[Tax Alert] IRS proposes regulations on the pass-through business income deduction

The Internal Revenue Service ("IRS") recently released the highly anticipated proposed regulations for the Section 199A deductions — allowing for the deduction of up to 20% of trade or business income of self-employed individuals and pass-through entities. While nothing has been finalized, the proposed regulations give tax payers a sense of what’s to come. Read on to learn about the deduction and strategize ways to maximize its benefit under the 2017 tax law.

What is the deduction?

For tax years beginning in 2018 and ending in 2025, the deduction – known alternatively as the pass-through deduction, the Section 199A deduction, or the QBI deduction – can be up to 20% of a pass-through entity owner’s qualified business income (“QBI”), subject to restrictions that can apply at higher income levels and another restriction based on the owner’s taxable income. For QBI deduction purposes, pass-through entities are defined as sole proprietorships, single-member (one owner) LLCs that are treated as sole proprietorships for tax purposes, S corporations, partnerships, and LLCs that are treated as partnerships for tax purposes.

Who is eligible?

The QBI deduction is available only to individuals, estates and trusts. The newly proposed regulations refer to all three as “individuals.” Only a “trade or business” is eligible for the QBI deduction. The proposed regulations adopt the Internal Revenue Code Section 162 definition of a trade or business. And, while there is much case law under Section 162 which strives to define “trade or business," it isn’t always clear. This is one aspect of the proposed regulations which, we hope, will be clarified further in the final version.

How does the phase out work? 

The proposed regulations supply operational rules for determining allowable QBI deductions, including how to apply the phaseout rules that can reduce or eliminate QBI deductions for individuals with taxable income (calculated before any QBI deduction) that exceeds the phaseout threshold of $157,500 ($315,000 for married joint filers). Phaseout is complete when an owner’s taxable income reaches $207,500 ($415,000 for married joint filers). At that point: 

1. QBI deductions for a nonservice business must be based on the business’s W-2 wages or its W-2 wages plus the basis of qualified property used in the business, and
2. no QBI deduction can be claimed based on income from a specified service trade or business (“SSTB”).

Are there deduction limitations? 

When an individual owns interests in several qualifying non-SSTB businesses, the individual can choose to aggregate and treat them as a single business for purposes of:

• Calculating QBI, and,
• Calculating the QBI deduction limitation based on either a) 50% of W-2 wages paid by a business to generate QBI or b) 25% of such W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of qualified property used to generate QBI.

In any case, the deduction can’t exceed 20% of QBI, and it can’t exceed 20% of the individual’s taxable income calculated before:

1. any QBI deduction and
2. any net capital gain amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends). 

The proposed regulations and an accompanying draft Revenue Procedure explain how to calculate a business’s W-2 wages for purposes of applying the QBI deduction limitations and how to allocate wages across multiple related trades or businesses. The guidance also makes it clear that wages paid by a third party on behalf of a trade or business may be attributed to that trade or business for purposes of calculating the limitation.

A business’s UBIA generally equals the original cost of the property. Qualified property is defined as depreciable tangible property, including real estate, that:

1. Is owned by a qualified business as of the tax year-end,
2. Is used by the business at any point during the tax year for the production of QBI, and
3. Hasn’t reached the end of its depreciable period as of the tax year-end.

Surprisingly, in defining UBIA the regulations exclude basis step-ups on transfers of partnership interests. Additionally, for property received in a Section 1031 exchange, UBIA includes only the remaining basis of the relinquished property plus any additional funds invested in the replacement property.

What is the benefit of aggregating businesses?

Aggregating businesses can allow an individual with higher taxable income to claim a larger QBI deduction when the limitations based on W-2 wages and the UBIA of qualified property would otherwise reduce or eliminate the allowable deduction. For instance, if a high-income individual owns an interest in one business with high QBI but little or no W-2 wages and an interest in another business with minimal QBI but significant W-2 wages, aggregating the two could result in a healthy QBI deduction. Keeping them separate could result in a lower deduction or maybe no deduction at all. However, certain tests set forth in the proposed regulations must be passed for businesses to be aggregated. Also, it’s important to remember that an specified service trade or business (“SSTB”) cannot be aggregated with any other business, including another SSTB.

What are specified service trades or businesses

In general, an SSTB is a trade or business that performs services in one or more of the following fields:

• Health,
• Law,
• Accounting,
• Actuarial science,
• Consulting,
• Financial, brokerage, investing or investment management,
• Trading,
• Performing arts, and
• Athletics.

In addition, the law passed last year stated that an SSTB can be any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. This rather open-ended definition might have eliminated the deduction for almost any business such as a restaurant with a well-regarded chef.

The proposed regulations very narrowly limit this definition to trades or businesses that meet one or more of the following descriptions:

• One in which a person receives fees, compensation or other income for endorsing products or services,
• One that licenses or receives fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark or any other symbol associated with that individual’s identity, or
• One that receives fees, compensation or other income for appearing at an event or on radio, television or another media format.

The proposed regulations attempt to define SSTBs. The status as an SSTB is important because QBI deductions based on SSTB income begin to be phased out after an individual’s taxable income (calculated before any QBI deduction) exceeds $157,500 ($315,000 for a married joint filer). The proposed regulations also include an anti-abuse rule intended to prevent service business owners from separating out parts of what otherwise would be an integrated SSTB, such as a law firm putting ownership of the building it operates from into a partnership and renting it back in an attempt to qualify the separated part for the QBI deduction.

Are there notable QBI deduction issues?

The proposed regulations supply guidance on when QBI deductions can be claimed based on qualified income from publicly traded partnerships (“PTPs”) and qualified dividends from real estate investment trusts (“REITs”).

Finally, the proposed regulations include special computational and reporting rules that pass-through entities, PTPs, trusts and estates may need to follow to provide their owners and beneficiaries with the information necessary to calculate allowable QBI deductions at the owner or beneficiary level.

What don’t the proposed regulations address?

While the proposed regulations address many taxpayer and practitioner questions, and contain many taxpayer favorable positions, there is still much uncertainty:

• Does rental real estate qualify as a trade or business?
• What is the definition of investment?
• What is consulting?
• Do you have to have a license to be a broker?
• How should UBIA be allocated among members of a partnership/LLC or S Corp shareholders?
• Must you have separate books and records to have separate trades or businesses within a single entity?
• What is the distinction between “line of business” and “separate trade or business?”

Additionally, there are even more technical questions and issues that practitioners will be raising in their comments to the IRS on the proposed regulations. We will address these during our upcoming webinar—details to follow.

The proposed QBI deduction regulations are lengthy and complex. Please contact your Friedman LLP tax adviser to discuss how the proposed regulations may affect your ability to claim the deduction on your 2018 Federal Income Tax Return and to learn what planning steps may be available.