A closer look at the new pass-through deduction proposed regulations

Aug 10, 2018
Aug 10, 2018
0 min. read

The following is a detailed discussion of several key provisions of the recently proposed regulations governing the 20 percent deduction authorized by section 199A. For an overview of the proposed regulations – including the important new rules governing the computation of wages formally paid by a party other than the common-law employer – see our release, IRS releases proposed regulations regarding pass through deduction. In addition, taxpayers should note that the proposed regulations contain anti-abuse provisions designed to curtail the use of multiple trusts to avoid phase-out limitations related to section 199A and other key tax reform provisions. For more detail on that issue, see our alert on estate and gift tax highlights of the new 199A proposed regulations.

This Alert summarizes the proposed rules governing “specified service trades or businesses” (which are generally not allowed to use the 20 percent deduction), the rules related to the aggregation of separate trades or businesses, and several of the more important computational rules. This order reflects the fact that, as a general rule, the first step in applying the rules of section 199A to a business or group of businesses is to determine whether there are any potential specified service trades or businesses involved. Then, taxpayers should determine how the aggregation rules may be usefully applied to help satisfy the wage or asset tests. Then, taxpayers must consider the vagaries of the computational rules governing special types of income or losses from qualifying businesses.

Defining a Specified Service Trade or Business

Specified Service Trades or Businesses

The 20 percent deduction is not allowable – other than for taxpayers with incomes below specified income levels – with respect to the income of a “specified service trade or business” or “SSTB”. The proposed regulations provide largely favorable answers to most of the important issues involved in identifying or defining an SSTB.

Many of the underlying rules defining an SSTB are contained in statutory cross-references to terms contained in section 1202 – the special capital gains rules for stock in certain small businesses. The section 199A proposed regulations make clear, however, that the meaning of those terms for purposes of section 199A will not necessarily be the same as the meaning of the identical terms for purposes of section 1202 or other provisions of the tax law. This will be important to keep in mind when conducting a choice of entity analysis, particularly if a taxpayer’s options include qualifying under either section 199A as a pass-through entity or under section 1202 as a C corporation.

Clarifying the List of Specifically Prohibited Services

By reference to section 1202, an SSTB includes any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.”

In addition, section 199A defines an SSTB as including any business “which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”

The proposed regulations provide several favorable interpretations of this list:

Health services appear to include only the “individual” services of health care professionals that are provided “directly” to a patient or other service recipient, and do not include services not directly related to a “medical services field” such as the operation of a health club or spa, the provision of payment processing services for physicians, or the research, testing, manufacture or sales of pharmaceuticals or medical devices. Somewhat confusingly, pharmacists are listed along with physicians and nurses as medical service professionals, despite the fact that a typical retail or wholesale pharmacy business might be excluded as involving the “sale of pharmaceuticals.” Under another rule, however, where a medical professional, for example, is engaged in selling non-medical services, such as teeth whitening, the ostensibly non-medical services may be considered to be part of the professional’s medical practice, an SSTB, if there are shared expenses and common control between the medical and non-medical services.

Somewhat similarly, services in the field of law are defined as “the performance of services by individuals such as lawyers, paralegals, legal arbitrators, mediators, and similar professionals performing services in their capacity as such” and does not include the provision of services that do not require skills unique to the field of law. For example, this would appear to exclude from the SSTB definition a firm that exclusively provided printing, delivery services, or stenography services, apparently even if the business provided such services only in connection with legal matters, such as a legal printer or a process server. However, if a law firm or its owners purported to provide such services separately from its traditional legal services, the taxpayer would need to scrutinize the anti-abuse rule relating to activities that are “incidental” to an SSTB.  

Accounting services are similarly defined as “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.” The preamble explains, however, that payment processing services, for example, would not be considered to be accounting services. A similar approach applies to the definition of prohibited actuarial services.

