Understanding the new Sec. 199A business income deduction

By Tony Nitti, CPA

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EXECUTIVE
SUMMARY

 
  • Sec. 199A allows taxpayers other than corporations a deduction of 20% of qualified business income earned in a qualified trade or business, subject to certain limitations.
  • The deduction is limited to the greater of (1) 50% of the W-2 wages with respect to the trade or business, or (2) the sum of 25% of the W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property (generally, tangible property subject to depreciation under Sec. 167). The deduction also may not exceed (1) taxable income for the year over (2) net capital gain plus aggregate qualified cooperative dividends.
  • Qualified trades and businesses include all trades and businesses except the trade or business of performing services as an employee and "specified service" trades or businesses: those involving the performance of services in law, accounting, financial services, and several other enumerated fields, or where the business's principal asset is the reputation or skill of one or more owners or employees.
  • Qualified business income is the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business that are effectively connected with the conduct of a business in the United States. However, some types of income, including certain investment-related income, reasonable compensation paid to the taxpayer for services to the trade or business, and guaranteed payments, are excluded from qualified business income.
  • The W-2 wage limitation does not apply to taxpayers with taxable income of less than $157,500 for the year ($315,000 for married filing jointly) and is phased in for taxpayers with taxable income above those thresholds. Income from specified service businesses is not excluded from qualified business income for taxpayers with taxable income under the same threshold amounts.
  • The new law also reduces the threshold at which an understatement of tax is substantial for purposes of the accuracy-related penalty under Sec. 6662 for any return claiming the deduction, from the generally applicable lesser of 10% of tax required to be shown on the return or $5,000 before the new law, to 5% of tax required to be shown on the return or $5,000.
  • The law's many yet-unclear points include its application to rental property, the netting of qualified business income and loss for taxpayers with multiple qualified trades or businesses, determining the deduction for tiered entities, allocating W-2 wages among businesses, and whether compensation paid to an S corporation shareholder is included in W-2 wages for purposes of that limitation.

With the enactment of legislation known as the Tax Cuts and Jobs Act (the Act)1 on Dec. 22, 2017, a new provision of the Internal Revenue Code was born: Sec. 199A, which permits owners of sole proprietorships, S corporations, or partnerships to deduct up to 20% of the income earned by the business. The motivation for the new deduction is clear: to allow these business owners to keep pace with the significant corporate tax cut also provided by the Act.

Income earned by a C corporation is subject to double taxation: first at the entity level, and then a second time at the shareholder level when the corporation distributes its income as a dividend. Part of the Act reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%. While the Act retained the top rate on dividend income of 20%,2 the dramatic decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%.3

In contrast to C corporations, income earned by a sole proprietorship, S corporation, or partnership is subject to only a single level of tax. There is generally no tax at the entity level; instead, owners of these businesses report their share of the business's income directly on their tax return and pay the corresponding tax at ordinary rates. The Act reduced the top rate on ordinary income of individuals from 39.6% to 37%, and Sec. 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S corporations, and partnerships to 29.6%.4

Thus, after the passage of the Act, owners of sole proprietorships, S corporations, and partnerships retained a similarly sizable federal tax rate advantage over owners of a C corporation that they enjoyed prior to the enactment of the new law.5

While the purpose of Sec. 199A is clear, its statutory construction and legislative text is anything but clear. The provision is rife with limitations, exceptions to limitations, phase-ins and phaseouts, and critical but poorly defined terms of art. As a result, Sec. 199A has created ample controversy since its enactment, with many tax advisers anticipating that until further guidance is issued, the uncertainty surrounding the provision will lead to countless disputes between taxpayers and the IRS. Adding concern is that, despite the ambiguity inherent in Sec. 199A, Congress saw fit to lower the threshold at which any taxpayer claiming the deduction can be subject to a substantial-understatement penalty.

This article examines the various computational and definitional elements of claiming the Sec. 199A deduction. It then discusses the primary areas of concern and confusion among tax advisers, highlighting areas where additional guidance is most desperately needed, as well as planning opportunities in the absence of such guidance.

Sec. 199A in general

Effective for tax years beginning after Dec. 31, 2017, and before Jan. 1, 2026,6 a taxpayer other than a corporation is entitled to a deduction equal to 20% of the taxpayer's "qualified business income" earned in a "qualified trade or business."7 The deduction is limited, however, to the greater of:

  • 50% of the W-2 wages with respect to the qualified trade or business;8 or
  • The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.9

The deductible amount of qualified business income for each of the taxpayer's qualified trades or businesses is determined separately and added together. The sum of these amounts is then subject to a second limitation equal to the excess of:

  • The taxable income for the year, over
  • The sum of net capital gain (as defined in Sec. 1(h)) plus the aggregate amount of the qualified cooperative dividends for the tax year.10

The purpose of this overall limitation is to ensure that the 20% deduction is not taken against income that is taxed at preferential rates.

