INSIGHT: Proposed Section 199A Rules Fill in Framework of Statute

The Tax Cuts and Jobs Act gave birth to a brand new provision: Section 199A, which permits owners of sole proprietorships, S corporations, or partnerships to deduct up to 20 percent of the income earned by the business.

While the provision has been lauded as a potential windfall for small business owners, the statutory language of Section 199A is little more than a framework, lacking the substance necessary for most taxpayers to confidently claim its benefits.

Quite simply, the birth of Section 199A has created more questions than answers. These queries range from the seemingly simple—what do we do about a fiscal-year business that crosses over Jan. 1, 2018?—to the much more complex—what exactly is a “specified service trade or business” for which a deduction is generally prohibited?

Fortunately, on Aug. 8, 2018, the Internal Revenue Service issued highly-anticipated regulations that provide much-needed clarity on many of the issues raised by the statute. Before examining the impact of the regulations, however, it is helpful to review the basic structure of Section 199A.

THE ABCs OF 199A

For tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, Section 199A provides a deduction for individual taxpayers (as well as some trusts and estates) of up to 20 percent of “qualified business income” (QBI) earned by a business operated as a sole proprietorship or through a partnership, S corporation, trust or estate. Section 199A also allows a separate deduction for up to 20 percent of a taxpayer’s combined amount of qualified real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income.

The sum of the two deductions is then subject to an overall limitation equal to 20 percent of the excess of the taxable income for the year over any income taxed as capital gain.

Example 1. A, a single taxpayer, is a 100 percent owner of an S corporation. In 2018, the S corporation allocates to A $100,000 of QBI. In addition, A earns $20,000 of PTP income, $50,000 of long-term capital gain and has total taxable income of $130,000. A’s Section 199A deduction is tentatively equal to $24,000, the sum of:

• $20,000 (20 percent of QBI of $100,000), plus
• $4,000 (20 percent of PTP income of $20,000)

The combined deduction of $24,000 is then subject to an overall limit of $16,000, 20 percent of the excess of taxable income ($130,000) over long-term capital gain ($50,000).

When the taxpayer claiming the deduction has taxable income in excess of $157,500 ($315,000 in the case of a joint return), the deduction is limited to the greater of:

• 50 percent of the W-2 wages with respect to the qualified trade or business (the “wage limitation”), or
• The sum of 25 percent of the W-2 wages, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property (the “property limitation”)

These limitations are phased in over the next $50,000 of taxable income ($100,000 in the case of a joint return), so that the limitations apply in full once taxable income exceeds $207,500 ($415,000 in the case of a joint return).

Example 2. A and B file a joint return. A operates a sole proprietorship that earns $400,000 of QBI and pays $120,000 of W-2 wages. A and B also have long-term capital gain of $30,000 and total taxable income of $500,000. A and B would generally be eligible to a deduction equal to 20 percent of QBI of $400,000, or $80,000. Because the taxable income of A and B exceeds $415,000, however, the wage and property limitations apply in full. As a result, the deduction of $80,000 is limited to the greater of:

• 50 percent of W-2 wages or $60,000, or
• 25 percent of W-2 wages ($30,000) plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property ($0) or $30,000

The resulting deduction of $60,000 is then subject to the overall limitation of $94,000: 20 percent of the excess of taxable income ($500,000) over net capital gain ($30,000). Thus, the final Section 199A deduction is $60,000.

In addition, when taxable income exceeds $157,500 ($315,000 in the case of a joint return), no deduction is generally available to the owner of a “specified service trade or business” (SSTB). Section 199A(d)(2) defines an SSTB as:

"…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 or owners, or any business which involves the performance of services that consist of investing and investing management, trading, or dealing in securities, partnership interests, or commodities.”

The prohibition on claiming the deduction against income earned in an SSTB is phased in over the next $50,000 of taxable income ($100,000 in the case of a joint return), so that once taxable income exceeds $207,500 ($415,000 in the case of a joint return) the deduction attributable to an SSTB is disallowed in full.