The definition of performing arts services provides that it includes “creative” professionals like actors and directors, but not the service of maintaining or operating equipment or facilities used in the performing arts, or the broadcasting or dissemination of video or audio of performances. It is unclear how these rules might apply to a cinematographer or camera operator, who some would argue involves a great deal of creativity, or to the host of a television show presenting vintage films, who might not himself be viewed as a performer having or utilizing creative talent – although one would also have to review the potential application of the “principal asset” test described below to fees received for personal appearances.

Similarly, the definition of services in the field of athletics includes athletes, coaches, and team managers but does not include services that do not require skills “unique to athletic competition” such as maintenance of facilities or equipment, or broadcasting or dissemination of video or audio of athletic events. Again, it is unclear how these rules might apply to the operator of an ice-hockey “Zamboni” machine or to a former athlete anchoring a television sports program.

In the field of consulting, there is good news and bad news. The good news is that consulting is defined narrowly as the provision of “advice and counsel” to a client, and apparently does not generally involve actually doing something a consultant might advise the client to do – such as the service of educating or training employees or installing new communications software or equipment. In addition, the definition of an SSTB does not include consulting that is, “embedded in, or ancillary to, the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB (such as typical services provided by a building contractor) if there is no separate payment for the consulting services.” (Emphasis supplied).

The bad news is that the provision of lobbying services is treated as consulting even if there is no “advice and counsel” given and the lobbyist instead simply performs the service of communicating with government officials in an attempt to influence their decisions. Even without this rule, however, such lobbying services could probably have been treated as impermissible personal services because they would arguably be personal services in the field of law.

Financial and brokerage services are defined somewhat narrowly. Financial services include 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 includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals performing services in their capacity as such.

Notably, however, the preamble explains that making a loan is not considered a financial service, and interest on an outstanding loan can qualify as QBI, but only if it is part of an active lending business. Caution may be needed, however, to ensure that a lender is not treated as an SSTB by virtue of being a “dealer” in securities.

Services in the field of “brokerage” includes services provided by stock brokers and other similar professionals, but does not include services provided by real estate agents and brokers, or insurance agents and brokers. In addition, the prohibited performance of the service of managing investments does not include directly managing real property.

A taxpayer, such as a manufacturer or a farmer, who engages in hedging transactions as part of his trade or business of manufacturing or farming is not considered to be engaged in the trade or business of trading commodities.

Finally, we would note that a reasonable inference from the preamble’s statement about lending businesses is that the business of writing or underwriting insurance contracts or annuities might not be considered an SSTB in the field of financial services, but this is not expressly addressed.  

The Principal Asset Test

Perhaps the area of greatest uncertainty under the statute relates to the exclusion of trades or businesses where “the principal asset of such trade or business is the reputation or skill of 1 or more of its employees” or owners. Fortunately, the proposed regulations adopt an extremely limited view of the meaning of this limitation.

In effect, the regulations seem to take the view that “reputation or skill” can only be an “asset” of a business where the business is earning fees from personal endorsements or the like. Thus, the proposed regulations treat as an SSTB only those trades or businesses in which a person receives fees, compensation, or other income for endorsing products or services, licenses or receives 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, or receives fees or compensation for appearing at an event or on radio, television, or another media format.

SSTB Operational Rules

Under a de minimis rule, an otherwise qualified business will not be a SSTB if less than 5 percent of its gross receipts are from activities that would cause the business to be an SSTB, or less than 10 percent of its gross receipts if it has gross receipts of $25 million or less for the taxable year.

In addition, several anti-abuse rules apply to multiple businesses with common ownership involving services typical of an SSTB. The proposed regulations state that an SSTB includes any trade or business that shares common ownership with an SSTB (50 percent or more) and that provides 80 percent or more of its property or services to that commonly owned SSTB. Where the common ownership test is met, but less than 80 percent of the firm’s property or services are provided to the SSTB, only an allocable portion of the firm’s income will be excluded from treatment as QBI. The proposed regulations provide an illustration of this rule:

A, a dentist, owns a dental practice and also owns an office building. A rents half the building to the dental practice and half the building to unrelated persons. Under proposed Prop. Reg. Sec. 1.199A-5(c)(2), the renting of half of the building to the dental practice will be treated as an SSTB.

