Press Room: Tax Release
Guidance Released on New 20% Pass-Through Deduction; Includes Aggregation Election
IRS and Treasury have released the first set of proposed regulations related to the new 20% deduction for qualified business income under Sec. 199A, enacted as part of the Tax Cuts and Jobs Act (TCJA). The new deduction available to applicable pass-through business income effectively reduces the top marginal federal tax rate on qualified income from 37% to 29.6%. Taxpayers operating a single trade or business across multiple legal entities can breathe a sigh of relief. The proposed regulations provide an aggregation election that will obviate the need to restructure to maximize the Sec. 199A deduction in many instances. An extremely narrow definition of the exclusion for service businesses based on reputation or skill is also welcome news to many taxpayers. The proposed regulations clarify that electing small business trusts (ESBTs) are entitled to the deduction under Sec. 199A. IRS and Treasury also strike a blow at potential strategies to avoid limits for specified service trades or businesses, wage and basis limits, or taxable income thresholds with a host of anti-abuse rules. In addition, the proposed regulations address many of the most pressing questions that taxpayers and practitioners have raised regarding the operation of the deduction.
The new deduction is available for tax years beginning after December 31, 2017, and it applies to noncorporate taxpayers (with special rules for taxpayers below an income threshold). The proposed regulations adopt many of the same mechanics and rules from the old Sec. 199 domestic production activities deduction. Below are some highlights of the proposed regulations.
Computing the Deduction
The proposed regulations provide basic computation rules and carryover loss rules. Any net negative combined Real Estate Investment Trust (REIT) dividend and qualified publicly traded partnership (PTP) income is treated as a separate carryover from qualified business income (QBI). If QBI from at least one business is less than zero, the loss is allocated among the businesses with positive QBI in proportion to their QBI, before applying wage/basis limits. Computation of W-2 wage limits and attributing wages paid by another person to the common law employer apply as under old Sec. 199.
Losses that are disallowed, suspended, limited, or carried forward are taken into account in the year they are allowed, however, losses arising in taxable years prior to 2018 are ignored. Any ordinary income with respect to a partnership is taken into account for determining QBI. Any gain which is treated as capital gain is not taken into account.
Unadjusted Basis Limits
The unadjusted basis amount is computed immediately after the property is placed in service by the taxpayer. For like-kind exchanges or other carryover basis transactions, the placed-in-service date is the earlier date the transferor placed the property in service prior to the transaction. The date is not reset at the time of exchange, contribution, etc. An improvement to existing property is treated as a separate asset. An anti-abuse rule disregards property acquired and disposed of in a short period of time for purposes of computing the basis limit.
The proposed regulations reject the grouping regime, but set forth a new elective regime for Sec. 199A purposes that is based on the nature of the trade or business, and not on the owner’s relationship to the trade or business. The aggregation election is intended to apply only to those businesses that are under common control and operationally act as a single trade or business, despite the fact that they span multiple legal entities. The election only applies to businesses that have 50% or more common control (with both indirect and familial attribution). In addition, at least two of three criteria must be met: (1) the businesses provide products and services that are the same or customarily offered together, (2) the businesses share facilities or centralized elements such as HR, IT, purchasing, etc., (3) the businesses operate in coordination with or reliance upon each other (such as supply chain interdependencies). Any business that is a specified service trade or business (SSTB) cannot be aggregated.
Once multiple trades and businesses are aggregated, the taxpayer must consistently report the aggregated group in subsequent tax years. The aggregation election is made at the individual level and is not binding on other owners. Although restricted to commonly controlled business, an individual’s own ownership percentage is not relevant, however, the individual must be able to document that the common control requirements are met. To aggregate, the individual must attach a statement to the tax return each year documenting the aggregation of relevant businesses.
Specified Service Trade or Business (SSTB)
Only items attributable to a qualified trade or business are taken into account in determining the Sec. 199A deduction. Certain categories of taxpayers were specifically excluded in the statutory provision (e.g., reputation or skill, law, accounting, health, consulting, financial services) but ambiguity existed with respect to the listed activities. The proposed regulations also devote significant coverage to defining the listed categories.
- Reputation or skill is narrowly defined to include fees for endorsements, use of an individual’s image, likeness, voice, name, etc., and fees for appearing at an event or on other media.
- Notably, professional sports team ownership is an SSTB, whether or not the owner provides services, but broadcast or operation of a venue is not an SSTB.
- Brokerage service is narrowly defined to involve arrangement of transactions with respect to securities (and not real estate or insurance brokers).
- Banking is not an SSTB, but financial services broadly includes managing wealth, advising on valuations, and transactions, underwriting, retirement advisors, etc.
- Investing and investment management includes receipt of fees for providing investing, asset management, or investment management services, but does not include directly managing real property.
- Further, the proposed regulations clarify that fees, compensation and other income includes the receipt of a partnership interest and the corresponding distributive share of partnership items.
The proposed regulations acknowledge some of the complexities that could arise when a business has some revenue from SSTB activities and non-SSTB activities. For businesses with gross receipts over $25 million, SSTB revenues will be ignored if they are less than 5% of total revenues (10% for businesses with gross receipts of $25 million or less). Performance of consulting services does not include services that are ancillary to or embedded in the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB so long as there is no separate payment for the consulting services.
The proposed regulations disqualify businesses under common control with an SSTB that are engaged in providing services to the SSTB. Multiple trusts created to circumvent the taxable income thresholds will be aggregated for purposes of Sec. 199A. Restrictions are included that limit taxpayers from transferring property with the principal purpose of increasing unadjusted basis limits for the Sec. 199A deduction.
In addition, an employer’s treatment of an individual as an employee versus an independent contractor is not dispositive for purposes of Sec. 199A and any former employee who becomes an independent contractor of the same business is presumed to continue to be treated as an employee. The general anti-abuse provisions of the proposed regulations are proposed to apply retroactively to tax years ending after the date of enactment (December 22, 2017).
IRS and Treasury have released the first set of proposed regulations with respect to the new 20% deduction for pass-through businesses. The proposed regulations provide welcome news to taxpayers in providing an aggregation election and a narrow definition of a specified service trade or business based on reputation or skill. The proposed regulations state that taxpayers may rely on the proposed regulations until final regulations are published. Taxpayers should carefully evaluate their structures in light of the proposed regulations.