The Nitti Gritty on Section 199A Regulations
The Tax Cuts and Jobs Act gave birth to a brand new provision: Section 199A, which permits owners of sole proprietorships, S corporations, or partnerships to deduct up to 20% of the income earned by the business.
Yesterday, the IRS issued highly-anticipated regulations that provide much-needed clarity on many – but not all – of the issues raised by the statute. Before examining the impact of the regulations, it is helpful to review the basic structure of Section 199A.
Effective for tax years beginning after December 31, 2017, and before January 1, 2026, a taxpayer other than a corporation is entitled to a deduction equal to 20% of the taxpayer’s “qualified business income” earned in a “qualified trade or business.” The deduction is limited for taxpayers with income in excess of a threshold, however, to the greater of:
- 50% of the W-2 wages with respect to the qualified trade or business, or
- The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
The resulting deduction is then subject to an overall second limitation equal to 20% of the excess of the taxable income for the year, over any income taxed as capital gain.
The W-2 and qualified property-based limitations do not apply when the taxpayer claiming the deduction has taxable income for the year of less than $315,000 (if married filing jointly, $157,500 for all other taxpayers). Taxable income for these purposes is determined without regard to any Section 199A deduction.
No deduction is generally available to the owner of a “specified service business.” Section 199A(d)(2) defines a specified service business as:
…any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, or any business which involves the performance of services that consist of investing and investing management, trading, or dealing in securities, partnership interests, or commodities.
This prohibition on claiming the Section 199A deduction against income earned in a specified service business does not apply if the taxpayer claiming the deduction has taxable income of less than $315,000 (if married filing jointly; $157,500 for all other taxpayers). Because the two W-2-based limitations also do not apply when taxable income is below those same thresholds, a taxpayer in a specified service business with taxable income below the thresholds simply deducts 20% of any qualified business income (subject to the overall limitation).
The proposed regulations provide clarity on many important aspects of Section 199A, including the following:
Definition of Specified Service Trades or Businesses (SSTB)
The regulations provide a de minimis exception that will allow a business that both sells product and performs services to avoid being treated as an SSTB. If a trade or business has gross receipts of $25 million or less for the tax year, it will not be treated as a SSTB as long as less than 10% of the gross receipts of the business are attributable to the performance of services in one of the disqualified fields. If a business has gross receipts in excess of $25 million, a similar de minimis rule exists, only 10% is replaced by 5%.
The regulations go on to add significant interpretation of what it means to provide services in a disqualified field; i.e., the field of health or law. For example, the regulations explain that while doctors, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide services directly to a patient are in the field of health, those who provide services that may improve the health of the recipient, such as the operator of a health club or spa, are not in the field of health. Similar guidance is provided for each disqualified field.
Among the more noteworthy examples: property management, real estate brokerage, and banking are not treated as specified service businesses.
The most concerning aspect of the Code’s definition of a SSTB is the catch-all that includes “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees.” This language, if interpreted broadly, threatened to ensnare many taxpayers who are not performing services in a disqualified field.
Fortunately, the regulations define the catch-all VERY narrowly. Only the following trades or businesses will be treated as having their principal asset the skill or reputation of its employees or owners, and thus fall victim to the catch-all:
- A trade or business in which a person receives fees, compensation, or other income for endorsing products or services,
- A trade or business in which a person licenses or receives fees, compensation, or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, or
- Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.
The moment the statute was finalized, strategies began to be developed to strip income out of an SSTB and into an eligible business. The first of these strategies was coined “cracking,” and involved removing a qualified business from an SSTB and having it charge a fee to the SSTB; for example, the owners of a law firm would purchase a building in a separate LLC and rent the building to the law firm. This would reduce the income in the law firm — which isn’t eligible for a 20% deduction — and move it to a rental activity, where it would be treated as qualified business income.
The proposed regulations put a big damper on cracking, however, by providing that 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.
Ex. A and B own law firm AB. A and B purchase a building in AB LLC, and rent the entire building to the law firm. The building is the only asset the LLC owns. Even though the rental of real property is generally not treated as an SSTB, because 1) more than 80% of the building is being rented to an SSTB (the law firm), and 2) the same owners own 50% or more of both the LLC and the law firm, the rental income is treated as being earned in an SSTB, and is not eligible for the 20% deduction.
If a trade or business provides LESS than 80% of its property or services to a commonly-controlled SSTB, while the entire business is not treated as an SSTB, any income earned from the rental of property or provision of services to the SSTB is treated as income earned in an SSTB and is ineligible for the 20% deduction.
Ex. Same facts as in the example above, except only 50% of the building is rented to the law firm, with the other 50% rented to an unrelated party. In this case, the entire rental business is not treated as an SSTB (because less than 80% of the rental is to a commonly-controlled SSTB), but the the income attributable to the rental of the building to the law firm IS treated as income earned in an SSTB, and is not eligible for the 20% deduction.
Aggregation of Commonly Controlled Businesses
The statutory language of Section 199A required that the deduction be determined on a business-by-business basis. This was going to send a lot of taxpayers scrambling in order to make sure the mix of qualified business income, W-2 wages, and property basis were such that it would maximize each, separate deduction.
The proposed regulations alleviate this concern by allowing an elective aggregation regime. A business owner can aggregate two or more businesses if the following requirements are met:
- The same person or group of persons, directly or indirectly, own 50% or more of each business to be aggregated.
- The “control test” is met for the “majority” of the tax year.
- The businesses share the same tax year.
- None of the businesses may be SSTBs.
- The businesses to be aggregated much satisfy two of the following three factors:
- They must provide products or services that are the same or customarily offered together;
- They must share facilities or significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources; or
- The businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group.
Aggregation under Reg. Section 1.199A-4 is purely elective, and generally cannot be revoked once an election is made.
If an election to aggregate is made, the Section 199A deduction is determined based on the total qualified business income, W-2 wages, and property basis for the aggregated businesses. Taxpayers will need to review their business interests with their advisor in order to maximize the benefit of this new aggregation regime.
Determining W-2 Wages for Commonly Controlled Businesses and PEOs
Under the statute, the Section 199A deduction was determined on a business by business basis, with the W-2 and property basis limitations applied separately for each business. This posed a problem to commonly controlled businesses who housed all of its employees in one entity, or for any business that used a professional employer organization (PEO) or employee leasing firm, leaving many business without W-2 wages paid.
While the aforementioned aggregation regime will often solve this problem in the case of commonly controlled businesses, the proposed regulations add a second form of relief by allowing a business to be allocated W-2 wages paid by another taxpayer provided the business is the common-law employer of the employees receiving the wages.
The proposed regulations under Section 199A provide clarity and relief to taxpayers seeking to maximize the 20% pass-through deduction. There is far more covered in the regulations then can be neatly summarized here; as a result, it is recommended that you please reach out to your Withum advisor to set up a more detailed conversation.
|Anthony J. Nitti, CPA, MST, Partner
(970) 925 7382