In addition, the proposed regulations state that if a trade or business shares 50 percent or more common ownership with an SSTB, and shares expenses with the SSTB, it will be treated as incidental to an SSTB and, therefore, will itself be considered an SSTB, if the purportedly non-SSTB business represents no more than five percent of gross receipts of the aggregate, combined businesses. Consider the following illustration.

A pass-through entity owns a number of parking lots throughout a city, as well as a professional sports team. While the parking lots do provide a service, the activity would not otherwise be a SSTB – the sports team, on the other hand, clearly would. One of the parking lots is used solely by the sports team (the players are required to pay to use the lot, but it is reserved for their use) and the sports team and the parking lot business share certain expenses, such as the costs of back-office administrative staff. Finally, gross receipts of the combined business come almost entirely from the sports team, as the team’s ticket sales and media contracts are significantly higher than the receipts from parking customers. As a result, the parking lot business could be considered incidental to the SSTB, and therefore the lot itself is an SSTB.

The interaction of these rules with the general aggregation rules, and the definition of what constitutes a separate trade or business for purposes of section 162, will need to be carefully scrutinized in some cases, both for planning and compliance purposes.

Anti-abuse Rule for Former Employees

In general, the trade or business of providing services as an employee is not an eligible business for purposes of the 20 percent deduction. Thus, employee wages cannot qualify for the deduction. To prevent pass-through employees from converting their status to nominal partners or S corporation shareholders, without any substantial change in their duties, the proposed regulations contain a special “presumption” for former employees who change their status to that of partners or owners. Such a former employee will be presumed to continue to be characterized as an employee of their former employer, solely for purposes of section 199A, if the person continues to provide the same services to his former employer (or related entity) after ceasing to be treated as an employee.

This presumed re-classification would not apply for any other purposes, including worker classification for employment tax purposes. In addition, the presumption can be overcome by showing that the person is not performing services as an employee under applicable tax and legal rules.

The regulations provide the following illustration:

C is an attorney employed as an associate in a law firm (Law Firm 1) and was treated as such for Federal employment tax purposes. C and the other associates in Law Firm 1 have taxable income below the threshold amount. Law Firm 1 terminates its employment relationship with C and its other associates. C and the other former associates form a new partnership, Law Firm 2, which contracts to perform legal services for Law Firm 1. Therefore, in form, C is now a partner in Law Firm 2 which earns income from providing legal services to Law Firm 1. C continues to provide substantially the same legal services to Law Firm 1 and its clients. Because C was previously treated as an employee for services she provided to Law Firm 1, and now is no longer treated as an employee with regard to such services, C is presumed (solely for purposes of section 199A(d)(1)(B) and paragraphs (a)(3) and (d) of this section) to be in the trade or business of performing services as an employee with respect to the services C provides to Law Firm 1 indirectly through Law Firm 2. Unless the presumption is rebutted with a showing that, under Federal tax law, regulations, and principles (including common-law employee classification rules), C’s distributive share of Law Firm 2 income (including any guaranteed payments) will not be QBI for purposes of section 199A. The results in this example would not change if, instead of contracting with Law Firm 1, Law Firm 2 was instead admitted as a partner in Law Firm 1.

These new rules may require taxpayers to be more deliberate in documenting changes in status, whether as the result of a bona fide change in relationship from employee to contractor, or through the granting or issuance of partnership interests to employees (who cannot retain their employee status while holding partnership interests even if there is no change in their duties, according to current IRS policies) including profits interests that may be issued as part of a new or established profit sharing plan.

Aggregation of trades or businesses

The proposed regulations governing the 20 percent deduction clarify when a taxpayer will be required or permitted to aggregate multiple businesses in calculating the allowable deduction. This may facilitate the use of some or all of the wages or property of one business to support a deduction for 20 percent of the income of another, commonly owned business.  Many observers thought the government might use the existing passive activity “grouping” rules for this purpose. Instead, Prop. Reg. Sec. 1.199A-4 creates entirely new guidelines for aggregating trades or businesses under section 199A.

