Proposed IRS Regulations Issued Providing Guidance on New 20% Deduction for Flow-Through Entities
By Michael D'Addio, Principal, Tax & Business Services
The IRS and Treasury issued proposed regulations providing interim guidance on the new Section 199A 20% deduction on Qualified Business Income (QBI) introduced under the Tax Cuts and Jobs Act. The law contains a series of complex provisions, definitions and computations, many of which are addressed by the Service. The preamble to the regulations provides that taxpayers can rely on this guidance until such time that final regulations are issued.
This new provision of the Internal Revenue Code allows owners of sole proprietorships, S corporations, LLCs, or partnerships a deduction of up to 20% of the income earned by the business. Limitations based on the businesses’ W-2 wages and unadjusted basis of assets are placed on this deduction if the taxpayer has taxable income in excess of certain thresholds ($415,000 for married joint filers and $207,500 for other filers). An additional limitation applies for those with income in excess of these thresholds, prohibiting the deduction for businesses which provide certain specified services. These specified service trades or businesses (SSTB) include those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investment management, and trading. There is also a catch-all provision treating as an SSTB “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.”
Those whose taxable incomes are beneath lower threshold levels ($315,000 for married joint filers and $157,500 for other filers) are not subject to either of the limitations discussed above. For those whose taxable income falls between the threshold levels, the limitations apply partially under complicated phase-out computations.
The statutory language for this new deduction creates many unknowns which have been partially explained under these proposed regulations:
- For an operation to be eligible for the deduction, it must be able to demonstrate that it is a “trade or business” as defined within the Internal Revenue Code and using general tax principles.
- Taxpayers are allowed an election to aggregate certain commonly controlled trades or businesses (50% or more common ownership) in computing the 20% QBI deduction. Certain conditions beyond common ownership must be satisfied in order to make this election. A potential benefit of the election is that the combined wages and investments of all the members of the aggregated business can be used to calculate the deduction where the limitations discussed above apply.
- An SSTB is prevented from spinning out service operations or property so as to create separate profit centers eligible for the 20% deduction (the “crack and pack” strategy). Where services or property are provided to commonly controlled parties (50% or more common ownership), the trade or business which provides the services or property can be treated as an SSTB in whole or part. It should be noted that this anti-abuse provision applies not just to the provision of services but also to the rental of real estate or other property.
- The specified service trades or businesses are defined. Surprisingly, the “catch-all” provision is defined very narrowly so as to apply in limited situations only to famous persons who receive income for endorsements, appearances, or their voice, images, trademark, or other representations.
- The statute suggests that a business which has any level of activity which is a specified service trade or business will be treated entirely as a SSTB. The de minimis rule provides that a business with less than $25 million in gross receipts can generate up to 10% of its gross receipts in a specified service trade or business (SSTB) activity and not be treated as an SSTB. The percentage drops to 5% where gross receipts exceed $25 million.
- A business which uses a common paymaster, a professional employer organization, a certified professional employer organization, or third party agent can utilize its share of the W-2 wages paid by such organization for the wage limitation under the law.
- When the law was enacted, there was considerable discussion about converting employees to independent contractor status. An employee will face a presumption that he/she is not an independent contractor if there is a change of status from employee to independent contractor and substantially the same services are performed for the former employer. This is an anti-abuse rule which reacts to this planning idea.
- The 20% deduction also applies to the owners of a qualifying business with fiscal year straddling December 31, 2017. The Service concluded that since the income is reported on the business owner’s 2018 tax return, it should be subject to the 20% deduction.
The proposed regulations contain many other computational, definitional, and miscellaneous provisions. Treasury is seeking comments concerning these provisions, which may cause the regulations to change when issued in final form.
Your Marcum professional can help you in understanding how these regulations and other tax changes may apply to your particular situation.