On Dec. 22, 2017, President Donald Trump signed what is commonly known as the Republican tax overhaul into law. The overhaul released a whirlwind of change that taxpayers and their advisers still are sorting out.
In recent weeks, the IRS has released long-awaited proposed regulations on the 20 percent pass-through deduction under IRC Section 199A. This IRS guidance provides businesses and tax preparers with some much-needed information, but there certainly are areas that still will require further clarification.
Many small and midsize businesses are pass-through entities. This includes sole proprietors, partnerships, LLCs taxed as partnerships and S corporations. If owned by individuals, the business income is taxed at the owners’ individual tax rate. The owners of these entities didn’t benefit from the 21 percent corporate tax rate that is available to “C“ corporations but may benefit from the 20 percent deduction that was included under Section 199A, which effectively reduces the top tax rate of 37 percent to 29.6 percent.
The IRS released proposed regulations on Aug. 8 pertaining to the 20 percent pass-through deduction (Section 199A guidance), which was likely one of the most unclear and complicated new code sections established by the tax overhaul. The calculation of the 20 percent deduction is computed at the shareholder or owner level. However, many of the computations and reporting requirements are imposed at the business or entity level.
One such determination made at the entity level is exactly what business income qualifies for this deduction. IRC Section 199A excludes “specified services trade or business” (SSTB) activities from qualifying for this deduction if income levels at the individual level rise above a certain threshold.
SSTB activities are defined as activities in the areas of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, dealing in securities and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employers.
Viewed by most as taxpayer friendly, the Section 199A guidance offers some definitions and examples as to which activities fall under each area included in the SSTB definition. Perhaps most notably, the previously vague “skill or reputation” definition is now defined to include income earned from endorsing products or services; income from the use of a person’s image, likeness, name, signature, voice, trademark or any other symbols associated with an individual’s identity; and income from appearing at an event, or on radio, television or another media format. This guidance significantly narrows the SSTB definition as compared to what some taxpayers were concerned would have fallen under the original unclear definition.
The Section 199A guidance also provides for a de minimis rule, which allows certain taxpayers to still qualify for the deduction if only a nominal percentage of its gross receipts are attributable to an SSTB-defined activity. The Section 199A guidance, in an effort to curb restructuring by SSTB entities to strip out their qualifying trade or business activity, includes such provisions as one that states an SSTB will include any trade or business that provides 80 percent or more of its property or services to an SSTB if certain common ownership thresholds are met.
Another area of concern stems from the actual trade or business definition, and the uncertainty as to which activities would be grouped together or stand alone when calculating the various limitations on the deduction. Because the deduction is taken at the individual taxpayer level, it is possible a business owner might have a single qualified trade or business conducted through multiple pass-through entities and that a single entity might conduct more than one qualified trade or business.
In yet another perceived taxpayer-friendly section of the Section 199A guidance, the IRS will allow some aggregation for certain commonly controlled businesses. One common example is business owners who house real estate assets or key intangibles in a separate legal entity; if certain requirements are met, these two activities can be elected to be combined at the individual level for purposes of the 20 percent deduction calculation. Because there are wage and property limitations on the deduction, the aggregation has the potential to increase the taxpayer benefit.
The Section 199A guidance also provides for some important definitions and computational direction as to which wages can be considered when calculating the limitation, providing some relief to taxpayers that utilize common paymasters or employee leasing companies that were concerned they would have to restructure operations in order to take advantage of the deduction. However, determinations still must be made as to which activities make up a trade or business, and the Section 199A guidance does not provide a separate specific definition for this, instead, following a definition in another section of the tax code (Section 162).
An additional limitation applied against the deduction is the basis of qualified property associated with the trade or business. Under the Section 199A guidance, bonus depreciation or Section 179 immediate expensing will not reduce the basis of property, allowing taxpayers to enjoy an accelerated deduction for capital expenditures and an increased property limitation for purposes of the 20 percent deduction calculation.
While the Section 199A guidance seems to provide overall taxpayer-friendly relief, it is clear this deduction is complex and will take taxpayers additional time to analyze their specific facts and circumstances and how those will factor into the 199A calculations. The Section 199A guidance also makes it clear pass-through entities must provide all of the relevant information by trade or business activity on each partner or shareholder K-1 or risk forfeiture of the deduction for their owners. The relevant information will include whether the business is considered an SSTB, as well as each owner’s share of qualified business income, W-2 wages and qualified property, all of which will take additional time to calculate.
While many of the changes brought about by the tax overhaul appear favorable, they will require close examination of the rules and regulations as well as each taxpayer’s specific facts and circumstances. Pass-through businesses should work closely with their tax advisers to explore the intricate new tax landscape in order to minimize risk and make well-informed, tax-efficient decisions.
Kelli Olson is a tax managing director and Eric Fischer is a tax senior manager with the local office of accounting firm BDO USA, LLP. The views expressed above are the authors’ and not necessarily those of BDO. The comments are general and not to be considered specific tax or accounting advice or relied upon for the purpose of avoiding penalties. Readers are urged to consult their professional advisers.