On Aug. 8, the U.S. Treasury Department and Internal Revenue Service (IRS) released proposed regulations (REG-107892-18) concerning a provision enacted under the new tax law that allows certain owners of sole proprietorships, partnerships, trusts, and S corporations to deduct 20 percent of their qualified business income (QBI).
The IRS also released in connection with the proposed regulations a list of “frequently asked questions” (FAQs) and Notice 2018-64 as a proposed revenue procedure for guidance on methods for calculating W-2 wages for purposes of section 199A.
The new deduction under section 199A was added to the Code by the tax law enacted Dec. 22, 2017. Under section 199A, non-corporate taxpayers may deduct up to 20 percent of their QBI from a partnership, S corporation, sole proprietorship, or trust for tax years beginning after Dec. 31, 2017. Eligible taxpayers can claim the 20 percent deduction for the first time on their 2018 federal income tax returns. The proposed regulations also address how to treat income received from a fiscal-year passthrough when part of the income received by an individual is received before Jan. 1, 2018. The proposed regulations allow an individual to take a deduction for all of the income received from a fiscal-year filer, which could include money earned by the pass-through entity in 2017.
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However, for taxpayers with taxable income exceeding a threshold amount ($157,500 for single filers and $315,000 for joint filers), the deduction may be significantly reduced. In such cases, the deduction is limited based upon the W-2 wages paid by the qualified business or the business’ basis in certain depreciable property combined with a more limited amount of W-2 wages. Also, for taxpayers with income over the threshold amount, most income earned in service professions (SSTB) does not qualify for the deduction. The Section 199A deduction will expire for tax years beginning after Dec. 31, 2025.
The proposed regulations provide guidance on six major topics with various definitions and computational rules. Some of the topics addressed, include:
- W-2 wages – W-2 wages are computed separately for each trade or business. Notice 2018-64 describes a proposed revenue procedure outlining alternative methods for taxpayers to calculate W-2 wages for purposes of the limitation and deduction amounts.
- Trade or business definition – The proposed regulations clarify that the business of performing services as an employee is not a trade or business for 199A purposes. Also, since the term “trade or business” is defined in more than one provision of the tax code and there is no definition of “trade or business” under the new law, the proposed rules provide that the “trade or business” definition in IRC §162 will govern for 199A purposes.
- UBIA – Unadjusted basis (UBIA) generally will be the property’s cost as of the date it is placed in service. The proposed rules provide UBIA guidance for qualified property contributed to an S corporation or a partnership, inherited from a decedent and immediately placed in service by the heir, or for short tax years. Determines what constitutes qualified business income and excluding, generally, capital gain and loss, dividend and interest income (other than trade or business interest such as interest on accounts or notes receivable), and compensatory income.
- Aggregation rules – Under the proposed regulations, an individual may aggregate trades or businesses provided that the same person or group or persons, directly or indirectly, own 50 percent or more of each trade or business for the majority of the taxable year and none of the trades or businesses are an SSTB. The aggregated businesses must provide similar products or services, share facilities or significant business elements (i.e., accounting, HR or legal) or operate in coordination or reliance on each other business in the aggregated group (i.e., supply chain).
- De minimus rule – A trade or business will not be a SSTB if it provides a small amount of services in a specified service activity. The proposed rules provide that a business is not a SSTB if it has gross receipts of $25 million or less and less than 10 percent of the gross receipts are attributable to the performance or services in an SSTB. For businesses with gross receipts of over $25 million, the amount that must be attributable to the performance of services in a SSTB is reduced to 5 percent.
- Anti-abuse provisions -The guidance contains several anti-abuse provisions including, but not limited to, measures to prevent conversions of independent contractor to employee status to increase tax deductions, bifurcation of qualified services from a SSTB (sometimes referred to as “cracking’), or the abusive use of multiple trusts.
- Other computational and operational issues – The new guidance provides helpful information to assist taxpayers with in many other areas including the computation of QBI, potential netting of losses, QBI carryforwards, and the treatment of suspended or carryover losses.
In addition to the proposed regulations, the IRS also issued Notice 2018-64 containing a proposed revenue procedure for calculating W-2 wages for purposes of Section 199A. The proposed revenue procedure provides three methods for calculating W-2 wages, largely based upon methods used for calculating wages under former Section 199 (the qualified domestic production activities deduction) which was repealed by the Tax Cuts and Jobs Act.
The proposed regulations also shut down a few strategies that have surfaced since the enactment of Section 199A. For example, because the threshold amount of taxable income with respect to trusts is calculated at the trust level, the proposed regulations prevent taxpayers from dividing trust assets into multiple trusts to avoid reaching the threshold and consequently being subject to the deduction limitations. Also, the proposed regulations limit the “crack-and-pack” strategy of separating out the service parts of a business so that the remainder of the business can qualify for the deduction.
The notice of proposed rulemaking (NPRM) calls for written or electronic comments to be submitted in time to be received by 45 days after its publication in the Federal Register. Additionally, Treasury has scheduled a hearing on the proposed 199A regulations for October 16, 2018. The NPRM specifically invites comments on a variety of topics, ranging from the regulatory burden of the regulations to specific complicated matters that the proposed 199A regulations address. The scheduling of a hearing and the short time frame for submitting comments appears to indicate a desire on the part of Treasury and the IRS to move quickly to finalize these regulations.