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Acting IRS Commissioner David Kautter, stated in his remarks made to the attendees of the annual Virginia Conference on Federal Taxation, held in Charlottesville, VA on June 8, that tax practitioners should expect the first tranche of section 199A regulations will be issued by mid-to-late July. As reported by Tax Notes Today, June 11, 2018, Kautter acknowledged that along with the international tax changes enacted as part of the Tax Cuts and Jobs Act (P.L. 115-97), section 199A guidance was important to issue as soon as possible in light of the new tax regimes introduced under these provisions.
Among the more notable areas for which guidance is needed under section 199A are: (i) determining whether a business qualifies for section 199A treatment; (ii) determining the amount of the deduction available for each qualified business; and (iii) the scope and application of expected anti-abuse rules. There also are problems in making allocations between qualified and non-qualified business income for business operations conducted by a partnership, S corporation or sole proprietor. Another important area for which guidance is needed is whether taxpayers will be allowed to elect to group activities similar to grouping rules provided under section 469. Additional guidance is presently needed for applying the 2.5% unadjusted basis limitation including how it applies when a new partner joins a partnership and receives a section 743(b) step-up in inside basis.
Summary of Section 199A
Section 199A, added to the Code by the Tax Cuts and Jobs Act of 2017, P.L. 115-97, and effective for taxable years beginning in 2018, allows certain noncorporate taxpayers to deduct an amount equal to 20% of their “qualified business income” generally provides a deduction equal to 20% of the “qualified business income” of a noncorporate taxpayer. Specified business are precluded from using section 199A and the businesses that may use it are subject to a ceiling rule permitting the deduction in certain instances only to the extent of wages paid and property amounts. The statute limits the section 199A deduction to 50% of W-2 wages or the sum of 25% of the W-2 wages paid with respect to a qualified trade or business plus 2.5% of the unadjusted asset basis immediately after acquisition of the qualified property.
The term “qualified trade or business” is defined under section 199A(d)(1) as a specified service trade or business or the trade or business of performing services as an employee. This definition is cross referenced to section 1202(e)(3). A specified service trade or business means any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees (emphasis in italics added). This is the definition included in section 1202(e)(3)(partial exclusion of gain from certain small business stock provision) but excluding the fields of engineering and architecture. The “reputation or skill” exclusion from section 199A is most controversial and applied literally could cast a very wide net. For taxpayers potentially vulnerable to the “reputation or skill” argument but reporting in accordance with section 199A, will such taxpayer be properly advised to file a disclosure statement? Is the potential risk worth a tax accrual for the rate differential between 37% and 29.6% on business income reported under section 199A for taxpayers using GAAP financial statements?
Section 199A applies to income from pass-thru entities, such as a partnership or S corporation, as well as to a sole proprietorship. The deduction does not apply with respect to an eligible taxpayer’s net capital gain. §199A(a). Where a taxpayer such as an individual realizes “qualified business income” such taxpayer’s normal 37% rate under section 1, the qualified business income is, by virtue of the deduction under section 199A, reduced to 29.6% with respect to such eligible income. The section 199A deduction, which is scheduled to terminate for tax years after 2025, is not a deduction allowed in computing adjusted gross income under section 62(a) and also is also not an itemized deduction per section 63(d)(3).
The deductible amount under section 199A is determined separately for each trade or business of the eligible taxpayer. For a partnership, limited liability taxed as a partnership or S corporation, section 199A is applied at the partner, LLC member or S shareholder level by taking into account each such partner’s or shareholder’s share of each item of qualified income, gain, deduction, and loss as well as each partner’ or shareholder’s share of W-2 wages and unadjusted basis in qualified property as to each trade or business of the taxpayer.
The section 199A deduction is determined by adding two amounts. The amount determined with respect to any qualified trade or business is the lesser of (a) 20% of the “qualified business income” from the qualified trade or business or (b) the greater of (i) 50% of the “W-2 wages” (but not wages paid to persons in foreign countries) with respect to the qualified trade or business or (ii) the sum of 25% of the W-2 wages plus 2.5%of the unadjusted basis just after the acquisition of “qualified property. Qualified business income is defined under section 199(c) as the net amount of items of income, gain, deduction and loss which is effectively connected with the conduct of a trade or business within the U.S. subject to exceptions for certain types of investment income (including capital gains and losses, nonbusiness interest income, certain items relating to foreign base company income, and nonbusiness annuity income. However, a partner’s or S shareholder’s share of qualified business income does not include reasonable compensation paid to the taxpayer for services rendered to the business, or (to the extent to be provided in regulations) guaranteed payments made by a partnership to a partner for services rendered to the partnership.
A special rule applies for a taxpayer whose taxable income (computed without regard to §199A) does not exceed a “threshold amount”. In such instance, the taxpayer can claim the full20% deduction if he has sufficient “qualified business income”. The limitation for W-2 wages and qualified property are inapplicable in this situation. However, a special, favorable rule applies for a taxpayer whose taxable income (without regard to Section 199A) does not exceed a “threshold amount.” Where this special rule applies, the taxpayer has a clear path to the full 20% deduction if the taxpayer has sufficient “qualified business income,” because the limitations, just discussed, relating to W-2 wages and qualified property do not apply. §199A(b)(3)(A). The threshold amount is $157,500 ($315,000 in the case of a joint return, with inflation adjustments). §199A(e)(2). The favorable rule phases out if the taxpayer’s taxable income is up to $50,000 more than the threshold amount ($100,000 more for a joint return).
Tax advisors have been studying methods to mitigate the 37% rate of Federal income tax on business income attributable to specified service business. The anticipated regulations may address such efforts in a scheduled anti-abuse regulation.
We will report on the proposed regulations when issued.
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 But see, e.g., PLR 201717010 (4/28/2017)(developer of tool used to provide complete and timely information to healthcare providers was engaged in qualified trade or business under §1203(e)(3); where it didn’t provide health care professionals with diagnosis or treatment recommendations for treating patients, taxpayer wasn’t aware of health care provider’s diagnosis or treatment of patients, and skills that its employees have were unique to work they perform for taxpayer and weren’t useful to other employers).