Many private companies will benefit from the new Tax Cuts and Jobs Act thanks to a key provision of the law that provides certain private businesses with a 20 percent deduction for certain qualified pass-through business income.
The deduction is covered under Section 199A of the Internal Revenue Code. The proposed regulation came out in August of 2018, and the rules for implementing the deduction were finalized in January. However, we can expect to see some further clarifications and updates to tax preparation software for at least the next few months.
Financial Executives International’s Committee on Private Companies has been an active advocate for clarity on this new portion of the law. During a recent FEI webinar, tax specialists who are partners at Ernst & Young discussed what’s been learned to date and what challenges remain.
“For every hour of tax simplification that occurred to individuals on the lower end (with the elimination of some deductions and the record keeping for them), that same complexity was added on the higher end for large family companies and large family businesses,” said David Kirk, a partner within the private client services practice at Ernst & Young LLP’s national tax department.
“This is much more complex and requires much more record keeping for the pass-through type entities. Taking the corporate rate from 35 percent to 21 percent was pretty easy, but this pass through is much more complicated,” said Steve Harpole, private client services tax leader for the Central region at Ernst & Young LLP.
“Everything you probably thought would never be on the table is on the table to think about,” said Bobby Stover, Americas family business tax leader at Ernst & Young LLP.
The top corporate tax rate was cut from 35 percent to 21 percent, but the number of businesses operating in pass-through forms greatly outnumbered the number of corporations. So, the government attempted to use the Section 199A deduction to provide some parity, according to Kirk. The regulation provides a 20 percent deduction for some preferential items.
Section 199A deduction details
There are basically two baskets for the Section 199A deduction. The basket for ordinary Real Estate Investment Trust (REIT) dividends and publicly traded partnership income is relatively straightforward.
However, much more complexity comes in when calculating the amount for the other basket, Qualified Business Income. QBI includes a taxpayer’s qualified income, gain, deduction and loss connected with the conduct of a trade or business within the United States, including Puerto Rico. For purposes of the deduction, the income includes any earned through partnerships, sole proprietorships and S corporations, with QBI calculated for each of the taxpayer’s qualified trades or business.
Excluded from the QBI calculation are qualified REIT dividends, certain investment income including, but not limited to interest, capital gains or losses, and gains or losses for certain commodities, foreign currency and notional principal contract transactions.
Also excluded from QBI are:
- Reasonable compensation paid to the taxpayer by any qualified business for services rendered, and
- Guaranteed payments to a partner for services rendered
With each of the above, the payment lowers the income for the trade or business.
So first, you have to determine what is qualified business income, then you have to make certain calculations in this basket on a business-by-business basis.
Some private companies have multiple separate businesses, some of which work closely together or use the same support infrastructure, while also having other businesses that are in completely different industries, resulting in multiple complex calculations.
Aggregation considerations
The IRS has allowed for some simplification by allowing a taxpayer to aggregate some of these calculations together. But the aggregation isn’t as simple as it might seem at first glance.
“I can think of a family that has a giant family partnership with many operating companies underneath,” Kirk said. “They have hundreds of K1s feeding into each one of them and they issue hundreds of K1s to others. There are thousands of calculations that are required for this potential benefit.”
Some private companies may benefit from the aggregation, but others may not. So the total effect on taxes needs to be considered. You cannot elect to aggregate for some businesses and not for others.
There are considerations for supply chains and other linked businesses as well. The businesses aggregated for tax purposes have to be integrated in some fashion. For example, a restaurant and a caterer may share some facilities, or there might be some supply-chain interdependencies among the businesses. However, once you make an election to aggregate the businesses for purposes of the deduction, you cannot disaggregate them down the road. You have to think about how these elections affect the tax liability in the current year and in the future.
The only reason to aggregate is to get the maximum Section 199A deduction. But some businesses could have a situation where there is no benefit, so there is no reason to aggregate the data.
Another consideration is that the business may not be able to take the QBI loss in the current year, and that loss is carried forward to the next year, so you have to look at these losses on a trade or business by trade or business basis, making the exercise much more complicated.
Questions remain
With the IRS not determining the final rules for the deduction until the end of January, the tax software is still struggling to catch up. So, it is important to review everything closely to ensure the software makes the expected calculations. “See what the software produces,” said Stover. “Is it in a reasonable range? The onus is on the tax preparers and tax advisers and companies to ensure everything is correct.”
With all of the complexities involved, companies that typically file before the deadline may want to wait until the deadline itself or file for an extension. Doing so will let the tax preparation software incorporate some of the Section 199A calculations, details and additional information that have yet to be included.
The IRS can provide numerous examples for the Section 199A deduction, but these examples do not cover every situation. For example, the treatment of Section 1231 gains and losses have yet to be finalized.
Additionally, the IRS has yet to precisely define all of the nuances of the deduction; some of these determinations may be made before the extended filing deadline.
Though the IRS clarified most of the major items, there are still numerous holes in the tax treatment of some items that may not be clarified for some time.
