Important guidance on the deduction applicable to certain business income of passthrough entities available under last year's tax reform.

The U.S. Department of Treasury and Internal Revenue Service released proposed regulations under the recently enacted section 199A of the Internal Revenue Code on August 8, 2018. Section 199A of last year's tax reform was intended, through a deduction, to reduce the highest marginal tax rate on certain business income earned by passthrough entities (e.g., partnerships, S corporations, and sole proprietorships) from 39.6 percent to 29.6 percent. This deduction achieves greater parity with the reduction in the corporate income tax rate from 35 percent to 21 percent.

The proposed regulations contain many technical details, of which key aspects include:

  • A clarification of the definition of the types of business income that do not qualify, including:

    • Expanding on the explicit statutory categories of service-based business income that do not qualify (e.g., medicine, law, accounting, financial, investment management, and performing arts);

    • Narrowing the otherwise broad catch-all category of business income that does not qualify (i.e., where the "reputation or skill" of one or more of the entity's employees or owners is "the principal asset" of the business); and

    • Eliminating the ability to segregate nonqualifying service-based income from other qualifying business income if certain common ownership and other requirements are satisfied with respect to the businesses.

  • Rules regarding the calculation of the business income that qualifies, including:

    • The netting of income and losses from different qualifying businesses owned by the same individual or group, and the carryforward of overall net losses to future years; and

    • The retention of the nonqualifying character of certain income earned through tiers of passthrough entities.