Key Provisions of the Final Section 199A Deduction RegulationsFebruary 2019
On January 18, 2019, the Internal Revenue Service (IRS) released final regulations addressing the 20% deduction for qualified business income (QBI) under Section 199A of the Internal Revenue Code (the “Code”). At the same time, the IRS released (i) a new set of proposed regulations; (ii) Notice 2019-7, providing an interim safe harbor for rental real estate enterprises; and (iii) Rev. Proc. 2019-11, which provides three methods for calculating W-2 wages for purposes of the Section 199A deduction. Taxpayers are entitled to rely on this guidance for purposes of filing their 2018 returns. The final regulations generally adopt the provisions set forth in the proposed regulations published on August 8, 2018, but they include significant clarification of several points. For tax years ending in 2018, the IRS is allowing taxpayers to rely on either the proposed regulations or the final regulations.
Subject to several limitations, for taxable years beginning after December 31, 2017, and before January 1, 2026, Section 199A allows non-corporate taxpayers to claim a deduction equal to the lesser of (i) their combined QBI amount, or (ii) 20% of the excess of their taxable income over their net capital gain for the year. Taxpayers entitled to claim the full deduction can lower the top federal income tax rate on their QBI from 37% to 29.6%.
In the case of income from a specified service trade or business (SSTB), the deduction is phased out for taxpayers with taxable income in excess of the "Applicable Threshold" ($157,500 for single filers or $315,000 for joint filers, adjusted annually for inflation). The deduction is phased out over the next $50,000 ($100,000 for joint filers) of income in excess of the Applicable Threshold, and it is completely disallowed once taxable income reaches the “SSTB Limitation” of $207,500 ($415,000 for joint filers). In addition, at these same income levels, the deduction is limited to the greater of:
- 50% of the taxpayer’s share of W-2 wages with respect to the business, or
- The sum of 25% of the taxpayer’s share of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of property used in the qualified business activity.
These additional limitations are referred to as the “Wage-Basis Limitations." Section 199A has separate rules for calculating the deduction in the case of any qualified trade or business of a specified agricultural or horticultural cooperative. The final regulations do not address these rules, and these are not addressed further in this client alert.
Definition of a Trade or Business
To claim the Section 199A deduction, the taxpayer must have QBI. To satisfy this requirement, the taxpayer must be engaged in a "trade or business," directly or through a relevant pass-through entity (RPE), such as a partnership, an LLC treated as a partnership, or an S corporation. The final regulations provide that a self-rental arrangement involving the rental or licensing of property to a related business is treated as a business under Section 199A if both businesses are commonly controlled. For all other activities that do not constitute an SSTB or a business of performing services as an employee, the final regulations adopt the definition of a "trade or business" under Section 162 (relating to deductions for business expenses). Given that the determination of being a trade or business affects eligibility for the Section 199A deduction, taxpayers had hoped that the IRS would provide safe harbors or a widely applicable definition of what constitutes a trade or business. Since neither Section 162 nor the regulations thereunder define a trade or business, taxpayers must continue to rely on unclear and sometimes inconsistent case law and IRS administrative rulings as to what constitutes a trade or business for these purposes.
However, the IRS did clarify whether certain rental real estate operations will qualify as a trade or business under Section 199A in a safe harbor set forth in Notice 2019-7. For a more detailed discussion of this safe harbor, please see our separate client alert on this issue.
Specified Service Trade or Business (SSTB)
An SSTB is defined as a business involving the performance of services in the fields of law, healthcare, accounting, consulting, financial services, brokerage services, athletics, or performing arts—but not architecture or engineering. The SSTB definition also contains a “catch-all” category that covers businesses that don't fit within any of the above-listed fields but whose principal asset is the reputation or skill of one or more of their employees or owners. The final regulations apply this “catch-all” category only to taxpayers who receive (i) endorsement income, (ii) income from the marketing of their image or likeness, or (iii) an appearance fee. The final regulations also clarify the scope of the other categories of SSTBs.
