What follows is the first in a series of posts that will review the long-awaited proposed regulations under Sec. 199A of the Code – the “20% deduction” – which was enacted by the Tax Cuts and Jobs Act to benefit the individual owners of pass-through business entities.
Today’s post will summarize the statutory provision, and will then consider some of the predicate definitions and special rules that are key to its application.
We will continue to explore these definitions and rules in tomorrow’s post.
Congress: “I Have Something for You”
The vast majority of our clients are closely-held businesses that are organized as pass-through entities (“PTEs”), and that are owned by individuals. These PTEs include limited liability companies that are treated as partnerships for tax purposes, as well as S corporations.
As the Tax Cuts and Jobs Act (“TCJA”)[i] moved through Congress in late 2017, it became clear that C corporations were about to realize a significant windfall.[ii] In reaction to this development, many individual clients who operate through partnerships began to wonder whether they should incorporate their business (for example, by “checking the box”[iii]); among those clients that operated their business as S corporations, many asked whether they should revoke their “S” election.
After what must have been a substantial amount of grumbling from the closely-held business community, Congress decided to add a new deduction to the TCJA – Section 199A – that was intended to benefit the individual owners of PTEs for taxable years beginning after 2017 and before 2026.[iv]
“Here It Is”
In general, under new Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.
A QTB includes any trade or business other than a “specified service trade or business” (“SSTB”)[v]. It also does not include the trade or business of rendering services as an employee.
An SSTB includes, among other things, 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.
The QBI of a QTB means, for any taxable year, the net income or loss with respect to such trade or business of the taxpayer for the year, provided it is effectively connected with the conduct of a trade or business in the U.S. (“effectively connected income,” or “ECI”).
Investment income is not included in determining QBI, nor is any reasonable compensation paid to a shareholder, nor any guaranteed payment made to a partner, for services rendered to the QTB.
If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction.
Assuming the limitation rule is fully applicable, the amount of the Section 199A deduction may not exceed the greater of:
- 50% of the W-2 wages with respect to the QTB that are allocable to QBI, or
- 25% of such W-2 wages, plus 2.50% of the “unadjusted basis” (“UB”)[vi] of all depreciable tangible property held by the QTB at the close of the taxable year, which is used at any point in the year in the production of QBI, and the depreciable period for which has not ended before the close of the taxable year (“qualified property”).
If the individual taxpayer carries on more than one QTB (directly or through a PTE), the foregoing calculation is applied separately to each such QTB, and the results are then aggregated to determine the amount of the Section 199A deduction.
Thus, a loss generated in one QTB may offset the net income generated in another, thereby denying the taxpayer any Section 199A deduction.
If the taxpayer carries on the business indirectly, through a partnership or S corporation, the rule is applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of QBI, as well as their allocable share of W-2 wages and UB (for purposes of applying the above limitation).
Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitation, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than others, even where they have the same percentage equity interest in the QTB.[vii]
Finally, the amount of a taxpayer’s Section 199A deduction for a taxable year determined under the foregoing rules may not exceed 20% of the excess of (i) the taxpayer’s taxable income for the taxable year over (ii) the taxpayer’s net capital gain for such year.
Taxpayer: “Thank You, But I Have Some Questions”
It did not take long after Section 199A was enacted as part of the TCJA, on December 22, 2017, for many tax advisers and their PTE clients to start asking questions about the meaning or application of various parts of the rule.
For example, what constitutes a “trade or business” for purposes of the rule? Would taxpayers be allowed to group together separate but related businesses for purposes of determining the Deduction? Would they be required to do so? Under what circumstances, if any, would a PTE be permitted to split off a discrete business activity or function into a different business entity? When is the reputation or skill of an employee the principal asset of a business?
Because of these and other questions, most advisers decided it would be best to wait for guidance from the IRS before advising taxpayers on how to implement and apply the new rules.[viii]
The IRS assured taxpayers that such guidance would be forthcoming in the spring of 2018; it subsequently revised its target date to July of 2018; then, on August 16, the IRS issued almost 200 pages of Proposed Regulations (“PR”). https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction
The Proposed Regulations
The PR will apply to taxable years ending after the date they are adopted as final regulations; until then, however, taxpayers may rely on the PR.
