Section 199A, enacted in the Tax Cuts and Jobs Act at the end of 2017, allows individuals and certain noncorporate taxpayers to deduct up to 20 percent of qualified business income (QBI) beginning in 2018. QBI generally includes taxable income with respect to a U.S. trade or business operated in flow-through form, such as a partnership, S corporation or sole proprietorship. If the taxpayer’s income is more than $157,500 (or $315,000 if married and filing jointly) (the Threshold Amounts), then certain limitations apply.
Treasury and the IRS published the highly anticipated proposed regulations for Section 199A on August 8. The proposed regulations address aggregation rules, the hotly debated interpretation of a specified service trade or business, and related-party anti-abuse rules.
Aggregation of Trades or Businesses
In determining which businesses may be aggregated, Treasury opted not to apply the grouping rules under the passive activity loss provisions of Section 469. The proposed regulations provide a separate aggregation framework. Under the framework, businesses may be aggregated if the following conditions are met:
- each business is a trade or business as defined in the Internal Revenue Code
- the same persons own a majority interest in each of the businesses
- none of the aggregated businesses is a specified service trade or business (SSTB)
- the taxpayer establishes that the businesses meet two of the following:
- the businesses provide the same products and services or products and services that are customarily provided together (e.g., gas station and a car wash)
- the businesses share facilities or share significant centralized business elements (e.g., common personnel, manufacturing, or human resources)
- the businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (e.g., supply chain interdependencies).
Aggregation is important due to certain limitations on the 20 percent deduction over the Threshold Amounts. The deduction is limited to the greater of either (a) 50 percent of W-2 wages paid with respect to the business or (b) the sum of 25 percent of the W-2 wages paid with respect to the business and 2.5 percent of the tax basis of certain tangible depreciable property used in the business.
Consider the case of a taxpayer with two businesses. Business 1 has high income and low wages, and Business 2 has low income and high wages. If the taxpayer is not able to aggregate, the taxpayer may only be allowed to take the deduction with respect to Business 2 due to the wage limitation. However, if the taxpayer aggregates the businesses, then the taxpayer may be able to take a deduction with respect to both businesses. Taxpayers will need to examine their businesses and the applicable limitations in considering which businesses to group.
Specified Service Trade or Business
The 20 percent deduction does not apply to income from SSTB if the taxpayer’s income is above the Threshold Amount. SSTB includes services in the fields of health, law, accounting, investment management, financial services and other industries or any trade or business where the principal asset is the reputation or skill of its employees or owners. Before the recent guidance, the scope of an SSTB was unclear — did health include animals or only humans? Did investment management include investment in real estate or not? Is a local barbershop an SSTB due to the reputation and skill of its employees?
The proposed regulations provide additional guidance in determining what constitutes an SSTB. For example, the guidance clarifies that health includes the provision of medical services by veterinarians, in addition to doctors, pharmacists, physical therapists and others who provide medical services directly to a patient. The field of health does not include the operation of health clubs or health spas or the research, testing, manufacture and sale of pharmaceuticals or medical devices.
Under the proposed regulations, investing and investment management is defined to include a trade or business involving the receipt of fees for providing investing, asset management or investment management services, including advice with respect to buying and selling investments. The proposed regulations exclude the business of "directly managing real property."
The proposed regulations provide a helpful limitation to SSTB where the principal asset is the reputation or skill of an employee or owner. The proposed regulations provide that "reputation or skill" is limited to situations where the taxpayer (1) receives income for endorsing services or products, (2) receives income for the use of the individual’s image, name, voice or any other symbol associated with the individual’s identity, or (3) receives appearance fees.
Anti-Abuse Related-Party Rules
The proposed regulations limit the "crack and pack" structure, whereby taxpayers separate an SSTB from other business activities. The proposed regulations deal with this through a related-party anti-abuse rule. Two entities are considered related if there is 50 percent or more common ownership. The anti-abuse rules will apply to treat a business as an SSTB where:
- a business provides 80 percent or more of its property or services to an SSTB
- a business shares expenses with an SSTB, and the business’s gross receipts represent 5 percent or less of the total combined gross receipts
- any portion of a business provides property or services to a related SSTB.
Focusing on ownership as a test for abuse provides for planning opportunities. The question will be whether owners of an SSTB are willing to give up control of a related non-SSTB in order to take advantage of the 20 percent deduction on a smaller piece of the pie. For example, if a dermatologist also owns the building in which she practices, will she be willing to give up ownership of 51 percent of the building in order to take advantage of a 20 percent deduction for the rental payment from her dental practice?
The proposed regulations provide much-needed color as to what constitutes an SSTB. There are still gray areas, but the definitions provide helpful insight with respect to certain provisions of these new rules. In addition, and perhaps most helpful, the proposed regulations provide a framework for taxpayers to consider in tax planning. Nevertheless, because of the new definitions of an SSTB that determine eligibility for a Section 199A deduction, taxpayers should consider assembling detailed information on how their business or businesses fit within the framework of the new rules before taking the deduction on their tax returns. This information gathering may involve capturing financial and employee information that has not been historically documented in the relevant format needed to support a Section 199A deduction. In addition, taxpayers should assess which businesses should be aggregated in order to provide for the largest available deduction and whether they should restructure businesses in order to avoid the related-party rules.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.