Example 3. Same facts as in Example 2, except A’s sole proprietorship is a law firm. Because A and B have taxable income in excess of $415,000, no Section 199A deduction is available against the QBI earned in the law firm, an SSTB.

Thus, when taxable income is below $157,500 ($315,000 in the case of a joint return), computation of the Section 199A deduction is straightforward: the wage and property limitations do not apply, and a deduction is allowed in full against income earned in an SSTB.

Example 4. A, a single taxpayer, owns an accounting firm as a sole proprietor. In 2018, A earns $100,000 of QBI from the firm and has total taxable income of $140,000. Because A’s taxable income is below $157,500, neither the prohibition on claiming the deduction against income earned in an SSTB nor the wage and property limitations apply. Thus, A’s deduction is equal to $20,000, the lesser of $20,000 (20 percent of QBI of $100,000), limited to $28,000 (20 percent of taxable income of $140,000).

PROPOSED REGULATIONS

The proposed regulations issued in early August clear up much of the confusion surrounding key aspects of Section 199A, including the following:

Treatment of Fiscal Year Businesses

The proposed regulations clarify that a taxpayer is permitted to take a full Section 199A deduction related to a fiscal-year qualified business whose tax year straddles Jan. 1, 2018.

Example 5. A, an individual, is a shareholder in an S corporation with a fiscal year-end of June 30. On A’s 2018 Form 1040, A may claim the Section 199A deduction for the QBI earned by the S corporation for its tax year beginning July 1, 2017, and ended June 30, 2018.

Definition of Qualified Business Income

Section 199A defines QBI as the net amount of qualified items of income, gain, deduction and loss with respect to a qualified trade or business. These items determine taxable income for the tax year that is effectively connected with the conduct of a trade or business.

The statute goes on to provide the following list of additional items that are not included in QBI:

• Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss
• Dividend income, income equivalent to a dividend or payment in lieu of a dividend described in tax code Section 954(c)(1)(G) for controlled foreign corporations under an agreement to which Section 1058 applies
• Patronage dividend paid in money, qualified written notices of allocation, or other property are not excluded from qualified business income under this rule
• Any interest income that is not properly allocable to a trade or business
• Net gain from foreign currency transactions (as defined in Section 988(b)) attributable to Section 988 transactions and described in Section 954(c)(1)(C) applied by substituting qualified trade or business for controlled foreign corporation), and net gains from transactions in commodities described in Section 954(c)(1)(D) (applied by substituting “qualified trade or business” for “controlled foreign corporation”)
• Income from notional principal contracts described in Section 954(c)(1)(F) (determined without regard to the limited hedging exception in Section 954(c)(1)(F)(ii)), except items attributable to notional principal contracts that were entered into as clearly identified hedging transactions and treated as ordinary income assets
• Any amount received from an annuity that is not received in connection with the trade or business
• Reasonable compensation paid to a shareholder in an S corporation
• Guaranteed payments to a partner for the use of capital
• Any guaranteed payments described in Section 707(a) or Section 707(c) paid to a partner for services rendered with respect to the trade or business

The proposed regulations expanded upon the statutory definition of QBI, clarifying the treatment of the following items that were left unaddressed by the statute:

Ordinary Income upon the Sale of a Partnership Interest
With respect to a partnership, if Section 751(a) or (b) applies upon the sale of a partnership interest, then gain or loss attributable to assets of the partnership giving rise to ordinary income (so-called “hot assets”) is considered QBI.

Net Operating Losses and Excess Business Losses
A net operating loss is generally not taken into account for purposes of computing QBI. However, to the extent the net operating loss is attributable to losses disallowed under Section 461(l)—the limitation on “excess net business losses”—the net operating loss is taken into account in computing QBI.

Section 481 Adjustments
Section 481 adjustments resulting from a change in accounting method—whether positive or negative—are taken into account in computing QBI only if the adjustment arises in tax years ending after Dec. 31, 2017.