Trade or Business – In General
The PR provide that, for purposes of Section 199A, the term “trade or business” shall mean an activity that is conducted with “continuity and regularity” and “with the primary purpose of earning income or making profit.” This is the same definition that taxpayers have applied for decades for purposes of determining whether expenses may be deducted as having been incurred in the ordinary course of a trade or business (so-called “ordinary and necessary” expenses).
However, in recognition of the fact that it is not uncommon, for legal or other bona fide non-tax reasons (for example, to limit exposure to liability), for taxpayers to segregate rental properties from operating businesses, the PR extend the definition of “trade or business” for purposes of Section 199A by including the rental or licensing of tangible or intangible property to a related trade or business – which may not otherwise satisfy the general definition of “trade or business” adopted by the PR (for example, where the entire property is rented only to the operating business) – if the “lessor/licensor trade or business” and the “lessee/licensee trade or business” are commonly controlled (generally speaking, if the same person or group of persons, directly or indirectly, owns 50% or more of each trade or business).
Trade or Business – Aggregation Rules
The above line of reasoning also informed the IRS’s thinking with respect to the “grouping” of certain trades or businesses for purposes of applying Section 199A.
Specifically, the IRS recognized that some amount of aggregation should be permitted because it is not uncommon, for what are commonly thought of as single trades or businesses, to be operated across multiple entities for various legal, economic, or other bona fide non-tax reasons.
Allowing taxpayers to aggregate trades or businesses offers taxpayers a means of combining their trades or businesses for purposes of applying the “W-2 wage” and “UB of qualified property” limitations (described above) and potentially maximizing the deduction under Section 199A. The IRS was concerned that if such aggregation were not permitted, taxpayers could be forced to incur costs to restructure solely for tax purposes. In addition, business and non-tax legal requirements may not permit many taxpayers to restructure their operations.
Therefore, the PR permits the aggregation of separate trades or businesses, provided certain requirements are satisfied; aggregation is not required.[ix]
An individual may aggregate trades or businesses only if the individual can demonstrate that certain requirements are satisfied:
- Each “trade or business” must itself be a trade or business for purposes of Section 199A.
- The same person, or group of persons, must directly or indirectly, own a majority interest in each of the businesses to be aggregated for the majority of the taxable year in which the items attributable to each trade or business are included in income. All of the items attributable to the trades or businesses must be reported on tax returns with the same taxable year.
- The PR provides rules allowing for family attribution.
- Because the proposed rules look to a group of persons, minority owners may benefit from the common ownership and are permitted to aggregate.
- None of the aggregated trades or businesses can be an SSTB (more on this tomorrow).
- Individuals must establish that the trades or businesses to be aggregated meet at least two of the following three factors, which demonstrate that the businesses are in fact part of a larger, integrated trade or business:
- The businesses provide products and services that are the same (for example, a restaurant and a food truck) or they provide products and services that are customarily provided together (for example, a gas station and a car wash);
- The businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources); or
- The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).
Trade or Business – Aggregation by Individuals
An individual is permitted to aggregate trades or businesses that the individual operates directly and trades or businesses operated indirectly – or, more appropriately, they may aggregate the businesses they operate directly with their share of QBI, W-2 wages and UB of qualified property from trades or businesses operated through PTEs of which the individual is an owner.
Individual owners of the same PTEs are not required to aggregate in the same manner.
An individual directly engaged in a trade or business must compute QBI, W-2 wages, and UB of qualified property for each such trade or business before applying the aggregation rules.
If an individual has aggregated two or more trades or businesses, then the combined QBI, W-2 wages, and UB of qualified property for all aggregated trades or businesses is used for purposes of applying the W-2 wage and UB of qualified property limitations.
