Proposed regulations issued for the 20 percent qualified business income deduction › acton › attachment › 15093 › f-0b04... · Proposed regulations issued for the 20 percent

Proposed regulations issued for the 20 percent qualified business income deduction One of the most significant aspects of the Tax Cuts and Jobs Act (TCJA) was the creation of a new deduction in Section 199A, the qualified business income deduction (QBID). This deduction is claimed by individuals, trusts, and estates and is equal to up to 20 percent of qualifying domestic business income from S corporations, partnerships, and sole proprietorships. As taxpayers and their advisors have sought to understand this new deduction, many interpretational questions have arisen. These range from basic definitional issues to more complex computational and reporting points. The Treasury Department and IRS have now provided the first round of tentative answers in the form of proposed regulations and a proposed revenue procedure. Summary of key takeaways The new guidance contains a lot of information but here is a summary of the key takeaways. A more detailed discussion of each of these items follows the summary.

1. Definition of a trade or business: The proposed regulations expand the definition of a trade or business for Section 199A to include rental or licensing of tangible or intangible property to a commonly owned trade or business. This provides relief for self-rental transactions involving triple-net leasing, which may not involve sufficient activity to be considered a trade or business and would otherwise be excluded from the QBID.

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2. Aggregation of commonly owned and integrated businesses: The proposed regulations adopt a new rule for the aggregation of certain nonservice businesses that are commonly owned and have integrated business operations (e.g., shared H.R. and I.T. services, and supply chain integration). If businesses are aggregated, then the W-2 wages and asset basis of one business is able to increase the limitation on the QBI of another aggregated business. This is favorable to multientity businesses.

3. Definitions of specified service trades or businesses: New definitions have been provided for the enumerated list of specified service trades or businesses (SSTBs) that are subject to the QBID phase-out. These definitions do not explicitly cover all scenarios, but do offer welcome guidance regarding what is included and excluded for each SSTB.

4. Broad anti-abuse rules: To combat planning strategies that Treasury and the IRS consider abusive, the proposed regulations include new anti-abuse rules. One rule provides that a non-SSTB providing services or property to a commonly owned SSTB will be treated as an SSTB with respect to that income. Similarly, a new rule provides a rebuttable presumption that an individual converting from employee status to an independent contractor while performing the same services to the business will not be eligible for QBID on that income.

5. Wages and assets: The proposed regulations provide clarity regarding the determination of W-2 wages and the cost basis of qualified property for purposes of the limitations based on those amounts. Among other things, these import the common law employer rules that were previously applicable to Section 199 (i.e., DPAD) providing relief to businesses that utilize employee leasing, professional employer organizations, and other similar arrangements.

6. Computational guidance: Mechanical rules have been provided to apply at the individual and pass-through business levels. In particular, these rules cover the netting of income and losses, carryover rules for net losses, treatment of passive activity and basis losses, and treatment of net operating losses. Overall, the proposed regulations provide much-needed direction in the computation of the QBID.

7. Reporting and disclosure: The proposed regulations also provide details regarding the information that must be reported by pass-through entities on Forms K-1 and the items to be included on the tax returns of individuals. However, the regulations do adopt “failure to report” standards such that omission of information from a K-1 can have negative consequences for QBID.

What is the QBID? An individual, trust, or estate may claim a QBID of up to 20 percent of qualified business income (QBI) from a partnership, S corporation, or sole proprietorship. QBI includes income that is effectively connected with a U.S. trade or business. However, QBI does not include items such as: (1) capital gains and losses; (2) interest and dividends; or (3) W-2 compensation received as an employee, W-2 compensation paid to S corporation shareholders, and guaranteed payments paid to partners. The deduction is subject to several limitations. Specifically, the tentative 20 percent QBID with respect to each business is limited to the greater of: (1) 50 percent of the taxpayer’s allocable share of W-2 wages paid by the business, or (2) the sum of 25 percent of the taxpayer’s allocable share of W-2 wages paid by the business and 2.5 percent of the taxpayer’s allocable share of the cost basis of depreciable property used in the trade or business. Those limitations are phased-in for individuals based on their taxable income.

