I realize that the last post began with “This is the fourth and final in a series of posts reviewing the recently proposed regulations (‘PR’) under Sec. 199A of the Code” – strictly speaking, it was. Yes, I know that the title of this post begins with “The Section 199A Deduction.” Its emphasis, however, is not upon the proposed regulations, as such; rather, today’s post will consider whether the recently enacted deduction, and the regulations proposed thereunder last month, will play a role in determining a taxpayer’s net economic gain from the sale of the taxpayer’s business.

 It has often been stated in this blog that the less a seller pays in taxes as a result of selling their business – or, stated differently, the more that a seller can reduce their resulting tax liability – the greater will be the seller’s economic return on the sale.[i]

 M&A and the TCJA – In General

The Tax Cuts and Jobs Act (“TCJA”)[ii] included a number of provisions that will likely have an impact upon the purchase and sale a business. Among these are the following:

  • the reduced C corporation income tax rate,
  • the exclusion of self-created intangibles from the definition of “capital asset,”
  • the elimination of the 20-year carryforward period for NOLs,
  • the limitation on a buyer’s ability to deduct the interest on indebtedness incurred to acquire a target company, and
  • the extension of the first-year bonus depreciation deduction to “used” property.

Code Section 199A

As we have seen over the last couple of weeks, Sec. 199A generally allows a non-corporate taxpayer a 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 taxable year.

The QBI of a QTB means, for any taxable year, the net income 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.

Investment income is not included in determining QBI. Thus, if a taxpayer’s rental activity with respect to a real property owned by the taxpayer does not rise to the level of a trade or business, the taxpayer’s rental income therefrom will be treated as investment income and will not be treated as QBI.

In addition, the trade or business of performing services as an employee is not treated as a QTB; thus, the taxpayer’s compensation in exchange for such services is not QBI.


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[iii], 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”)[iv] 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”).

In addition, 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:

  1. the taxpayer’s taxable income for the taxable year, over
  2. the taxpayer’s net capital gain for such year.

Pass-Through Entities

If the non-corporate taxpayer carries on the QTB indirectly, through a partnership or S corporation (a pass-through entity, or “PTE”), the Section 199A rules are applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of the PTE’s QBI, as well as their allocable share of the PTE’s W-2 wages and UB (for purposes of applying the above limitations).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitations, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than other owners of the same QTB, even where they have the same percentage equity interest in the QTB (or in the PTE that holds the business). Stated differently, one taxpayer may have a different after-tax outcome with respect to the QBI allocated to them than would another taxpayer to whom the same amount of QBI is allocated, notwithstanding that they may have identical tax attributes[v] and have identical levels of participation in the conduct of the QTB.

Income or Gain from the Sale of a PTE’s Business

Although the sale of a business may be effected through various means as a matter of state law[vi], there are basically two kinds of sale transactions for tax purposes:

  1. the owners’ sale of their stock or partnership interests (“equity”) in the PTE that owns the business, and
  2. the sale by such PTE of the assets it uses to conduct the business, which is typically followed by the liquidation of such entity.

The character of the gain realized on the sale – i.e., capital or ordinary – will depend, in part, upon whether the PTE is an S corporation or a partnership, and whether the sale is treated as a sale of equity or a sale of assets.

Sale of Assets

If the PTE sells its assets, or is treated as selling its assets[vii], the nature and amount of the gain realized on the sale will depend upon the kind of assets being sold and the allocation of the purchase price among those assets. After all, the character of any item of income or gain included in a partner’s or a shareholder’s allocable share of partnership or S corporation income is determined as if it were realized directly from the source from which realized by the PTE, or incurred in the same manner as incurred by the PTE.[viii]

Thus, any income realized on the sale of accounts receivable or inventory will be treated as ordinary income.

The gain realized on the sale of property used in the trade or business, of a character that may be depreciable, or on the sale of real property used in the trade or business, is generally treated as capital gain.[ix]

However, some of the gain realized on the sale of property in respect of which the seller has claimed accelerated depreciation will be “recaptured” (to the extent of such depreciation) and treated as ordinary income.[x]

Sale of Equity

If the shareholders of an S corporation sell their shares of stock in the corporation, the gain realized will be treated as gain from the sale of a capital asset.[xi]

When the partners of a partnership sell their partnership interests, the gain will generally be treated as capital gain from the sale of a capital asset, except to the extent that the purchase price for such interests is attributable to the unrealized receivables or inventory items (so-called “hot assets”) of the partnership, in which case part of the gain will be treated as ordinary.[xii]

Related Transactions

Aside from the sale of the business, the former owners of a PTE may also engage in other, closely-related, transactions with the buyer.