Suspended Losses
Similarly, partnership or S corporation business losses suspended because of basis limitations (Section 704 and Section 1366(d)), at-risk limitations (Section 465), or passive activity limitations (Section 469) are taken into account in computing QBI when allowed for taxable purposes. This is only for losses originally disallowed in tax years beginning after Dec. 31, 2017. Losses that were suspended, limited, or carried over from tax years ending before Jan. 1, 2018, are not taken into account in computing QBI.

This rule will create an administrative burden because under current law, there is no ordering rule for utilizing losses suspended under Section 704, Section 1366(d), Section 465, or Section 469. The fact that no vintage is assigned to suspended losses will not only create confusion, but potential opportunities, for taxpayers in computing QBI. Consider the following example:

Example 6. A owns 100 percent of S Co. A has $100,000 in suspended losses from S Co. in 2017 and another $100,000 in suspended losses from S Co. in 2018. In 2019, S Co. allocates to A $100,000 of QBI. For regular income tax purposes, A reduces the $100,000 of income from S Co. by $100,000 of the $200,000 of suspended losses. But which loss was used? If it was the 2017 loss, the loss does not reduce QBI, and A has $100,000 in QBI in 2019. If it was the 2018 loss, however, the loss reduces A’s QBI from $100,000 to $0.

Section 1231 Gains and Losses
The proposed regulations take a wait-and-see approach for Section 1231 gains and losses and their impact on QBI. In general, a Section 1231 asset is any depreciable asset or real property used in a trade or business for more than one year. Furthermore, it is specifically excluded from the definition of a capital asset. The character of Section 1231 gains and losses is a chameleon: an individual must net together all Section 1231 gains and losses, with any net gain taxed as long-term capital gain, and any net loss deducted as an ordinary loss. Before a taxpayer may treat net Section 1231 gain as capital gain, however, the taxpayer must recapture any ordinary losses taken in the previous five years.

The proposed regulations require the taxpayer claiming the Section 199A deduction to wait until that netting process has taken place. If the net result is capital gain, neither the gains nor losses are included in QBI.

Example 7. A owns 100 percent of S1 and S2. S1 allocates to A $50,000 of Section 1231 gain. S2 allocates to A $30,000 of Section 1231 loss. These are A’s only Section 1231 gains or losses. Because the net of the gains and losses is a $20,000 net gain, the gain is taxed as capital gain. As a result, the $50,000 gain is not taken into account in computing the QBI of S1, and the $30,000 loss is not taken into account in computing the QBI of S2.

If the net result is an ordinary loss, the gains and losses are included in QBI.

Example 8. A owns 100 percent of S1 and S2. S1 allocates to A $20,000 of Section 1231 gain. S2 allocates to A $30,000 of Section 1231 loss. These are A’s only Section 1231 gains or losses. Because the net of the gains and losses is a $10,000 net loss, the loss is taxed as an ordinary loss. As a result, the $20,000 gain is taken into account in computing the QBI of S1, and the $30,000 loss is taken into account in computing the QBI of S2.

Definition of Specified Service Trades or Businesses (SSTB)

Perhaps most importantly to many taxpayers, the proposed regulations expand upon what it means to provide services in one of the specifically identified SSTBs (i.e., the field of health, accounting, or law). For example, with regard to the field of health, the regulations explain that while doctors, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide services directly to a patient are in the field of health, those who provide services that may improve the health of the recipient, such as the operator of a health club or spa, are not in the field of health. Similar guidance is provided for each disqualified field. Among the more noteworthy items are the exclusion from SSTB status of property management, real estate brokerage, and banking businesses.

In addition, the proposed regulations greatly narrow the scope of the finishing catch-all to the SSTB definition that includes “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees.” This language, if interpreted broadly, threatened to ensnare many taxpayers who are not performing services in a disqualified field.

