor trusts to avoid federal income tax. The proposed regulations under section 643(f) provide that when two or more trusts have the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and a purpose of such trusts is to avoid federal income tax, all of such trusts will be treated as a single trust for federal income tax purposes. Absent this anti-abuse rule, taxpayers could own a trade or business through multiple nongrantor trusts such that each trust would have taxable income below the threshold amount for applying the W-2 wage and UBIA limitations on the section 199A deduction.
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