IRS Issues Proposed Regulations Under Section 199A

Section 199A of the Internal Revenue Code of 1986, as amended (the "Code"), has become one of the most talked-about provisions of the Tax Cuts and Jobs Act of 2017. This section allows individuals, trusts, and estates a deduction of up to 20% of their "qualified business income" from sole proprietorships, partnerships, and S corporations if certain requirements are satisfied. For taxpayers who own businesses independently or through pass-through entities, this new deduction could provide significant tax savings beginning this year.

Although the deduction has been discussed at length, the language of the statute raised a number of questions regarding the calculation and applicability of the deduction. To address these questions, the IRS recently issued proposed regulations under Section 199A (the "Regulations"). The stated purpose of the Regulations "is to provide taxpayers with computational, definitional, and anti-avoidance guidance regarding the application of section 199A."

Below is a summary of the issues raised by practitioners and some of the guidance provided by the Regulations:

What is a trade or business?

The Section 199A deduction is available only with respect to qualified business income of a taxpayer's trade or business. Section 199A does not define the term "trade or business," and this phrase is interpreted differently in various sections of the Code. The Regulations clarify that a "trade or business" means a trade or business as defined under Section 162 of the Code. Such a standard is familiar to practitioners and is the subject of extensive guidance intended to assist taxpayers in its application. However, this guidance emphasizes that whether an activity is a "trade or business" is a facts and circumstances issue. Accordingly, in some areas there may be no clear test for determining whether an activity is a trade or business. In addition, solely for purposes of Section 199A, a trade or business generally includes any rental or licensing of property that would not be a trade or business under Section 162, if the property is rented or licensed to a commonly controlled trade or business (as determined under the aggregation rules discussed below).

Is being an employee a qualified trade or business?

Being an employee is not a qualified trade or business for purposes of Section 199A. Because of this, commentators speculated as to whether it would be more beneficial for employees to be reclassified as independent contractors, as compensation received by an independent contractor could qualify for the Section 199A deduction. The Regulations, however, provide that whether a taxpayer is an employee for Section 199A is not controlled by whether the payor of the compensation treats the taxpayer as an employee or an independent contractor. Rather, the Regulations provide that, solely for purposes of Section 199A, an individual who was properly treated as an employee for federal employment tax purposes and is now treated as other than an employee, despite performing substantially the same services, is presumed to be an employee.

What is "qualified business income"?

Qualified business income (QBI) is the net amount of qualified items of income, gain, deduction, and loss with respect to a trade or business of the taxpayer. QBI includes (1) the amount of any Section 481 adjustment arising in 2018 or later years, (2) disallowed losses arising in 2018 or later years, and (3) any loss items under Section 1231. QBI generally does not include (1) net operating loss, (2) the amount of any Section 481 adjustment arising in 2017 or prior years, or (3) any disallowed losses arising in 2017 or prior years.

QBI also does not include:

• income attributable to guaranteed payments for the use of capital;
• reasonable compensation received by an S corporation shareholder;
• a guaranteed payment or a payment under Section 707(a) received by a partner for services rendered;
• any short-term or long-term capital gain or loss (including any gains under Section 1231);
• any dividend or payment equivalent to a dividend; and
• any interest or annuity income (except to the extent it is properly allocable to a trade or business).

Note that while guaranteed payments and reasonable compensation are not included in the recipient's QBI, the deduction attributable to such payments is included in calculating the payor's QBI, provided such amount is properly allocable to the trade or business and otherwise deductible.

How is the W-2 wage limitation calculated?

If the taxpayer has income in excess of certain amounts, the Section 199A deduction may be limited by the amount of wages with respect to the trade or business. To qualify, the W-2 wages must be reported on a Form W-2 and Form W-3, Transmittal of Wage and Tax Statements. On an acquisition or disposition of a trade or business, the wages are allocated based on the period during which the employees of the acquired or disposed-of trade or business were employed by the individual or entity.

Prior to the issuance of the Regulations, practitioners expressed concern as to whether wages paid and reported by another entity (for example, a management company) would be considered as wages paid in connection with the operating entity's trade or business. The Regulations provide that a taxpayer can take into account wages paid and reported by another person, provided that the wages are paid to common law employees or officers of the individual or pass-through entity for employment by the individual or pass-through entity and provided that the reporting person does not take such wages into account. Under current law, it is not entirely clear whether a management company would constitute a common law employer; this determination would depend on the facts and circumstances of the employment arrangement. This problem is eliminated if the taxpayer qualifies for aggregation of its trades and businesses, as discussed below.

How is the property basis limitation calculated?