Example 1: In 2018, A, a married taxpayer, has $100,000 of qualified business income, $100,000 of long-term capital gain, and $30,000 of deductions, resulting in taxable income of $170,000. A's Sec. 199A deduction is limited to the lesser of $20,000 (20% of $100,000) or $14,000 (20% of $70,000, the excess of taxable income of $170,000 over net capital gain of $100,000).

Taxpayers entitled to claim the deduction

The Sec. 199A deduction is available to any taxpayer "other than a corporation."11 This includes:

  • Individual owners of sole proprietorships, rental properties, S corporations, or partnerships; and
  • An S corporation, partnership, or trust that owns an interest in a passthrough entity.

With regard to the latter group, future regulations will provide guidance on how to determine the deduction in the case of tiered entities.12

The statute is unclear regarding the determination of the deduction in 2018 for a fiscal-year qualified business. A version of the Act passed by the House of Representatives, which would have generally imposed a top rate of 25% on qualified business income, made clear that taxpayers would be entitled to only a proportional benefit of the reduced rate related to fiscal-year businesses with a tax year that included Dec. 31, 2017.13

The conference committee report to the Act, however, states only that the final version of Sec. 199A is effective "for tax years beginning after Dec. 31, 2017," without differentiating between the tax year of the taxpayer claiming the deduction and the tax year of the business generating the qualified business income.14 Because Sec. 199A is written from the perspective of the taxpayer claiming the deduction — and because the final Act does not contain the specific language governing fiscal-year businesses found in the House bill — it is reasonable to conclude that a calendar-year owner of a fiscal-year business is entitled to claim the full deduction on his or her 2018 tax return, despite the fact that a portion of the income earned by the fiscal-year business was earned prior to 2018.

Example 2: A, an individual, is a shareholder in an S corporation with a fiscal year end of June 30. On A's 2018 Form 1040, U.S. Individual Income Tax Return, A may claim the Sec. 199A deduction for the qualified business income earned by the S corporation for its tax year beginning July 1, 2017, and ended June 30, 2018.

Qualified trade or business

A taxpayer must be engaged in a "qualified trade or business" to claim the Sec. 199A deduction. Sec. 199A defines a qualified trade or business by exclusion; every trade or business is qualified, other than:

  • The trade or business of performing services as an employee;15 and
  • A specified service trade or business.16

The first prohibition prevents an employee from claiming a 20% deduction against his or her wage income.

Example 3: A is an employee, but not an owner, of a qualified business. A receives a salary of $100,000 in 2018. A is not permitted a Sec. 199A deduction against the wage income because A is not engaged in a qualified business.

Specified service business

This second category of disqualified businesses serves the same purpose as the first — to prevent the conversion of personal service income into qualified business income. This latter category, however, takes aim at business owners, rather than employees, prohibiting the owner of a "specified service trade or business" from claiming a Sec. 199A deduction related to the business.

Sec. 199A(d)(2) defines a specified service trade or business by reference to Sec. 1202(e)(3)(A), which includes among the businesses ineligible for the benefits of that section:

any trade or business involving the performance of services in the fields of health, law, engineering, architecture, 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.

Sec. 199A modifies this definition in two ways: first, by removing engineering and architecture from the list of prohibited specified services businesses17 before then amending the final sentence to reference the reputation or skill of one or more of its "employees or owners" rather than merely its "employees."18 Sec. 199A(d)(2)(B) then adds to the list of specified service businesses any business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.19 However, see the discussion below of the taxpayer income threshold exception to the denial of the deduction for a specified service trade or business.

Qualified business income

Once a taxpayer has established that he or she is engaged in a qualified trade or business, the taxpayer must determine the "qualified business income" for each separate qualified trade or business.

Qualified business income is defined as the net amount of qualified items of income, gain, deduction, and loss with respect to a qualifiedtrade or business20 that are effectively connected with the conduct of a business within the United States.21 Qualified business income does not include, however, certain investment-related income, including:22

  • Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss;
  • Dividend income, income equivalent to a dividend, or payment in lieu of a dividend described in Sec. 954(c)(1)(G);
  • Any interest income other than interest income properly allocable to a trade or business;
  • Net gain from foreign ­currency transactions and commodities transactions;
  • Income from notional principal contracts, other than items attributable to notional principal contracts entered into as hedging transactions;
  • Any amount received from an annuity that is not received in connection with the trade or business; and
  • Any deduction or loss properly allocable to any of these bulleted items described above.