The first step is to determine that there are, in fact, multiple trades or businesses for purposes of section 199A as defined in Prop. Reg. Sec. 1.199A-1(b)(13). That rule provides, with seeming simplicity, that a trade or business for purposes of section 162 – the general rule allowing deductions for trade or business expenses – is considered a trade or business for purposes of section 199A. In addition, when an entity holds and rents or licenses tangible or intangible property to a commonly controlled entity that qualifies as a trade or business, the entity renting or licensing the property is also considered a trade or business for purposes of section 199A, even if it would not otherwise be considered a trade or business. The definition of common control is provided in Prop. Reg. Sec. 1.199A-4(b)(1).

Aggregation is generally elective on the part of the taxpayer – once it is determined that there are multiple trades or businesses. The preamble suggests that in most cases, where there are multiple entities each of which is engaged in trade or business activities, they will be considered separate trades or businesses for purposes of sections 162 and 199A unless they are aggregated for purposes of section 199A under these rules. Somewhat confusingly, the preamble notes elsewhere that in some cases a single trade or business, within the meaning of section 162, may be operated through multiple entities. Accordingly, even where the taxpayer believes he or she is engaged in a single trade or business operated through multiple entities, taxpayers wanting certainty on the issue will want to ensure that the section 199A aggregation requirements are also satisfied.

In order to voluntarily aggregate the following requirements must be satisfied:

  1. The same person, or group of persons, must directly or indirectly own a majority interest in each of the distinct trades or business, for a majority of the taxable year. In applying this rule:
    1. Each of the trades or businesses to be aggregated must have the same taxable year (e.g., a calendar year, or a year ending on the last day of a specified month.) Special rules are provided for short tax years.
    2. A “majority interest” means 50 percent or more of the issued and outstanding shares of S corporation stock or 50 percent or more of the capital OR profits interests in a partnership (or an LLC treated as a partnership for tax purposes).
    3. Family attribution rules will apply. For example, an individual will be deemed to own the interests of their spouse, children, grandchildren, and parents.
  2. None of the aggregated trades or businesses can be an SSTB as defined in Prop. Reg. Sec. 1.199A-5. Note, however, that there are de minimis rules excusing minor amounts of otherwise prohibited activities or income. Prop. Reg. Sec. 1.199A-5 addresses SSTBs, trades or businesses with SSTB income, and how a seemingly qualified trade or business might unexpectedly be treated as a SSTB. Please see the detailed discussion above with respect to SSTBs.
  3. Each of the trades or businesses to be aggregated must meet at least two of the following three factors:
    1. The trades or businesses provide products and/or services that either are the same or are customarily provided together.
    2. The trades or businesses share facilities or share significant centralized business elements (accounting, legal, purchasing, HR, IT, manufacturing, etc.).
    3. The businesses are operated in coordination with or reliant upon other businesses in the aggregated group.

The proposed regulations permit, but do not require, an aggregation of separate trades or businesses for the purposes of the qualified business income (“QBI”), unadjusted basis limitation, and the W-2 limitation. Therefore, if multiple trades or businesses qualify for aggregation, a taxpayer can aggregate all, some, or none of the trades or businesses for purposes of computing their section 199A deduction. Once trades or businesses are aggregated, a taxpayer looks to the combined QBI (including all income and deductions), combined unadjusted basis of property used to qualify under section 199A, and combined W-2 amounts used to qualify under section 199A for their section 199A computation. It is not entirely clear how the rules will apply to a decision not to aggregate, that is followed in a later year by a decision to aggregate. Generally, however, once aggregation is elected it must be continued absent a change in circumstances.

The aggregation election is generally made at the level of the ultimate taxpayer. To permit that flexibility, a pass-through entity will be required to provide its partners with the section 199A attributes for each of the separate trades or businesses in which it invests (another rule that incidentally suggests that a single entity may have multiple trades or businesses). This information allows each ultimate taxpayer to decide whether he wants to aggregate the trades or businesses in question.  

