The Tax Cut and Jobs Act (TCJA), enacted on December 22, 2017, has brought tremendous excitement to business owners across the nation, specifically resulting from the creation of Internal Revenue Code (IRC) §199A, more popularly known as the “Pass-through Deduction.” The newly enacted provision provides noncorporate taxpayers with a deduction of up to 20% of their Qualified Business Income (QBI). Non-corporate taxpayers include sole proprietors, Sub-chapter S corporations, and partnerships as well as certain trusts and estates.
Before pulling out the crystal champagne flutes or making any rash decisions (you get a Tesla, and you get a Tesla, and you get a Tesla!), it’s probably best to contact a tax advisor. As with many things in life, the devil is in the details.
Since the enactment of the TCJA, tax practitioners have been anxiously awaiting guidance on some of the more intricate scenarios facing businesses. For example, the Department of Treasury recently issued proposed regulations on how the pass-through deduction will apply. The purpose of the proposed regulations is to provide taxpayers with computational, definitional, and anti-avoidance guidance regarding the application of IRC §199A. Before delving into the proposed regulations, here’s a recap of what was known prior to the issuance of the proposed regulations.
What we know
- The deduction is temporary and applies for tax years beginning after 12/31/17 and before 1/1/26
- The deduction applies to taxpayers other than C-corporations
- The deduction does not apply to wage income
- The deduction 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
- The deduction is not available for certain Specified Service Trades or Businesses (SSTB) (i.e. attorney, doctors, CPAs, consultants, etc.)
- There are certain di minimus rules, phase-out thresholds and exclusion amounts depending on the filing status of the taxpayer
While this may all sound simple enough, tax practitioners and clients alike will find themselves wondering how to apply these rules, and the definitions behind the terms.
Proposed regulation highlights:
- 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. This rule allows taxpayers to aggregate their trades or businesses with the associated rental or intangible property when they meet certain requirements.
- If a taxpayer has multiple trades or businesses, the individual must calculate the QBI from each trade or business and then net the results.
- When QBI is negative for any given year, it will be treated as a loss from QBI in the succeeding taxable year.
- The deduction applies solely to qualified trade or business income conducted within the United States and requires taxpayers to bifurcate domestic and non-domestic activities.
- The definition of SSTB uses the definition under IRC Section 1202, but continues to exclude engineering and architecting activities from the prohibited list of professional services businesses, as stated in the Code.
- The proposed regulations narrowly define the “catch-all” provision included in the Code’s definition of a SSTB. This provision appears to apply to those who receive compensation for endorsements, appearance fees, and similar types of income streams.
- As promised, the proposed regulations include anti-avoidance provisions. An SSTB includes any trade or business that provides 80% or more of its property or services to an SSTB, as long as the two businesses share 50% or more common ownership. In other words, a company cannot strip income out of a SSTB into a separate business that is eligible for the deduction (such as a self-rental activity).
- A de minimis rule has been established in relation to non-corporate entities whose operations inherently include an aspect of SSTB along with non-SSTB activities.
- There is a fair amount of guidance related to determining W-2 wages for commonly-controlled businesses and Professional Employer Organizations (PEOs). If a PEO is used, the W-2 wages are allocated to the “common law” employer and the PEO must reduce their wages by that amount. If the common law employer owns more than one business, there are very specific rules on how the wages are required to be allocated among the different businesses.
- Fiscal year end businesses seem to 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 12/31/17, and the new pass-through deduction is effective 1/1/18. 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.
Unfortunately, all of the above items are proposed regulations and cannot be relied upon until final regulations are issued. In sum, the highlighted points are only the tip of an iceberg. When it comes to IRC §199A, it is imperative that facts and circumstances be evaluated on a case-by-case basis.
So, for now, put the champagne on ice, pick-up the phone and contact Clayton & McKervey.