One of the most discussed changes in the Tax Cuts and Jobs Act of 2017 is the pass-through entity deduction created by the new Internal Revenue Code section 199A. While its attempt at equalizing tax rates of business entities was sought by many, its implementation requires some complicated calculations, and as yet there is still little guidance from regulatory authorities. The author provides a step-by-step guide to implementation of the deduction as it currently stands, discussing the extant guidance and providing a helpful visual aid.
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The Tax Cuts and Jobs Act of 2017 introduced an entirely new tax deduction, commonly referred to as the pass-through entity deduction. There is no requirement for this deduction to be “paid” or “incurred,” as are most other allowable tax deductions; instead, the deduction is calculated as a percentage of net income within certain qualified business structures.
Available to taxpayers other than C corporations for years beginning after December 31, 2017, the deduction created by the new Internal Revenue Code (IRC) section 199A attempts to equalize the after-tax cash flow of distributed profits from sole proprietorships and pass-through entities with the after-tax cash flow associated with C corporation distributions. In other words, corporate profits are taxed first at the corporate level (now at a 21% tax rate) and second at the owner level in the form of dividends (generally at the long-term capital gains rate). Congress perceived the cumulative tax burden of this double, corporate tax to be less than the burden imposed on owners of sole proprietorships and pass-through entities under the new individual tax rates. The essence of IRC section 199A is to discount taxable profits of qualified sole proprietorships and pass-through entities by 20%. The intent is to eliminate a tax rate bias toward incorporation as a form of business.
Although well intentioned, IRC section 199A creates one of the most complicated individual provisions in the IRC and promises to send many noncorporate business owners to their accountants for assistance in navigating the maze of calculations and limitations. This article describes a road map for compliance with section 199A.
An important note to remember is that the primary guidance for taxpayers available at this point is the statutory language of IRC section 199A, the accompanying Joint Explanatory Statement of the Committee of Conference, proposed regulations (Treasury Regulations sections 1.199A-1 through 1.199A-6), and the proposed revenue procedure in Notice 2018-64. The Treasury Department undoubtedly will issue additional clarifications over the coming months that may alter the process outlined in this article.
Step 1: Identify Qualified Business Activities
Exhibit 1 presents a flowchart of the process described by the statutory language and illustrated in the proposed regulations. It is useful to follow a step-by-step approach in calculating the IRC section 199A deduction because the code section itself is ambiguous about certain steps of the calculation. The proposed regulations have provided more clarity, and following a logical path facilitates compliance and identifies points of planning opportunities.
Step 1 is to identify activities with qualified business income (QBI) and calculate the QBI for each activity. QBI during the tax year for an activity is the net amount of qualified items of income, gain, deduction, and loss relating to any qualified trade or business of the taxpayer and can be positive or negative (i.e., income or loss). The proposed regulations indicate that trade or business income for purposes of section 199A fits the meaning of a trade or business as defined in IRC section 162 (other than as an employee). QBI can be positive or negative.
This generally includes a Schedule C business, an owner’s share of nonpublicly traded partnership income, and S corporation income. Proposed regulations section 1.199A-1(b)(13) clarifies that income from rental activities that rise to the level of an IRC section 162 business activity is QBI; substantial case law exists holding that rental real estate activities generally rise to the level of a section 162 business activity, except in triple net lease arrangements, where the tenant is responsible for taxes, insurance, and repairs. In addition, income from rental activities that do not rise to the level of a section 162 business activity is QBI if tangible property is rented to a related business that is commonly controlled (but only for purposes of section 199A).
The income or loss can be either active or passive under IRC section 469. The code section itself excludes from QBI a number of items, such as wages, capital gains and losses, dividends, interest income, guaranteed payments to partners under section 707(c), REIT dividends, and income from a publicly traded partnership.
The proposed regulations further clarify items of QBI. Proposed Treasury regulations section 1.199A-3(b)(2)(ii)(J) states that partnership payments under IRC section 707(a) are not QBI; section 1.199A-3(b)(1)(i) states that ordinary income from IRC section 751(a) or (b) partnership payments can be included in QBI if all other requirements are met; and section 1.199A-3(b)(2)(ii)(A) clarifies that QBI does not include IRC section 1231 gains and losses.