Instead, the proposed regulations define the catch-all very narrowly. Only the following trades or businesses will be treated as having their principal asset as the skill or reputation of its employees or owners, and thus fall victim to the catch-all:

• A trade or business in which a person receives fees, compensation, or other income for endorsing products or services
• A trade or business in which a person licenses or receives fees, compensation, or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity
• Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format

Example 9. H is a well-known chef and the sole owner of multiple restaurants, each of which is owned in a disregarded entity. Due to H’s skill and reputation as a chef, H receives an endorsement fee of $500,000 for the use of H’s name on a line of cooking utensils and cookware. H is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, H is also in the trade or business of receiving endorsement income. H’s trade or business consisting of the receipt of the endorsement fee for H’s skill and/or reputation is an SSTB.

De Minimis Exception From SSTB Status

The regulations provide a de minimis exception that will prevent a business that performs a small amount of services in a prohibited field from being treated as an SSTB. If a trade or business has gross receipts of $25 million or less for the tax year, it will not be treated as a SSTB as long as less than 10 percent of the gross receipts of the business are attributable to the performance of services in one of the disqualified fields. If a business has gross receipts in excess of $25 million, a similar de minimis rule exists but the 10 percent threshold is lowered to 5 percent.

Example 10. S Co. is in the business of selling computer software. In 2018, it generated $20 million in revenue from its software sales. Also in 2018, A earned $2 million in revenue from providing consulting services in conjunction with its software sales. Although the consulting services are considered an SSTB, because the consulting revenue is less than 10 percent of the total revenue, the consulting revenue is ignored and the entire business is not an SSTB.

SSTB Status for Property and Services Provided to a Related Taxpayer

The proposed regulations provide that an SSTB includes any trade or business that provides 80 percent or more of its property or services to a commonly-controlled SSTB. This effectively puts an end to a tax-planning strategy that gained popularity after the enactment of Section 199A known as “cracking,” whereby an SSTB attempts to “strip out” income and move it to a related, non-SSTB activity.

Example 11. A and B own law firm AB. A and B purchase a building in AB LLC, and rent the entire building to the law firm. The building is the only asset the LLC owns. Even though the rental of real property is generally not treated as an SSTB, because (1) more than 80 percent of the building is being rented to an SSTB (the law firm), and (2) the businesses are commonly controlled, the rental income is treated as being earned in an SSTB and is not eligible for the 20 percent deduction.

If a trade or business provides less than 80 percent of its property or services to a commonly-controlled SSTB, while the entire business is not treated as an SSTB, any income earned from the rental of property or provision of services to the SSTB is treated as income earned in an SSTB. Therefore, it is ineligible for the 20 percent deduction.

Example 12. Same facts as in Example 11, except only 50 percent of the building is rented to the law firm, with the other 50 percent is rented to an unrelated party. In this case, the entire rental business is not treated as an SSTB (because less than 80 percent of the rental is to a commonly-controlled SSTB). But, the income attributable to the rental of the building to the law firm is treated as income earned in an SSTB and is not eligible for the 20 percent deduction.

Aggregation of Commonly Controlled Businesses

The statutory language of Section 199A required the deduction to be determined separately for each of a taxpayer’s trades or businesses. This would have sent taxpayers scrambling to make sure the mix of QBI, W-2 wages, and property basis were such that it would maximize each separate deduction.

The proposed regulations alleviate this concern by allowing an elective aggregation regime. A business owner can aggregate two or more businesses if the following requirements are met:

• The same person or group of persons, directly or indirectly, own 50 percent or more of each business to be aggregated
• The control test is met for the majority of the tax year
• The businesses share the same tax year
• None of the businesses may be SSTBs
• Each business to be aggregated must satisfy two of the following three factors:

• They must provide products or services that are the same or customarily offered together
• They must share facilities or significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources
• The businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group

Example 13. 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. A satisfies the first factor because both businesses offer prepared food to customers. A also satisfies the second factor because the two businesses share the same kitchen facilities in addition to centralized purchasing, marketing, and accounting. As a result, A may treat the catering business and the restaurant as a single trade or business.

