Treasury Proposes Regulations for 20% Pass-Through Deduction
One particular provision of the Tax Cuts and Jobs Act of 2017 (“TCJA”), the 20% pass-through deduction under new IRC Sec. 199A of the Internal Revenue Code,1 has spawned numerous queries as to its application to certain taxpayers and its underlying mechanics. In August 2018, the Treasury released proposed IRC Sec. 199A regulations to provide some needed clarity. Although these proposed regulations are not finalized and do not have the force of law, they may be relied upon in the interim in terms of tax planning and compliance. The following revisits the 20% pass-through deduction as contained in the TCJA and highlights the main components of these proposed regulations.
Background of IRC Sec. 199A and Questions Created
For tax years beginning after December 31, 2017, and prior to January 1, 2026, business taxpayers other than C corporations (e.g., partnerships, S corporations, sole proprietorships, trusts and estates) are potentially eligible for an up to 20% deduction subject to statutory requirements and limitations. To determine if a taxpayer is eligible for this deduction, the analysis is both qualitative and quantitative. First, determine if the taxpayer’s income is qualified business income (“QBI”) generated via a qualified trade or business. Assuming a positive answer, the taxpayer’s deduction is subject to a limitation based on W-2 wages paid by the qualified trade or business or, if applicable, a mixture of W-2 wages and the unadjusted basis of tangible depreciable property used in the business.2 Because of the manner in which the legislation was drafted, it has been unclear what lines of business qualify for the 20% deduction and how to implement the aforementioned limitations based on W-2 wages. The proposed regulations—at more than 180 pages—make a significant effort to tackle all of these issues.
The W-2 limitations referenced above do not apply to a taxpayer with an income below $157,500 per year ($315,000 for married taxpayers filing jointly) and are phased in gradually for a taxpayer with a taxable income above these amounts. A taxpayer who is generating income from a trade or business excluded from QBI may still benefit from the Section 199A deduction if his/her taxable income is below these threshold amounts.
Employees Cannot Be Reclassified As Independent Contractors
IRC Sec. 199A provides that the trade or business of providing services as an employee is not eligible for the IRC Sec. 199A deduction. Accordingly, it may be beneficial for employees to treat themselves as independent contractors or as having an equity interest in a partnership or S corporation in order to benefit from the deduction. However, the proposed regulations are clear that an individual who was treated as an employee for federal employment tax purposes by the person to whom he or she provided services, and who is subsequently treated as other than an employee by such person with regard to the provision of substantially the same services directly or indirectly to that person (or related person), is presumed to be in the trade or business of performing services as an employee with regard to those services.
Guidance Regarding Qualified Trade or Business
A qualified trade or business for purposes of IRC Sec. 199A is any trade or business other than a specified service trade or business (“SSTB”). IRC Sec. 199A borrows definitions from IRC Sec. 1202 (modified to exclude architects and engineers), IRC Sec. 448(d)(2)(A) and Treas. Reg. 1.448-1T(e)(4)(i). An SSTB is defined as any business involving the performance of services in the fields of health, law, consulting, athletics, financial services or any trade or business where the principal assets of such trade or business is the reputation or skill of one or more of its employees or owners. The proposed regulations provide taxpayers with much-needed relief that the aforementioned “reputation or skill” portion of the SSTB definition will be applied narrowly to essentially situations where an employee’s or owner’s likeness generates income (e.g., celebrity endorsements), royalty income, or appearance fees or income. A broad interpretation of this language could have eliminated a large swath of taxpayers from eligibility under IRC Sec. 199A.
Guidance Regarding Entities with Mixture of Trade/Business and SSTB
The proposed regulations provide a de minimus exception that will allow a business that both sells product and performs services to avoid being treated as an SSTB. The regulations state that if a trade or business has gross receipts of $25 million or less for the year, it will not be treated as an SSTB as long as less than 10% of the gross receipts of the business are attributable to the performance of services in one of the disqualified fields (e.g., law, accounting). If a business has gross receipts in excess of $25 million, 10% is replaced by 5%.
For example: ABC Co. has annual revenue of $20 million. Of note, $18.5 million of the revenue is attributable to the sales of computers, and the remaining $1.5 million is attributable to consulting, installation and training services. Because ABC’s consulting services are less than 10% of its total receipts, those services are ignored, and ABC Co. is not treated as an SSTB.
Guidance Regarding “Crack and Pack” Strategy
Upon passage of the TCJA, numerous commentators questioned if it would be possible to siphon eligible revenue streams away from SSTBs to exploit the 20% deduction under IRC Sec. 199A. While the proposed regulations are complex, the general answer is no. The proposed regulations prohibit a pass-through entity from eligibility under IRC Sec. 199A if (1) 80% or more of its income is received from an SSTB; and (2) the pass-through entity and the SSTB share 50% or more in terms of common ownership. This strategy was dubbed “crack and pack.”