IRC section 199A specifically refers to the trade or business definition in IRC section 864(c), substituting “qualified trade or business within the meaning of section 199A” in place of “nonresident alien individual or foreign corporation” and “foreign corporation.” An important implication of this definition is that only income “effectively connected with a United States trade or business” qualifies as QBI. For example, a U.S. partner of a partnership that operates a trade or business in both the United States and a foreign country would only include the items of income, gains, deductions, and losses that would be effectively connected with a United States trade or business.
Furthermore, the explanation of the proposed regulations clarifies that “effectively connected” under IRC section 864(c) is by itself insufficient; the income or deduction must also be in connection with a trade or business. Certain items in the tax code are allowed to be treated as “effectively connected” even though they do not rise to the level of a trade or business (e.g., foreign persons elect to treat income from real property interests as effectively connected, deductible expenses for theft losses, and charitable contributions). These items are not included in QBI calculations.
QBI very likely does not include activities defined as a hobby under IRC section 183, which defines an activity “not engaged in for profit” (i.e., a hobby) as an activity other than one covered under IRC section 162.
Section 199A defines the calculation of QBI as income, gain, deduction, and loss included or allowed in determining taxable income for the taxable year. QBI is therefore calculated after the passive loss limitations under IRC section 469 and the new loss limitations under section 461(l). Although net operating loss (NOL) carryovers generally are not QBI, any carryover NOL caused by section 461(l) will be QBI if all other requirements are met.
Step 2: Net QBI Activities
The next step is to net a taxpayer’s QBI activities (including any negative QBI carryover from the prior year). If net QBI from all activities in Step 2 is positive, then combine the negative QBI activities (if any) proportionally with the positive QBI activities, then separately carry the individual activities with positive QBI to the next step. Exhibit 2 shows this calculation. In this example, the total QBI for positive activities is $400,000, while the negative activity QBI is $100,000. Activity 1 has $250,000 positive QBI and Activity 2 has $150,000 positive QBI, so $62,500 [($100,000 × (250 ÷ 400)] of the negative QBI is allocated to Activity 1 and $37,500 [($100,000 × (150 ÷ 400)] is allocated to Activity 2. Any qualified W-2 wages or qualified property in Activity 3 are disregarded in the subsequent limitation calculations.
Step 2 for Net Positive QBI Amount
If the current year net QBI in Step 2 is negative, then the net QBI ($200,000 in Exhibit 3) is carried forward to next year (along with any prior year negative carryforward), and there is no section 199A deduction in the current year. The sequence of steps of the statutory language in IRC section 199A, the proposed regulations, and examples in the Joint Explanatory Statement of the Committee of Conference indicate that the carryover is treated as a single activity in the next year. None of the qualified W-2 wages or qualified property of the three activities are allowed for limitation purposes.
Step 2 for Net Negative QBI Amount
Step 3: Determine Taxable Income
The next step is to determine whether the taxpayer’s taxable income in 2018 (before the IRC section 199A deduction) is equal to or less than $315,000 (for married taxpayers filing jointly) or $157,500 (for any other filing status). If taxable income is equal to or less than the appropriate threshold, then transfer the separate QBI for each activity to Step 7, as the taxpayer is not subject to the specified service trade or business or the wage and property limitations. If taxable income is greater than the appropriate threshold, then go to Step 4.
Step 4: Determine SSTB Status
Determine if each activity with positive QBI is a specified service trade or business (SSTB). If an activity is an SSTB, carry the QBI for that activity to Step 5. If an activity is not an SSTB, carry the QBI for the activity to Step 6.
IRC section 199A attempts to equalize the after-tax cash flow of distributed profits from sole proprietorships and pass-through entities with the after-tax cash flow associated with C corporation distributions.
The activity is an SSTB if the trade or business is in one of the following areas with respect to the performance of services:
- Financial services
- Brokerage services
- The trade or business’s principal asset is the reputation or skill of one or more of its employees or owners.
Generally, IRC section 199A tracks the definition of “qualified personal service corporation” under IRC section 448 for SSTBs. The IRC section 448 language refers to section 1202(e)(3)(A) applied without regard to the words “engineering” or “architecture” to define an SSTB; the intent of the law therefore seems to be to exclude engineering and architecture from the definition. The language also includes, however, “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”; this seems inclusive enough to embrace engineering and architecture. Proposed Treasury Regulations section 1.199A-5(b)(2)(xiv) clarifies the issue by narrowly confining activities dependent on “reputation and skill” to those with revenues such as royalties, signatures, trademarks, and endorsements, thus excluding most engineering and architectural activities as SSTBs.