Sec. 1231 gain

The statute is silent on the treatment of Sec. 1231 gain in determining qualified business income. In general, a Sec. 1231 asset is any depreciable asset or real property used in a trade or business for more than one year.23 A Sec. 1231 asset is specifically excluded from the definition of a capital asset.24

When an S corporation or partnership sells a Sec. 1231 asset, the transaction is not characterized as long-term capital gain or loss at the business level; rather, the item simply retains its character as Sec. 1231 gain or loss as it passes through to the owners. At the ­individual owner level, the taxpayer must net all Sec. 1231 gains and losses. A net gain is treated as long-term capital gain,25 while a net loss is deducted as an ordinary loss.26

Both the House and Senate versions of what would become Sec. 199A stated that qualified business income does not include any item taken into account in determining net long-term capital gain or net long-term capital loss, without specifying whether it needs to be "taken into account" at the business or owner level.27 If it is the former, because Sec. 1231 gain is separately stated at the S corporation or partnership level, with its ultimate character determined only after netting at the shareholder or partner level, one could reasonably conclude that the Sec. 1231 gain is not "taken into account" in determining the long-term capital gain of the business and thus should not be excluded from qualified business income.

There is an additional, and perhaps more straightforward, reason that qualified business income should include Sec. 1231 gain. The bulleted items listed above are meant to codify the intent of the legislative history of Sec. 199A that certain "investment-related income" not be included in qualified business income.28 Because a Sec. 1231 asset is, by definition, not a capital asset but rather an asset used in a trade or business, gain from the sale of such an asset should not be treated as investment-related income. As a result, until guidance from the IRS provides otherwise, it is reasonable to include Sec. 1231 gains and losses in qualified business income.

Reasonable compensation and guaranteed payments

In addition, qualified business income does not include:29

  • Reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business;
  • Any guaranteed payments described in Sec. 707(c) paid to a partner for services rendered with respect to the trade or business; and
  • To the extent provided in regulations, any payment described in Sec. 707(a) to a partner for services rendered with respect to the trade or business.

As discussed later in this article, Congress's decision to exclude from qualified business income wages paid to a shareholder or guaranteed payments to a partner will place those taxpayers at a disadvantage relative to sole proprietors at certain income levels.

Shareholder or partner's allocable share

A shareholder in an S corporation and a partner in a partnership must take into account only his or her allocable share of each qualified item of income, gain, deduction, and loss. A shareholder determines his or her allocable share of S corporation income on a per-share, per-day, pro rata basis, as provided by Sec. 1377. A partner determines his or her allocable share of partnership income by taking into consideration any special allocations permitted by Sec. 704.

Example 4: A is a 30% shareholder in an S corporation for all of 2018. The S corporation generates $100,000 of qualified business income in 2018. Under the pro rata, per-share, per-day allocation rules of Sec. 1377, A's share of the qualified business income is $30,000.

Determining the deductible amount

Tentative deduction

A taxpayer determines his or her deductible amount separately for each qualified trade or business. The taxpayer begins by computing a tentative deduction equal to 20% of qualified business income.

Example 5: A owns 20% of X, an S corporation, and 30% of Y, a partnership. Both X and Y are qualified businesses. X allocates to A $40,000 of qualified business income. Y allocates to A $20,000 of qualified business income. A's tentative deduction related to X is $8,000, and his tentative deduction related to Y is $4,000.

50% of W-2 wages limitation

For taxpayers with taxable income in excess of a threshold, the tentative deduction attributable to each separate qualified trade or business is limited to the greater of:

  • 50% of the W-2 wages with respect to the qualified trade or business;30 or
  • The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.31

"W-2 wages" are the total wages (as defined in Sec. 3401(a)) subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to its employees during the calendar year ending during the tax year of the taxpayer.32 The wages must be properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for the return.33

A shareholder in an S corporation and a partner in a partnership take into account only their allocable share of the W-2 wages paid by the business before applying the 50% limitation.34 The shareholder determines his or her allocable share on a strict per-share, per-day, pro rata basis.35 A partner's allocable share is determined in the same manner as the partner's share of the partnership's wage expense.36

Example 6: A owns a 30% interest in Partnership ABC, which conducts a qualified business. Pursuant to the terms of the operating agreement, A is specially allocated 40% of all of the ordinary income or loss of the partnership and 70% of all depreciation expense. Partnership ABC pays $100,000 of W-2 wages in 2018.

Because the partnership's deduction for W-2 wages is part of its ordinary income or loss, A must be allocated 40% of the partnership's W-2 wages.

25% of W-2 wages plus 2.5% of unadjusted basis limitation

The version of Sec. 199A that initially passed the Senate contained only the "50% of W-2 wages" limitation. During the subsequent conference committee meetings, however, an alternate limitation was added: 25% of W-2 wages, plus 2.5% of the unadjusted basis of "qualified property."

The unstated motivation behind this late addition to the statute was to permit owners of rental property to qualify for the benefits of Sec. 199A. Often, an entity that owns rental property — typically, a partnership — does not pay W-2 wages; rather, it pays a management fee to a management company. Because a management fee is not considered W-2 wages for the purposes of Sec. 199A, without this last-minute change, many large landlords would have been shut out from claiming the deduction.

