The IRS issued proposed regulations—all 189 pages– to clarify some of the complexities of its new §199A rule established under the 2017 Tax Act (Tax Act). Practitioners such as CPAs and attorneys, as well as the American public, can make comments over a 45-day period, after which the IRS will assess the comments and finalize the rules.
Although it will take time to digest these proposed regulations, there are 5 take-aways we can share right now. Stay tuned for a more in-depth summary.
1. Spinning off the business is considered abusive.
Some leading industry tax planners suggested having “service” companies that are structured as pass-throughs, whose income exceeds the 199A income thresholds (after which the 20% deduction from Qualified Business Income (QBI) is phased out and then completely unavailable), explore the possibility of splitting the business into two pass-through entities: the service portion of the business and the operations portion, to qualify for the deduction. This strategy, referred to as “crack and pack” in the media, segregates operations and consultation services into two pass-through entities that would have allowed the individual entities to each qualify under the rules of 199A. The IRS considers this strategy abusive, according to the proposed regulations.
2. Definition of “Service” companies is clarified, sort of.
Certain service businesses structured as pass-throughs– such as law firms, accounting firms, investment firms, brokerage firms and physician practices– can take advantage of the 20% write-off only if taxable income is less than a threshold amount: $315,000(MFJ), or $157,500(S). That is, the 20% deduction is phased out over the next $100,000(MFJ) and $50,000(S) of taxable income, respectively—after which no deduction is allowed for these “service” firms–referred to in the code as Specified Service Trade or Business (SSTB). Interestingly, a special exception was made for architect and engineering firms (which are “service” firms) so that their deduction is not limited by the amount of the taxable income.
The proposed regulations have clarified that “SSTB” does not apply to real estate agents and brokers, insurance agents and brokers, or bankers who take deposits and make loans. However, the proposed regulations clarify that financial advisers and investment bankers, as well as securities brokers who have income above the threshold limits described are excluded from taking the deduction.
3. Calculation of W-2 wages clarified.
For those pass-throughs that do qualify under 199A — and are not defined as a SSTB described above — the 20% deduction is subject to potential reductions based on a hair-pulling formula. When income exceeds the top of the taxable income threshold–$415,000 (MFJ) and $207,500 (S)– the actual amount of the deduction allowed is calculated based on the following- the lessor of either 1) 20% of QBI, or 2) the greater of:
- 50% of the W-2 wages from the qualified trade or business, or
- 25% of the W-2 wages from the qualified trade or business, plus 2.5% of the original purchase price of all “qualified property”.
The proposed regulations clarified 3 ways the taxpayer can calculate the W-2 wages portion of the formula, which is less of a hair-pulling exercise than the above and more than we need to cover here.
Just know that wages must be wages that are reported to Social Security Administration, as well as wages paid by a party related to the employer and must include elective deferrals under §402(g)(3), deferred compensation under §457, and any amount of designated Roth contributions under §402A.
To summarize, the 20% deduction is taken from QBI and is reduced based on:
- whether the business is an SSTB or not;
- the taxable income of the taxpayer (not the business) and based on whether the business is an SSTB or not;
- the calculation used for the W-2 wages paid by the business; and
- the unadjusted basis of certain property used by the business (UBIA)
4. Relabeling employees as independent contractors is a no-go.
Since the deduction formula, applicable above the income thresholds, considers how much the company pays in employee wages, relabeling employees as independent contractors won’t be an effective strategy to push income below the thresholds either, according to the proposed regulations.
5. Business aggregation statement must be attached to tax return.
If taxpayer aggregates businesses for 199A purposes, a statement identifying each business must be included in tax return. If the statement is not included the IRS can disaggregate them.
More to follow.
Meanwhile, for a quick review of 199A, see below FAQs.
What is Section 199A anyway?
When the 2017 Tax Act lowered the corporate tax rate from 35% to 21%, it left businesses structured as pass-throughs without any relief. Therefore, the Tax Act included a special deduction for these businesses. Small businesses that do not operate as a C-corporation and instead “pass- through” their qualified business income (QBI) to their individual tax return, may now be eligible to deduct 20% of QBI.
What are Pass-Through businesses?
Businesses structured as Sole proprietorships, and partnerships set up as limited liability companies (LLC) or Family Limited Partnerships (FLP), as well as S-Corporations and trusts may be able to take advantage of the new 199A deduction. However, there are complex rules that govern the extent of the tax benefits and impose deduction limits for ‘service” businesses defined as STTB, described below.
What is the deduction under 199A?
Effectively, those pass-throughs that can benefit from the 20% deduction will effectively pull their new individual top tax rate of 37% down to 29.6% when using the 20% deductibility in full.
However, certain service businesses structured as pass throughs– such as law firms, accounting firms, investment firms and physician practices– can take advantage of the 20% write-off only if taxable income is less than a threshold amount: $315,000(MFJ), or $157,500(S). That is, the 20% deduction is phased out over the next $100,000(MFJ) and $50,000(S) of taxable income, respectively—after which no deduction is allowed for these “service” firms–referred to in the code as Specified Service Trade or Business (STTB); the deduction for taxable income above $415,000 (MFJ) and $207,500 (S) is not allowed. Interestingly, a special exception was made for architect and engineering firms (which are “service” firms) so that their deduction is not limited by the amount of the taxable income.
How is QBI defined?
Qualified Business Income is defined as the net income from a qualified business. Capital gains and losses, certain dividends and interest income are excluded from QBI. The proposed regs clarify that QBI is calculated on a per business basis, and not on a per taxpayer basis.
If total QBI is less than zero, the 199A deduction is zero but carries over to subsequent years to offset QBI. However, the 199A status of that loss does not affect the deductibility of it for purposes of other code sections. Note that a 2017 loss cannot be carried over into 2018.
Just tell me how to calculate the 199A deduction–simply?
How’s this for simple: Generally, if the taxpayer’s income is below the threshold amount– $315,000(MFJ), or $157,500(S)– the amount of QBI that is deductible is 20% for each business. This rule applies to everyone- even the STTBs.
However, if QBI income is coming from an STTB and taxable income falls within the phase-out range– between $315,000-$415,000(MFJ) and $157,500 -$207,500(S)– then the deduction is reduced. If taxable income is above these amounts for an STTB, the deduction is completely unavailable.