Example. Individual A wholly owns and operates a catering business and a restaurant through separate disregarded entities. The catering business and the restaurant share centralized purchasing to obtain volume discounts and a centralized accounting office that performs all of the bookkeeping, tracks and issues statements on all of the receivables, and prepares the payroll for each business. A maintains a website and print advertising materials that reference both the catering business and the restaurant. A uses the restaurant kitchen to prepare food for the catering business. The catering business employs its own staff and owns equipment and trucks that are not used or associated with the restaurant.
Because the restaurant and catering business are held in disregarded entities, A will be treated as operating each of these businesses directly. Because both businesses offer prepared food to customers, and because the two businesses share the same kitchen facilities in addition to centralized purchasing, marketing, and accounting, A may treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.
Example. Assume the same facts as above, but the catering and restaurant businesses are owned in separate partnerships and A, B, C, and D each own a 25% interest in the capital and profits of each of the two partnerships. A, B, C, and D are unrelated.
Because A, B, C, and D together own more than 50% of the capital and profits in each of the two partnerships, they may each treat the catering business and the restaurant as a single trade or business for purposes of applying the limitation rules.
Trade or Business – Aggregation by PTEs
PTEs must compute QBI, W-2 wages, and UB of qualified property for each trade or business. A PTE must provide its owners with information regarding QBI, W-2 wages, and UB of qualified property attributable to its trades or businesses.
The PR do not address the aggregation by a PTE in a tiered structure.
Trade or Business – Aggregation – Reporting and Consistency
The PR requires that, once multiple trades or businesses are aggregated into a single aggregated trade or business, individuals must consistently report the aggregated group in subsequent tax years.
The PR provides rules for situations in which the aggregation rules are no longer satisfied, as well as rules for when a newly-created or newly-acquired trade or business can be added to an existing aggregated group.
Finally, the PR provides reporting and disclosure requirements for individuals that choose to aggregate, including identifying information about each trade or business that constitutes a part of the aggregated trade or business. The PR allows the IRS to disaggregate trades or businesses if an individual fails to make the required disclosure.
[*] Anyone remember the following scene from “The Jerk”?
Navin: “The new phone book’s here! The new phone book’s here!”
Harry: “Well I wish I could get so excited about nothing.”
Navin: “Nothing? Are you kidding?! Page 73, Johnson, Navin, R.! I’m somebody now! Millions of people look at this book every day! This is the kind of spontaneous publicity, your name in print, that makes people. I’m in print! Things are going to start happening to me now.”
[i] Pub. L. 115-97.
[ii] See, e.g., https://www.taxlawforchb.com/2018/01/some-of-the-tcjas-corporate-tax-changes/ ; https://www.taxlawforchb.com/2018/01/will-tax-reform-affect-domestic-ma/ ; https://www.taxlawforchb.com/2018/06/s-corps-cfcs-the-tax-cuts-jobs-act/.
[iv] That’s right – the provision is scheduled to disappear in a few years. However, on July 24, the House Ways and Means Committee released “Tax Reform 2.0 Listening Session Framework” which would make the deduction permanent. These proposals will not be considered until after the Congressional elections this fall. Enough said. https://waysandmeansforms.house.gov/uploadedfiles/tax_reform_2.0_house_gop_listening_session_framework_.pdf
[v] It should be noted that a SSTB will not be excluded from QTB status with respect to an individual taxpayer-owner of the SSTB if the taxpayer’s taxable income does not exceed certain thresholds. It is assumed herein that these thresholds, as well as the range of taxable income above such thresholds within which the benefit of Section 199A is scaled back, are exceeded for every owner of the SSTB.
[vi] In general, the unadjusted basis, immediately after acquisition, of all qualified property.
[vii] Query whether this may influence business and investment decisions.
[viii] Others, however, saw a wasting opportunity, given the scheduled elimination of the deduction after the year 2025, and may have acted hastily. Among other things, many of these advisers and taxpayers sought to bootstrap themselves into a QTB by separating its activities from a related SSTB.
[ix] The IRS is aware that many taxpayers are concerned with having multiple regimes for grouping. Accordingly, it has requested comments on the aggregation method described in the PR, including whether this would be an appropriate grouping method for purposes of the passive activity loss limitation and net investment income surtax rules, in addition to Section 199A.