Example 7: A owns a commercial rental property through a limited liability company (LLC). His share of the rental income earned by the LLC is $800,000. The LLC pays no W-2 wages, but A's share of the unadjusted basis of the building is $10 million.

In the absence of the alternate limitation, A would be entitled to no deduction because the "50% of W-2 wages" limitation would be zero. Under the final version of Sec. 199A, however, A is entitled to a deduction of $160,000, the lesser of 20% of qualified business income or the greater of:

  • 50% of W-2 wages = $0; or
  • 25% of W-2 wages plus 2.5% of $10 million = $250,000.

A shareholder or partner may only take into consideration 2.5% of his or her allocable share of the unadjusted basis of qualified property. A shareholder is allocated basis on a strict per-share, per-day basis. A partner, however, must be allocated basis in the same manner in which he or she is allocated the partnership's depreciation expense.37

Example 8: A owns a 30% interest in Partnership ABC, which conducts a qualified business. Pursuant to the terms of the operating agreement, A is specially allocated 40% of all of the ordinary income of the partnership and 70% of all depreciation expense. Partnership ABC pays no W-2 wages but owns a commercial building with an unadjusted basis of $20 million in 2018.

In computing A's share of that unadjusted basis, A must be allocated 70% of the basis, the same percentage A is allocated of the partnership's depreciation expense. Thus, A's alternate limitation is $350,000 ($20,000,000 × 70% × 2.5%).

Only the unadjusted basis of qualified property is counted toward the limitation. Qualified property is tangible property subject to depreciation under Sec. 167; as a result, the basis of raw land and inventory, for example, would not be taken into account.38 The basis of property used to determine the limitation is unadjusted basis determined "immediately after acquisition."39 Thus, the basis is not reduced for any subsequent depreciation. It is not clear whether capitalized leasehold improvements, which are generally treated as an adjustment to basis of the underlying building, are considered qualified property.

It is also unclear whether a partnership that elects to step up the basis in its underlying property pursuant to Sec. 754 may include the step-up in its qualified property. At first blush, because the increase in basis is treated for tax purposes as a new asset placed in service by the partnership, to the extent the step-up is allocated to depreciable assets, it would appear to create qualified property.40 If the policy reason behind allowing the "2.5% of unadjusted basis" limitation was to reward business owners who invest in tangible assets, however, it is unlikely that a Sec. 754 step-up, which reflects an increase in the ­underlying value of partnership property, rather than a new investment, should be included in qualified property. As with many aspects of Sec. 199A, advisers must await further guidance.

Qualified property must have been used at any point during the tax year in the production of qualified business income and be held by, and available for use in, the qualified business at the close of the tax year.41

A taxpayer may take into consideration the unadjusted basis of property only for a year for which the "depreciable period" of the property has not ended before the close of the tax year.42 The depreciable period begins on the date the property is placed in service and ends on the later of:

  • 10 years after the date placed in service;43 or
  • The last day of the last full year in the applicable recovery period that would apply to the property under Sec. 168 (ignoring the alternative depreciation system).44

    Example 9: On April 12, 2010, Partnership AB, a calendar-year partnership, places in service a piece of machinery purchased for $50,000 that has a five-year modified accelerated cost recovery system (MACRS) life.

The partners may take into account their allocable share of the $50,000 unadjusted basis of the property in 2018, despite the fact that the asset was fully depreciated before the year began. This is because the depreciable period runs for the longer of:

  • 10 full years from April 12, 2010 (to April 12, 2020); or
  • The last day of the last full year in the recovery period, which for a five-year MACRS asset placed in service during 2010 would have been 2014.

The partners will also take into account the $50,000 unadjusted basis of the property in 2019. The basis will not be taken into account in 2020, however, because the depreciable period ends on April 12, 2020, before the end of the 2020 tax year.

Alternatively, assume the machinery was placed in service on June 1, 2008. The partners of Partnership AB would not take the $50,000 unadjusted basis into account in 2018 because the depreciable period ended on June 1, 2018, before the close of the 2018 tax year.

Regulations will provide rules for determining the unadjusted basis immediately after acquisition of qualified property acquired in like-kind exchanges or involuntary conversions.45

Exception to W-2 and qualified property—based limitations based on taxable income

The W-2 and qualified property-based limitations do not apply when the taxpayer claiming the deduction has taxable income for the year of less than $315,000 (if married filing jointly; $157,500 for all other taxpayers).46 Taxable income for these purposes is determined without regard to any Sec. 199A deduction.47

Example 10: A is a sole proprietor. The business generates $100,000 of qualified business income during 2018 but pays no W-2 wages and has no qualified property. A files jointly with his wife for 2018, and their combined taxable income for the year, including the qualified business income, is $250,000.

Absent this exception, A's tentative deduction of $20,000 would be limited to zero, the greater of:

  • 50% of W-2 wages = $0; or
  • 25% of W-2 wages plus 2.5% of unadjusted basis of qualified property = $0.

