Highlights from the 199A Proposed Regulations
Treasury and the IRS released IRC § 199A proposed regulations, REG-107892-18, on August 8, 2018. The regulations will not officially apply until they are adopted as final; however, taxpayers can rely on §§1.199A-1 through 1.199A-6 until final rules are adopted. Following is a summary of significant highlights from the proposed regulations. More detailed analysis will follow in the days ahead.
The estimated total annual reporting burden for the proposed regulations is 25 million hours. (Preamble, p. 4)
IRC § 199A is not an easy provision to interpret and, as 25 million hour assertion affirms, it will not be an easy provision to implement. Likely, just about the time the most difficult rules get clarified through further IRS guidance or court rulings, the provision will expire.
The proposed regulations define “trade or business” as an IRC § 162 trade or business (other than the trade or business of performing services as an employee). (Proposed § 1.199A-1)
Section 199A requires that qualified business income eligible for the 199A deduction must come from a “qualified trade or business.” The proposed regulations state that for purposes of 199A, IRC § 162(a) provides the most appropriate definition of “trade or business.” IRS notes that the definition is “derived from a large body of existing case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries.” IRS states, “Defining trade or business as a section 162 trade or business will reduce compliance costs, burden, and administrative complexity.”
There is no bright-line definition of what types of rental activities constitute trades or businesses for purposes of IRC § 162. The courts make trade or business determinations on a case-by-case basis after a highly factual inquiry. For more detailed information on this key issue, read this post.
The proposed regulations automatically deem most self-rentals to be “trades or businesses.” (Proposed 1.199A-1)
Solely for purposes of IRC § 199A, the rental of property to a related trade or business is automatically treated as a trade or business if the rental and the other trade or business are commonly controlled (regardless of whether the rental activity and the trade or business are otherwise eligible to be aggregated under § 1.199A-4(b)(1)). Where the conditions are met, taxpayers may aggregate their trades or businesses with the associated rental.
The proposed regulations create a new aggregation system for grouping trades and businesses. (Proposed §1.199A-4)
Section 199A requires each trade and business to calculate its own QBI deduction. The proposed regulations, however, provide a way by which taxpayers can aggregate trades and businesses for purposes of applying the W-2 wages/UBIA limitation to potentially maximize their 199A deduction. These aggregation rules, however, are separate and apart from the grouping rules for IRC § 469, which IRS deems “inappropriate” for the 199A deduction. Section 469 is a loss limitation rule intended to prevent taxpayers from sheltering losses with non-passive income. Section 199A, on the other hand is “not based on the level of a taxpayer’s involvement in the trade or business (both active and passive owners of a trade or business may be entitled to the deduction).”
The proposed regulations allow aggregation where:
- Each trade or business is a trade or business (with a special exception for self-rentals)
- The same person or group must directly or indirectly own a majority interest in each of the businesses to be aggregated for a majority of the year
- None of the trades and businesses can be SSTBs.
- Individuals and trusts must show that the trades or businesses meet two of the following three factors:
- The businesses provide products and services that are the same or that are customarily provided together (i.e. a gas station and a car wash)
- The businesses share facilities and significant centralized business elements such as personnel, accounting, or human resources
- The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group
Family attribution rules state that for purposes of determining ownership, an individual is considered as owning the interest owner directly or indirectly by his or her spouse, children, grandchildren, and parents. The IRS and Treasury request comments on whether this aggregation rule might also be appropriate for IRC sections 469 and 1411.
S corporation shareholders and partners can take the 199A deduction in 2018 for QBI generated by an entity with a fiscal year ending in 2018. (Preamble, p. 81)
The proposed regulations state that if an individual receives QBI, W-2 wages, or UBIA of qualified property from a pass-through entity with a taxable year that begins before January 1, 2018, and ends after December 31, 2017, such items are treated as having been incurred by the individual during the individual’s tax year during which the entity’s taxable year ends.
