These new regulations are only proposed, so they may change before a final version is adopted. However, you can rely on them until final regulations are issued.
The 199A deduction
The proposed regulations provide operational rules for calculating the QBI deductions. They describe the mechanics of the deduction, including the phaseout rules that apply over the Threshold Amount.
For tax years beginning on or after January 1, 2018 and on or before December 31, 2025, the 199A deduction can be up to 20% of QBI for the owners of pass-through entities (PTE). The deduction also applies to certain income from real estate investment trusts (REITs), publically traded partnerships (PTP) and cooperatives. This article only addresses the deduction for QBI.
PTEs are sole proprietorships, S corporations and partnerships. This includes LLCs taxed as sole proprietorships or partnerships. The QBI deduction is taken only by eligible owners, which are individuals, estates and trusts.
The additional deduction is subject to limitations over the Threshold Amount of $315,000 for joint filers and $157,500 for all other filers. These limitations phase-in above the relevant Threshold Amount. The phase-in is complete when an owner’s taxable income reaches $415,000 for joint filers and $207,500 for all other filers.
At incomes over the phase-in, the deduction is lost for certain specified service trades or businesses (SSTB). For all other businesses, the deduction can be limited unless the business has adequate payroll or qualified property. Specifically, the deduction for each business is limited to the greater of:
- 50% of the business’s W-2 wages; or
- 25% of its W-2 wages plus 2.5% of the cost of qualified property.
For Section 199A, the cost of qualified property is the unadjusted cost basis immediately after acquisition (UBIA). The proposed regulations provide that wages can be allocated from a common paymaster or similar arrangements.
In no case can the deduction exceed 20% of taxable income (excluding capital gains). See our previous client alert, “New Pass-Through Tax Provisions: The Devil is in the Details” for more details on the basic calculation.
Reduction in Cost Basis – for purposes of Section 199A only
In what is a bit of a surprise, the UBIA of qualified property is reduced when a taxpayer transfers property in a transaction that does not require recognizing any taxable gains. The affected transfers include like-kind exchanges (Section 1031), contributions to partnerships (Section 721) and contributions to corporations (Section 351). These rules do not impact other areas of taxation, like the deduction for depreciation.
What is a trade or business?
QBI must come from an activity that is significant enough to be treated as a trade or business. This term is not defined in the statues or regulations.
The proposed regulations look to the existing cases and rulings that define a trade or business under Section 162. Section 162 allows deductions for business expenses that would not be allowed if they were personal expenses.
This provides adequate guidance in many areas, but in some cases it is not clear if the activity is regular and continuous enough to be treated as a business. This may be a particularly difficult classification for certain rental activities.
PTEs are required to provide the information necessary for owners to take the appropriate 199A deduction. This includes making the determination as to what activities constitute a trade or business and the items relevant to calculating QBI for each business.
Can businesses be aggregated?
An eligible owner or PTE may have interests in several businesses. Businesses with 50% or more common ownership can be aggregated if certain other factors are present that demonstrate the businesses are integrated. However, an SSTB cannot be aggregated with any other business.
This can help taxpayers that have businesses with income, but only a small amount of wages or property. For example, if one business has high QBI, but little or no W-2 wages, and another business has minimal QBI, but significant W-2 wages, aggregating the two could result in a larger QBI deduction. Keeping them separate could result in a lower deduction (or maybe no deduction at all) because the first business is subject to the limitations and the second business has little net income.
Specified service trades or businesses (SSTB)
For many businesses, there was a concern that they would be treated as an SSTB, and therefore, not benefit from the deduction at higher income levels. Much of the anxiety came from a provision that treated any business that relied on the skill or reputation of one or more employees as an SSTB. The proposed regulations have relieved much of that anxiety and clarified the definitions of other SSTBs.
There are also anti-abuse rules intended to prevent SSTB owners from separating out parts of their businesses to artificially create a business that could qualify for the deduction. For example, a law firm that spun out its administrative staff to a new entity owned by the law firm partners would not qualify as a separate business because it has common ownership and the new staffing entity sells services only to the law firm.
In general, an SSTB is a trade or business that performs services in one or more of the following fields: Health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing or investment management, trading and dealing in securities.
The proposed regulations provide explanations for each of these categories. Significantly, brokerage services are limited to those services with respect to securities and will not apply to other brokerage, such as for real estate or freight loads. In addition, the proposed regulations do not treat direct management of real estate as investment management for purposes of Section 199A.
The law provides a final category of SSTB for businesses where the principal asset is the reputation or skill of one or more of its employees or owners. The proposed regulations limit the application of that category to businesses:
- In which a person receives income for endorsing products or services;
- That receive income for the use of an individual’s identity including the use of an image, name, voice, trademark, etc.; or
- That receive income for an appearance at an event, on television or other media formats.
The narrowing of this final category is both logical and helpful to taxpayers in many industries.
The new law is complex and does not lend itself to simple answers that can be applied to everyone. This client alert only scratches the surface of the law and the new proposed rules. If you still have questions, we can help you sort through the details.