199A – The Real Regulatory Story: Revelations From The Proposed Regulations
The regulations for Section 199A were released on Wednesday morning, so many Tax Advisors are short on sleep and almost ready to roll. These regulations are exceedingly complex and it will take months of study and discussion before the major implications are fully understood. The regulations use a host of abbreviations, from QBI (“Qualified Business Income”) to UBIA (Unadjusted Basis Immediately after Acquisition – referring to Qualified Property).
As a brief reminder, Section 199A provides a 20% deduction for Qualified Business Income from flow-through entities, which includes S corporation, partnership, and Schedule C and E income as reported on a Form 1040 tax returns (commonly known as sole proprietorships). The deduction is subject to limitations based on whether the entity engages in certain services (“Specified Services” – referred to as SSTBs in the proposed regulations) or based on the amount of wages paid or Qualified Property held by the entity, and these limitations begin to apply once a taxpayer’s taxable income exceeds certain thresholds. Generally, once a taxpayer has significant taxable income ($157,500 for single filers and $315,000 for married filers), they must pass a wages or wages / Qualified Property hurdle to avoid a significant decrease in their Section 199A deduction.
Thank heaven for amazing tax law experts like Jonathan Blattmachr and Marty Shenkman who spent much of Wednesday night and Thursday morning reading the 184 pages of new Proposed Regulations issued by the IRS Wednesday at 10 a.m.
Yesterday, the three of us presented a live 60-minute Webinar on what these will mean for taxpayers who may save 20% on their taxes from “flow through” income, with over 600 in attendance.
Some highlights are as follows and will be refined and set forth in more detail as we progress with our analysis, but you can also watch/listen to the recording by clicking here.
Please remember that there will be inevitable errors made by those of us who draw conclusions about the regulations early in the process, and that these regulations are only proposed, and may therefore not be relied upon by taxpayers or necessarily reflect what the IRS’s position will be if and when final regulations are ever promulgated.
We welcome questions, comments and suggestions with respect to this big job of applying the law to the situations of taxpayers to make the best of a complicated but fascinating law that advisors can use to help their clients save significant taxes.
The regulations mention that an estimated 10,000,000 taxpayers will be impacted by this tax provision, and that over 25 million hours will be spent complying with this one code provision. Let’s make sure that the tax savings will be maximized to make all of this worthwhile! Let me know if you would like a copy of our draft white paper in progress on these rules by e-mailing firstname.lastname@example.org and thanks for what you do for clients and others.
1. The Regulations confirm that real estate leasing activities can qualify for the 20% deduction without regard to whether they are highly active or passive in nature if the rental is between “commonly controlled” entities, which is defined as common ownership of 50% or more in each entity.
2. The Regulations confirm that leased employees and employees who are paid by one employer for services rendered to another employer may have their wages counted for purposes of passing the wage hurdle.
3. The Regulations provide that certain trusts that hold S corporation stock, which are known as Electing Small Business Trusts (“ESBTs”) can qualify for the deduction on S corporation income, even though the statute may not explicitly allow this.
4. The Regulations provide that entities that are set up to provide management, billing, wholesaling, or other services or products to a services business will be considered to be an extension of that business, so that the special limitations that apply to specified service businesses will apply to the separate entity if there is at least 50% common ownership between them under very broad attribution rules.
5. The Regulations provide that property that has been received in a like kind tax-free exchange will be considered as acquired when the property that it is replacing was acquired, and will be considered to have cost what the property that it is replacing had cost.
6. If property is inherited and immediately placed in service by the heir, the basis in the property will generally be its fair market value at the time of the decedent’s death, but the Regulations do not mention whether this resets the property’s depreciation period for the purposes of Section 199A.
7. When an entity conducts multiple trades or businesses, wages and Qualified Property must be allocated among the trades or businesses using reasonable allocation methods, which include gross income or direct tracing methods.
8. The Regulations create a new method of aggregation of trades or businesses so that taxpayers can combine multiple trades or businesses for the purposes of applying the wage and Qualified Property limitations and maximizing the deduction. In order to be aggregated, the businesses must meet the following requirements: a. The same person or group of persons directly or indirectly own 50% or more of each trade or business;
b. For purposes of determining ownership under this subsection, ownership by spouses, as well as children, grandchildren, and parents, can be attributed to each other.
c. The ownership existed for a majority of the tax year;
d. The items must be reported on returns within the same taxable year;
e. It must not be a Specified Service Trade or Business; and
f. The aggregated trades or business must also satisfy at least two of the following factors:
i. The trade or businesses provide products or services that are the same or customarily offered together;
ii. The trade or businesses share facilities or significant centralized business elements such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources; iii. The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chains interdependencies).
