Clayton & McKervey, an international certified public accounting and business advisory firm located in metro Detroit, has noticed business owners’ enthusiastic response to the newly enacted Internal Revenue Code (IRC) §199A or the “pass-through deduction,” as part of the Tax Cut and Jobs Act (TCJA) that became law in December 2017. Margaret Amsden, CPA and Clayton & McKervey shareholder who heads the firm’s tax practice, cautions that businesses need to evaluate all facts and conditions of the deduction because there are a number of proposed regulations still on the table.
“The new pass-through deduction has received considerable attention because it provides noncorporate taxpayers, like sole proprietors, sub-chapter S corporations, partnerships, and certain trusts and estates with a deduction of up to 20 percent of their Qualified Business Income (QBI),” Amsden said. “Before popping the bottles of champagne, however, know that the devil is in the details. This deduction really depends on the context of each business on a case-by-case basis.”
In addition to businesses, tax practitioners like Amsden have been eagerly awaiting guidance on some of the more intricate scenarios facing businesses. The Department of Treasury recently issued proposed regulations on how the pass-through deduction will apply with the purpose of providing tax payers computational, definitional, and anti-avoidance guidance regarding the application of IRC §199A, but there are still questions on how to apply these rules and the definitions behind the terms.
Qualified Business Income Deduction
Prior to the issuance of the proposed regulations, Amsden points out the pass-through deduction’s definitive knowns:
- It’s temporary—applying to tax years after December 31, 2017 and before January 1, 2026
- Pertains to taxpayers other than C-corporations
- Does not apply to wage income
- Is the lessor of:
- The greater of 50% of the allocable W2 wages of the entity with respect to its qualified trade or business, OR the sum of 25% of the allocable W2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property
- 20% of the excess of taxable income of the taxpayer for the taxable year over the net capital gains of the taxpayer for the taxable year
- It is not available for certain Specified Service Trades or Businesses (SSTB) like attorneys, doctors, CPAs and consultants
- Particular di minimus rules, phase-out thresholds and exclusion amounts apply depending on the filing status of the taxpayer
The following proposed guidelines show what points are still up for discussion:
- The definition of a trade or business may include the rental or licensing of tangible or intangible property to related trade or businesses that are commonly controlled.
- If a taxpayer has multiple trades or businesses, the individual would have to calculate the QBI from each trade or business and then net the results.
- When QBI is negative for any given year, it would be treated as a loss from QBI in the succeeding taxable year.
- Would apply solely to qualified trade or business income conducted within the United States and requires taxpayers to bifurcate domestic and non-domestic activities.
- SSTB would use the definition under IRC Section 1202, but continue to exclude engineering and architecting activities from the prohibited list of professional services businesses stated in the Code.
- Would narrowly define the “catch-all” provision included in the Code’s definition of a SSTB and would apply to those receiving compensation for endorsements, appearance fees and similar income streams.
- Anti-avoidance provisions would be included. A company would not be able to strip income out of a SSTB into a separate business eligible for the deduction (such as a self-rental activity).
- Would establish a de minimis rule in relation to non-corporate entities whose operations inherently include an aspect of SSTB along with non-SSTB activities.
- If a commonly-controlled business or Professional Employer Organization (PEO) is used, would allocate the W-2 wages to the “common law” employer, and the PEO would have to reduce their wages by that amount.
- Fiscal year-end businesses would get the best of both worlds under the “old” Domestic Production Activities Deduction (DPAD), under IRC §199 and the “new” pass-through deduction, under IRC §199A. The old DPAD applies to activity prior to December 31, 2017, and the new pass-through deduction is effective January 1, 2018. The proposed regulations make clear that the full amount of QBI, W-2 wages and property basis are treated as being incurred during the taxable year in which the pass-through entity’s year ends. This, essentially, gives certain taxpayers a double benefit.
“These proposals are only the tip of an iceberg,” Amsden says. “When it comes to IRC §199A, it’s best to consult with a tax advisor. For now, put the champagne on ice and save the celebration for when the final regulations are issued.”