Because A's taxable income for 2018 is less than $315,000, however, the W-2 limitations do not apply, and A is entitled to claim the full $20,000 deduction.

The W-2 limitations are phased in over the next $100,000 of taxable income (if married filing jointly; $50,000 for all other taxpayers).48 Thus, once taxable income reaches $415,000 for a married taxpayer filing jointly ($207,500 for all other taxpayers), the W-2 limitations apply in full.

Example 11: A is a sole proprietor. During 2018, the business generates $400,000 of qualified business income, pays $120,000 of W-2 wages, and has $100,000 of qualified property. A files jointly with his spouse for 2018, and their combined taxable income for the year, including the qualified business income, is $600,000.

A's tentative deduction is $80,000 ($400,000 × 20%). Because A's taxable income for 2018 is greater than $415,000, however, the W-2 limitations apply in full. As a result, A's deduction is limited to the greater of:

  • 50% of W-2 wages = $60,000; or
  • 25% of W-2 wages ($30,000) plus 2.5% of unadjusted basis of qualified property ($2,500) = $32,500.

Thus, A is entitled to a $60,000 deduction in 2018.

Exception to the denial of deductions for specified service businesses based on taxable income

Similarly, the prohibition on claiming the Sec. 199A deduction based on income earned in a specified service business does not apply if the taxpayer claiming the deduction has taxable income of less than $315,000 (if married filing jointly; $157,500 for all other taxpayers).49 Because the two W-2-based limitations also do not apply when taxable income is below those same thresholds, a taxpayer in a specified service business with taxable income below the thresholds simply deducts 20% of any qualified business income (subject to the overall limitation).

Example 12: A, a single taxpayer, is an attorney who operates his business as a partnership. The partnership pays no W-2 wages during the year. During 2018, A earns $100,000 from his law business and has total taxable income of $150,000. While A would otherwise be barred from claiming a deduction under Sec. 199A by virtue of being engaged in a specified service business, because A's taxable income is less than $157,500, the prohibition on specified service businesses does not apply. In addition, because taxable income is less than $157,500, the W-2 limitations do not apply. As a result, A's final deduction is $20,000 (20% of $100,000).

The ability for owners of a specified service business to claim the deduction is phased out over the next $100,000 of taxable income (if married filing jointly; $50,000 for all other taxpayers), so that once taxable income exceeds $415,000 (if married filing jointly; $207,500 for all other taxpayers), the deduction is lost completely.50 The W-2-based and property-based limitations are phased in over the same span of taxable income.

Example 13: Assume the same facts as in the previous example, except A has taxable income of $230,000. Because taxable income exceeds $207,500, A is not entitled to any deduction under Sec. 199A.

Reporting the deduction

The Sec. 199A deduction does not reduce a taxpayer's adjusted gross income.51 The deduction is taken after adjusted gross income is determined, but it is not an itemized deduction;52 rather, the deduction is available to both taxpayers who itemize deductions and those who claim the standard deduction.53 For purposes of determining a taxpayer's alternative minimum taxable income, qualified business income is computed without any adjustments or preference items under Secs. 56 through 59.54 As a result, a taxpayer's Sec. 199A deduction for alternative minimum tax purposes will be identical to the deduction against regular tax.

The Sec. 199A deduction is allowed only for purposes of Chapter 1 of the Code (income taxes).55 Thus, the deduction does not reduce a taxpayer's self-employment income (as this tax is levied under Chapter 2) or net investment income (Chapter 2A). The Sec. 199A deduction is also not allowed in determining a net operating loss deduction.56

Increased exposure to underpayment penalty

Sec. 6662 imposes a 20% accuracy-related penalty on an underpayment of tax due to a substantial understatement of tax. Generally, for taxpayers other than C corporations, the understatement is substantial if its amount for the tax year exceeds the greater of:

  • 10% of the tax required to be shown on the return for the tax year; or
  • $5,000.57

Part of the Act amended Sec. 6662 to provide that any taxpayer who claims a Sec. 199A deduction is subject to a lower threshold before a substantial-understatement penalty is applied, equal to the greater of:

  • 5% of the tax required to be shown on the return for the tax year; or
  • $5,000.58

This lower threshold is particularly harsh, given the lack of guidance surrounding key aspects of Sec. 199A and the resulting challenges taxpayers and their advisers face in implementing the provision. Importantly, the changes to Sec. 6662 do not require the substantial understatement to be attributable to the Sec. 199A deduction. Thus, any taxpayer who claims the deduction will be subject to the lower threshold, even if the understatement on the return is unrelated to Sec. 199A.

Problem areas and planning opportunities

Satisfying the 'trade or business' standard

Congress's use of the term "qualified trade or business" for purposes of Sec. 199A could prove problematic. While a "trade or business" is not defined in the Code or regulations, the most established use of the term is in Sec. 162, which permits a deduction for all the ordinary and necessary expenses paid or incurred in carrying on a trade or business.