To illustrate, consider a tax and accounting firm, a trade or business defined as an SSTB not eligible for the IRC Sec. 199A deduction. Further, this accounting firm owns a commercial building in New York City. The firm effectively will not be permitted to contribute this real estate to a newly created pass-through entity, lease the real estate back to itself, and expect the new pass-through entity to be eligible for IRC Sec. 199A if (1) more than 80% of the new entity’s rental income is generated from an SSTB; and (2) there is 50% or more common ownership. Even if the revenue is less than 80%, the income attributable to the SSTB will not be eligible for IRC Sec. 199A. The proposed regulations are considerably nuanced in this area and, therefore, to achieve a success outcome (where the 20% deduction is permitted) in this type of transaction would require careful planning. For these purposes, a party is deemed related by operation of IRC Sec. 267(b) and 707(b) [related party provisions of the IRC].
Guidance Regarding Aggregating Multiple Business Lines
At the taxpayer’s election, the proposed regulations permit an aggregation regime in order to calculate QBI and limitations under IRC Sec. 199A. This election is useful when the taxpayer has multiple entities and on a separate basis will not be able to get the full QBI. If aggregated with another entity, the taxpayer can get a larger QBI deduction. Aggregation has some strict requirements regarding ownerships and business lines. For example, A is the majority shareholder of ABC Company (not an SSTB), an S corporation. A is also the majority partner in ABC Real Estate LLC that owns the building in which ABC Company is located. Since A has common ownership and meets other requirements, A is eligible to elect to aggregate treatment for IRC Sec. 199A purposes. Note: The election to aggregate cannot be revoked once effective, and there are disclosure requirements that must be made annually on the taxpayer’s tax return.
The IRS clarifies in the proposed regulations that, for purposes of the wage limitation in the QBI formula, wages paid by a payroll agency are considered the taxpayer’s wages.
The regulations also clarify that if wages are paid by one company as “an agent” of another, those wages count as wages for this purpose. This is typical when you have a group of affiliated companies and one group acts as the “common paymaster.” Of course, this should be documented by a management fee, and the payor of the wages will need to subtract the allocated wages to avoid any wage duplication.
Guidance on Treatment of QBI losses
Under the proposed regulations, if the net amount of all positive and negative QBI is a loss, as was provided in the statute, no deduction is allowed in the current year, and the net loss is carried forward to the next year. The proposed regulations make clear, however, that no W-2 or basis amounts carry forward.
If the net of all positive and negative QBI is positive, however, but at least one business produces a loss, the loss must be allocated among all of the businesses that produce QBI in proportion to their respective amounts of QBI. Only after this allocation and netting takes place are the W-2 and basis limitations applied. No part of the W-2 amounts or basis of property attributable to the loss business is taken into account by the income-producing businesses.
A taxpayer can circumvent this by electing to group qualifying businesses together. If this is done, the QBI income and loss, W-2 wages and basis of property are all combined.
IRC Sec. 1231 – If a gain or loss is treated as a capital gain under IRC Sec. 1231, it is excluded from QBI. However, if an IRC Sec. 1231 loss is treated as ordinary, it must reduce QBI. This would appear to put the taxpayer in a difficult position because net IRC Sec. 1231 gain will not be QBI, but an IRC Sec. 1231 loss will reduce QBI.
IRC Sec. 751 – If a partner sells a partnership interest and some portion of the gain is recharacterized as ordinary income under the “hot asset” rules of IRC Sec. 751, then the gain is included in QBI.
IRC Sec. 179 and Bonus Depreciation – The unadjusted cost basis of qualified property is determined before any bonus depreciation and IRC Sec. 179 expensing.
The above is not meant to be an exhaustive analysis of the proposed regulations. Instead, it surveys major highlights of the proposed regulations. Readers are strongly encouraged to contact their tax advisors to determine the applicability of these proposed regulations to their specific fact patterns.
1 Any references to IRC, Code, Sec. and § refer to the Internal Revenue Code of 1986, as amended, and the regulations promulgated thereunder.
2 Assuming a taxpayer’s income exceeds a statutory threshold, W-2 wage and capital limitations are applicable. The deductible QBI amount for the business is generally equal to the lesser of (1) 20% of the business's QBI; or (2) the greater of (a) 50% of the W-2 wages for the business or (b) 25% of the W-2 wages plus 2.5% of the business' unadjusted basis in all qualified property. This deduction is further limited to 20% of a taxpayer’s taxable income in excess of any net capital gain.