United States: Opportunities And Limitations: Proposed Pass-Through Deduction Regulations Provide Clarity

Since new Section 199A was enacted late last year as part of the Tax Cuts and Jobs Act (the TCJA, discussed in Congressional Conferees Approve Long-Awaited Tax Reform), business owners and tax professionals alike have been struggling to interpret its wage limitations and service business exclusion in the context of integrated businesses and transactions. Recently proposed regulations provide much-needed clarity to this process while simultaneously erecting guardrails intended to curb abuse.

Section 199A: The Pass-Through Deduction

Section 199A generally permits a deduction for up to 20 percent of qualified business income from pass-through entities and up to 20 percent of real estate investment trust (REIT) dividends and publicly traded partnership income. For taxpayers with taxable income exceeding $207,500 (or $415,000 for joint filers), the deduction is not available for certain specified service trades or businesses (SSTBs), and the deductible amount for other businesses is limited based on W-2 wages and property basis. These limitations are phased in for taxpayers with taxable income exceeding $157,500 (or $315,000 for joint filers).

For purposes of 199A, SSTBs include the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading or dealing in securities, or any trade or business the principal asset of which is the reputation or skill of one or more of its employees or owners. Engineering and architecture services, however, are not SSTBs and therefore are eligible for the deduction.

Related Businesses May Be Aggregated to Maximize Deduction

If the same person or group of persons owns a majority of several businesses for the majority of the tax year, the owners may (but are not required to) aggregate such businesses for purposes of calculating the deduction, regardless of the legal entity structure. Although SSTBs may not be included in the aggregated business, the rental or licensing of property to a business under common control may be aggregated, even if it would not otherwise be considered a trade or business. In addition, aggregated businesses must satisfy at least two of three requirements:

  1. They provide products and services that are the same or customarily offered together.
  2. They share facilities or centralized business elements such as HR, IT, purchasing or accounting.
  3. They operate in coordination with or reliance upon one or more of the businesses in the group, such as through supply chain interdependencies.

By permitting calculation on a combined basis, the aggregation rules may expand the availability of the deduction for commonly controlled businesses, which otherwise would be limited based on the amount of W-2 wages and property basis.

Within Reason: Restrictions Imposed to Prevent Abuse

Immediately after the enactment of Section 199A, many tax practitioners began to suggest restructuring transactions designed to maximize the availability of the deduction. The proposed regulations contain several anti-abuse provisions specifically targeted to these strategies, in particular those that attempt to separate an SSTB from a business that otherwise may qualify for the deduction. The regulations specify three limitations for businesses under common control with an SSTB:

  • If 80 percent or more of property or services are provided to the SSTB, no deduction is permitted.
  • If less than 80 percent of property or services are provided to the SSTB, that portion of the business is treated as part of the SSTB.
  • If the business shares expenses (e.g., wages and overhead) with the SSTB and its receipts comprise less than 5 percent of the combined total, it is deemed to be part of the SSTB.

The proposed regulations include other anti-abuse rules:

  • Property acquired within 60 days of the end of a taxable year, held for 120 days or less and not used in the relevant business for at least 45 days prior to disposition is excluded for purposes of calculating total basis.
  • REIT dividends on stock held for less than 45 days do not qualify for the deduction.
  • If an individual was previously an employee of a business but is later treated as an independent contractor despite directly or indirectly providing the same services to the same business, such individual is presumed to remain an employee and is therefore ineligible for the deduction.
  • Multiple trusts established to circumvent the threshold income amount with the same grantors and the same beneficiaries will be aggregated.

Although the proposed regulations are generally not binding on taxpayers until finalized (they may be relied upon for guidance), these anti-abuse provisions apply retroactively to the TCJA date of enactment (Dec. 22, 2017).

Specified Services Are Narrowly Defined

The proposed regulations provide a more generous approach to defining SSTBs, however, generally confining the exclusion to businesses clearly covered by the statute. For example, the "consulting" SSTB does not include services embedded in or ancillary to the sale of goods if there is no separate payment for the consulting services (e.g., setup, operation, and repair of computers sold to a customer). In addition, perhaps no SSTB has caused greater confusion than the "trade or business the principal asset of which is the reputation or skill of one or more employees or owners." The proposed regulations narrowly define such businesses to include making endorsements, licensing one's likeness or other symbols of identity, or collecting appearance fees.

A de minimis exception also allows taxpayers to engage in relatively minor SSTB activity and still qualify for the deduction; if annual gross receipts do not exceed $25 million, less than 10 percent of those receipts may be attributable to SSTBs. For trades or businesses with gross receipts in excess of $25 million, the SSTB threshold is limited to 5 percent. However, taxpayers planning to take advantage of this exception should beware of its cliff effect – any SSTB receipts in excess of the prescribed threshold will disqualify the entire business.

Other Items of Note

Finally, the proposed regulations offer clarity on numerous other issues raised by the statute, including:

  • The requirement that owners must receive reasonable compensation for services is limited to S corporations and does not extend to partnerships or LLCs.
  • In calculating the W-2 wage limitations, wages paid and reported by a third party (e.g., professional employer organizations or agents) are treated as W-2 wages of the common law employer.
  • The Section 199A deduction does not impact the calculation of either self-employment taxes or the 3.8 percent tax on net investment income.

Final Thoughts

Although these rules may have arrived too late for many taxpayers to engage in restructuring for current-year benefits, some businesses may be able to achieve more significant deductions in future tax years by making relatively minor changes to ownership or operations to satisfy the aggregation rules. Perhaps more important, however, business owners can take comfort knowing the Treasury Department has largely fulfilled its promise to apply the statute in a reasonable manner by limiting application of the SSTB exclusion and taking a holistic approach to defining qualified businesses.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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