For example, one or more of the former owners may become employees of, or consultants to, the buyer; in that case, the consideration paid to them will be treated as compensation received in exchange for services.
One of more of the former owners may enter into non-competition agreements with the buyer; the consideration received in exchange may be characterized as compensation for “negative” services.

If one or more of the former owners continue to own the real property on which the business will be operated, they may enter into lease arrangements with the buyer that provide for the payment of rental income.

Tax Rates

If any of the gain from the sale of the PTE’s business is treated as capital gain, each individual owner will be taxed on their allocable share thereof at the federal capital gain rate of 20%.

If any of such gain is treated as ordinary income, each individual owner will be subject to federal income tax on their allocable share thereof at the ordinary income rate of 37%.

If an owner did not materially participate in the business, the 3.8% federal surtax on net investment income may also be applicable to their allocable share of the above gain and ordinary income.[xiii]

Of course, any compensation for services (or “non-services”) would be taxable as ordinary income, and would be subject to employment taxes.

Any rental income would also be subject to tax as ordinary income, and may also be subject to the 3.8% surtax.[xiv]

Based on the foregoing, one may conclude, generally, that it would be in the best interest of the PTE’s owners to minimize the amount of ordinary income, and to maximize the amount of capital gain, to be realized on the sale of the PTE’s business.[xv]

Of course, the selling PTE and its owners cannot unilaterally, or even reasonably expect to, direct this result. The buyer has its own preferences and imperatives[xvi]; moreover, one simply cannot avoid ordinary income treatment in many circumstances.

Enter Section 199A

No, not astride a horse, but on tip toes, wearing sneakers.[xvii]

The tax treatment of M&A transactions was certainly not what Congress was focused on when Section 199A was conceived. PTEs already enjoyed a significant advantage in the taxation of M&A transactions in that capital gains are taxed to the individual owners of a PTE at a very favorable federal rate of 20%.

Rather, Congress sought to provide a tax benefit to the individual owners of PTEs in response to complaints from the PTE community that the tax bill which eventually became the TCJA was heavily biased in favor of C corporations, especially with the reduction in the federal corporate income tax rate from a maximum graduated rate of 35% to a flat rate of 21%.

It order to redress the perceived unfairness, Congress gave individual business owners the Section 199A deduction as a way to reduce their tax liability with respect to the ordinary net operating income of their PTEs.

Sale of a Business

This is borne out by the exclusion from the definition of QBI of dividends and interest, and by the exclusion of capital gains[xviii], regardless of whether such gains arise from the sale of a capital asset; thus, the capital gain from the sale of a property used in the PTE’s trade or business, and of a character which is subject to the allowance for depreciation, is excluded from QBI.

Does that mean that Section 199A has no role to play in the taxation of M&A transactions? Not quite.

Simply put, a number of the business assets disposed of as part of an M&A transaction represent items of ordinary income that would have been realized by the business and its owners in the ordinary course of business had the business not been sold; the sale of these assets accelerates recognition of this ordinary income.

Ordinary Income Items

For example, the ordinary income realized on the sale, or deemed sale[xix], of accounts receivable and inventory by a PTE as part of an M&A deal should qualify as QBI, and should be taken into account in determining the Section 199A deduction for the individual owners of the PTE.

Unfortunately, neither the Code nor the proposed regulations explicitly state that this is the case, though the latter clearly provide that any ordinary income arising from the disposition of a partnership interest that is attributable to the partnership’s hot assets – i.e., inventory and unrealized receivables – will be considered attributable to the trade or business conducted by the partnership and taken into account for purposes of computing QBI.[xx]

Of course, the partnership rules[xxi] define the term “unrealized receivables” expansively, so they include other items in addition to receivables; for example, the ordinary income – i.e., depreciation recapture – realized on the sale of tangible personal property used in the business, the cost of which has been depreciated on an accelerated basis, or for which a bonus depreciation deduction or Section 179 deduction has been claimed.

In light of the foregoing, the same result should obtain where the inventories and receivables are sold as part of an actual or deemed asset sale, though the proposed regulations do not speak directly to this situation. These assets are not of a kind that appreciate in value, or that generate income, as in the case of investment property. Rather, they represent “ordinary income in-waiting” and should be treated as QBI.

Similarly in the case of tangible personal property used in a business and subject to an allowance for depreciation; taxpayers are allowed to recover the cost of acquiring such assets on an accelerated basis so as to reduce the net cost thereof, and thereby to incentivize taxpayers to make such investments.; i.e., they are allowed to reduce the ordinary income that otherwise would have been realized (and taxed) in the ordinary course of business. The “recapture” of this depreciation benefit upon the sale of such property should, likewise, be treated as QBI.