The proposed regulations provide examples and clarifications regarding the application of the SSTB definition to fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, and securities/partnership/commodities dealings. For example, if a partnership owns a sports team, the partners’ distributive shares of income from the partnership’s athletics trade or business are not QBI because the activity is the performance of services in the field of athletics.
The essence of IRC section 199A is to discount taxable profits of qualified sole proprietorships and pass-through entities by 20%.
To reduce the administrative burden, proposed Treasury Regulations section 1.199A-5(c)(1) provides that a trade or business (determined before the aggregation election) is not an SSTB if the trade or business has gross receipts of $25 million or less (in a taxable year) and less than 10% of those gross receipts is attributable to the performance of services in an SSTB. For trades or business with gross receipts greater than $25 million (in a taxable year), a trade or business is not an SSTB if less than 5% of the gross receipts are attributable to the performance of services in an SSTB.
Step 5: Apply SSTB Limitation
The next step involves calculating the allowable QBI, qualified W-2 wages, and qualified property basis for each separate SSTB identified in Step 4. Each non-SSTB activity proceeds to Step 6.
The SSTB limitation phasein is determined by the percentage that taxable income (before the QBI deduction) encroaches into the phasein range. The phasein range for married-filing-jointly returns in 2018 is $315,000–$415,000 and $157,500–$207,500 for any other filing status. The remaining percentage is called the “applicable percentage” and is used to calculate the allowable QBI, qualified W-2 wages, and qualified property basis of each SSTB, which are then used to calculate the wage and property limitation in Step 6.
For example, a married couple filing jointly with an SSTB that has taxable income before the QBI deduction of $350,000 has encroached into the phase-in range by 35% [($350,000 − $315,000) ÷ 100,000, giving the couple an applicable percentage of 65%. A single person that has taxable income before the QBI deduction of $200,000 has encroached into the phasein percentage by 85% [($200,000 − $157,500) ÷ 50,000], giving the single person an applicable percentage of 15%.
Now assume the couple above with an applicable percentage of 65% has an SSTB with QBI of $250,000. The allowable QBI after the SSTB limitation phasein is $162,500 (65% × $250,000); the tentative deductible amount is $32,500 (20% × $162,500). The couple must also reduce their share of W-2 wages and allowable property tax basis, multiplying these amounts by 65%, before applying the wage and property limitation in Step 6.
Step 6: Apply Wage/Property Limitation to All Activities
The wage and property limitation must be applied to all non-SSTBs with positive QBI amounts identified in Step 2 and all SSTB tentative deductions that have not been phased out in Step 5. This limitation is subject to a phasein for lower taxable incomes that is calculated the same way as the limitation in Step 5 for SSTBs; in other words, the limitation phasein is determined by the percentage that taxable income (before the QBI deduction) encroaches into the phasein range—$315,000–$415,000 for married filing jointly returns and $157,500–$207,500 for any other filing status.
The wage and property limitation limits the tentative deductible amount for each activity to the greater of 50% of qualified W-2 wages of the activity or 25% of qualified W-2 wages of the activity plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property.
The proposed revenue procedure in Notice 2018-64 is very specific about how actual W-2 wages are calculated and describes three allowable methods using specific boxes on Form W-2. Furthermore, the proposed regulations disallow any wages for this purpose that have not been reported on a proper Form W-2.
“W-2 qualified wages” means any wages described in paragraphs (3) and (8) of IRC section 6051(a) paid by an employer during the year. This includes elective deferrals and deferred compensation if subject to withholding under IRC sections 3101 or 3402. Once the amount of W-2 wages is determined, the proposed regulations require that the wages be allocated to a QBI activity according to how the wage deductions are allocated in calculating QBI. There are no related party restrictions, so wages paid from a closely held S corporation to an owner will qualify. Payments to a partner or to a sole proprietorship owner are never considered wages; however, a partner’s share of wages paid by the partnership to nonpartners will be included in qualified wages.
