It’s Not Easy

The owners of many closely held businesses recently filed federal income tax returns on which they claimed, for the first time, the deduction based on “qualified business income” under Section 199A of the Code; many others will be doing so in October of this year.[i]

Fortunately, these taxpayers and their advisers are able to rely upon the guidance published by the IRS in the form of proposed and final regulations, in August 2018 and January 2019.

The fact remains, however, that many taxpayers, as well as many tax advisers, continue to raise questions relating to the application of Section 199A. This should not surprise anyone.

The deduction is the product of one of the most convoluted provisions to have ever entered the Code. What’s more, its relatively brief lifespan (2018 through 2025), coupled with the introduction and implementation of many other equally difficult provisions,[ii] challenged the resources of both the IRS and tax advisers to produce a timely and workable set of rules by which to administer the new deduction. [iii]

One question that I have been asked more than a few times by owners of closely held businesses that operate both domestically and overseas concerns the application of Section 199A to income derived from activities outside the U.S.[iv]

At this point, a number of readers may interject that “199A does not apply to such income – the 20-percent deduction is based upon income that is effectively connected with a U.S. trade or business.”

This not unreasonable reaction underscores the need for tax advisers to continue to educate themselves and their clients as to the application of Section 199A, lest they fail to realize the full benefit of the deduction.

Sec. 199A – Qualified Business Income

In general, for taxable years beginning after December 31, 2017, and before January 1, 2026,[v] an individual taxpayer may deduct 20-percent of their qualified business income with respect to a partnership, S corporation, or sole proprietorship.[vi]

Qualified business income (“QBI”) means the net amount of “qualified items” of income, gain, deduction, and loss with respect to the qualified trade or business (“QTB”) of the taxpayer, to the extent they are included in taxable income under the QTB’s accounting method.[vii]

Effectively Connected

Items of income, gain, deduction, and loss are treated as qualified items only to the extent they are “effectively connected” with the conduct of a trade or business within the U.S.[viii]

In determining whether such items are effectively connected with a U.S. trade or business for purposes of Section 199A, taxpayers are directed to apply the rules under Section 864(c) of the Code by substituting QTB for “nonresident alien individual or a foreign corporation,” or for “a  foreign corporation,” each place it appears in Sec. 864(c).[ix]

If only the application of Section 864(c) to Section 199A were as simple as implied by the straightforward substitution of “QTB” for “foreign person” described above. In order to better understand the interplay between the two provisions, we begin with a brief review of the ECI rules as they apply to foreigners doing business in the U.S.[x] However, it is important not to lose sight of the fact that the focus of this discussion is on the U.S. taxpayer who is planning for the Section 199A deduction, and part of whose income may be generated by overseas activities.

ECI for Foreigners

A foreign person that is engaged in the conduct of a trade or business within the U.S. is subject to U.S. net-basis taxation[xi] on any income that is ‘‘effectively connected’’ with their conduct of the U.S. trade or business.[xii]

In general, the test for determining whether a foreign person is engaged in a trade or business in the U.S. is very similar to the test that is applied for purposes of determining whether a pass-through entity[xiii] is engaged in a trade or business for purposes of Section 199A – a person will be treated as engaged in a U.S. trade or business if, based on all the facts and circumstances, it may be said that they carry on substantial profit-oriented activities in the U.S. with “continuity and regularity.”

Assuming a foreign person is engaged in a U.S. trade or business, the Code provides various rules that help determine whether income is ECI with respect to such trade or business.[xiv]

U.S.-Source

In general, all income realized by a foreign person from sources within the U.S. (other than income that is FDAP) is treated as effectively connected with the foreign person’s conduct of a U.S. trade or business;[xv] stated differently, a foreign person’s U.S.-source non-FDAP income is generally treated as ECI.[xvi]

That being said, there are situations in which U.S.-source income that would otherwise be FDAP may, instead, be treated as ECI.[xvii]