Case law has determined that to reach the standard of a Sec. 162 trade or business, a taxpayer must be involved in the activity "with continuity and regularity" and not merely sporadically, and the taxpayer's primary purpose for engaging in the activity must be for income or profit.59 As a result, determining whether an activity constitutes a Sec. 162 trade or business is generally a factual decision.

If Sec. 199A does indeed require a qualified business to satisfy a Sec. 162 trade-or-business standard, this may create problems for some taxpayers who own rental property. In the preamble to the Sec. 1411 regulations governing the imposition of the net investment income tax, the IRS stated that "the Treasury Department and the IRS do not believe that the rental of a single piece of property rises to the level of a trade or business in every case as a matter of law."60

Decades of judicial precedent have provided little resolution to the issue. When determining whether a rental rises to the level of a trade or business, the courts have based their decisions on various factual elements including the type of property (e.g., commercial real property versus a residential condominium versus personal property); the number of properties rented; the day-to-day involvement of the owner or its agent; and the type of rental (e.g., a net lease versus a traditional lease, or short-term versus long-term lease).

Perhaps future regulations under Sec. 199A will take a page from the Sec. 1411 final regulations and offer a safe harbor whereby rental owners can quantitatively establish that a rental rises to the level of a Sec. 162 business, or even provide that all rental activities will be treated as having met this standard.

Until then, however, evidence in Sec. 199A indicates that Congress intended for all rental activities to be treated as qualified trades or businesses. Sec. 199A(b)(1)(B) permits a noncorporate taxpayer to deduct 20% of any qualified dividends from a real estate investment trust (REIT). REITs are prohibited by statute from engaging in rental activities that require significant personal services; as a result, REITs largely generate the very type of passive income — for example, rental income earned via a triple-net lease — that if earned by a non-REIT rental activity could cause the activity to fail to rise to the level of a Sec. 162 trade or business. Thus, it follows that if a 20% deduction is permitted against dividends earned by a REIT, the deduction should similarly be permitted against even the most hands-off of rental activities.

Netting of qualified business income and loss

Sec. 199A requires that a deduction be determined separately for each qualified trade or business. The statute does not specifically address, however, how to compute the deduction for a taxpayer who operates multiple qualified trades or business, one or more of which generate qualified business income, and one or more of which generate a loss.

A detailed analysis of the legislative text, coupled with a review of the conference committee report, yields some answers but also raises a critical new question.

The conference committee report describing the Senate version of Sec. 199A — which allowed for a 23% deduction rather than the 20% under final law — states:61

If the net amount of qualified business income from all qualified trades or businesses during the taxable year is a loss, it is carried forward as a loss from a qualified trade or business in the next taxable year.

The language continues:

Similar to a qualified trade or business that has a qualified business loss for the current taxable year, any deduction allowed in a subsequent year is reduced (but not below zero) by 23 percent of any carryover qualified business loss. [emphasis added]

The second quote is critical; it establishes that Congress intended for a "negative deduction" attributable to a qualified business loss to reduce or offset a deduction attributable to qualified business income. This intent is illustrated by the following example:

Example 14: In year 1, A is allocated qualified business income of $20,000 from qualified business 1 and a qualified business loss of $50,000 from qualified business 2. A is not permitted a deduction under Sec. 199A in 2018 and has a carryover qualified business loss of $30,000 to 2019. In year 2, A has qualified business income of $20,000 from qualified business 1 and qualified business income of $50,000 from qualified business 2.

To determine the Sec. 199A deduction for 2019, A reduces the 20% deductible amount determined for the qualified business income of $70,000 from qualified businesses 1 and 2 by 20% of the $30,000 carryover business loss.62

This requirement that a taxpayer use a negative deduction to offset a positive deduction is essential to limiting the Sec. 199A deduction to the amount attributable to the taxpayer's net qualified business income.

Example 15: In 2018, A, a married taxpayer, is allocated $400,000 of qualified business income from qualified business 1 and $300,000 of qualified business loss from qualified business 2. Assume that A's share of the W-2 wages paid by business 1 is $200,000 and that A's taxable income exceeds $415,000, so that the W-2 limitations apply in full.

A is required to compute his Sec. 199A deduction for each separate business. His deduction attributable to business 1 is $80,000, the lesser of 20% of $400,000 ($80,000) or 50% of business 1's W-2 wages ($100,000). By allowing qualifying business income to be negative, when determining his deduction attributable to business 2, A takes into account a $300,000 qualified business loss. His tentative deduction related to the business is a negative $60,000, which, by definition, will always be less than any W-2-based or basis-based limitations. Thus, the $60,000 negative deduction reduces the $80,000 positive deduction attributable to business 1, leaving A with a $20,000 deduction on $100,000 of net qualified business income.