The proposed regulations significantly reign in the definition of specified service trades and businesses. (Proposed §1.199A-5)
Taxpayers in a specified service trade or business (SSTB) are ineligible for the deduction for income from their SSTB if their taxable income exceeds the statutory threshold and phase-out ranges ($157,500 for singles and $315,000 for MFJ with phase-out ranges of $50,000 and $100,000 of income respectively). The statute provides that specific fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or investment management are automatically deemed SSTBs, as is “any trade or business where the principal asset of such trade or business is the reputation or skill of the owner or 1 or more of its employees.”
Interpreted broadly, the latter phrase has the potential to swallow up all service businesses. In the proposed regulations, however, IRS significantly curbs the troublesome phrase by limiting its meaning to a list of specific situations where the income received is based directly on the skill and/or reputation of the employees or owners: (1) receiving income from endorsing products or services, (2) licensing or receiving income from one’s image, likeness, name, etc., or (3) receiving appearance fees or income.
The regulations also clarify the reach of the different specified fields. For example, “health” includes services provided by doctors, nurses, veterinarians, dentists, psychologists, etc., but does not include the operation of health clubs or spas or payment processing, or the manufacture and sales of pharmaceuticals and medical devices. The proposed regulations specifically state that the term “brokerage services” does not include services provided by real estate agents and brokers or insurance agents and brokers. “Financial services” includes services provided by financial advisors, investments bankers and wealth planners, but it does not include taking deposits or making loans. “Investment services” does not include property management.
SSTBs can’t spin-off non-SSTB parts of their business and take the deduction. (Proposed §1.199A-5)
The preamble states that it is “inconsistent with the purpose of section 199A” for taxpayers to separate out parts, such as the administrative functions, of what otherwise would be an integrated SSTB, to qualify a portion of the business for the deduction. This so-called “crack and pack” strategy is severely curtailed by § 1.199A-5(c)(2), which provides that an SSTB includes any trade or business with 50 percent or more common ownership (directly or indirectly) that provides 80 percent or more of its property or services to an SSTB. And, if a trade or business has 50 percent or more common ownership with an SSTB, any portion of the property or services provided to the SSTB will be treated as an SSTB. The IRS notes, for example, that a dentist’s self-rental income from renting his office building to his practice is SSTB income, not entitled to the deduction.
The proposed regulations do provide a safe harbor for de minimis income from a trade or business attributable to an SSTB. For trades or businesses with gross receipts of $25 million or less (in a taxable year), a trade or business will not be an SSTB if less than 10 percent of the gross receipts are attributable to the performance of services in an SSTB. That percentage drops to 5 percent for trades or businesses with gross receipts greater than $25 million.
Employees who become independent contractors to take advantage of the QBI deduction will be disappointed. (Proposed §1.199A-5)
Proposed § 1.199A-5(d)(3) provides that for purposes of IRC § 199A, if an employer improperly treats an employee as an independent contractor, the improperly classified employee will be treated as an employee and ineligible for the 199A deduction. Specifically, an employee who becomes an independent contractor providing services for his or her former employer is presumed to be an employee. This presumption, which can be overcome upon a proper showing by the taxpayer, is only for purposes of the 199A deduction and does not actually change the employment tax classification of the individual.
IRC § 1231 gains or losses are often not QBI. (Proposed §1.199A-3)
The proposed regulations clarify that IRC § 1231 gain or loss is excluded from the definition of QBI to the extent that it is treated as a capital gain or loss. In other words, such capital gain or loss is excluded from the definition of QBI whether or not it arises from the sale or exchange of a capital asset. Specifically, QBI does not include any item taken into account in determining net long-term capital gain or net long-term capital loss.
Reasonable compensation requirement is not extended to partners. (Proposed § 1.199A-3)
“Reasonable compensation,” which is excluded from the definition of QBI is limited to the context from which it derives: compensation of S corporation shareholders-employers. The proposed regulations state that this rule is not extended to partnerships.