Seemingly aware of the potential burden pass-through entities may face in reporting attributes of numerous separate business, Treasury is seeking guidance on whether there should be an exemption or exclusion from this reporting requirement for certain interests or businesses below a specified size or income level.

Finally, there is, in effect, a mandatory aggregation rule for certain purportedly distinct businesses that are integrated with other businesses that are SSTBs. This is discussed in more detail above.

Miscellaneous computational issues under section 199A

Among other computational rules, the proposed regulations clarify that QBI – the income to which the 20 percent is applied to determine the amount of the deduction – will include gains of an eligible business that are re-characterized from capital gains to ordinary income as a result of the application of section 751 to the “hot” assets of a partnership. QBI will not include net capital gains attributable to section 1231 property of an otherwise qualified business, but it will be computed taking into account any ordinary losses attributable section 1231 property. This may lead to additional complexity, since the computation of whether there is a net section 1231 gain or loss is determined at the taxpayer level, not at the trade-or-business level.  

The proposed regulations contain detailed rules governing the computation and carryforward of losses arising from qualified businesses, both in years in which all such businesses generate losses and in years in which some of the businesses generate gains. In particular, the regulations contain ostensibly taxpayer friendly current year “netting” rules that may prevent losses in one business from disproportionately negating deductions arising from another. These rules should be carefully scrutinized in combination with the aggregation rules, the SSTB rules, and the limitations that may apply differently to different owners, partners, or S corporation shareholders based on their particular income levels.

As an illustration of the complexity that may be involved, consider the following example from the proposed regulations:

(i) F, an unmarried individual, owns as a sole proprietor 100 percent of three trades or businesses, Business X, Business Y, and Business Z. None of the businesses hold qualified property. F does not aggregate the trades or businesses under §1.199A-4. For taxable year 2018, Business X generates $1 million of QBI and pays $500,000 of W-2 wages with respect to the business. Business Y also generates $1 million of QBI but pays no wages. Business Z generates a loss that results in ($600,000) of negative QBI and pays $500,000 of W-2 wages. After allowable deductions unrelated to the businesses, F's taxable income is $2,120,000. Because Business Z had negative QBI, F must offset the positive QBI from Business X and Business Y with the negative QBI from Business Z in proportion to the relative amounts of positive QBI from Business X and Business Y. Because Business X and Business Y produced the same amount of positive QBI, the negative QBI from Business Z is apportioned equally among Business X and Business Y. Therefore, the adjusted QBI for each of Business X and Business Y is $700,000 ($1 million plus 50 percent of the negative QBI of $600,000). The adjusted QBI in Business Z is $0, because its negative QBI has been fully apportioned to Business X and Business Y.

(ii) Because F's taxable income is above the threshold amount, the QBI component of F's section 199A deduction is subject to the W-2 wage and UBIA of qualified property limitations. These limitations must be applied on a business-by-business basis. None of the businesses hold qualified property, therefore only the 50 percent of W-2 wage limitation must be calculated. For Business X, the lesser of 20 percent of QBI ($700,000 x 20 percent = $140,000) and 50 percent of W-2 wages ($500,000 x 50 percent = $250,000) is $140,000. Business Y pays no W-2 wages. The lesser of 20 percent of Business Y's QBI ($700,000 x 20 percent = $140,000) and 50 percent of its W-2 wages (zero) is zero.

(iii) F must combine the amounts determined in paragraph (ii) of this example and compare the sum to 20 percent of taxable income. F's section 199A deduction equals the lesser of these two amounts. The combined amount from paragraph (ii) of this example is $140,000 ($140,000 + $0) and 20 percent of F's taxable income is $424,000 ($2,120,000 x 20 percent). Thus, F's section 199A deduction for 2018 is $140,000. There is no carryover of any loss into the following taxable year for purposes of section 199A.


The new proposed regulations are generally quite favorable to taxpayers, but are well within the apparent limits of the underlying statutory language. However, there may be potential traps or counter-intuitive results in many cases, and the rules are certainly not simple to apply. As we and others scrutinize and apply the new proposed regulations, we will continue to provide appropriate updates to this preliminary summary.

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