An overview of three provisions of IRS §199A Proposed Regulations
Last week the IRS issued much anticipated proposed regulations regarding the new 20 percent qualified business income (QBI) deduction, part of the sweeping tax reform bill (the Tax Cuts and Jobs Act) passed into law in late 2017. While the deduction creates a potentially significant benefit for business owners, the language of the law left numerous questions as to its application. The proposed regulations address many of these questions, including the following three:
How will the 50% W-2/25% W-2 plus 2.5% of qualified property limitation apply to related entities?
For taxpayers with income over certain thresholds – $157,500 for single taxpayers, $315,000 for joint filers – the QBI deduction is limited to the greater of 50 percent of the owner’s allocable share of the business’s W-2 wages, and 25 percent of their share of wages plus 2.5 percent of their share of the cost of qualified property used in the business. The language of the law calls for this limitation to apply on a business-by-business basis. This was a cause of significant concern for owners of multiple businesses where wages and assets might live in one entity, and business income in another.
Business owners commonly use a related management company to pay their employees. If their operating entity has business income but no wages, will the IRS allow the related businesses to be counted together? Fortunately, the proposed regulations allow for aggregation of commonly controlled businesses. The aggregation provisions do not follow §469, but create a new method for aggregating commonly owned entities. Aggregation is accomplished through an irrevocable election made at the partner or shareholder level, not the entity level, and requires, among other things, that the same person or group of persons, directly or indirectly, own 50 percent or more of each business.
What is a qualified “trade or business” for purposes of the deduction?
To be eligible for the QBI deduction, the activity must be a qualified “trade or business.” Until the regulations were passed, it was uncertain how to define trade or business income for purposes of the deduction. For example, is rental income business income?
The proposed regulations require a business to rise to the level of a Section 162 trade or business to be eligible for the deduction. This makes it difficult for rental activities to qualify and the aggregation rules discussed above do not help. The determination must be made for each individual rental activity and will be based on the facts and circumstances, including the owner’s involvement in the day-to-day operations, type of rental activity and number of rented properties. The regulations do allow self-rental income to be included in qualified business income eligible for the deduction.
What are specified service trades or businesses (SSTB) not eligible for the deduction for taxpayers with income over the threshold amounts?
The QBI deduction is not available for SSTBs, unless the taxpayer’s income is below certain thresholds. The law pointed to Section 1202 for the definition of SSTBs, which includes the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investment management, trading, and dealing in securities. While not all situations are addressed, the regulations provide a more detailed definition of what is meant by the performance of services for each of those practices.
The code also includes a potential catch-all provision for 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.” However, the proposed regulations limit the application of this provision, stating it will only apply to trades or businesses where a person is paid for endorsing a product, or for the use of their personal likeness.
Note: This article is intended as a high-level discussion of three important provisions contained in the proposed regulations. Please contact HBK with questions regarding your specific tax situation.