If an election to aggregate is made, the Section 199A deduction is determined based on the total QBI, W-2 wages, and property basis for the aggregated businesses.

Example 14. F, an unmarried individual, owns as a sole proprietor 100 percent of three trades or businesses—Business X, Business Y, and Business Z. None of the businesses hold qualified property. For tax year 2018, Business X generates $1 million of QBI and pays $500,000 of W-2 wages with respect to the business. Business Y also generates $1 million of QBI but pays no wages. Business Z generates a loss that results in ($600,000) of negative QBI and pays $500,000 of W-2 wages with respect to the business. After allowable deductions unrelated to the businesses, F’s taxable income is $2.12 million.

F aggregates Business X, Business Y, and Business Z under the rules of Proposed Treasury Regulation Section 1.199A-4. Because F’s taxable income is above the threshold amount, the pass-through deduction is subject to the wage and property limitations. Because the businesses are aggregated, these limitations are applied on an aggregated basis. None of the businesses holds qualified property, therefore only the wage limitation must be calculated. F applies the limitation by determining the lesser of 20 percent of the QBI from the aggregated businesses ($1,400,000 x 20% = $280,000) and 50 percent of W-2 wages from the aggregated businesses ($1,000,000 x 50% = $500,000), or $280,000. F’s Section 199A deduction is equal to the lesser of $280,000 and 20 percent of F’s taxable income ($2,120,000 x 20% = $424,000). Thus, F’s Section 199A deduction for 2018 is $280,000.

Once an election to aggregate qualifying businesses has been made, it generally cannot be revoked. As a result, going forward this new aggregation regime is a catalyst for taxpayers to review their business interests with their advisor in order to maximize their Section 199A deduction.

Determining W-2 Wages for Commonly Controlled Businesses and PEOs

As previously highlighted, when a taxpayer’s taxable income exceeds a threshold, the Section 199A deduction is subject to the wage and property limitations. Because the statute required the deduction—as well as the limitations—to be determined separately for each trade or business, it was imperative that each business of a high-income taxpayer have adequate W-2 wages to support a full deduction. This posed a problem for commonly-controlled businesses housing all of its employees in one entity or for any business that used a professional employer organization (PEO) or employee leasing firm, leaving many businesses without W-2 wages paid.

While the aforementioned aggregation regime will often solve this problem in the case of commonly controlled businesses, the proposed regulations add a second form of relief by allowing a business to be allocated W-2 wages paid by another taxpayer provided the business is the common-law employer of the employees receiving the wages. Pursuant to the regulations, a common-law employer may take into account any W-2 wages paid by another person—including a certified professional employer organization under Section 7705, statutory employers under Section 3401(d)(1), and agents under Section 3504. These wages can be reported by the other person on Forms W-2 with the other person as the employer listed in Box c of the Forms W-2, provided that the W-2 wages were paid to common law employees or officers of the trade or business for employment by the trade or business. In these cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 must reduce its own W-2 wages for purposes of the wage limitation in Section 199A.

Example 15. S Co. is the common law employer of six employees. S Co. uses a PEO, who pays $300,000 in total W-2 wages on behalf of S Co.’s six common law employees and reports those wages on Forms W-2 that indicate PEO as the employer. S Co. may include the $300,000 of W-2 wages paid by PEO on behalf of its six common-law employees in the computation of S Co.’s W-2 wages for purposes of the Section 199A wage limitation. PEO must reduce its W-2 wages for purposes of the Section 199A wage limitation by $300,000.

Netting of Income and Loss

After the enactment of Section 199A, it was unclear how a taxpayer treated negative QBI. The proposed regulations provide a well-defined roadmap.

If a taxpayer’s QBI from at least one trade or business is less than zero—and the businesses are not aggregated together—the taxpayer must offset that loss against any trades or businesses that produce positive QBI in proportion to the relative amounts of QBI in the trades or businesses with positive QBI. In this netting process, any W-2 wages and basis of qualified property attributable to the trades or businesses that produced negative QBI is not taken into account by the trades or businesses with positive QBI, nor are the W-2 wages or QBI of qualified property carried over into the succeeding year.