If the taxpayer has income in excess of certain amounts, the Section 199A deduction may be limited by the unadjusted basis immediately after acquisition (UBIA) of property used in the trade or business. Prior to the issuance of the Regulations, Section 199A(f)(1)(A) merely stated that a partner's allocable share of the basis would be based on his or her share of depreciation. The Regulations specify that a partner's share of UBIA is equal to the partner's share of tax depreciation with respect to the subject property (or, if the property is no longer depreciable, each partner's share of gain on a hypothetical sale of the property).

The Regulations also adopt an anti-abuse rule. Specifically, the Regulations provide that property is not considered qualified property for purposes of calculating UBIA if it is (1) acquired within 60 days of the end of the year, (2) disposed of within 120 days, and (3) is not used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the transaction was other than obtaining the benefits of the Section 199A deduction.

How is the property basis limitation calculated if a trade or business acquires property in a non-taxable transaction?

Generally, individuals and pass-through entities can acquire property in non-taxable transactions under Section 1031 (like-kind exchanges), Section 721 (contributions to partnerships), Section 731 (distributions from partnerships), and Section 351 (contributions to corporations). Under Section 199A, qualified property is tangible property for which the depreciable period has not ended before the close of the taxable year (regardless of any additional first-year depreciation). Typically, this is cost basis; however, the results change in non-taxable transactions:

For property contributed to a partnership in a Section 721 transaction, UBIA is the property's carry-over basis (i.e., the adjusted basis of the property in the hands of the contributing partner).

For property distributed by a partnership in a Section 731 transaction, UBIA is the property's carry-over basis (i.e., the adjusted basis of the property in the hands of the distributing partnership).

For property contributed to an S corporation in a Section 351 transaction, UBIA is the property's carry-over basis (i.e., the adjusted basis of the property in the hands of the contributing shareholder).

For property exchanged in a Section 1031 transaction, UBIA is the property's carry-over basis (i.e., the adjusted basis of the property in the hands of the transferor).

As a result of the carry-over basis rule, a property recipient may "lose" basis for UBIA purposes. While the transferor owns the property, the property's UBIA will be the transferor's cost basis (even if the transferor is depreciating the property). Once the property is transferred in one of the above tax-deferred transactions, the transferee will need to use the lower adjusted basis (i.e., cost basis adjusted for depreciation and other deductions) to calculate the property's UBIA.

What if a taxpayer engages in more than one trade or businesses?

Unless the taxpayer can aggregate its trades or businesses, as discussed below, each trade or business is separate for purposes of applying the W-2 wage limitation or the UBIA limitation. The Regulations provide that items of income, gain, deduction, and loss must be allocated among several trades or businesses "using a reasonable method based on all the facts and circumstances." The chosen method must be applied consistently for each year.

When can a taxpayer aggregate its trades or business?

Prior to the issuance of the Regulations, it was unclear how the W-2 wage limitation and the UBIA limitation would apply to taxpayers conducting multiple lines of business or one line of business through multiple entities. The Regulations allow taxpayers to aggregate their trades or businesses in certain circumstances. To qualify for aggregation,

1. The same person or group of persons must own 50% or more of each trade or business;
2. The ownership described in (1) must exist for a majority of the taxable year in which the aggregation is to occur;
3. All of the trades or businesses being aggregated are reported on returns with the same taxable year;
4. None of the trades or businesses is a specified service trade or business (discussed below); and
5. The trades or businesses to be aggregated satisfy at least two of the following factors:
   1. the trades or businesses provide products and services that are the same or customarily offered together;
   2. the trades or businesses share facilities or significant centralized business elements (i.e., personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology); or
   3. the trades or businesses are operated in coordination with, or reliance upon, one or more of the other trades or businesses in the aggregated group (for example, supply chain interdependencies).

If businesses are aggregated, then the W-2 wages paid or UBIA with respect to all of the businesses are used to calculate the W-2 wage or UBIA limitation for QBI from all of the aggregated trades or businesses. For purposes of determining control, family attribution rules apply. Once a taxpayer elects to aggregate trades or businesses, they must be aggregated in all subsequent years, although the taxpayer can add new businesses to an existing aggregated group. Reporting requirements apply to a taxpayer's aggregation of trades or businesses.

What is a specified service trade or business?