The proposed regulations provide no guidance for the cooperative deduction. (Preamble, p. 79)
IRS and the Treasury are continuing to study the new deduction for specified agricultural and horticultural cooperatives and their patrons under IRC § 199A(g). They intend to issue separate proposed regulations describing rules for applying this subsection later this year.
The proposed regulations detail how to handle QBI and losses. (Proposed §1.199A-3)
One question of particular interest has been how to handle the situation where one trade or business of a taxpayer has a QBI loss, but other trades or businesses have positive QBI, and the net QBI for all trades and businesses of the taxpayer is positive. The proposed regulations authorize a netting approach. In other words, the QBI loss is allocated among the trades or businesses with income before the W2 wages/UBIA limitation for each trade or business is applied. The allocation is proportionate to the respective QBI of each trade or business. The W-2 wages/UBIA attributable to the loss are not taken into account in making the calculation, and they are not carried over into the next year. The IRS and the Treasury specifically request comments on this approach.
Losses or deductions disallowed for taxable years beginning before January 1, 2018, are not taken into account for purposes of computing QBI in a later taxable year. Likewise, net operating losses are not treated as QBI in subsequent years. If they were, the same loss could be taken into account in multiple tax years. But, if a loss is disallowed under the new excess business loss rule, the net operating loss attributable to that disallowance will constitute QBI in future years, if other requirements are met. IRS and Treasury are specifically requesting comments on this section.
The proposed regulations close the door on some potential abuses through trusts. (Proposed §1.643(f)-1)
Proposed § 1.643(f)-1 states that, in the case where two or more trusts have substantially the same grantor or grantors and substantially the same beneficiaries, the trusts will be treated as a single trust for federal income tax purposes if a principal purpose for establishing the trusts or contributing additional property into them is the avoidance of federal income tax. Spouses are treated as a single person for purposes of this rule.
The proposed regulations and Notice 2018-64 detail the W-2 wages limitation. (Proposed §1.199A-2)
The proposed rules for W-2 wages generally follow the rules that were used for DPAD W-2 wages. However, the W-2 wages limitation for 199A, unlike DPAD, applies separately for each trade and business. The W-2 wages for each trade or business are determined in proportion to the deductions for each trade or business associated with those wages. A taxpayer must first determine total wages paid, second allocate those wages among trade or businesses, and third, allocate those wages to QBI. Notice 2018-64, issued concurrently with the proposed regulations, provides three methods by which W-2 wages can be calculated:
- Under the unmodified box method, W-2 wages are calculated by taking, without modification, the lesser of— (A) The total entries in Box 1 of all Forms W-2 filed with SSA by the taxpayer with respect to employees of the taxpayer for employment by the taxpayer; or (B) The total entries in Box 5 of all Forms W-2 filed with SSA by the taxpayer with respect to employees of the taxpayer for employment by the taxpayer.
- Under the modified box 1 method, the taxpayer makes modifications to the total entries in Box 1 of Forms W-2 filed with respect to employees of the taxpayer. W-2 wages under this method are calculated as follows— (A) Total the amounts in Box 1 of all Forms W-2 filed with SSA by the taxpayer with respect to employees of the taxpayer for employment by the taxpayer; (B) Subtract from the total amounts included in Box 1 of Forms W-2 that are not wages for Federal income tax withholding purposes, including amounts that are treated as wages for purposes of income tax withholding under section 3402(o) (for example, supplemental unemployment compensation benefits within the meaning of Rev. Rul. 90-72); and (C) Add to that amount the total of the amounts that are reported in Box 12 of Forms W-2 with respect to employees of the taxpayer for employment by the taxpayer and that are properly coded D, E, F, G, and S.
