On August 8th, the IRS released its much-awaited Proposed Regulations on the new Section 199A 20% profit deduction for pass-through businesses. The new deduction applies to essentially all types of businesses other than C corporations, and was created under the 2017 Tax Cuts and Jobs Act. Individuals can begin claiming the deduction on their upcoming 2018 tax returns. The Proposed Regulations issued by the IRS, and released through Announcement IR-2018-162, provide important guidance to taxpayers and tax practitioners alike on this new federal income tax deduction.
The Proposed Regulations state that Congress enacted section 199A to provide individuals, estates, and trusts with a deduction of up to 20 percent of “Qualified Business Income” (QBI) from domestic businesses, which includes trades or businesses operated as a sole proprietorship or through a partnership, S corporation, trust, or estate. The IRS observes in the Proposed Regulations that Congress provided this tax benefit to sole proprietorships and owners of other “pass-through entities” because these business owners and beneficiaries do not benefit from the substantial corporate income tax rate reduction afforded to C corporations under the 2017 Tax Cuts and Jobs Act.
The Proposed Regulations affirm that an individual business owner or owner of a pass-through business entity is “entitled” to a Section 199A deduction generally equal to the lesser of (i) 20 percent of the taxable profit of a business (generally defined as the active net income of a business) or (ii) 20 percent of the excess of the individual’s taxable income over his/her net capital gains.
However, and as the Proposed Regulations carefully note, the new Section 199A deduction will not apply to everyone, and limits do apply. Specifically, married individuals with taxable income of less than $315,000 and individual filers with less than $157,500 in taxable income may largely claim the deduction without restriction. “Phase-out” rules then begin to apply, however, as taxable income rises to $415,000 for joint filers and $207,500 for individual filers. Above these higher “phase-out” taxable income limits, many “service providers” will not receive the deduction at all (e.g. doctors, lawyers, athletes, stock brokers), while others may still be eligible but only where 20% of the QBI from a business is more than the greater of either (1) 50% of the W-2 wages of the business allocable to the owner, or (2) 25% of these W-2 wages plus 2.5% of the unadjusted tax basis in certain depreciable property of the business. Thus, businesses without employees or depreciable assets may not qualify as well.
In interpreting new Section 199A under the Proposed Regulations, the IRS expressed concern that many individuals and businesses will seek to “structure their affairs” based on the new tax law. In this regard, the IRS observes that “[a]n economically efficient tax system generally aims to treat income derived from similar economic decisions similarly in order to reduce incentives to make choices based on tax rather than market incentives.” The Proposed Regulations under Section 199A are designed to “provide a uniform signal to businesses and thus lead taxpayers to make decisions that are more economically efficient contingent on the overall [tax] Code.”
The Proposed Regulations provide helpful interpretive guidance concerning the Section 199A 20% profit pass-through deduction in a number of important areas, including:
- Income Thresholds, Phase-Out, and Limits. The Proposed Regulations provide clear guidance and the taxable income levels where the deduction may largely be claimed without restriction; the “gray area” of the “phase-out” where some of the deduction may be available, but not all of it; and the top-end taxable income limits which define the line where many now will not qualify for the deduction and where others may qualify but only if they employ W-2 workers or have certain depreciable property in their business.
- The Definition of “Qualified Business Income”. The Proposed Regulations provide important definitions now for this essential component of the deduction – the “profit” of a business on which the 20% deduction is based. Income which is excluded from Qualified Business Income, and which therefore reduces the amount of the potential deduction, is identified and also defined. The Proposed Regulations define “Specified Service Trade or Business” income, which is also excluded from Qualified Business Income.
- W-2 Wages and Basis in Property. The Proposed Regulations provide guidance on wages and other compensation that will be considered for purposes of the “50% W-2 limit/25% W-2 limit” on the 20% profit deduction, and also provide a new definition for “unadjusted basis immediately after acquisition” (UBIA) for qualifying depreciable property of a business.
- Professional Employer Organizations. Perhaps one of the biggest “winners” under the Proposed Regulations are Professional Employer Organizations (PEO), and specifically “Certified Professional Employer Organizations” (CPEO). PEOs and CPEOs are essentially employee-leasing businesses which pay wages and report and pay taxes on wages on behalf of workers for their clients. The Proposed Regulations specifically identify CPEOs (and also identify PEOs in the preamble “Explanation”) and state that a taxpayer/client which engages such an organization to handle its employer wages and payroll tax reporting/payment can still qualify to include the W-2 wages paid to these employees for purposes of determining the “50% W-2 limit/25% W-2 limit” on the 20% profit deduction; conversely, however, if the taxpayer/client can receive the benefit of including the wages for purposes of testing the deduction limits, the PEO/CPEO cannot.
- Aggregation. The Proposed Regulations importantly recognize that individuals who own interests in different businesses may “aggregate” or combine these businesses for purposes of computing Qualified Business Income and the related 20% profit deduction. An example provided in the Proposed Regulation shows how aggregation can result in a higher deduction given the facts.
- S Corporations and Reasonable Compensation. The Proposed Regulations importantly identify that S corporations may pay compensation to owner/employees, that “reasonable compensation” paid by the S corporation to an owner/employee remains fully deductible by the S corporation, but that the compensation is not “added back” to Qualified Business Income. The Proposed Regulations state that partnerships (including LLCs and other business entities taxed as partnerships) must generally treat “guaranteed payments” to owners in the same manner, although the IRS will not apply “reasonable compensation” standards to these guaranteed payments.
- Trusts and Estates. The Proposed Regulations contain guidance, including examples, on how trusts and estates, including their beneficiaries, may qualify for the deduction (or not) and under what circumstances. Helpful guidance and comparisons are provided for grantor trusts and non-grantor trusts.
Additional and further blog posts will be coming out shortly covering each of the above major areas addressed in the Proposed Regulations. Stay tuned!
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