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Those with taxable income below the threshold amount ($157,500 for a single taxpayer, and $315,000 for married taxpayers filing jointly) are not subject to the wage and asset limitations. The limitation phases in over the next $50,000 of taxable income for single taxpayers and $100,000 of taxable income for married taxpayers filing jointly. Taxpayers with taxable income above the phase-out ranges are fully subject to the W-2 wage and asset limitation. Income from SSTBs is eligible for QBID, but the deduction is subject to a phase-out over the same taxable income ranges as the W-2 wage and asset limitations. Thus, taxpayers with taxable income in excess of the phase-out range will receive no QBID with respect to income from an SSTB. Income of services businesses that are not SSTBs is fully eligible for the QBID regardless of the owner’s taxable income. An SSTB includes those in the fields of:

Health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services.

Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.

Investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

Finally, the deduction is limited to the lesser of 20 percent of net QBI of the taxpayer (after application of the other limitations) and 20 percent of taxable income of the taxpayer reduced by net capital gains and qualified dividends. If the taxpayer has a net negative QBI, that amount is treated as a loss carryforward that reduces QBI in future years. Key takeaways of the proposed rules The proposed regulations cover a wide variety of topics. Here are our initial takeaways on the seven key topics:

1. Defining a trade or business for purposes of QBID In order to be QBI, income must be derived from a trade or business. Thus, a threshold question is what level of activity is required for an activity to rise to the level of a trade or business for purposes of QBID. This question is particularly important for real estate lease arrangements. It is common for a business to lease real property from a commonly controlled entity under a triple-net lease. Some existing authorities conclude that the leasing of real estate pursuant to a triple-net lease is not sufficiently active to rise to the level of a trade or business. The proposed regulations provide clarity on this point. They begin by providing that a trade or business for purposes of QBID is based on whether an activity is a trade or business under Section 162. The proposed regulations then go even further by providing that the rental or licensing of tangible or intangible property will be considered a trade or business for purposes of QBID as long as the property is rented or licensed to a trade or business that has at least 50 percent common ownership (see the aggregation section below for more details on how to measure the 50 percent). This proposed regulation is helpful in that it permits most ‘self-rental’ real estate to qualify for QBID even if it does not otherwise rise to the level of a Section 162 trade or business. However, there are two key

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situations that will still result in unfavorable treatment under this standard. First, real estate business that lease property to unrelated parties will still need to meet the Section 162 standard. Second, for business activities that are conducted through multiple entities, each entity must qualify as a trade or business on its own even and an activity that does not rise to the level of a trade or business cannot be aggregated with another activity that is a trade or business. This may be particularly problematic for real estate businesses that may have each piece of real estate in a separate entity.

2. Aggregation

While QBID is claimed by individuals, trusts, and estates, the deduction is based on the QBI, W-2 wages, and assets of each individual trade or business. It is common for an overall business enterprise to be conducted through multiple legal entities. When examining existing business structures, many taxpayers found that applying the W-2 wage or asset tests separately for entities that are under common control resulted in unfavorable computations because, for example, wages may be paid by one business but the income is generated in another. In response to these concerns, the proposed regulations permit taxpayers to aggregate related businesses. Note that these aggregation rules are unique to QBID, and do not rely on any other existing aggregation rules, such as passive activity grouping or at-risk grouping rules. In order to aggregate for QBID purposes, each of five requirements must be met:

1) Common ownership: Each trade or business must be under common ownership, with the same person or group of persons owning 50 percent or more of each trade or business that will be aggregated. For purposes of determining ownership, an individual is treated as owning the interest of their spouse, children, grandchildren, and parents.

2) Period of common ownership: The common ownership must exist for the majority of the tax year. 3) Same taxable year: The businesses must have the same taxable year. An exception to this

requirement exists for short-periods. 4) No SSTBs: None of the aggregated businesses can be SSTBs. 5) Operational coordination: The aggregated trades or businesses must satisfy at least two out of

three additional factors demonstrating that they operate in coordination with or reliance upon each other. Those factors are: a) They provide products and services that are the same or customarily offered together. b) They share facilities or significant centralized business elements (personnel, accounting, legal,

manufacturing, purchasing, HR, or IT). c) They are operated in coordination with one or more of the businesses in the aggregated group

(e.g., supply chain interdependency). Aggregation is only done by individuals, estates, or trusts, and it is fully elective. This is done by including aggregation disclosures with the tax return. Once a decision has been made to aggregate certain trades or businesses, they are treated as one trade or business for QBID and must be consistently reported as such by the electing owner in future years. Aggregation decisions can only change when new trades or business are acquired or created, or where certain businesses no longer qualify for aggregation. Each owner of a business is able to make their own aggregation decisions irrespective of the aggregation decisions of other owners.

