Many taxpayers and their advisors are frustrated by the uncertainties created by a number of new provisions of the Tax Cuts and Jobs Act of 2017. Some uncertainties are unavoidable – such as whether the new 20 percent pass-through deduction and other individual provisions will be made permanent, or whether the 21 percent corporate tax rate, theoretically ‘permanent,’ will be increased by a later Congress.
Other issues arise from the novelty of many of the new provisions, the existence of apparent gaps or possible errors in the expedited drafting process, and questions as to whether those gaps can or will be filled by technical corrections legislation, regulations or other IRS guidance. Alternatively, taxpayers and their advisors will simply have to deal with the statutory language as is, and make their best determination as to what Congress intended in any particular case.
Types of tax uncertainties
There are three ways in which tax uncertainties become business problems.
The first is when the taxpayer must compute and pay estimated taxes for 2018, and there is uncertainty, for example, as to whether the 20 percent pass-through deduction will apply. There, the ‘cost’ of the uncertainty is having to come up with cash for tax payments that may end up being overpayments of estimated taxes. Although this can be difficult and costly, many tax advisors will recommend taking a highly conservative position for estimated tax purposes. Estimated tax penalties can be substantial, and although they are computed as a substitute for interest, they are not deductible as interest. In addition, there is generally no ‘reasonable cause‘ or ‘substantial authority‘ exception to their imposition – even if the law is changed or clarified retroactively.
It’s crucial to note that that estimated payment calculations are based on the taxpayer’s original, timely filed return. Therefore, if a taxpayer reduces their quarterly estimated tax payments based on the assumption that they will be able to take a particular return filing position, but ultimately do not take that position on their timely filed original tax return – perhaps as the result of guidance released near the end of taxable year and before returns are filed – and instead file a return with a liability greater that than which was used to calculate estimated tax payments, the taxpayer may face an estimated tax penalty.
The second business problem arises when there is still tax uncertainty at the time a return is filed. There, interest on tax deficiencies is a potential risk, along with accuracy related penalties. Penalties, but not interest, can generally be avoided if there is sufficient support for the position as filed. That may be a ‘reasonable basis’ in some cases, ‘substantial authority’ in other cases, and in some cases a ‘more likely than not’ tax opinion may be key to avoiding penalties. Importantly, these determinations must generally be valid at the time the return is filed. Thus, an opinion or conclusion in December 2018 that a position is reasonable may not be correct when the return is actually filed, say, in April 2019, if intervening guidance is issued. Also, there is generally no way to avoid interest. And for individual taxpayers, including individuals reporting their share of a pass-through entity’s business income on their Form 1040, the interest is not deductible.
The third potential business problem arises where there are possible restructuring opportunities to avoid or minimize tax uncertainty, but there are substantial costs involved, which the taxpayer would prefer to avoid if they will not be needed. An example might be a business that is paying their wages through one entity and earning revenues through another entity, and there is uncertainty as to whether the wages paid by one entity will qualify as wages paid for purposes of applying the 20 percent deduction to the income of the other entity. Restructuring could minimize or avoid that uncertainty, but substantial costs might be involved.
Obviously, each type of uncertainty must be dealt with on its own terms – evaluating risks, costs, and potential benefits. With that as an introduction, here is an overview of the conventional wisdom, as we understand it, related to some of the most significant uncertainties in the domestic pass-through provisions that are being talked about.
- Section 199A – What is a 'service' in certain professional fields?
If a medical practice has a subsidiary or affiliate that only provides flu shots, or blood tests, is that a professional service in the field of health? If a law firm has a subsidiary or affiliate that only provides the service of process-serving, or printing briefs and appellate records, or notarizing documents, is that a professional service in the field of law? If a plumbing contractor advises a homeowner on what type of replacement fixtures are legal under the local building code, and then sells and installs a fixture, is that ‘consulting‘? Is it a professional service in the field of ‘law?‘
In a recent letter to the IRS and Treasury, some members of our WNT office suggested that there is sound existing guidance in the existing IRS rulings under Section 1202 dealing with similar cases. There, the letter argued, the rulings suggest that if a service is a commodity, such that the user of the service is fundamentally indifferent as to the identity of the person providing the service, it is not considered a ‘service” even though it may be providing benefits to the customer or client in the field of health, law, accounting, etc.
Other advisors have suggested that taxpayers look to existing guidance in unrelated code sections using similar language, such as section 448. For example, there is guidance explaining what is meant by the term 'consulting.‘
In this area, if guidance is issued some expect that – other than in abusive cases – it will be issued in the form of a proposed regulation that will not be effective until it is issued in final form. Of course, there can be no assurances on that.
- Section 199A – What does the 'principal asset' test mean?