While the "negative deduction" in the preceding example leads to a just result, in certain scenarios, the requirement that a taxpayer compute the Sec. 199A deduction on a business-by-business basis could conceivably lead to a situation where the taxpayer generates a net negative deduction,or stated another way, taxable income. Consider the following example:

Example 16: Assume the same facts as in the preceding example, except business 1 pays only $100,000 of W-2 wages. A's tentative deduction attributable to business 1 of $80,000 is limited to $50,000 (50% of $100,000). A continues to generate a negative deduction of $60,000 attributable to business 2 (20% of a $300,000 qualified business loss). Thus, A has a positive Sec. 199A deduction of $50,000 but a negative Sec. 199A deduction of $60,000, for a net negative deduction of ($10,000).

This is not a logical result, but, at present, nothing in the legislative text appears to prevent it. The final version of Sec. 199A incorporates the examples in the conference committee report, allowing for a carryover of losses only when net qualified business income for the year is a negative number.63 In Example 16, however, net qualified business income is a positive number; only the net deduction is negative. So what is to be done with the net negative deduction? Is it taken into income during the current year? Or, much more likely, is it carried forward to a subsequent year to reduce a future positive Sec. 199A deduction? Tax advisers await guidance on this critical issue, as it will impact 2018 estimated payments as early as April.

W-2 wage limitation: Allocation among businesses

Additional guidance is also needed to clarify several aspects of the W-2-based limitations.

First, Sec. 199A requires the deduction to be determined with respect to each separate qualified trade or business. This could prove problematic for many common business structures, particularly businesses that do not hold a significant amount of property.

To illustrate, consider a group of commonly controlled businesses. The shareholders form a separate S corporation in each state in which the business operates, but all of the employees for the operating companies are housed in one management company. In addition, none of the operating companies hold significant qualified property.

At present, Sec. 199A does not allow for an allocation of the W-2 wages paid by the management company to each of the operating companies. As a result, assuming the shareholders of the operating companies have taxable income exceeding the threshold amounts, they would be precluded from claiming a deduction, courtesy of the W-2 limitations. Similar problems arise in the case of employees leased through a professional employer organization (PEO) or employee leasing firm.

This problem could be remedied through an elective grouping regime that allows owners to aggregate their qualified trades or businesses for purposes of Sec. 199A. For example, the W-2 wages paid by a centralized management company could be combined with the qualified business income of the operating companies, enabling the owners to claim a deduction that would otherwise be unavailable.

As currently constructed, however, Sec. 199A does not appear to be trending toward a grouping regime. Had Congress envisioned such a path, it likely would have written Sec. 199A in terms of "activities" rather than "qualified trades or businesses," so that future regulations could leverage off the existing grouping regime found in the passive-activity rules of Sec. 469.

Further evidence that a grouping regime is unlikely to come to fruition is found in the late addition to Sec. 199A of the alternate "2.5% of unadjusted basis" limitation. As discussed above, this limitation was added specifically to generate a deduction for owners of rental properties that generally do not pay W-2 wages but, rather, pay a management fee to a management company, with the management company in turn paying W-2 wages to employees. If a grouping election were forthcoming, the "2.5% of unadjusted basis" limitation would have been unnecessary where the owners of the rental property also were the owners of the management company, as the owners would simply aggregate the businesses, combining the W-2 wages and qualified business income for purposes of the Sec. 199A deduction.

A fix may be looming in future regulations, however, because Sec. 199A(f)(4) requires the IRS to issue regulations "for requiring or restricting the allocation of items and wages under this section . . . as the Secretary determines appropriate." The IRS will not have to look far for a framework to be used in allocating W-2 wages among commonly controlled entities because a predecessor to Sec. 199A — Sec. 199 — dealt with a similar conundrum.

Sec. 199, which was repealed effective Jan. 1, 2018,64 provided a deduction to domestic producers. That deduction, however, was limited to 50% of the W-2 wages of the taxpayer for the year.65 For determining a taxpayer's W-2 limitation, regulations under Sec. 199 permitted the taxpayer to take into account any wages paid by another entity and reported by the other entity on Forms W-2, provided that the wages were paid to employees of the taxpayer for employment by the taxpayer.66 The result was that a "common law employer" was allocated wages for the purposes of the W-2 limitation even if the wages were paid by a related party, PEO, or employee leasing firm. A similar provision would provide much-needed relief to many taxpayers seeking to claim a deduction under Sec. 199A.

W-2 wage limitation: Inclusion of shareholder compensation

There is a second shortcoming with the current W-2 limitations. In its definition of W-2 wages counted toward the limitation, Sec. 199A does not differentiate between wages paid to nonowner employees and wages paid to a shareholder in an S corporation. This can yield inequitable results for similarly situated businesses when taxable income is above the thresholds at which the W-2 limitations apply in full.