Non-U.S. Source: Categories of Income

In general, no income of a foreign person from sources outside the U.S. – as distinguished from activities outside the U.S. – will be treated as effectively connected with the conduct of a U.S. trade or business by that person.[xviii]

That being said, a foreign person engaged in a U.S. trade or business may have certain categories of “foreign-derived” income that are considered ECI.[xix]

Specifically, a foreign person’s income from foreign sources may be considered ECI if the foreign person has an office or other fixed place of business (“Office”) within the U.S. to which such income is attributable, and the income falls within one of a few identified categories of foreign-source income.[xx]

Among these categories is income that is derived from the sale outside the U.S., through the foreign person’s U.S. Office,[xxi] of inventory or personal property held by the foreign person primarily for sale to customers in the ordinary course of the trade or business.[xxii]

However, this income will not be treated as ECI if the property is sold “for use, consumption, or disposition outside” the U.S., and an Office of the foreign person outside the U.S. “participated materially in such sale.”[xxiii]

Sourcing Rules for Inventory

The sourcing rules for income that is derived from the sale of inventory property are complex, to say the least, but they are essential in the application of Section 864(c) and, therefore, of Section 199A. Whether income is U.S. or foreign-source is determined under Sections 861, 862, 863, and 865 of the Code, and the regulations thereunder.

Income that is derived from the purchase of inventory[xxiv] without the U.S. and then sold within the U.S. (where title to the property passes) is treated as U.S.-source income. Similarly, income that is derived from the purchase of inventory within the U.S. and then sold without the U.S. is treated as non-U.S.-source income.[xxv]

Income from the sale of inventory produced (in whole or in part) by the taxpayer within and sold without the U.S., or produced (in whole or in part) by the taxpayer without and sold within the U.S., is to be allocated and apportioned between sources within and without the U.S. solely on the basis of the production activities with respect to the property.[xxvi]

Notwithstanding the foregoing, if a foreign person maintains an Office in the U.S., income from any sale of inventory attributable to such Office will be sourced in the U.S., unless the inventory is sold for use, disposition, or consumption outside the U.S. and an Office of the taxpayer in a foreign country materially participated in the sale.[xxvii]

It appears that this last provision – under Section 865(e)(2) of the Code – has supplanted the ECI rule under Sec. 864(c)(4)(B) of the Code, described above (relating to the sale of inventory outside the U.S. through a foreign person’s U.S. Office), by treating such income as U.S.-source; in turn, such income becomes ECI.[xxviii] Although not explicitly stated in the regulations issued under Section 199A, it would make sense to apply the ECI rules as to inventory under Section 864(c) consistently with the sourcing rule of Section 865(e).[xxix]

Attributable to U.S. Office

If income from the sale of inventory is received by a foreign person engaged in a U.S. trade or business, such income will be treated as U.S.-source under Sec. 865(e)(2), and as ECI under Sec. 864(c), if the income is “attributable” to the foreign person’s U.S. Office.

Income is attributable to a foreign person’s U.S. Office only if such Office is a “material factor” in the realization of the income,[xxx] and if the income is realized in the ordinary course of the trade or business carried on through that Office.[xxxi]

For this purpose, the activities of the Office will not be considered a material factor in the realization of the income unless they provide “a significant contribution to” the realization of the income by being “an essential economic element” in such realization.[xxxii] However, it is not necessary that the activities of the Office in the U.S. be a major (as opposed to a “material”) factor in the realization of the income.

Material Factor

A U.S. Office of a foreign person engaged in a U.S. trade or business will be considered a material factor in the realization of income from the sale of inventory if the Office actively participates in soliciting the order, negotiating the contract of sale, or performing other significant services necessary for the consummation of the sale which are not the subject of a separate agreement between the seller and the buyer.