Example 16. F, an unmarried individual, owns as a sole proprietor 100 percent of three trades or businesses—Business X, Business Y, and Business Z. F does not aggregate the trades or businesses. For tax year 2018, Business X generates $1 million of QBI and pays $500,000 of W-2 wages with respect to the business. Business Y also generates $1 million of QBI but pays no wages. Business Z generates a loss that results in ($600,000) of negative QBI and pays $500,000 of W-2 wages with respect to the business. After allowable deductions unrelated to the businesses, F’s taxable income is $2.12 million. Because Business Z had negative QBI, F must offset the positive QBI from Business X and Business Y with the negative QBI from Business Z in proportion to the relative amounts of positive QBI from Business X and Business Y. Because Business X and Business Y produced the same amount of positive QBI, the negative QBI from Business Z is apportioned equally among Business X and Business Y. Therefore, the adjusted QBI for each of Business X and Business Y is $700,000 ($1 million plus 50 percent of the negative QBI of $600,000). The adjusted QBI in Business Z is $0, because its negative QBI has been fully apportioned to Business X and Business Y.

Because F’s taxable income is above the threshold amount, the pass-through deduction is subject to the wage and property limitations. These limitations must be applied on a business-by-business basis. For Business X, the lesser of 20 percent of QBI ($700,000 x 20% = $140,000) and 50 percent of W-2 wages ($500,000 x 50% = $250,000) is $140,000. The lesser of 20 percent of Business Y’s QBI ($700,000 x 20% = $140,000) and 50 percent of its W-2 wages (zero) is zero.

F must combine the amounts and compare the sum to 20 percent of taxable income. F’s Section 199A deduction equals the lesser of these two amounts. The combined amount of pass-through deduction is $140,000 ($140,000 + $0) and 20 percent of F’s taxable income is $424,000 ($2,120,000 x 20%). Thus, F’s Section 199A deduction for 2018 is $140,000.

If an individual’s QBI from all trades or businesses combined is less than zero, no deduction attributable to QBI is allowed for the tax year. This negative amount is treated as negative QBI from a separate trade or business in the succeeding tax year of the individual for purposes of Section 199A. This carryover rule does not affect the deductibility of the loss for purposes of other provisions of the tax code. The W-2 wages and basis of qualified property from the trades or businesses, which produced net negative QBI, are not taken into account in the current year and are not carried over to the subsequent year.

Example 17. Assume the same facts as in Example 16, except that Business Z generates a loss that results in ($2.15 million) of negative QBI and pays $500,000 of W-2 wages with respect to the business in 2018. Thus, F has a negative combined QBI of ($150,000) when the QBI from all of the businesses are added together ($1 million plus $1 million minus the loss of ($2.15 million)). Because F has a negative combined QBI for 2018, F has no pass-through deduction with respect to any trade or business for 2018. Instead, the negative combined QBI of ($150,000) carries forward and will be treated as negative QBI from a separate trade or business for purposes of computing the Section 199A deduction in the next tax year. None of the W-2 wages carry forward.

One Giant Step Forward for Pass-Through Deductions

There is no doubt the proposed Section 199A regulations represent a significant step forward in the evolution of the pass-through deduction. With the additional computational, definitional, and anti-abuse guidance provided by the regulations, many of the previous questions and shortfalls created by the statutory language have been addressed and answered.

Tony is a tax partner based in the Aspen, Colo., office of WithumSmith+Brown PC and is a certified public accountant in the states of New Jersey and Colorado. He has 20 years of accounting and tax experience, including working in the tax departments of Arthur Andersen LLP and Price Waterhouse LLP. Tony’s practice focuses primarily on corporate and partnership tax planning, with a special focus on the consolidated return regulations and the reorganization provisions, including the structuring of acquisitions, mergers, reorganizations, spin-offs and other restructuring transactions.