There is almost no guidance on what the 'principal asset' test in section 1202, incorporated into section 199A, means. Some have argued that – as applied to employees, at least, it is essentially meaningless, since an employer does not ‘own‘ the skill or reputation of his employees as an ‘asset‘ – except perhaps in the case where a tax asset attributable to ‘work force in place‘ exists for tax purposes. In addition, as to the ‘owners’ of the business, it has been suggested that a mechanical test should apply. For employees, the test could not apply unless the amortization deduction for ‘workforce in place‘ or something similar was more than 50 percent of the firm’s gross revenues. For owners, the test could not apply unless the profit margin – attributable to active owners – was more than 50 percent of gross revenues.
Others argue that 'asset' is a shorthand reference to the ‘factors’ going into the production of the goods or services, such as land, labor, capital, etc. Under that view, one would presumably look to whether wages (or the wages of highly skilled workers) constitutes more than 50 percent of gross revenues, to determine if labor (or skilled labor) was the ‘principal’ factor. However, some believe that this interpretation would run at cross purposes with the evident intention of the Congress to create as many jobs as possible with this provision.
Another group believes that the test is getting at what the principal attraction to customers may be. In that light, if the service provided is a commodity, where the identity of the particular individual providing the services is a matter of indifference, the test might not apply. This may be how the IRS has viewed the test – at least in concluding that it doesn’t apply – but that approach could be difficult to enforce, requiring a somewhat subjective analysis of the marketing strategy of each company.
Again, if guidance is issued here, some expect that – other than in abusive cases – it will be issued in the form of a proposed regulation that will not be effective until it is issued in final form. However, no assurances can be provided.
- Is 'crack and pack' abusive? Is it necessary?
Can single trade or business, in a single entity, be bifurcated into distinct activities, some of which qualify and some do not? In theory, it appears that should be permissible, as long as arm’s length pricing is maintained and documented among the different activities. Certainly breaking up into different entities would be helpful, if not too costly.
Thus, if a private hospital maintains a hospital parking structure for the discounted use by patients and employees – funded by a lump sum lease payment from the hospital to a separate entity owning the structure, but with common or overlapping ownership, it appears that the income properly attributable to the parking structure, using arm’s length pricing, should qualify for the 20 percent deduction if it is otherwise eligible as a trade or business. This does not seem abusive, as long as there is a reasonable, arm’s length method of determining the true taxable income of separate activities or entities. The IRS may be concerned with the difficulties of auditing such arrangements, however.
Here too, if guidance is issued, some expect that – other than in abusive cases – it will be issued in the form of a proposed regulation that will not be effective until it is issued in final form. Again, there can be no assurances here.
- Section 199A – Who must pay the 'wages' of a qualifying trade or business?
This issue is extremely complicated. By its terms, however, the legislation suggests that if the economic cost of a 'wage' is incurred, directly or indirectly, by a proprietor, partner, or S corporation shareholder, and it is incurred in the same ‘trade or business‘ generating income inuring to that individual, that should be sufficient to qualify the trade or business income as being from a trade or business paying the 'wages.'
If guidance is issued, some expect that – other than in abusive cases – it will be issued in the form of a proposed regulation that will not be effective until it is issued in final form. Again, however, no assurances can be provided.
- Section 1061 – Will the S Corporation gap be filled?
It seems unlikely that the Congress will allow the new carried interest provision to be avoided, simply by arranging for a carried interest to be held through an S corporation, as the statute suggests is possible. A recent notice (Notice 2018-18) announced that this gap will be closed by retroactive regulations. However, the longer the delay in obtaining regulations and/or technical corrections legislation, the less likely such change would be retroactive.
If there is little cost associated with employing an S corporation, some advisors suggest it may be worth taking the longshot risk that any change to the law will be prospective only. There also may be other types of corporations that may provide benefits, such as certain foreign entities.
- Section 1061 – Section 1231 gains
There is much less agreement as to whether the exclusion of section 1231 gains from 'net long term capital gains' subject to the new carried interest rules was intended or not. There are many who believe a regulation could not overturn the clear statutory language excluding section 1231 gains. If legislation is considered to change the statutory language, it is even more likely to be prospective in effect than legislation changing the S corporation provision.
Additionally, the IRS has recently stated the proposed regulations regarding management fee waivers – when a taxpayer elects to forgo a management fee and instead receives a profits interest in a partnership for management services rendered – have been removed from the priority guidance plan originally issued in October of 2017. The IRS has still been enforcing the code provision regarding management fee waivers in egregious cases, and has stated it will continue to do so. But final regulations are not expected to be a priority.
This may further indicate that the entire subject of ‘carried interest’ is simply not on the priority list for action by the government.