The U.S. Office will also be considered a material factor in the realization of income from a sale made as a result of a sales order received in such Office, except where the sales order is received unsolicited and that Office is not held out to potential customers as the place to which such sales orders should be sent. The income must be realized in the ordinary course of the trade or business carried on through the U.S. Office.[xxxiii]

A foreign person’s U.S. Office will not be considered to be a material factor in the realization of income merely because of one or more of the following activities:

(a) The sale is made subject to the final approval of such Office,

(b) The property sold is held in, and distributed from, such Office,

(c) Samples of the property sold are displayed (but not otherwise promoted or sold) in such Office, or

(d) Such Office performs merely clerical functions incident to the sale.[xxxiv]

Sale for Use Outside the U.S.

Notwithstanding the foregoing, a U.S. office of a foreign person will not be considered to be a material factor in the realization of income from sales of inventory if the property is sold for use, consumption, or disposition outside the U.S. and an Office which such foreign person has outside the U.S. participates materially in the sale. This foreign Office will be considered to have participated materially in a sale made through the U.S. Office if the foreign Office actively participates in soliciting the order resulting in the sale, negotiating the contract of sale, or performing other significant services necessary for the consummation of the sale which are not the subject of a separate agreement between the seller and buyer.[xxxv]

As a general rule, inventory which is sold to an unrelated person is presumed to have been sold for use, consumption, or disposition in the country of destination of the inventory sold.[xxxvi]

Application to Section 199A

Section 199A refers taxpayers to the rules of Section 864(c) of the Code for purposes of determining whether the income of their QTB is effectively connected with the conduct of a trade or business within the U.S.

Specifically, the term “qualified items” of income, gain, deduction, and loss are those items that are effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c), determined by substituting “trade or business (within the meaning of section 199A)” for “nonresident alien individual or a foreign corporation” or for “a foreign corporation” each place it appears).

Under Section 864(c)(4), income from sources without the U.S. is generally not treated as effectively connected with the conduct of a U.S. trade or business unless an exception under section 864(c)(4)(B) applies. Thus, a trade or business’s foreign-source income would generally not be included in QBI, unless the income meets an exception in section 864(c)(4)(B).

Where a taxpayer’s income from the sale of inventory would previously have been treated as foreign-source, yet also treated as ECI under Section 864(c),[xxxvii] the rule under Section 865(e)(2) will treat such income as U.S.-source and, consequently, as ECI if the taxpayer has a U.S. Office to which such income, gain, or loss is attributable.[xxxviii]

This income from the sale will not be treated as ECI, however, if the inventory is sold for use, consumption or disposition outside the U.S., and the taxpayer has an Office outside the U.S. that materially participated in the sale.

Parting Thoughts[xxxix]

As if the Section 199A rules weren’t difficult enough to negotiate without introducing the rules applicable to the U.S. taxation of income generated overseas.

Those U.S. taxpayers with business activities that extend beyond the borders of the U.S. already have a lot to think about as a result of the changes enacted by the Tax Cuts and Jobs Act. For example, should they form foreign corporate subsidiaries[xl] (basically, CFCs) through which to operate these activities and, thereby, to position themselves for a better result under the GILTI rules? Should they operate through foreign branches to take advantage of the foreign tax credit for foreign-source income?

To these (and other) questions, we may now add: can the U.S. taxpayer organize its operations in a way that maximizes its ECI under Section 864 – perhaps by increasing its U.S.-source income? – so as to take advantage of the Section 199A deduction?

All of these factors have to be considered in light of each taxpayer’s unique facts and circumstances in order to determine how best to structure the taxpayer’s operations from a tax perspective.

As always, however, the desired tax results should not overshadow or compromise business priorities.

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[i] Pursuant to an automatic six-month filing extension; IRS Form 4868.

See, e.g., Line 9 on page 2 of IRS Form 1040.

Section 199A was enacted by the Tax Cuts and Jobs Act (P.L. 115-97). It applies to all non-corporate taxpayers, whether such taxpayers are domestic or foreign. Accordingly, section 199A applies to both U.S. citizens and resident aliens as well as nonresident aliens that have QBI.