“Qualified property” includes any tangible property (personal or real) subject to depreciation (not land or intangibles) held at year-end and available for use if the depreciable period has not ended. Once the Modified Accelerated Cost Recovery System (MACRS) depreciable period ends, the property is no longer qualified. The depreciable period begins when the property is placed in service and ends at the end of the MACRS [not Alternative Depriciation System (ADS)] depreciable life or 10 years, whichever is later.
The proposed regulations emphasize that unadjusted basis is the original basis, not as reduced by MACRS depreciation or by any portion of the basis the taxpayer has elected to expense (e.g., IRC section 179 expense or bonus depreciation). Basis is reduced, however, for the percentage of the property not used for business.
The application of the wage and property limitation is fairly complicated and is best illustrated with a worksheet. Exhibit 4provides just such a worksheet, in conjunction with the below example.
Wage and Property Limitation Worksheet, Non-SSTB Activity
Assume a married couple filing jointly has QBI (non-SSTB activity) of $250,000, qualified W-2 wages in the activity of $20,000, and UBIA in qualified property of $5,000. Also assume that because the couple has taxable income (before the IRC section 199A deduction) of $350,000 in 2018, their applicable percentage is 65%. Calculate each activity’s tentative deductible amount separately and carry each tentative deductible amount after the wage and property limitation to Step 7.
Exhibit 5 illustrates the same calculation for QBI from an activity that qualifies as an SSTB. Assume the couple has QBI in an SSTB of $250,000, qualified W-2 wages in the activity of $20,000, and UBIA in qualified property of $12,000. Also assume that because their taxable income (before the IRC section 199A deduction) is $350,000, their applicable percentage is 65%. Again, calculate each activity’s tentative deductible amount separately and carry each tentative deductible amount after the wage and property limitation to Step 7.
Wage and Property Limitation Worksheet, SSTB Activity
Step 7: Calculate Tentative QBI Deduction
Then the tentative deductible amounts allowed (after the SSTB activity limitation and the wage and property limitation) from each QBI activity must be combined. This is the tentative deduction for the QBI component of IRC section 199A.
Step 8: Calculate REIT Dividend/PTP Income Deduction Amount
The next step is to separately net any qualified real estate income trust (REIT) dividends and qualified publicly traded partnership (PTP) income, including negative carryovers from prior years. Multiply the netted amount by 20% to reach the allowed REIT dividends and PTP deduction amount before the taxable income limitation in Step 9. If the combined qualified REIT dividend and PTP deduction amount is negative, do not net the negative amount with the QBI tentative deductible amounts calculated in Steps 1–7; instead, carry over the negative REIT dividend and PTP deduction amount to next year.
A qualified REIT dividend is defined in proposed Treasury Regulations section 1.199A-3(c)(2) as any dividend from a REIT that is not a capital gain dividend under IRC section 857(b)(3) or a qualified dividend under IRC section 1(h)(11). PTP income as defined in proposed Treasury Regulations section 1.199A-3(c)(3) means a partner’s allocable share of any item of income, gain, deduction and loss from PTP as defined in IRC section 7704(b) that is not taxed as a corporation under section 7704(a). It also includes any gain recognized by the taxpayer on the sale of a publicly traded partnership interest that is treated as ordinary income under IRC section 751(a).
Note that when calculating qualified PTP income, PTPs must determine and report QBI under the rules of IRC section 199A(c)(3) and (4) for any “qualified trade or business.” IRC section 199A(d) excludes an SSTB from the definition of a qualified trade or business; in fact, proposed Treasury Regulations section 1.199A-6(c)(1) specifically requires PTPs to separately report income from an SSTB in which the PTP is engaged. Although no examples exist in the proposed regulations, this strongly suggests that taxpayers are required to exclude SSTB income flowing from a PTP (if taxable income exceeds the phasein thresholds) in the same manner as in calculating SSTB income from other sources. A PTP must also determine whether it has received any qualified REIT dividends or qualified PTP income or loss from another PTP. These items must be reported on or with the Schedule K-1. A PTP is not required to determine or report W-2 wages or the UBIA of qualified property, because PTP income is not subject to these limitations.
Step 9: Calculate Final Section 199A Deduction
The final IRC section 199A deduction is the lesser of: 1) the combined tentative deductible amounts from QBI (calculated in Step 7) plus the aggregate REIT dividends and qualified PTP income deduction (calculated in Step 8), or 2) 20% of taxable income after subtracting net capital gain. Net capital gain is defined under IRC section 1(h).