A "specified service trade or business" (SSTB) is a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services; where the principal asset of the business is the reputation or skill of one or more of its employees; or which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. If a taxpayer has income in excess of certain thresholds, no Section 199A deduction is available with respect to QBI from an SSTB, regardless of the wages paid by the SSTB or the SSTB's UBIA. SSTBs include the following:

• Health services include the provision of services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other, similar healthcare professionals who provide medical services directly to a patient in their capacity as such. Health services do not include the provision of such services as the operation of a health club or health spa or the research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.
• Legal services include the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals in their capacity as such. Legal services do not include the provision of such services as printing, delivery, or stenography.
• Accounting services include the provision of services by accountants, enrolled agents, return preparers, financial auditors, and similar professionals in their capacity as such.
• Actuarial science services include the provision of services by actuaries and similar professionals in their capacity as such.
• Performing arts services include the provision of service by actors, singers, musicians, entertainers, directors, and similar professionals in their capacity as such. Performing arts services do not include the maintenance and operation of equipment or facilities for use in the performing arts or the broadcast or dissemination of video or audio of the performing arts.
• Consulting services include the provision of professional advice and counsel to clients to assist the clients in achieving goals and solving problems, as well as lobbying and similar services. Consulting services do not include sales or economically similar services or the provision of training and educational courses.
• Athletic services include the provision of services by athletes, coaches, and team managers. Athletic services do not include the maintenance and operation of equipment and facilities for use in athletic events or the broadcast or dissemination of video or audio of athletic events.
• Financial services include the provision of services by financial advisors, investment bankers, wealth planners, retirement advisors, and other, similar professionals in their capacity as such. Specifically, financial services include services such as managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, providing advisor and similar services regarding valuations, mergers, acquisitions, dispositions, restructurings, or raising financial capital, or acting as a client's agent in the issuance of securities and similar services.
• Brokerage services include the provision of services by stock brokers and other, similar professionals in their capacity as such. Specifically, a brokerage service is a service in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee. Brokerage services do not include services provided by real estate agents or insurance agents.
• Investing and investment management services include the provision of services such as investing, asset management, or investment management, including the provision of advice with respect to buying and selling investments. Investing and investment management services do not include the direct management of real property.
• Trading services include the provision of services of trading in securities, commodities, or partnership interests.
• Dealing services include the regular purchase of securities, commodities, or partnership interests from, and sale of securities, commodities, or partnership interests to, customers in the ordinary course of business, or the regular offering to enter into, assume, offset, assign, or otherwise terminate positions in securities, commodities, or partnership interests with customers in the ordinary course of business.
• In addition, Section 199A defines SSTB to include a trade or business where the principal asset is the reputation or skill of one or more employees or owners. The Regulations limits this prong of the definition to (1) the receipt of fees, compensation, or other income for endorsing products or services; (2) the receipt of fees, compensation, or other income for the use of an individual's image, likeness, name, signature, voice, trademark, etc.; and (3) the receipt of fees, compensation, or other income for appearing at an event or on radio, television, or another media format. Because the definition is limiting, this is a fairly taxpayer-friendly provision. Note that the phrase "fees, compensation, or other income" includes amounts received as distributions from a partnership or an S corporation.

What if a taxpayer's business is partly an SSTB?

• De Minimis Rule: The Regulations provide a de minimis rule for situations where only a minimal part of a taxpayer's trade or business is an SSTB. Specifically, a trade or business will not be treated as an SSTB if (1) the trade or business has gross receipts of $25,000,000 or less for the year and (2) less than 10% of the gross receipts of the trade or business is attributable to an SSTB. If the trade or business has gross receipts of more than $25,000,000, the de minimis rule still applies, but the gross receipts of the trade or business attributable to an SSTB cannot exceed 5%.
• Anti-Avoidance Rule: Prior to the issuance of the Regulations, commentators discussed whether an SSTB, such as a law firm or an accounting firm, could spin out its non-SSTB business functions in order to claim the Section 199A deduction with respect to the non-SSTB business. The Regulations attempt to deter this conduct by providing that an SSTB also include any trade or business that (1) provides 80% or more of its property or services to an SSTB and (2) is 50% or more commonly owned. In determining common ownership, related party attribution applies. The Regulations also provide, however, that a trade or business that has 50% or more common ownership with an SSTB and has shared expenses (including wage or overhead expenses) will not be treated as an SSTB if the gross receipts of the non-SSTB trade or business are no more than 5% of the total combined gross receipts of the SSTB and non-SSTB trades or businesses.

What is the effect of the Section 199A deduction on other Code provisions?

Prior to the issuance of the Regulations, the effect, if any, that the Section 199A deduction would have on certain other tax provisions was unclear. The Regulations confirm that the deduction does not affect a partner or shareholder's basis or an S corporation's accumulated adjustments account. The Regulations also confirm that the deduction does not reduce net earnings from self-employment or net investment income.