- Under the tracking wages method, the taxpayer actually tracks total wages subject to Federal income tax withholding and makes appropriate modifications. W-2 wages under this method are calculated as follows— (A) Total the amounts of wages subject to Federal income tax withholding that are paid to employees of the taxpayer for employment by the taxpayer and that are reported on Forms W-2 filed with SSA by the taxpayer for the calendar year; and (B) Add to the amount the total of the amounts that are reported in Box 12 of Forms W-2 with respect to employees of the taxpayer for employment by the taxpayer and that are properly coded D, E, F, G, and S.
Notice 2018-64 was modeled after Rev. Proc. 2006-22, which detailed W-2 wages computations for DPAD. As it was under DPAD, W-2 wages will not include true commodity wages paid to agricultural workers or remuneration paid to children under 18 employed by their parents for agricultural labor because those payments are not subject to federal withholding under IRC § 3401(a)(2). IRS Publication 51, p, 24. Under IRC § 3401(a)(2), remuneration for agricultural labor is generally only subject to federal withholding if it is subject to FICA (as determined by whether the remuneration is "wages" under IRC § 3121(a)). The definition of “wages” in 3121(a), is “all remuneration for employment…” “Employment” under 3121(b)(3)(A) does not include service performed by a child under the age of 18 in the employ of his father or mother. The child must be employed by a sole proprietor parent or a partnership where each partner is a parent for the exemption to apply. Commodity wages are excluded from the definition of wages by IRC § 3121(a)(8)(A).
The proposed regulations detail the UBIA limitation. (Proposed § 1.199A-2)
The alternative limitation for taxpayers above the income thresholds is 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of qualified property. Unadjusted basis generally means the cost basis of the property immediately after acquisition, without deductions for depreciation, or for improvements. Prop. Treas. Reg. § 1.199A-2 clarifies that UBIA is not reduced by additional first-year depreciation or a section 179 deduction. The UBIA for property inherited and immediately placed into service by the heir will be the FMV of the property at the death of the decedent. The UBIA must be reduced for any personal use of the property. Improvements to qualified property included in the unadjusted basis are treated as separate qualified property, which will have its own UBIA.
In the case of a like-kind or involuntary exchange, the date the exchanged basis in the replacement qualified property is first placed in service by the trade or business is the date on which the relinquished property was first placed in service and the date the excess basis in the replacement qualified property is first placed in service is the date on which the replacement qualified property was first placed in service. In other words, the depreciable period under section 199A for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.
Some entity-specific issues also arise with UBIA. If a sole proprietor, for example, converts to an S corporation, property contributed to the new corporation will have a UBIA equal to the adjusted basis of the property at the time of conversion. Prior to the conversion, however, the sole proprietor was not required to take depreciation adjustments into consideration for purposes of the UBIA. On the partnership side, the proposed regulations provide that IRC § 743 basis adjustments (when a 754 election is made) are not taken into account for purposes of UBIA. Thus the UBIA reflects the lower basis.
Taking a 199A deduction subjects taxpayers to a lower threshold for “substantial understatement” penalties. (Proposed §1.199A-1(e)(5))
The new law attempts to ensure that taxpayers do not get too aggressive in claiming the 199A deduction. IRC § 6662(a) generally provides a 20 percent accuracy-related penalty for a “substantial understatement” of income tax, which is defined as an understatement that exceeds the greater of 10 percent of the tax or $5,000. But IRC § 6662(d)(1)(C) creates a special rule for any taxpayer who claims the 199A deduction for the taxable year. These taxpayers are subject to an accuracy-related penalty if their understatement exceeds the greater of five percent of the tax or $5,000. Notably, this lower threshold applies even if the understatement is not related to the 199A deduction itself.
IRS and Treasury are receiving comments on these proposed regulations. A public hearing has been scheduled for October 16, 2018. Although taxpayers may rely on the proposed regulations in the interim, the final regulations could have substantial differences. We will continue to analyze the proposed regulations and provide more detailed information on specific topics in the days ahead.
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