The IRS has released long-awaited guidance on new Code Sec. 199A, commonly known as the “pass-through deduction” or the “qualified business income deduction.” Taxpayers can rely on the proposed regulations and a proposed revenue procedure until they are issued as final.
Code Sec. 199A allows business owners to deduct up to 20 percent of their qualified business income (QBI) from sole proprietorships, partnerships, trusts, and S corporations. The deduction is one of the most high-profile pieces of the Tax Cuts and Jobs Act ( P.L. 115-97).
In addition to providing general definitions and computational rules, the new guidance helps clarify several concepts that were of special interest to many taxpayers.
Trade or Business
The proposed regulations incorporate the Code Sec. 162 rules for determining what constitutes a trade or business. A taxpayer may have more than one trade or business, but a single trade or business generally cannot be conducted through more than one entity.
Taxpayers cannot use the grouping rules of the passive activity provisions of Code Sec. 469 to group multiple activities into a single business. However, a taxpayer may aggregate trades or businesses if:
- each trade or business is itself a trade or business;
- the same person or group owns a majority interest in each business to be aggregated;
- none of the aggregated trades or businesses can be a specified service trade or business; and
- the trades or businesses meet at least two of three factors which demonstrate that they are in fact part of a larger, integrated trade or business.
Specified Service Business
Income from a specified service business generally cannot be qualified business income, although this exclusion is phased in for lower-income taxpayers.
A new de minimis exception allows some business to escape being designated as a specified service trade or business (SSTB). A business qualifies for this de minimis exception if:
- gross receipts do not exceed $25 million, and less than 10 percent is attributable to services; or
- gross receipts exceed $25 million, and less than five percent is attributable to services.
The regulations largely adopt existing rules for what activities constitute a service. However, a business receives income because of an employee/owner’s reputation or skill only when the business is engaged in:
- endorsing products or services;
- licensing the use of an individual’s image, name, trademark, etc.; or
- receiving appearance fees.
In addition, the regulations try to limit attempts to spin-off parts of a service business into independent qualified businesses. Thus, a business that provides 80 percent or more of its property or services to a related service business is part of that service business. Similarly, the portion of property or services that a business provides to a related service business is treated as a service business. Businesses are related if they have at least 50-percent common ownership.
A higher-income taxpayer’s qualified business income may be reduced by the wages/capital limit. This limit is based on the taxpayer’s share of the business’s:
- W-2 wages that are allocable to QBI; and
- unadjusted basis in qualified property immediately after acquisition.
The proposed regulations and Notice 2018-64, I.R.B. 2018-34, provide detailed rules for determining the business’s W-2 wages. These rules generally follow the rules that applied to the Code Sec. 199 domestic production activities deduction.
The proposed regulations also address unadjusted basis immediately after acquisition (UBIA). The regulations largely adopt the existing capitalization rules for determining unadjusted basis. However, “immediately after acquisition” is the date the business places the property in service. Thus, UBIA is generally the cost of the property as of the date the business places it in service.
The proposed regulations also address several other issues, including:
- basic computations;
- loss carryovers;
- Puerto Rico businesses;
- coordination with other Code Sections;
- special basis rules;
- previously suspended losses and net operating losses;
- other exclusions from qualified business income;
- allocations of items that are not attributable to a single trade or business;
- anti-abuse rules;
- application to trusts and estates; and
- special rules for the related deduction for agricultural cooperatives.
Taxpayers may generally rely on the proposed regulations and Notice 2018-64 until they are issued as final. The regulations and proposed revenue procedure will be effective for tax years ending after they are published as final. However:
- several proposed anti-abuse rules are proposed to apply to tax years ending after December 22, 2017;
- anti-abuse rules that apply specifically to the use of trusts are proposed to apply to tax years ending after August 9, 2018; and
- if a qualified business’s tax year begins before January 1, 2018, and ends after December 31, 2017, the taxpayer’s items are treated as having been incurred in the taxpayer’s tax year during which business’s tax year ends.
The IRS requests comments on all aspects of the proposed regulations. Comments may be mailed or hand-delivered to the IRS, or submitted electronically at www.regulations.gov (indicate IRS and REG-107892-18). Comments and requests for a public hearing must be received by September 24, 2018.
The IRS also requests comments on the proposed revenue procedure for calculating W-2 wages, especially with respect to amounts paid for services in Puerto Rico. Comments may be mailed or hand-delivered to the IRS, or submitted electronically to Notice.email@example.com, with “ Notice 2018-64” in the subject line. These comments must also be received by September 24, 2018.