One of the more complex areas of the Tax Cuts and Jobs Act (TCJA) is the 20% deduction for the “qualified business income” of sole proprietorships, partnerships, LLCs, and S corporations. While the deduction is an important tax break for passthrough businesses, it is restricted based on:
- income level
- the type of business
- W-2 wages paid out and
- depreciable assets held in the business.
To address the complexities of the new law, the IRS has published 184 pages of proposed regulations on Section 199A, the now-famous new Code section. The regulations answer important questions about which type of businesses will be considered professional service firms (and therefore not qualified for the deduction) and about how taxpayers holding interests in multiple entities aggregate their activities. The IRS also released Notice 2018-64, which explains how to compute W-2 wages to measure a firm’s qualification for the write-off.
The 20% deduction is allowed for “qualified business income” from a passthrough entity. Qualified business income includes domestic income from a trade or business, but not all income. Employee wages, other compensation, a partner’s guaranteed payments, capital gain, interest and dividend income are not eligible for the deduction.
Income Level. The first restriction is related to income level. The deduction is allowed for qualified income from any type of business if the taxpayer’s taxable income is less than $157k for singles and $315k for joint filers. The deduction phases out completely at taxable income of $207k/$415k for income from professional service firms. The income restriction applies at the owner level, not the entity level. For example, if a partnership’s income is below the threshold, but an individual partner’s total taxable income is above the threshold, that partner does not get the deduction.
Professional Service Firms. The next restriction depends on whether the passthrough is a professional service firm where “reputation or skill” is the main asset of the business. For these firms, no deduction is allowed if the taxpayer’s taxable income exceeds the income thresholds shown above. Doctors, accountants, lawyers, financial services, and other credentialed professionals are considered professional service firms. However, engineers and architects are not. The regulations define these disqualified firms as “specific service trade or businesses (SSTBs).” The new regulations make important distinctions about which professions are covered, as explained below.
W-2 Wages and Depreciable Property. For non-professional service firms and taxpayers with income above the $207k/$415k phase-out levels, the deduction is limited based on a business’s W-2 wages and depreciable property holdings. The deduction is the lesser of 20% of qualified business income or 50% of the W-2 wages paid by the entity. This limit is computed on a business-by-business basis, so you cannot use W-2 wages from one business to compute the deduction for a different business. For capital-intensive businesses, the taxpayer’s deduction is the higher of (1) 50% of the W-2 wages paid by the business; or (2) 25% of wages paid plus 2.5% of the cost of depreciable property held by the business.
New Regulations Allow Income Aggregation
The proposed regulations allow separate trades or businesses to be grouped when applying the deduction rules. However, the aggregation is only for purposes of computing qualified income and cannot be used to increase the wage or depreciable property limits or to qualify a professional services firm for the deduction by combining it with a qualified business.
A flexible aggregation method is allowed that is based on common ownership, shared services, and other related activities. Once multiple trades or businesses are aggregated into a single business, taxpayers must consistently report the group as aggregated in later tax years.
Regs Narrow Definition of Professional Service Firms
A key part of the regulations is the clarification of exactly which types of professional service firms do not qualify for the deduction. There was concern that the broad language of the TCJA would disqualify any type of business that provided services based on skill or reputation, but the regulations do not take an expansive view of those terms. Instead, the new regulations examine each of the following fields and provide a definition of disqualified services:
Real Estate, Insurance Not Considered Brokerage Services
Brokerage services include arranging securities transactions between a buyer and a seller for a commission or fee and covers stock brokers and similar professionals but do not include real estate agents and brokers, or insurance agents and brokers. The insurance industry is particularly happy with the proposed regulations exempting their agents from the professional services restriction because two-thirds of insurance agencies operate as passthroughs.
Disqualified professional health firms include medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other healthcare professionals who provide medical services directly to a patient. It does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.
Consulting is described as lobbying activities and providing professional advice or counsel to a client to meet goals or solve problems but does not include consulting related to the sale of goods if there is no separate billing or payment for the consulting services. For example, a company that sells computers may provide customers with consulting services relating to the setup, operation, and repair of the computers, or a contractor who remodels homes may provide consulting in conjunction with remodeling a kitchen.
The regulations define disqualified financial services as services typically performed by financial advisors, investment bankers, wealth planners, and retirement advisors. These services include managing wealth, giving financial advice to clients, and developing retirement and wealth transition plans. Financial services also include advisory services relating to valuations, mergers, acquisitions, dispositions, bankruptcy restructurings, and raising financial capital by underwriting, or acting as the client’s agent in the issuance of securities. Regular banking services, such as taking deposits or making loans, are not considered financial services.
Investing, Trading or Dealing in Securities, Partnership Interests or Commodities
The regulations describe investing and investment management as earning fees for investment, asset management services, or investment management services including providing advice for buying and selling investments. It does not include directly managing real property. Trading involves trading insecurities, commodities, or partnership interests and the IRS will look at the source and type of profit sought from the activity regardless of whether the services are being provided for customers or for a taxpayer’s own account.
