United States

Final regs highlight actions for taxpayers using 20 percent deduction

Critical action items taxpayers need to take

INSIGHT ARTICLE  | 

The Treasury has issued final regulations under section 199A allowing a deduction for up to 20 percent of qualified business income. The final regulations address numerous comments on the proposed regulations and make a number of important substantive changes, some favorable to taxpayers and some unfavorable.

For 2018, the good news is that taxpayers may choose to apply either the older proposed regulations or the new final regulations, but they must generally do so on an 'all-or-nothing' basis. Thus, both sets of regulations may need to be analyzed and compared quickly for returns currently being prepared for 2018. In addition, any restructuring to comply with the final regulations for 2019 may need to be considered now, since the year is underway. To ease both the compliance and the planning process, here is an overview of what we believe are the most important issues of concern and areas for potential immediate action by taxpayers. 

  • Determine if your business activities constitute one or more 'trades or businesses.' These rules are applied at the 'trade or business' level, so the first step in any analysis is to identify the business activities an entity or taxpayer is conducting. In addition, activities that do not constitute a 'trade or business' do not qualify for the deduction.
  • Determine if your business (or businesses) engage in activities that may taint it as an 'SSTB' ineligible for the deduction. Income earned by Specified Service Trades or Businesses (SSTBs) is generally ineligible for the deduction, with exceptions for lower income taxpayers. The ability for even a minimal amount of specified service income to taint an entire trade or business heightens the need for proper identification of the identity and number of trades or businesses carried on by a taxpayer.
  • Determine if your business (or businesses) pays sufficient wages or holds sufficient depreciable assets to enjoy the 20 percent deduction – and if not take appropriate remedial action.  Even 'good' businesses, for owners above certain income limits, must pay sufficient wages or hold sufficient depreciable property to qualify.
  • Determine if aggregation of multiple businesses is necessary or appropriate for 2018 or later years – and take appropriate action.  This can help in ensuring that the benefits of qualifying wages or property are shared amongst related businesses.
  • Determine whether you or your business earn income that does not qualify for the deduction, such as foreign income, guaranteed payments or investment income. Taxpayers may wish to revisit the form and nature of their various investments and income streams to maximize qualifying income.
  • Determine how you will report key items to investors, including the new option to aggregate businesses at the entity level. The ability to aggregate at the entity level is a double-edged sword with compliance benefits and potential planning detriments.

Comparing the final and proposed regulations

Returns filed for 2018 may rely either on the final regulations or the proposed regulations, but must generally do so on an 'all-or-nothing' basis. One cannot 'cherry-pick' favorable provisions from each set of regulations. However, if one is relying on either set of regulations, and there is an open issue not addressed, one can rely on a reasonable interpretation of the statutory language. In all cases, the generally applicable standard for applying the final or proposed regulations or the statute to a set of facts presented on a tax return is whether the interpretation and application has 'substantial authority.' Keep in mind that for taxpayers claiming this deduction the 'substantial authority' penalty – if applicable -- is imposed more readily (i.e., on smaller understatements as a percentage of total tax liability) than is generally the case. In addition, some taxpayers will want to apply a higher standard, such as whether the interpretation is 'more likely than not' correct. This is particularly the case where restructurings or other planning for the future are being considered.

Issue

Final regulations
(Mandatory for 2019 and later, optional for 2018)

Proposed regulations
(Optional for 2018)

Statute
(Relevant to all years if issue not addressed in regulations being applied)

Notes

Definition of 'trade or business'
The deduction is only available against income earned by a trade or business.

Aside from a reference to existing guidance under section 162, the regulations are generally silent on the definition of what constitutes a trade or business. However, they do provide an exception to treat the rental or license of property between related taxpayers (other than C corporations) as a trade or business - regardless of their general treatment under section 162. In addition, a limited safe harbor procedure applicable to the rental of real estate was concurrently issued with the final regulations.

Similar to final regulations, except without a direct statement excluding C corporations from special rule for rentals to related companies.

Not directly addressed.

The existence of separate trades or businesses will be of utmost importance for entities and taxpayers with specified service activities.

Determining whether separate 'trades or businesses' exist
The existence of multiple trades or businesses can impact many aspects of the calculation including the allocation of wages and UBIA against income, the ability to aggregate items, and application of the SSTB rules.

While not directly addressed, the final regulations and related preamble do make several references to use of existing guidance under section 446 to determine the existence of a separate trade or business. In addition, several examples are included illustrating situations were a taxpayer or entity engages in more than one trade or business.

Limited discussion of issue.

Not directly addressed.

 

Definition of 'specified service trade or business'(SSTB)
Income earned by an SSTB is generally not eligible for the deduction.