"Crack and Pack" Strategies
Some practitioners had advocated “crack and pack” strategies as a means of mitigating the limitations on the Section 199A deduction from income from an SSTB. Under a “cracking strategy,” the non-SSTB portions of a business would be separated from the SSTB and provide services to the SSTB. The hope was this would allow the non-SSTB to claim the Section 199A deduction. The final regulations effectively limit this strategy by stating that, if a trade or business provides property or services to an SSTB and there is 50 percent or more common ownership of the trade or business, the portion of the business that is providing property or services to the commonly-owned SSTB will be treated as a separate SSTB with respect to the related parties. For this purpose, 50% or more common ownership includes direct or indirect ownership by related parties within the meaning of Code Section 267(b) or Code Section 707(b).
In contrast, “packing” strategies involve combining non-SSTB activities with SSTBs in order to argue that the overall business is not an SSTB. The final regulations address this strategy by providing that a trade or business will not be an SSTB if (1) it has gross receipts of $25 million or less, and (2) less than 10% of the gross receipts are attributable to the performance of services in an SSTB. Moreover, a trade or business with gross receipts greater than $25 million will not be an SSTB if less than 5% of the gross receipts are attributable to the performance of services in an SSTB. The low 10% and 5% thresholds make “packing” difficult.
The final regulations recognize, however, that the same entity could have two or more trades or businesses, only one of which may be an SSTB. The final regulations address circumstances in which one of the businesses may be treated as a separate business that is not an SSTB.
Trade or Business of Performing Services as an Employee
Performing services as an employee is not considered a trade or business for purposes of Section 199A. This led some employees to reclassify themselves as independent contractors to take advantage of the Section 199A deduction. The proposed regulations provided that an individual who was previously treated as an employee and was subsequently no longer treated as an employee but performs substantially the same services to the same person or to a related person will be presumed to be in the trade or business of performing services as an employee for purposes of Section 199A. The final regulations state that this presumption applies for only three years after the worker has ceased to be treated as an employee for employment tax purposes. Also, an individual may rebut this presumption by showing records, such as contracts or partnership agreements, that provide sufficient evidence to corroborate the change in an individual’s status to that of a non-employee.
If the taxpayer has taxable income above the Applicable Threshold, the Section 199A deduction generally cannot exceed the Wage-Basis Limitations. At the same time as it released the final regulations, the IRS released Rev. Proc. 2019-11, which provides detailed guidance on the three methods for calculating W-2 wages for purposes of the Wage-Basis Limitations.
The final regulations also clarify the definition of “qualified property” for calculating the unadjusted basis component of the Wage-Basis Limitations. Qualified property must meet the following requirements: (i) the property must be depreciable, (ii) the property must be held by the business and available for use at the end of the year, (iii) the property must be used during the year in the production of QBI, and (iv) the depreciable period must not have ended. The depreciable period for purposes of Section 199A begins when property is placed in service by the taxpayer and ends on the later of (A) 10 years after it was placed in service, or (B) the end of the recovery period under the Modified Accelerated Cost Recovery System (MACRS) rules. The final regulations address issues relating to property acquired in non-recognition transactions, including like-kind exchanges and transactions under Code Section 351 or Code Section 721.
Aggregation of Businesses
The proposed regulations allowed individuals (but not other taxpayers) to aggregate multiple businesses for purposes of calculating the Wage-Basis Limitations. The final regulations, however, also permit aggregation by RPEs at the pass-through entity level in addition to allowing individuals to aggregate multiple businesses. An individual may aggregate businesses operated directly or through an RPE to the extent that the aggregation is not inconsistent with the aggregation of a lower-tier RPE and to the extent that the aggregation requirements listed below are otherwise satisfied. An individual may not separate from the businesses aggregated by an RPE in which the individual owns an interest, but the individual may aggregate his or her other businesses with the RPE’s businesses. Similarly, an RPE cannot separate businesses aggregated by a lower-tier RPE, but it may aggregate its own businesses with businesses aggregated by the lower-tier RPE. The final regulations provide that multiple businesses may be aggregated only if the following six requirements are satisfied:
- Each business must be a trade or business for purposes of Section 199A;
- At least 50% common ownership (directly or by attribution) between the businesses must exist;
- The common ownership must have existed for a majority of the year in which the income is recognized, including the last day of the tax year;
- All items must be reported on tax returns with the same tax year (ignoring short tax years);
- No SSTBs may be aggregated; and
- The businesses must meet two of the three following requirements:
- The businesses must provide products, property, or services that are customarily provided together;
- The businesses must share facilities or have significant centralized business elements; and
- The businesses must be operated in coordination with, or reliance on, other businesses in the aggregated group.