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This new aggregation rule provides welcome relief for many closely held business structures. In essence, this allows the owners of existing, interrelated businesses to maintain their structures while treating the overall enterprise as a single business for QBID. However, because pass-through businesses cannot aggregate at the entity level, this will require those entities to report all information for each trade or business to their owners as if there will be no aggregation. For complex, multitiered business structures (e.g. holding companies or investment funds), this will result in voluminous K-1 reporting. Similarly, it may be difficult for individuals with minority ownership in a business to determine whether certain businesses are eligible for aggregation. Still, aggregation will be favorable for taxpayers, but the trade-off is increased complexity and reporting requirements.

3. Specified services One of the most hotly debated aspects of the QBID involves the definition of SSTBs — the owners of which are not eligible for QBID if their income exceeds the thresholds discussed above. The statute provides an enumerated list of fields and a catch-all “skill or reputation” clause but provides no detailed definitions. The proposed regulations include detailed definitions for the enumerated list of SSTBs and also narrows the scope of the “skill or reputation” clause. The more detailed definitions are:

Health: The provision of medical services by individuals such as physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals performing services in their capacity as such who provide medical services directly to a patient. It does not include services not directly related to a medical services field even though the services provided may purportedly relate to the health of the service recipient such as spas, payment processing services, medical research, or the manufacture or sale of pharmaceuticals or medical devices.

Law: The performance of services in the field of law means the performance of services by individuals such as lawyers, paralegals, legal arbitrators, mediators, and similar professionals performing services in their capacity as such. It does not include ancillary services that are not unique to the field of law, such as printers, delivery services, or stenography services.

Accounting: The provision of services by individuals such as accountants, enrolled agents, return preparers, financial auditors, and similar professionals performing services in their capacity as such. It includes book keeping services but does not include payment processing or billing analysis.

Actuarial science: The provision of services by individuals such as actuaries and similar professionals performing services in their capacity as such. It does not include the provision of services by analysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events.

Performing Arts: The performance of services by individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors, and similar professionals performing services in their capacity as such. It does not include services that are not unique to the creation of performing arts, such as facility maintenance and operation, and audio or video broadcast.

Consulting: The provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems, and includes advice and counsel regarding advocacy provided with the intention of influencing decisions of government and legislators. Consulting does not include services where advice and counsel is not provided, such as sales or the provision of training and educational courses. Moreover, this does not include consulting services that are

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embedded in, or ancillary to, the sale of goods or performance of non-SSTB services where there is no separate payment for the consulting services.

Athletics: The performance of services by individuals who participate in athletic competitions such as athletes, coaches, and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing. It does not include services that are not unique to the athletic competition, such as facility maintenance and operation, and audio or video broadcast. It does, however, include a business whose employees are the individuals that participate in the sporting event (i.e., a professional sports team).

Financial services: The provision of financial services to clients including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings (including in Title 11 or similar cases), and raising financial capital by underwriting, or acting as a client’s agent in the issuance of securities and similar services. This specifically includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors. However, it excludes banking activities.

Brokerage services: The provision of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee. This does not include services provided by real estate agents, insurance agents, or any other person brokering transactions for property that is not a security.

Investing and investment management: The provision of services involving the receipt of fees for providing investing, asset management, or investment management services, including providing advice with respect to buying and selling investments. This does not include the direct management of real property.

Trading: This includes the trading in securities, commodities, or partnership interests. However, this does not include hedging transactions that are undertaken by a business, such as a manufacturer or farmer, that is not otherwise considered a trader.

Dealing: The provision of deal that involves regularly purchasing securities, commodities, or partnership interests from and selling those assets to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in those assets with customers in the ordinary course of a trade or business. This does not include a business that regularly originates loans but only engages in negligible sales of those loans.

Skill or reputation: This includes a trade or business involving any of the activities listed below. Therefore, any business not including one of the following activities will not fall in to this category even though the success of the business may be heavily dependent on the skill or reputation of the employees or owners (e.g., restaurant of a celebrity chef).

o Endorsements – receiving fees, compensation, or other income for endorsing products or services

o Name/Likeness – licensing or receiving fees, compensation, or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity

o Paid appearances - receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format

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The statute provides that engineers and architects are not SSTBs. The proposed regulations do not directly define these exempted fields. Thus, there remains some uncertainty especially where engineering and architecture activities may overlap with SSTBs. The proposed regulations also include a de minimis rule whereby a business with gross receipts of $25 million or less will not be considered an SSTB if less than 10 percent of its gross receipts are from specified services. For businesses with more than $25 million of gross receipts, the threshold is lowered to 5 percent. However, this safe harbor only works in one direction. Therefore, business involving multiple activities may be considered an SSTB if one part of the business is a specified service with gross receipts that exceed the de minimis threshold. Businesses with these facts will have to determine if the specified services should be considered a separate trade or business from the remainder of the activity. As discussed above, the SSTB will not be eligible for aggregation, so the relevant wage and asset limitations will need to be reviewed carefully. The definitional guidance included in the proposed regulations is generally helpful. It provides additional clarification of what is meant by the listed fields and includes specific exceptions within several definitions. However, it takes a fairly broad view of SSTBs so businesses that resemble a specified service or that may perform some specified services alongside other activities should review these rules very carefully.

