IRS Tax Reform Regulations Clarify Business Pass-Through Deduction

There was a great deal of fanfare about the positive impact that businesses would see following the passage of the tax reform bill at the end of 2017. While many hailed the fact that the tax rate on C-corporations was cut down to 21%, there was also a lot of interest in the changes involving sole proprietorships, partnerships, S-corporations and similar entities, which received the benefit of a new 20% pass through deduction referred to as the Sec 199A deduction. It is safe to say that part of why the deduction generated so much buzz was that it was so complicated that nobody was quite sure of exactly what it meant. With more questions than answers, tax preparers have been patiently awaiting guidance on the deduction, and now that has come in the form of 184-pages of proposed regulations that the Treasury Department and IRS released on August 8^thof this year. Far from being the last word – or even providing comprehensive answers – the newly-published proposals are now awaiting feedback and inquiries before they will be released in their final state.

What is a “trade or business?”

There are several specific topics surrounding the Sec. 199A deduction that have garnered both attention and confusion, and one of those is how the new law interprets a “trade or business.” Though the language in the tax bill was fuzzy at best in defining a trade or business, it is essential for tax preparers to have a clear sense of what is meant, since it is what distinguishes what kinds of income-generating activities qualify for use of the deduction. The proposed regulations that were just released do little to clear up this mystery: instead, it refers back to a subjective definition that is already in place within the tax code, resting on decisions and interpretations of ‘what a trade or business is' that the IRS has issued in court cases in the past under code section 162. The lack of a bright line definition means that the questions will continue to be asked, and tax preparers are likely to use their own interpretations until proven wrong. One question that is likely to be asked often pertains to whether the Sec. 199A deduction will be able to be used for rental real estate income. After some investigation, we believe that it will unless the rental real estate activity is entirely passive, such as in the case of triple net leases.

Who qualifies?

Another area of uncertainty about the Sec 199A deduction surrounds exactly who qualifies to take advantage of it? The deduction is available to all trades and businesses that have pass-through income (which is referred to as qualified business income (QBI), and whose taxable income falls below the 32% tax bracket threshold. This threshold is $315,000 for married couples filing a joint return and is $157,500 for everybody else. That means that the 20% Sec 199A deduction is available on any net profit from K-1 income, sole proprietorship, partnership or S-corporation, or from a rental. If you have multiple sources of QBI income, the 20% deduction is calculated separately for each, below the line This means that it is handled in the same way as standard or itemized deductions on your 1040 tax return, and will not impact your adjusted gross income (AGI) or the amount that you owe in self-employment tax.

As if to offset how straightforward these rules are for taking advantage of the Sec 199A deduction, things get much more complicated once a taxpayer's taxable income exceeds the stated thresholds, especially for those whose business is categorized as an SSTB, or specified service trade or business. For taxpayers whose are married filing jointly and whose income derives from those types of businesses, the 20% deduction begins to phase out between $315,000 and $415,000 with eligibility ending at $415,000: for those using any other filing status, the phase out is between $157,500 and $207,500 with eligibility ending at $207,500.

What is a specified service trade or business (SSTB)?

The question of what constitutes an SSTB is another area of confusion, and particularly with reference to a subjective phrase that references the reputation or skill of one or more of a business' employees or owners being the principal asset of the business or trade. The wide range of interpretations of what that could mean left tax preparers wonder wondering whether a tradesman such as a self-employed electrician – whose business is reliant on his skill – would be ineligible to take the deduction. The newly-released regulations clear up what “reputation and skill” mean with the following citation of defining characteristics:

“(1) receiving income for endorsing products or services, including an individual's distributive share of income or distributions from an RPE for which the individual provides endorsement services; (2) licensing or receiving income for the use of an individual's image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual's identity, including an individual's distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual's image; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players).”

Beyond these specifications of what “reputation and skill” identifies a business as an SSTB, the newly-released document also provides additional guidance that encompasses several pages of granular detail, but which is represented by the list below:

• Accounting
• Actuarial science
• Athletics
• Brokerage services (investing, investment management, trading, or dealing in securities, partnership interests, or commodities)
• Consulting
• Financial services
• Health (services by physicians, nurses, dentists, veterinarians, and other similar health care providers. But that does not apply to the businesses of spas and health clubs)
• Law
• Performing arts (but does not apply to the services of others in the industry such as promoters and broadcasters)

For businesses that are not SSTBs, the 20% 199A deduction has different rules. It can be used by taxpayers who are at a higher income level, but at the same time the calculation becomes more complex. Once the $415,000 or $207,500 thresholds are exceeded (for married filing jointly or other filing statuses respectively), the taxpayer has to determine both the “wage limit” amount and what 20% of their QBI is and claim the lesser of the two.

What is the “wage limit?”

To determine the wage limit for a business, the taxpayer needs to calculate the following two numbers:

• Half of the W-2 wages that are paid by the business
• One-quarter of the number above added to 2.5% of the unadjusted basis of the qualified property of the business activity.

Whichever of these two is larger is the wage limit. For an example, consider a non-SSTB business owner who files as single and whose taxable income is above the $207,500 threshold range. If that taxpayer's business pays no W-2 wages during the calendar year and doesn't have any qualified property, then they are not entitled to take any 199A deduction at all. 

The regulations make clear that W-2 wages used in this calculation must have been paid during the calendar year, and include wages paid to employees and to the officers of an S-corporation, but not to statutory employees (for whom box 13 on the W-2 is checked). If an employee is being paid by a third party, such as a staffing company, they can be included, but only if the staffing company is not claiming the wage.