Taxpayers with income above the Applicable Threshold will need to analyze which businesses, if any, to aggregate to minimize the impact of any applicable Wage-Basis Limitations on the allowable deduction. These determinations should be made carefully because once the taxpayer elects to aggregate certain businesses, the final regulations require consistent treatment in later years. Additionally, other than for the 2018 tax year, an individual that fails to aggregate may not aggregate businesses on an amended return for that year. However, the failure to aggregate businesses in a year does not preclude a taxpayer from deciding to aggregate in a later year; that is, if a taxpayer does not choose to aggregate, he can still choose to aggregate in a later year. Once the decision to aggregate is made, consistent treatment is required in subsequent years. Taxpayers must keep records that substantiate that any aggregation met the above requirements.
Because the rules for aggregating businesses under Section 199A differ from those for grouping activities under Section 469 of the Code, the manner in which a taxpayer may have previously grouped activities for purposes of Section 469 will not affect the decision of whether to aggregate businesses for purposes of Section 199A, or vice versa. Therefore, taxpayers will need to ensure that both their grouping of activities under Section 469 and their aggregation of businesses under Section 199A are supported by taxpayer records.
QBI excludes wages received as an employee-owner and excludes guaranteed payments to partners for services rendered to the business. Reasonable compensation wages paid to an S corporation shareholder-employee are therefore excluded from the definition of QBI. The final regulations also provide that any item of capital gain or capital loss, including any item treated as such under any other provision of the Code, is not included in determining QBI. Thus, if the sale of property used in a business results in a capital gain under Code Section 1231, the gain is not included in QBI. In contrast, if the sale of a partnership interest results in a gain that is treated as ordinary income under Code Section 751, it is included in QBI.
Income from publicly traded partnerships (PTPs) and dividend income from real estate investment trusts (REITs) are specifically excluded from the definition of QBI. However, Section 199A does provide that taxpayers may claim a deduction of up to 20% of their qualified PTP income and REIT dividends without regard to the Wage-Basis Limitations.
New Set of Proposed Regulations
The IRS released an additional set of proposed regulations at the same time as the final regulations were released.
These new proposed regulations provide guidance on the treatment of previously suspended losses or disallowed losses that constitute QBI, including losses disallowed under the at-risk rules of Code Section 465, under the passive activity loss rules of Code Section 469, under the rule in Code Section 704(d) disallowing partnership losses in excess of basis, and under the rule in Code Section 1366(d) disallowing losses of an S corporation in excess of a shareholder’s basis in his or her S corporation stock. Under the final regulations, losses suspended under these rules are not taken into account in calculating QBI. In addition, when losses suspended under these rules become usable, they would be applied on a first-in, first-out basis. The new proposed regulations provide that when these losses cease to be suspended, they are treated as losses from a separate trade or business.
The new proposed regulations also provide rules on determination of the Section 199A deduction for taxpayers that hold interests in regulated investment companies (i.e., mutual funds), as well as charitable remainder trusts, and other split-interest trusts. Developments pertaining to these rules may be covered in future alerts.
Although the proposed regulations generally apply to taxable years ending after the date they are finalized, taxpayers may rely on them in their entirety until final regulations are published.
The Section 199A final regulations address many more issues than those covered in this alert. If you have any questions regarding the impact of Section 199A, the final regulations, or the additional guidance concerning the pass-through deduction, please contact Michael T. Donovan at (314) 444-7715 or Ryan C. Furtick at (314) 444-7798.