Assume that the couple in Exhibit 5 (with taxable income of $350,000 and a tentative deductible amount after limitation of $23,400) has net capital gain of $5,000 and REIT dividends of $3,000. The allowable IRC section 199A deduction is $24,000—that is, the lesser of $24,000 ($23,400 + 20% of $3,000) or $69,000 [20% × ($350,000 − $5,000)].
Planning Considerations and Special Issues
Aggregation of activities.
The proposed regulations allow (but do not require) aggregating QBIs by commonly held business activities. This could be advantageous if a taxpayer’s wage and property limitations would otherwise reduce the IRC section 199A deduction.
Consider an unmarried individual who owns three non-SSTB business activities: Business X with QBI of $1,000,000 and W-2 wages of $500,000, Business Y with QBI of $1,000,000 and no W-2 wages, and Business Z with $2,000 of QBI and $500,000 of W-2 wages. None of the businesses have UBIA. Assume also the individual has no REIT dividends or PTP income and has taxable income over $3,000,000.
Business X has a tentative allowable deduction of $200,000 (the lesser of $1,000,000 × 20% or $500,000 × 50%). Business Y has no tentative allowable deduction because W-2 wages are zero. Business Z has a tentative allowable deduction of $400 (the lesser of $2,000 × 20% or $500,000 × 50%). Without an aggregation election, the individual has a total section 199A deduction of $200,400, which is not limited by taxable income. If, however, the individual elects to aggregate the three activities into one activity, then the total section 199A deduction is $400,400 (the lesser of $2,002,000 × 20% or $1,000,000 × 50%).
Aggregation is generally allowed if the same person or group of persons owns directly or indirectly 50% or more of each trade or business to be aggregated for the majority of the year, none of the aggregated business is an SSTB, and the trades or businesses exhibit at least two of the following three factors:
- The businesses provide products or services that are the same.
- The businesses share facilities or centralized business elements.
- The businesses are operated in coordination with or in reliance on the other businesses in the aggregated group.
For purposes of the 50% ownership rule, an individual is considered to own the interests of his spouse, children, parents, and grandchildren. Once the election is made, it is binding in all future years.
Previously deferred losses.
The proposed regulations require that the IRC section 199A deduction be calculated on business income after other limitations in the tax code are applied. This means that the passive loss rules, at-risk limitations, partnership basis limitations, and S corporation basis limitations are applied first.
Fortunately, any deferred losses occurring before January 1, 2018, do not affect QBI when they are later allowed. Unfortunately, losses that are incurred on January 1, 2018 or later must be included in QBI when they are ultimately recognized.
IRC section 199A deductions only affect taxable income. The deduction does not reduce self-employment tax under IRC section 1402 or net investment income tax under section 1411.
IRC section 199A provides a tax savings opportunity previously unavailable to owners of pass-through activities; however, it is a complicated provision with limited current guidance beyond the statutory language of the code section and the proposed regulations.
Alternative minimum tax.
Proposed Treasury Regulations section 1.199A-1(e)(4) clarifies that the QBI deduction for regular tax will be the same deduction for AMT without adjustment.
Anti-abuse provision to prevent reclassification of employees.
Proposed Treasury Regulations section 1.199A-5(d)(3) states that former employees who were reclassified to appear as independent contractors will still be treated as employees for purposes of IRC section 199A. This anti-abuse provision will eliminate the opportunity to restructure many employee relationships to take advantage of the pass-through deduction.
Anti-abuse provision to prevent back-loading qualified property acquisitions.
Proposed Treasury Regulations section 1.199A-2(c)(1)(iv) states that property does not qualify for the wage and property limitation if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the IRC section 199A deduction.
S corporation wages to owners.
There is a trade-off when paying an S corporation owner W-2 wages: the higher the wages to the owner, the higher the wage and property limitation, but the lower the QBI from the S corporation to the owner. Tax planners with S corporation clients should consider this trade-off.
Smoothing the Process
IRC section 199A provides a tax savings opportunity previously unavailable to owners of pass-through activities; however, it is a complicated provision with limited current guidance beyond the statutory language of the code section and the proposed regulations. It is important for tax professionals to understand this provision thoroughly and think about how it applies to specific clients.