Figuring out exactly what the W-2 wage amount will be depends upon a number of variables, and the regulations offer three different options for the process. In most cases, “Modified Box 1 Method” is likely to be the choice for small and midsized businesses: it adds up the figure provided in box 1 of the W-2, adds items listed in box 12 codes D, E, F, G, and S (excludable pension contributions) and deducts any amounts not subject to income tax withholding. For those who are in either partnership or who are shareholders in S corporations, only prorated shares of wages from the business should be applied.

IMPORTANT ISSUE - The proposed regulations make it clear that W-2 wages must be properly allocated so only wages associated with QBI are included in the wage limitation calculation. A business entity could have non-U.S. source income, investment income, and capital gains income – none of which is QBI. An activity may have a concoction of business activities and perhaps not all of the activities produce QBI, and a W-2 wage allocation may be required

Qualified property

For the purposes of the Sec. 199A deductible, tangible, depreciable property held by and available for use in the qualified business or trade at the end of the tax year is classified as qualified property if it's been used during the tax year at any point to produce qualified business income. In order to be categorized as qualified property, its depreciable period also can't have expired before the tax year's end. To determine when the depreciable period ends, the proposed regulations indicate that it would be either 10 years after the date that the property is placed in service or the last day of the full year of the applicable MACRS recovery period of the property(Code Sec. 199A(b)(6)(B).

Examples of qualified property would include: vehicles, residential, farm or commercial buildings (but not land), fruit and nut trees and vines once they reach production stage, machinery and tools, office furnishings and computer systems, as well as softer that was sold along with a computer. Other examples would be restaurant, retail or leasehold improvements, over-the-counter software, and certain animals, to include racehorses and livestock purchased for dairy, draft or breeding. Property that would not qualify are defined under the list of Sec 197 intangibles, and include: workforce in place, know-how, goodwill, government licenses and permits, going concern value, and franchises, trademarks and trade names.

NOTE -The proposed regulations made it clear that qualified property that is expensed under 100% bonus depreciation or Section 179 will be included based upon their normal MACRS recovery period.  

Example: Gary has a retail store that he operates in rented retail space. His property that he used in his business during 2018 included:

When looking at the example, remember that the value we use for “qualifying 199A property” is the unadjusted basis. So depreciation previously deducted and expensing is ignored for this purpose.  However, property counts as “qualifying property” within its depreciable life or 10 years whichever is greater. Items 1, 4, 5 and 7 are past their useful lives but only 1 has been in service for a period greater than 10 years. So all of Gary's property counts as “qualifying 199A property” except item #1. Thus when the wage limitation is computed for Gary the qualifying property amount used in the computation will be $15,775.

Additional points of interest:

• For those who fall into the category of either partnership or shareholders of an S-corporation, the proposal explicitly states that qualified property as described below must be divided in the same way that depreciation is.
• The guidance for business activities that result in a loss state that if there is only one such activity or multiple activities for which the sum of each is negative, that/those activity's 199A deduction is zero and the loss is to be applied again in the following tax year's deduction calculation, and there will be no impact on whether the business owner can deduct the loss or losses in other areas under the tax code.
• The guidance for business activities that have a total business that is positive but one or more of them resulted in a loss, take the negative from the losses and use them to reduce the total QBI before calculating the deduction amount. In that application, negative activities' QBIs will not carry over to the next tax year.
• When a business is calculating its 199A deduction and there are either publicly traded partnerships (PTPs) or REITS included in their business activities, the calculations for those two types of vehicles are to be done distinct of all others, and will have no impact on the calculation of all other types of financial vehicles' calculations. If there is a loss reflected in the QBI from PTPs or REITs, they do not get combined with the rest of the business' activities.
• For those who had considered moving QBI from an SSBT to a non-SSBT business activity in order to access the 199A deduction (a practice known as “cracking”.) the regulations have explicitly eliminated the ability to do that with the following message: “The Treasury Department and the IRS are aware that some tax payers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the section 199A deduction. Such a strategy is inconsistent with the purpose of section 199A”.In order to prevent this from happening the agency has provided a strict definition of an SSTB, stating that it is any trade or business for which half or more direct or indirect common ownership provides 80 percent or more of its property or services to an SSTB. It adds that if the ownership is as described, that in so far as the entity gives property or services to the SSTB, then that same percentage that is provided will be treated as an SSTB (and income will be treated as such.)

Example: A dentist owns a dental practice and also owns an office building.  He rents half the building to the dental practice and half the building to unrelated persons. Under the proposed regulation the renting of half of the building to the dental practice will be treated as a SSTB.

In summary, the best way to figure the 199A deduction is to follow the following four steps:

1. Identify each individual business activity's 199A deduction separately. Be sure to figure in losses and account for loss adjustments.
2. Go through the same process separately for publicly traded partnerships and REITS.
3. Adjusting down for net capital gains, calculate what 20% of the taxpayer's taxable income is.
4. Determine whether the product of Step #1 and #2 or of Step #3 are lower. Whichever is the smaller amount is the amount of the Sec 199A deduction.

Remember that each individual partner or S corp shareholder's Sec 199A deduction has to be calculated separately, as the deduction is based upon their individual taxable income, not the business' income. 

The complex nature of the Sec 199A deduction calculations suggest that taxpayers would be well advised to consult a tax professional for assistance in its calculations.


Bob Mason, CPA writes for CountingWorks, an accounting news and advice website. Reach his office at [email protected]. 

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