4. Anti-abuse rules Since the enactment of the TCJA, various strategies have been discussed to maximize the potential QBID for particular businesses. Three potential strategies are directly addressed in the proposed regulations.

Disaggregating SSTBs: The first strategy, often referred to as “crack and pack,” would take an SSTB and break it into multiple businesses. For example, a law firm that conducts an SSTB could separate out its real estate into a separate partnership, which would then lease it back to the law firm. The proposed regulations state that this strategy is inconsistent with the purpose of QBID. Accordingly, a new rule was created to provide that any business that is under common ownership (50 percent or more common ownership, including direct and indirect ownership by related parties) will be treated as an SSTB with respect to the income from the services or property provided to the related SSTB. If the business provides 80 percent or more of its property or services to a commonly controlled SSTB, then that entire business will be considered an SSTB. In applying this rule to the law firm example described above, the rental real estate rental activity would be considered an SSTB if the law firm was the only tenant. However, income from any portion of the building rented to third parties could be eligible for QBID if those third parties occupied at least 20 percent of the building, assuming all other requirements are met.

Employee to independent contractor: The definition of a qualified trade or business excludes the trade or business of performing services as an employee. Some individual taxpayers have considered converting from an employee to an independent contractor so that the amounts previously paid as wages would become eligible for QBID. The proposed regulations attack this by adopting a rebuttable presumption that an individual that was previously treated as an employee for federal employment tax purposes with respect to a business will still be treated as an employee of that business despite a change in federal

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employment tax classification. That presumption applies irrespective of whether the individual provides services directly or indirectly through a separate legal entity. However, the presumption can be rebutted by showing that the individual is properly classified as an independent contractor under federal tax law. While it is certainly possible to rebut this presumption, it is expected that heightened documentation will be needed and that the IRS will view this type of change with a great deal of skepticism.

Asset stuffing: The determination of the cost basis of qualified property is made as of the end of

the tax year for purposes of the 2.5 percent limitation discussed above. If a business needs more assets to support a full 20 percent QBID, one possible option is to acquire or contribute qualifying property just prior to year end and potentially sell or distribute that property shortly after year end. The proposed regulations impose time and use restrictions on property that is acquired by a business in close proximity to its year end. Under the general rule, property that is acquired within 60 days of year end and is disposed within 120 days of acquisition will not be considered qualified property unless it has been used for at least 45 days in the business. Property that does not meet the 45 day use standard can still be considered qualified property if the taxpayer demonstrates that the principle purpose of the acquisition and disposition was a purpose other than increasing its QBID eligibility.

5. Wages and assets

As discussed further above, the potential QBID for each trade or business is limited to the greater of 50 percent of W-2 wages or 25 percent of W-2 wages plus 2.5 percent of asset basis for individuals with taxable income above the threshold amount. The proposed regulations clarify several matters related to W-2 wages and asset basis.

W-2 wages: In general, the proposed regulations provide that the term W-2 wages means amounts reported for federal employment tax purposes, including certain deferred compensation and Roth contributions. This definition includes amounts paid by another entity as long as the trade or business claiming the wages is the common law employer of the employees. Therefore, businesses that lease employees or utilize professional employer organizations may still be able to claim those W-2 wages as their own. Additionally, any entity with multiples trades or businesses must allocate its W-2 wages between those businesses. W-2 wages must be allocated to the owners of pass-through businesses in the same manner as wage expense is allocated. The IRS has also issued a proposed revenue procedure, which details how taxpayers must calculate W-2 wages paid for a period.

Cost basis of qualified property: For purposes of the asset limitation, qualified property means tangible, depreciable property that is held by and used in the trade or business for the production of QBI, and for which the depreciable period has not ended. The depreciable period is the normal tax recovery period but can never be shorter than 10 years. The cost basis of qualified property means the tax basis on the date placed in service, and does not reflect any depreciation or other expensing (e.g., Section 179). Basis is allocated to the owners of pass-through businesses in the same manner as tax depreciation expense is allocated. Special rules exist for assets transferred in tax-free transactions, like-kind exchanges, and other similar types of transactions.