Under the new rules, dealing in securities means regularly purchasing securities from and selling securities to customers in the ordinary course of business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers. A taxpayer that regularly originates loans in the ordinary course of a trade or business of making loans but engages in no more than negligible sales of the loans is not dealing in securities.
For law, disqualified services include the services of lawyers, paralegals, legal arbitrators, mediators, and similar professionals. It does not include services by printers, delivery services, or stenographers.
Services by accountants, enrolled agents, return preparers, financial auditors, and similar professionals do not qualify for the deduction, even if the individual performing them is not state-licensed. Accounting services include tax return preparation, bookkeeping services, and other services which require training or mastery of accounting principles as a CPA. It does not include payment processing and billing analysis.
Actuarial science includes services by actuaries or similar professionals but does not include services by analysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events.
Performing arts includes services by actors, singers, musicians, entertainers, directors, and similar professionals. It does not include maintenance and operation of equipment or facilities for use in the performing arts. It also does not include broadcasts or otherwise distribution of performing arts video or audio to the public.
Athletics services are treated like performing arts under the proposed regulations and include services by those who participate in athletic competition such as athletes, coaches, and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing. It does not include maintenance and operation of equipment or facilities used in athletic events or services that broadcast or distribute video or audio of athletic events to the public.
Principal Asset is Reputation or Skill Means Celebrities
The most welcome clarification relates to the language that disallows the deduction for “any trade or business where the principal asset is the reputation or skill of one or more of its employees.” Until the regulations were released, it was unclear exactly what Congress meant by this broad phrase, but the regulations define this type of business as one in which an individual endorses products, licenses his or her image, name, signature or voice, or receives income from appearances or performances, essentially the activities or a public figure or celebrity.
De Minimis Rule
The regulations contain a de minimis rule. If a business only provides a small amount of the disqualified services it will not be disqualified from the deduction. A business with gross receipts of $25 million or less in a tax year won’t be disqualified if less than 10% of its gross receipts is attributable to the performance of disqualified services. For businesses with gross receipts greater than $25 million, the de minimis level is 5% of gross receipts attributable to disqualified services.
If a trade or business is a disqualified service business, then none of the income from that trade or business qualifies for the deduction, regardless of whether the owner participates in the specified service activity.
The regulations also include an anti-abuse rule preventing taxpayers from separating out parts of a disqualified service business, such as the administrative functions, in an attempt to qualify those separated parts for the passthrough deduction.
Computing W-2 Wages
Each passthrough’s W-2 wages must be separately calculated for purposes of the deduction limitation based on W-2 wages paid, described above. Notice 2018-64, issued along with the proposed regulations, offers three methods for calculating W-2 wages. Wages are presumed to be zero if they are not reported and only wages allocable to qualified business income may be taken into account.
If W-2 wages are allocable to more than one trade or business, the portion allocable to each trade or business is determined based on how the deductions associated with those wages are allocated to each trade or business.
Unadjusted Basis of Property Increases Deduction
A taxpayer can get an increased deduction based on a percentage of depreciable property’s unadjusted basis immediately after acquisition, so-called “UBIA.” The proposed rules explain that “qualified property” means tangible property subject to depreciation that used to produce qualified business income. The proposed regulations clarify that bonus depreciation does not affect the inclusion of depreciable property in the deduction calculation.
To prevent transfers of property made just to increase the Sec. 199A deduction, the regulations do not allow taxpayers to take the property into account if it is acquired within 60 days of the end of the tax year and is disposed of within 120 days without being used in the business for at least 45 days prior to disposition. If property is in this category, the taxpayer must demonstrate that the principal purpose of the acquisition and disposition was for a different purpose other than increasing the passthrough deduction.
Other anti-abuse rules disallow strategies to separate out parts of a professional service firm, such as administrative functions, in an attempt to qualify those separated parts for the passthrough deduction. Other anti-abuse rules relate to trusts and independent contractors.
Relabeling Employees as Independent Contractors
Section 199A includes a rule that providing services as an employee is not a trade or business eligible for the passthrough deduction. Therefore, it may be beneficial for employees to treat themselves as independent contractors or as having an equity interest in a partnership or S corporation to qualify for the deduction. To prevent this “abuse”, the regulations state that an individual who has been treated as an employee in the past and who is later treated as a contractor for performing the same services is presumed to be an employee for those services. In short, the IRS will ignore the conversion to independent contractor status.
Outlook For Regulations
The proposed regulations are welcome guidance for the many taxpayers who hold interests in passthrough entities. They clear up important issues, such as the reach of the professional services ban and exactly how the deduction will be calculated for multiple business interests. Your Frazier & Deeter tax advisors can help you sort through these issues and give you insight into what the new regulations mean for your business interests.
Overall, the regulations represent a clarification and simplification of the Sec. 199A rules, but the rules are not yet final. A public hearing has been scheduled for October 16, 2018, and the regulations could be finalized sometime thereafter, with changes. The IRS has invited public comments which can be submitted through the Federal eRulemaking Portal at www.regulations.gov for Regulation project REG-107892-18.