[ii] The “transition tax” under IRC Sec. 965, the GILTI rules under IRC Sec. 951A, and the Qualified Opportunity Zone program under IRC 1400Z-1 and 1400Z-2 come immediately to mind; there are others.

[iii] During the lifespan of most additions or changes to the Code, one would expect Congress, the IRS, and the courts – informed through their interaction and experience with taxpayers, tax professionals and each other – to amend or interpret a provision as necessary to attain the legislative goal that motivated its enactment.

However, where a taxpayer has only a few years – eight years in the case of Section 199A – during which to plan for and benefit from a provision, the normal evolutionary track does not apply.

[iv] Generally speaking, familiarity with the U.S. taxation of foreigners and foreign-sourced income was once limited to those who advise non-U.S. taxpayers with business interests in the U.S., or to those who represent large U.S. enterprises with foreign operations. Today, however, many smaller, closely held, U.S. businesses are now doing business overseas through branches or through corporate subsidiaries, or are engaged in joint ventures, both within and without the U.S., with foreign partners.

Of course, U.S. persons are subject to U.S. income tax on their worldwide income. Any income generated during a taxable year by a foreign branch of a U.S. person is included in their gross income for such year for U.S. tax purposes. The same is true of a U.S. person’s share of income of a partnership that operates overseas. In addition, anti-deferral rules, such as the CFC and GILTI rules, cause the current inclusion in a U.S. shareholder’s gross income of their share of the foreign corporation’s income.

[v] The statutorily prescribed lifespan of Section 199A. IRC Sec. 199A(i).

[vi] IRC Sec. 199A(a). A limitation on the amount of the deduction – based on W–2 wages, or W–2 wages plus capital investment (as applicable) – is phased in above a prescribed threshold amount of taxable income. IRC Sec. 199A(b).

A disallowance of the deduction on income from “specified service trades or businesses” is also phased in above the same threshold amount of taxable income.

[vii] IRC Sec. 199A(c).

[viii] IRC Sec. 199A(c)(3)(A)(i); effectively connected income (“ECI”).

[ix] IRC Sec. 199A(c)(3)(A); Reg. Sec. 1.199A-3(b)(2)(i)(A).

For the text of IRC Sec. 864: https://www.law.cornell.edu/uscode/text/26/864 .

[x] This post will not address the ability of nonresident aliens to claim the Section 199A deduction with respect to a U.S. trade or business in which they are engaged.

[xi] They may claim deductions for expenses paid or incurred with respect to their ECI; the resulting taxable income is taxed according to a graduated rate schedule. Compare to a foreigner’s fixed or determinable, annual or periodic income (“FDAP”), the gross amount of which is taxed, and subject to withholding, at a flat rate of 30-percent (subject to reduction by a treaty). IRC Sec. 871(a) and Sec. 881(a). In general, FDAP includes dividends, interest, rent.

[xii] IRC Sec. 871(b), 872, 882. The preamble to the proposed regulations provides that certain items of income, gain, deduction, and loss are treated as effectively connected income, but are not with respect to a U.S. trade or business (such as items attributable to the election to treat certain U.S. real property sales as effectively connected pursuant to section 871(d)), and are thus not QBI because they are not items attributable to a qualified trade or business for purposes of section 199A.

[xiii] A sole proprietorship, a partnership, or an S corporation.

[xiv] IRC Sec. 864(c)(1)(A). In the case of a foreign person not engaged in a U.S. trade or business, none of its income is treated as ECI. IRC Sec. 864(c)(1)(B).

[xv] IRC Sec. 864(c)(3).

[xvi] This is a so-called “force of attraction” concept.

[xvii] IRC Sec. 864(c)(2). Among the factors to consider in making this determination is whether the income is derived from assets used in, or held for use in, the conduct of a U.S. trade or business, and whether the activities of the U.S. trade or business were a material factor in the realization of the amount. Under these tests, “due regard” is given to whether such asset or such income was accounted for through the trade or business.

[xviii] IRC Sec. 864(c)(4)(A).

