Plumbing the mysteries of Section 199A
One of the most convoluted sections of the Tax Cuts and Jobs Act is new Section 199A, which provides a 20 percent deduction on “qualified business income” of a qualified business, operated directly as a sole proprietorship or as a pass-through entity.
“The Section 199A deduction is one of the cornerstones of the Tax Cuts and Jobs Act,” said Mark Friedlich, senior director of global content assets at Wolters Kluwer Tax & Accounting NA. “This is an important deduction against income tax of up to 20 percent of qualified business income from a domestic business operated as a sole proprietorship, partnership, S corporation, trust or estate. Congress intended that Treasury provide detailed guidance with respect to the complex deduction,” he said. “The IRS recently issued these proposed regulations and a notice intended to provide more clarity and detail around the new tax provision.”
“Under the TCJA, QBI eligible for the deduction is all ordinary income earned in a trade or business, but it does not include shareholder wages, guaranteed payments or capital gains, even if they are earned from a pass-through entity,” Friedlich said. “The 199A deduction may be taken by eligible taxpayers for the first time on their 2018 federal income tax return to be filed in 2019. In the meantime, taxpayers may rely on the rules in the proposed regulations until final regulations are published in the Federal Register.”
The IRS has indicated that taxpayers involved in health, law, accounting, actuarial sciences and certain other professions do not get any 199A deduction once their income exceeds a specific threshold, he noted. “All others do not have this limitation. In any case, calculations for the deduction are complex and need to be carefully computed to avoid what will certainly be a target on audit.”
A look at the regs
While the Section 199A pass-through regulations proposed in August 2018 are not the last word on the subject, they clarify a number of areas and offer tax professionals a sense of direction on what might be to come. And with the comment period ending and a public hearing scheduled for Oct. 18, 2018, it is likely that more certainty will be available by the end of the year.
The Blue Book itself may provide some additional explanations for Section 199A, according to Jim Brandenburg, a tax partner at Top 100 Firm Sikich. It is produced by the Joint Committee on Taxation and attempts to clarify newly enacted tax legislation.
“The Blue Book is often used by the IRS in coming up with regulations and guidance,” he said. Initially, the Joint Committee hoped to have the Blue Book for the Tax Cuts and Jobs Act out by the end of the summer, but as Accounting Today went to press, it had yet to be released.
“Having some guidance is helpful,” said Brandenburg. “We’ll see what they come up with in the final regs. There are some questions regarding the aggregation rules. I have seen many groups offer comments to the IRS in advance of the hearings on the proposed regulations. Each group is trying to get the IRS to modify or clarify what will be in the final regulations to obtain the best tax treatment under Section 199A for their group or organization.”
“In general, the proposed rules are taxpayer-friendly, but there is a lot of complexity and nuances that are more involved, like the aggregation rules,” agreed Ryan Bryker, tax senior manager at Top 100 Firm Rehmann. “[Real estate investment trust] dividends and [publicly traded partnership] income are grouped separately from other activities,” he said.
“It will be a relatively painless process for doing the taxes for our generic plain-vanilla clients,” he said. “But some of our more complex clients — those with multiple trades or businesses or a more complicated structure — will require a much deeper analysis. There will be analysis and decisions to be made on how companies or business units are grouped to get the most beneficial treatment, and it will differ based on facts and circumstances.”
“For example, if there are several business units under one filing, there could be companies that have losses that you may or may not want to exclude from the aggregation to maximize the deduction based on wage limitations,” he said. “There’s not going to be a one-size-fits-all solution.”
The Treasury and IRS did a good job of responding to practitioner concerns, according to Jerry August, shareholder and chair of the Philadelphia federal tax practice at law firm Chamberlain Hrdlicka.
“The proposed regulations cover important definitional, computational and anti-avoidance guidance,” he said. “However, there are still open issues. There are a lot of weeds in these regulations.”
The proposed regulation addresses “stuffing,” in which high-cost property is stuffed into a qualified trade or business to calculate the 2.5 percent test at the end of the year.
The proposed regulations permit, but don’t require, individuals to aggregate related businesses into one activity, explained Howard Wagner, a partner at Top 10 Firm Crowe: “An individual is permitted to aggregate trades or businesses operated directly and trades or businesses operated through pass-through entities. Assume a taxpayer owns two pass-through entities that are an integrated business. Each one on its own is a business that qualifies for the pass-through entity deduction. Pass-through entity No. 1 has high profits and low wages. Pass-through entity No. 2 has low profits and high wages. The aggregation rules allow the individual to aggregate the two separate trades or businesses to maximize the benefits of the 20 percent deduction.”
The regs also contain some of the anti-abuse provisions expected by many practitioners, Wagner indicated.
“These anti-abuse provisions prevent service providers who are ineligible for the 20 percent deduction from separating their businesses into separate entities to take advantage of the 20 percent deduction,” he said. “For example, the owners of an accounting firm can’t get the 20 percent deduction for income generated by leasing a building from a separate entity back to the accounting firm.”
“The proposed regulations also clarify that you can count wages paid to your employees even if the wages are reported by someone else under a payroll agent relationship,” Wagner noted. “This is favorable to taxpayers, and it is not provided for in the statute.”
Lastly, the proposed regulations attempt to narrow the scope of service businesses that are ineligible for the pass-through entity deduction, according to Wagner.
“The definition of an ineligible consulting business has been limited to businesses that provide advice and counsel,” he said. “Along the same lines, the definition of a business that is ineligible for the 20 percent deduction has been narrowed to include only those businesses that provide endorsement services or receive income from licensing an individual’s image, likeness, voice, etc.”