As stated above, a taxpayer’s QBI does not include any amount of compensation paid to the individual taxpayer in their capacity as an employee. In other words, if a former owner of the PTE-operated business is employed by the new owner of the business (for example, as an officer), the compensation paid to the former owner will not be treated as QBI.

If the former owner is not employed by the new owner, but is retained to provide other services as an independent contractor, the payments made to them in exchange for such services may constitute QBI, provided the service provider is properly characterized as a non-employee and the service is not a “specified service trade or business.”[xxii] Query whether the “consulting” services often provided by a former owner to the buyer are the equivalent of providing the kind of “advice and counsel” that the proposed regulations treat as a specified service trade or business, the income from which is not QBI.


As was mentioned above, it is not unusual for the owners of a PTE to sell their operating business while retaining ownership of the real property on which the business may continue to operate – hopefully, it has been residing in an entity separate from the one holding the business. Under these circumstances, the owners may ensure themselves of a continued stream of revenue, a portion of which may be sheltered by depreciation deductions.

Whether such rental activity will rise to the level of a trade or business for purposes of Section 199A will depend upon the facts and circumstances. However, if the property is wholly-occupied by one tenant – i.e., by the business that was sold, as is often the case – it is unlikely that the rental activity will represent a QTB and, so, the net rental income will not be QBI.

Don’t Forget the Limitations

Even assuming that a goodly portion of the income arising from the sale of a QTB will be treated as QBI, the individual taxpayer must bear in mind the “W-2-based” and “taxable-income-based” limitations described above.

This Time, I Promise

Well, that’s it for Section 199A – at least until the proposed regulations are finalized.

“I’m so glad we had this time together . . .”[xxiii] I know, “Lou, keep you day job.”

[i] The flip-side may be stated as follows: the faster a buyer can recover their investment – i.e., the purchase price – for the acquisition of a business, the greater is the buyer’s return on its investment in the business. See, e.g.

[ii] P.L. 115-97.

[iii] Meaning that the taxpayer’s taxable income for the taxable year exceeds the threshold amount ($315,000 in the case of married taxpayers filed jointly) plus a phase-in range (between the threshold amount and $415,000).

[iv] The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased by or contributed to the PTE.

[v] Other than taxable income.

[vi] For example, a sale of assets may be accomplished through a merger of two business entities; a stock sale may be accomplished through a reverse subsidiary merger in which the target is the surviving entity.

[vii] In the case of an S corporation, where the shareholders make an election under Sec. 336(e), or where the shareholders and the buyer make a joint election under Sec. 338(h)(10), to treat the stock sale as a sale of assets by the corporation followed by the liquidation of the corporation.

In the case of a partnership, a buyer who acquires all of the partnership interests is treated, from the buyer’s perspective, as acquiring the assets of the partnership. Rev. Rul. 99-6.

[viii] Sec. 702 and Sec. 1366.

[ix] Sec. 1231. Specifically, if the “section 1231 gains” for a taxable year exceed the “section 1231 losses” for such year, such gains and losses shall be treated as long-term capital gains or losses, as the case may be.

[x] Sec. 1245.

[xi] Sec. 1221.

[xii] Sec. 741 and Sec. 751.

[xiii] Sec. 1411. The tax is imposed on the lesser of (a) the amount of the taxpayer’ net investment income for the taxable year, or (b) the excess of (i) the taxpayer’s modified adjusted gross income, over (ii) a threshold amount ($250,000 in the case of a married taxpayer filed a joint return).

[xiv] Assuming it is a passive activity. See Reg. Sec. 1.1411-5.

[xv] In the case of a PTE that is an S corporation that is subject to the built-in gains tax, the shareholders may also be interested in allocating consideration away from those corporate assets to which the tax would apply.

[xvi] See endnote “i”, supra.

[xvii] I wish I could recall the name of the presidential scholar who coined the phrase, that I am trying to paraphrase, to describe how presidents get things done. It may have been Prof. Richard Pious of Columbia University.

[xviii] Sec. 199A(c)(3)(B); Prop. Reg. Sec. 1.199A-3(b)(2).

[xix] For example, upon the filing of a Sec. 338(h)(10) election.

[xx] Prop. Reg. Sec. 1.199A-3(b).

[xxi] Sec. 751(c).

[xxii] Prop. Reg. Sec. 1.199A-5.

[xxiii] Remember Carol Burnett’s sign-off song?