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In addition to the above, the proposed regulations address other matters such as measuring amounts during years in which a trade or business in purchased or sold and short tax years.

6. Computational matters The proposed regulations also address a number of computational matters at the pass-through business and individual level. Some of the noteworthy items include:

Netting QBI: The statute is written to force the netting of positive and negative QBI. For example, an individual with $60 of positive QBI from business 1, $120 of positive QBI from business 2, and $60 of negative QBI from business 3 has a net $120 of QBI. The proposed regulations clarify that the negative QBI is netted against the positive QBI in proportion to the relative amounts of positive QBI from the trades or businesses with positive QBI. Accordingly, business 1 produced one-third of all positive QBI ($60 out of $180), so one-third of the negative QBI (or $20) is applied to reduce business 1’s QBI. Conversely, the QBI of business 3 is reduced by $40 to a net $80. The adjusted QBI of each business with positive QBI is then compared to W-2 wage and asset basis limitations for that particular business to determine the tentative QBID for that business. The W-2 wages and asset basis of the trade or business that produced negative QBI are not taken into account by the trades or businesses with net positive QBI.

Carryover of net QBI losses: If an individual has net negative QBI from all trades or businesses, then there will be no QBID for that tax year and the net negative amount will carryover. In the subsequent tax year, that negative QBI is treated as an amount from a separate trade or business, which will then follow the loss reallocation rules discussed above in later years. The W-2 wages and asset basis of the trades or businesses producing the net negative QBI do not carryover to the subsequent year.

Net operating losses and other loss carryforwards: The passive activity loss limitations and

basis/at-risk basis loss limitations are applied before QBID is calculated. Therefore, losses that are suspended are not included in QBI for that year. However, when those losses are utilized in later tax years, the losses will be taken into account in computing QBI at that point in time. Still, any losses suspended in years prior to 2018 will not reduce QBI when utilized in later taxable years. W-2 wages and asset basis do not carryforward to later years even if losses are carried forward. Additionally, net operating losses incurred in one year will not reduce QBI when utilized in a later year. However, any net operating loss resulting from an excess business loss under new Section 461(l) will be taken into account in computing QBI in the year that loss is utilized.

Fiscal-year pass-through entities: The proposed regulations provide that QBI reported to individuals on K-1s in 2018 from fiscal-year pass-through entities does qualify for QBID (provided all other requirements are met). For example, an individual that receives a K-1 from an S corporation with a tax year ending June 30, 2018, will be able to claim QBID on its 2018 individual tax return with respect to all income on the K-1 even though a portion of it was generated during the 2017 calendar year. This is a very welcome clarification for all fiscal-year pass-through business owners.

7. Reporting and disclosure

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The proposed regulations include a number of procedural items regarding reporting of QBID information for both individuals and pass-through businesses. Overall, the tax reporting process for pass-through businesses will be substantially more complex due to QBID. The proposed regulations include “failure to report” rules that require an owner to presume that QBI, W-2 wages, and asset basis of a business is zero, if they are not properly reported on a K-1. Similarly, the aggregation rules require annual filings or else the trades or businesses will not be permitted to be aggregated. What’s next? A comment period on the proposed regulations is now underway, and a public hearing has also been scheduled for Oct. 16, 2018. These regulations may change based on comments submitted to the Treasury Department and IRS. Until that time, taxpayers are permitted to rely on the proposed regulations. Overall, these regulations provide a great deal of clarity and allow businesses to proceed with tax planning with more certainty. However, not all of the proposed rules are favorable. Businesses and their owners should review these rules closely because there is still time left in the 2018 tax year to mitigate any potential unfavorable aspects of these rules or to maximize the benefit of the favorable portions. If you have any questions, please contact your tax advisor or: Mike Monaghan 586-416-4943 [email protected]

James Minutolo 513-744-4722 [email protected]

Kurt Piwko 586-416-4948 [email protected]

Robert Shefferly III 586-416-4927 [email protected]

Stephen Eckert 312-602-3653 [email protected] The information provided in this alert is only a general summary and is being distributed with the understanding that Plante & Moran, PLLC, is not rendering legal, tax, accounting, or other professional advice, position, or opinions on specific facts or matters and, accordingly, assumes no liability whatsoever in

connection with its use.