Once a taxpayer chooses to aggregate two or more trades or businesses, they must be consistently reported and aggregated for all subsequent taxable years, unless there is a change in facts and circumstance so that a taxpayer’s prior aggregation no longer qualifies for aggregation.
9. The Regulations enumerate the categories of Specified Service Trades or Businesses, which are treated differently because income derived therefrom by high earner taxpayers (over 157,500 for single filers of $315,000 for married filers) will be limited or not qualify for the deduction. The proposed regulations give some useful examples of what functions are considered to be under these definitions and what functions are not, and we have prepared the following chart to show what they say:
There is also a de minimis exception that applies when income from a Specified Service Trade or Business is less than 10% of gross receipts, if the entity has $25,000,000 or less of annual receipts or 5% of gross receipts if annual receipts are greater than $25,000,000.
The final category discussed is known as the Trade or Business Where the Principal Asset of The Trade or Business is the Reputation or Skill of One or More Employees or Owners. Many advisors were concerned with the potential breadth of this “catch all” provision.
Fortunately, under the proposed regulations, the Treasury choose to narrowly construe this category, and it will not apply unless one of the following exists:
(A) Fees or other compensation is received for endorsement of products or services,
(B) License or fees are received for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated therewith,
(C) Compensation is received for appearing at an event or on radio, television, or other media.
For the purposes of the above, compensation includes ownership in a business entity that is received in lieu of cash.
An example in the regulations is that a famous chef may own a restaurant, and the income from the restaurant would qualify for the Section 199A deduction, but any income earned as a license fee for the use of his or her name to brand the restaurant or sell cookware would be considered as income from a Specified Service Trade or Business.
10. The Regulations state that an individual who was formerly treated as an employee for federal income tax purposes, and who is subsequently characterized as an independent contractor and provides services for the same individual or entity, will be presumed to continue to be an employee, or to be ineligible for the Section 199A deduction by reason of being “in the trade or business of performing services as an employee.” 11. For trusts and trust beneficiaries, the $157,500 threshold to allow the deduction to apply to income, notwithstanding whether the entity has paid wages, has Qualified Property, or is a specified trade or business, may only apply cumulatively to all of the income of the trust, including the trust income that is distributed under the “distributable net income” rules.
12. Many taxpayers will establish trusts for children or others that are separately taxed and can own interests in companies and partnerships and qualify for the deduction under situations where the parents would not qualify because of their income levels or other factors. The proposed Regulations specifically state that “Trusts formed or funded with a significant purpose of receiving a deduction under Section 199A will not be respected for purposes of Section 199A.” This is a highly unusual clause and will be very controversial or may be a mistake if the drafters were alluding to the multiple trust rule described below, and did not intend that the savings for a single trust could be set aside.
13. Many years ago, an Internal Revenue Code Section was passed that allowed the IRS to treat two or more trusts as a single trust if they were formed by one grantor and had substantially the same primary beneficiaries, and were formed for the principle purpose of avoiding income taxes.
The proposed regulations under Section 199A were connected to new proposed regulations under the above-referenced multiple trust provision, and the new regulations state that a principle purpose will be presumed if it results in a significant income tax benefit, unless there are significant non-tax purposes that could not have been achieved without the creation of the separate trust.
In the end, we may find that any trust that has a reasonable family planning purpose will be respected, but that multiple trusts will be aggregated for tax purposes, if they have common beneficiaries and would save tax dollars.
The Regulations provide that a public hearing is scheduled to discuss the Regulations on October 16, 2018 at 10:00 a.m., and comments may be sent to Internal Revenue Service, P.O. Box 7604, Ben Franklin Station, Washington, D.C., 20044, or hand delivered at the Courier’s Desk of the Internal Revenue Service Offices at 1111 Constitution Avenue NW, Washington, D.C. 20224, or via the federal eRulemaking which can be found here.
I will be speaking on Section 199A at the following conferences – in case you would like to have a tax deductible trip and support a worthy not-for-profit organization:
Notre Dame Tax Institute, South Bend Indiana – October 12, 2018 Contact: Jerome Hesch – email@example.com
Federal Tax Institute of New England, Portland Connecticut – October 18, 2018
Contact: Deborah J. Tedford – DTedford@mysticlaw.com
Florida Institute of Certified Public Accountants (FICPA), Tampa, Florida – October 25, 2018
Contact: Nathan Wadlinger (USF) – firstname.lastname@example.org
American Academy of Attorney – Certified Public Accountants (AAA-CPA), Miami, Florida – November 5, 2018
Contact: Jo Ann Koontz – Joann@koontzassociates.com