[xix] IRC Sec. 864(c)(4). Foreign-source income that is not included in one of those categories is generally exempt from U.S. tax.

[xx] IRC Sec. 864(c)(4)(B).

[xxi] Within the meaning of Reg. Sec. 1.864-7.

[xxii] IRC Sec. 864(c)(4)(B)(iii); Sec. 1221(a)(1).

[xxiii] IRC Sec. 864(c)(4)(B)(iii). Compare this to the language in IRC Sec. 865(e)(2).

[xxiv] IRC Sec. 865(i)(1), Sec. 1221(a)(1).

[xxv] IRC Sec. 861(a)(6), Sec. 862(a)(6).

[xxvi] IRC Sec. 863(b)(2), and the last sentence of Sec. 863(b), which was added by the Tax Cuts and Jobs Act (P.L. 115-97). Prior to this addition, such income was treated as partly U.S.-source and partly foreign-source on the basis of the place of sale and the place of production. Now, the income from the sale or exchange of inventory property produced partly in, and partly outside, the U.S. is allocated and apportioned on the basis of the location of production with respect to the property, and not the place of sale.

[xxvii] IRC Sec. 865(e)(2).

[xxviii] Unless the property is sold “for use, consumption, or disposition outside” the U.S., “and an office or other fixed place of business” of the foreign person outside the U.S. “participated materially in such sale.” In this regard, Sec. 864(c)(4)(B) and 865(e)(2) are “identical”: the former causes the income not to be ECI; the latter causes it to be foreign-source and, thereby, not ECI.

[xxix] Some clarification would be welcomed here. Sec. 199A requires that Sec. 864(c) be applied to determine whether income is ECI, with the following modification: in applying Sec. 864(c), references to a “foreign person” are replaced with “QTB.” That leaves the general sourcing rules in place.

Under Sec. 865(e), however, a different sourcing rule applies with respect to the sale of inventory by foreign persons (Sec. 865(e)(2)) than by U.S. persons (Sec. 865(e)(1)).

Query: for purposes of applying Sec. 864(c) to Sec. 199A, should Sec. 865(e)(2) be applied first because Sec. 864(c) applies only to foreign persons, and then Sec. 864(c) would be applied as modified for purposes of Sec. 199A?

[xxx] IRC 864(c)(5)(B).

[xxxi] Reg. Sec. 1.864-6.

[xxxii] Thus, for example, meetings in the U.S. of the board of directors of a foreign corporation do not, by themselves, constitute a material factor in the realization of income.

[xxxiii] 1.864-6(b)(2)(iii).

Thus, if a foreign person is engaged solely in a manufacturing business in the U.S., the income derived by its U.S. Office as a result of an occasional sale outside the U.S. is not attributable to the U.S. Office if the sales office of the manufacturing business is located outside the U.S. On the other hand, if a foreign person establishes a sales office in the U.S. to sell for consumption in the Western Hemisphere merchandise which the foreign person produces in Africa, the income derived by the sales office in the U.S. as a result of an occasional sale made by it in Europe shall be attributable to the U.S. sales office.

[xxxiv] Reg. Sec. 1.864-6(b)(2)(iii).

[xxxv] An office outside the U.S. shall not be considered to have participated materially in a sale merely because of one or more of the following activities: (a) The sale is made subject to the final approval of such office or other fixed place of business, (b) the inventory sold is held in, and distributed from, such office, (c) samples of the inventory sold are displayed (but not otherwise promoted or sold) in such office, (d) such office is used for purposes of having title to the inventory pass outside the U.S., or (e) such office performs merely clerical functions incident to the sale.

[xxxvi] Reg. Sec. 1.864-6(b)(3).

[xxxvii] Under Sec. 864(c)(4)(B)(iii).

[xxxviii] In accordance with Reg. Sec. 1.864-6.

[xxxix] My head hurts.

[xl] Being mindful of the repeal of Sec. 367’s exception for the incorporation of an active foreign business. Former Sec. 367(a)(3).