Dear Clients & Friends~
Last month, the Treasury department issued long-awaited proposed reliance regulations covering the new 20% pass through deduction (PTD) enacted by the Tax Cut and Jobs Act of 2017. Although not final, the regulations can be relied upon immediately and will likely be close to the final regulations. While a full analysis is beyond the scope of this writing, we’ll do our best to cover the highlights. Even so, this is a lengthy newsletter – there’s no way around that.
First, a quick review of how the PTD works. Although the deduction applies to individuals, trusts and estates, this write-up focuses on its application to individuals.
- Individuals are allowed a deduction equal to 20% of qualified business income (QBI) for the years 2018 through 2025.
- QBI includes income from a domestic trade or business operated as a sole proprietorship or thorough a partnership, S corporation, trust, or estate. QBI does not include guaranteed payments for services to a partnership or reasonable compensation paid to the owner of an S corporation.
- For taxpayers with taxable income in excess of the threshold amount ($157,500 or twice that for joint returns, adjusted for inflation for years beginning after 2018), the deduction for a particular business is limited to the greater of (a) 50% of W-2 wages paid by the business, or (b) 25% of W-2 wages paid by the business plus 2.5% of the unadjusted basis immediately after acquisition of depreciable property used in the trade or business. The limitation begins at the threshold amount and completely phases in when the threshold is exceeded by $50,000 or $100,000 for joint returns. Therefore, taxpayers with income of less than the threshold amount qualify for a deduction regardless of whether the particular business has wages and/or qualifying property while taxpayers with income exceeding the threshold amount may have their deduction limited if wages and/or qualifying property are insufficient.
- For taxpayers with income from a specified service trades or business (SSTB) the deduction is limited in the same manner as in the previous bullet point, regardless of wages paid or property used. In other words, if the PTE deduction attributable to the SSTB would be totally phased out based on the income limits, no PTE deduction is allowed for the SSTB even if ample wages and/or property are present. An SSTB includes a business performing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, or dealing in securities, or any trade or business where the principal asset of such trade or business in the reputation or skill of 1 or more of its employees.
- In addition, individuals are allowed a PTD equal to 20% of REIT and qualified publicly traded partnership income. This component is not limited by the W-2 wages or unadjusted basis of qualified property.
- The total deduction is limited to taxable income less net capital gain.
The law as written left us with numerous questions, many of which have been answered by the regulations, such as:
- Does rental income qualify as QBI?
- Will there be an opportunity to group or combine trades or businesses for the purpose of calculating the W-2 wage limitation? If so, excess wages from a qualifying business could be used to free up a deduction for a qualifying business with less wages. We wondered whether the regulations would implement the same grouping regime as used for the passive loss rules and the net investment income tax.
- Do section 1231 gains (gains from the sale of business property) qualify as QBI?
- What exactly does “unadjusted basis immediately after acquisition” mean? For example, if one avails themselves of the section 179 deduction or bonus depreciation, does that matter?
- How closely defined will an SSTB be, particularly the inclusion of “any trade or business where the principal asset of such trade or business in the reputation or skill of 1 or more of its employees”, which could potentially include just about every business.
- How do suspended loss carryforwards affect the computation? Do those losses reduce qualifying income?
Now for the regulation highlights:
QBI includes rental income if it rises to the level of a trade or business. This is a complex topic but suffice it to say that it requires some degree of continuity and regularity as opposed to merely holding property for investment. Our opinion is that operation of a business park, for example, would usually qualify. We do not have a definitive answer on residential real estate but with the right facts and circumstances, we feel that treatment as QBI could be justified.
Notably, QBI includes the rental of property to a related trade or business if the lessor and the lessee are commonly controlled in a way that would allow aggregation of the two activities. This is allowed even if the rental activity itself doesn’t rise to the level of a trade or business.
AGGREGATION OF TRADES OR BUSINESSES
The Treasury department most certainly did NOT look to the passive loss rules in developing the rules for the PTD. Instead, they proposed a very different set of facts and circumstances tests. To aggregate multiple trades or businesses, the following tests must be met:
- Each activity must rise to the level of a trade or business under Internal Revenue Code section 162.
- The same person or group of persons must directly or indirectly own a majority interest in each of the businesses to be aggregated for the majority of the taxable year. For this purpose, one is considered to own the interests of his or her spouse and his or her children, grandchildren, and parents.