The final regulations include some favorable, and some unfavorable changes to the definition of an SSTB - while leaving other areas without guidance. Those in the lending, banking, staffing and physical commodity industries will generally see a more favorable result under the final regulations.

Certain industries may see a more favorable result under the proposed regulations. This includes healthcare, for which the proposed regulations required services to be provided 'directly to a patient' to be considered an SSTB.

 

Determination of whether to follow proposed or final regulations - or whether to look only to the statute will vary widely based on industry and specific circumstances.

Businesses tainted by seemingly minor amounts of  SSTB activity
Businesses that involve even minor amounts of forbidden SSTB activities may be tainted and disqualified. 

Businesses with greater than 5% of their revenues from SSTB activities (10% for certain small businesses) will be treated as SSTBs.   However, an entity with 'excess' SSTB activity can argue that it is really two separate trades or businesses -- an SSTB and a non-SSTB.  E.g., giving eye exams and selling or manufacturing eye-glasses. exams.

Similar to final.

Harsh 'cliff' rule not explicitly stated in the statute, although some believe text should be interpreted in that manner.

Taxpayers with SSTB activities must determine whether they are operating one, or multiple, trades or businesses before applying these rules.

SSTB - Treatment of commonly owned entities
In an effort to prevent shifting of SSTB income to related entities, the regulations include  "anti-abuse" rules that treats income earned by related entities as earned by the SSTB itself.

Income earned in exchange for services or products provided to a commonly controlled SSTB-entity is tainted as SSTB income.

Similar, with harsher rule stating that if over 80% of such revenue is from the commonly owned SSTB - all income is SSTB. That rule is not in final regulations.
In addition, smaller, commonly owned businesses that share expenses with an SSTB may be deemed SSTBs if their revenues are not greater than 5% of the total combined group - regardless of the source of income. This rule was also removed from the final regulations

Not addressed.

Final regulations are generally favorable to groups of business that include both SSTB and non-SSTB components.

Calculation of UBIA
Although primarily based on the unadjusted basis (often the cost) of an asset, the regulations provide additional guidance related to the calculation of an assets basis for purposes of calculating the 199A deduction.

UBIA amounts generally higher than those under the proposed regulations, due to additional inclusion of basis from certain step-up transactions, and allowance of basis from carryover transactions.

UBIA amounts are reduced for certain carryover transactions, do not include additional 'step-up'basis amounts.

Not directly addressed.

Final regulations will provide a favorable result in most cases.

Allocation of UBIA
As UBIA is not an item of expense, and thus does not have direct economic effect, the regulations include specific rules on allocating this item to owners of a pass-through entity.

Partnerships - UBIA is allocated in the same manner that section 704 depreciation would be allocated on the  LAST DAY of the tax year.
S Corporations -  UBIA is allocated in accordance with ownership on the LAST DAY of the tax year.

UBIA is allocated in the same proportion as tax deprecation (including 704-c) for the FULL YEAR.

Not directly addressed.

Investors that sell ownership interests during the year may see a zero allocation of UBIA under the final regulations.

Aggregation
To the extent that a taxpayer holds an interest in more than one trade or business, opportunities may exist to aggregate wages and UBIA  - thereby allowing increased benefit of the deduction is one business lacks sufficient wages or UBIA and ensuring that UBIA and wages paid by an unprofitable business are not "lost."

Pass-through entities, as well as individuals, may elect to aggregate their interests in different non-SSTB businesses that are commonly owned and meet certain tests related to interdependencies and common business operations.  Pass-through entities include partnerships, S corporations and trusts.

Similar to final, but only individuals may aggregate -- not pass-through entities.  In addition, family attribution rules are more narrowly defined than in the final regulations - further limiting the ability to aggregate businesses.

Aggregation not available, but taxpayers may be able to argue that activities in multiple entities are part of a single, larger trade or business.

Entity-level aggregation is a double-edged sword.  It may simplify compliance for the entity, but it may deprive partners/owners of certain opportunities.   Family owned business will see enhanced ability to aggregate under the final regulations.

Reporting UBIA and wages
Although the calculation of the deduction occurs at the ultimate taxpayer level, pass-through entities must provide certain data to owners to facilitate this computation.

An entity with more than enough wages and UBIA can exclude certain items - such as UBIA - from its calculation and reporting without putting the entire calculation at risk.

Failure to report any separate item of the overall 199A calculation may cause all items - and therefore the deduction itself - to be deemed zero.

Reporting methods not directly addressed.

Taxpayers should review all implications inherent in omitting or disregarding portions of the calculation and reporting - on both the entity and its owners.

 

Download our table comparing final and proposed regulations under section 199A and listen to our collaborative podcast with the AICPA, Tax reform: Section 199A & tax season.

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