- None of the aggregated trades or businesses can be SSTBs.
- Two of the following three factors must be met:
- The businesses provide products and services that are the same OR they provide products and services that are customarily provided together;
- The businesses share facilities or share significant centralized business elements such as common personnel, accounting, legal, manufacturing, purchasing, human resources, or IT resources;
- The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).
Remember that aggregation is permitted but not required and individuals must consistently report the aggregated group in subsequent years once businesses are aggregated.
We’ve had a lot of fun (relatively speaking) running through different scenarios that might or might not result in permitted aggregation under these rules. The regulation contains a number of examples, but they don’t cover all conceivable circumstances.
SECTION 1231 GAINS AND LOSSES
As you may know, the general rule is that section 1231 gains are treated as long term capital gains and section 1231 losses are treated as ordinary losses. However, if one has incurred net section 1231 losses in the 5 prior years which were treated as ordinary, section 1231 gains are recharacterized as ordinary to that extent. The new regulations tell us that if 1231 gains are treated as capital, they do not constitute QBI but if they are treated as ordinary income, they do.
UNADJUSTED BASIS IMMEDIATELY AFTER ACQUISITION
The definition of UBIA under the regulations includes the property’s cost, undiminished by the section 179 deduction or bonus depreciation. Consistent with the statute, UBIA includes property for which the depreciable period has not ended before the close of the tax year. The depreciable period is defined as the longer of (a) 10 years, or (b) the property’s depreciable period for tax purposes.
DEFINITION OF SSTB
The regulations do provide a de minimis rule which provides that a trade or business will not be considered an SSTB if the trade or business has annual gross receipts of $25 million or less and less than 10% of the gross receipts of the trade or business is attributable to the performance of services in an SSTB. Example – a company that sells computers but also provides consulting services related to the installation or maintenance of the computers.
The regulations do a pretty good job of delving into each SSTB category (i.e. health, law), providing a level of specificity within each and naming various professions that do or do not constitute an SSTB within each broad category. We can’t possibly cover that level of detail here but if you google regulation 1.199A-5 you can read the regulation yourself.
We were pleased to see “any trade or business where the principal asset of such trade or business in the reputation or skill of one or more of its employees” defined in very limited terms. It is limited to businesses which receive income for endorsements, the use of an individual’s image, likeness, name, or similar items associated with the individual’s identity, or from appearance fees on TV and other media.
Loss carryforwards do reduce current year QBI but only if they arose in a year beginning after December 31, 2017. Net operating losses however do not affect QBI regardless of when they arise.
The regulations contain numerous anti-abuse provisions such as those which limit one’s ability to (1) transfer property to a qualifying activity in hopes of increasing the deduction by 2.5% of the basis; (2) switch one’s status from a W-2 employee to an independent contractor (and thus a sole proprietorship); and (3) spin off potentially qualifying activities into a new entity aka “crack and pack.” The crack and pack strategy is one which many taxpayers have already implemented and involves cracking an SSTB in part and packing as much profitability as possible into the non SSTB part. For example – a law firm spins off its HR and payroll duties to a separate entity which charges the law firm for services. This strategy is not totally dead, but it has been severely curtailed.
Take-aways from regulations and new law in general
It’s worth noting that wages paid by an S corporation to owners create wages for purposes of the limitation (50% of W-2 wages or 25% of W-2 wages + 2.5% of UBIA), but guaranteed payments paid by a partnership do not. Therefore, if one runs a business with only owner compensation, it might pay to conduct this business as an S corporation rather than a partnership. There are other items to consider in conjunction with such a decision however.
Because guaranteed payments made by a partnership reduce QBI to the owners, it might be worth considering replacing such payments with a preferred income and distribution allocation.
It is still possible to utilize the crack and pack strategy under the right circumstances. For one, ownership of the SSTB and the new spin-off should be sufficiently different.
If aggregation of multiple business is important (and it might not be if each has ample qualifying wages), the specifics of qualification should be considered. Perhaps it would make sense to make changes resulting in the sharing of centralized business elements or to tweak ownership.
We hope you’ve found this article informative, if in fact you were able to get through it. As always, we’re here to help. Let us know what questions and insights you have.
Zirkle, Long & Associates, LLC