To illustrate, consider the following example:

Example 17: A and B own identical businesses. Neither business has any employees or any qualified property. Each business generates $500,000 of qualified business income before any wages are paid. A operates his business as a sole proprietor; B as a wholly owned S corporation.

Because A's business has no employees — and because, as a sole proprietor, A cannot pay himself a wage — A has a W-2 wage limitation of zero. Thus, A is entitled to no deduction.

As opposed to a sole proprietor, a shareholder who provides significant services to an S corporation is required to receive "reasonable compensation."67 This requires a shareholder to be paid W-2 wages from the corporation, wages that Sec. 199A appears to include in the total wages paid by the business for the purposes of the W-2 limitation. This will place sole shareholders in an S corporation in an advantageous position relative to sole proprietors at income levels where the W-2 limitations apply in full.

Example 18: Continuing the previous example, B, as a shareholder in an S corporation, must comply with the reasonable-compensation requirement. As a result, assume B pays himself $80,000 in 2018. Because the $80,000 of reasonable compensation B receives from the corporation is not included in qualified business income, B's tentative deduction is $84,000 (20% × $420,000). This reasonable compensation creates $80,000 of W-2 wages, however, and a corresponding W-2 limit of $40,000. This leaves B with a deduction of $40,000.

In summary, A, who operates a business as a sole proprietorship, gets no deduction, while B, who operates an identical business as a wholly owned S corporation, is entitled to a deduction of $40,000 by virtue of being required to pay himself wages. This result makes little sense, given the objectives of Sec. 199A.

Inclusion of owner's compensation in qualified business income

Making matters worse, contrary to the preceding example, a shareholder of an S corporation is disadvantaged relative to a sole proprietor when the owner's taxable income is below the threshold at which the W-2 limitations apply. This is because Sec. 199A provides that qualified business income does not include reasonable compensation paid to a shareholder in an S corporation or guaranteed payments made to a partner in a partnership. Consider the following example:

Example 19: Assume the same facts as in the previous two examples, except the income earned in each business is $150,000 rather than $500,000. Assume further that both A and B have taxable income below the $315,000/$157,500 thresholds.

A, the sole proprietor, is entitled to a deduction of $30,000 (20% of $150,000). B, the sole shareholder of the S corporation, remains required to pay himself reasonable compensation. Assume he is paid W-2 wages of $70,000. This reduces the qualified business income B receives from the S corporation to $80,000 and in turn reduces B's Sec. 199A deduction to $16,000.

Thus, when income is below the threshold, the reasonable-compensation requirement works against the shareholder in the S corporation, reducing both his qualified business income and Sec. 199A deduction. A, the sole proprietor, has no such requirement and thus preserves the full amount of his qualified business income, giving him a deduction of $30,000, when his S corporation shareholder counterpart receives a deduction of only $16,000.

The results reflected in Examples 17 through 19 are problematic; similarly situated taxpayers should generally enjoy similar federal income tax consequences. But by virtue of two pieces of Sec. 199A — the inclusion of wages paid to an owner in the W-2 limitation and the exclusion from qualified business income of reasonable compensation and guaranteed payments paid to an owner — inequities arise at all income levels.

These inequities could be resolved fairly simply by:

  1. Providing that the W-2 wage limitations do not include any amounts paid to an S corporation shareholder; and
  2. Providing that any reasonable compensation or guaranteed payments received by an owner of a qualified business are included in the determination of qualified business income.

There is support for the latter position in the legislative history. The version of Sec. 199A proposed by the House specifically included both items in the definition of "qualified business income."68 The conference committee report explained the reasoning as follows:

Net business income or loss includes the amounts received by the individual taxpayer as wages, director's fees, guaranteed payments and amounts received from a partnership other than in the individual's capacity as a partner, that are properly attributable to a business activity. . . . This rule is intended to ensure that the amount eligible for the 25-percent tax rate is not erroneously reduced because of compensation for services or other specified amounts that are paid separately . . . from the individual's distributive share of passthrough income.69

Perhaps future guidance under Sec. 199A will embrace this concept as well as the removal of shareholder compensation from the W-2 wage limit, creating equity between sole proprietors and sole shareholders of an S corporation. Absent these modifications, however, tax preparers must apply the statute as it is written, despite the anomalous results.

Reasonable compensation

There is, however, another potential solution to the inequity described immediately above. As discussed previously, Sec. 199A(c)(4) provides that qualified business income does not include any reasonable compensation paid to the taxpayer by any qualified trade or business for services. Some have speculated that this provision seeks to expand the reasonable-compensation requirement beyond shareholders in an S corporation, requiring sole proprietors and partners in a partnership to treat a portion of their business income as reasonable compensation. This would reduce the qualified business income eligible for the Sec. 199A deduction, putting them on equal footing with a shareholder in an S corporation.

Applying a reasonable-compensation standard to sole proprietors and partners would not remedy all of the inequities currently resulting under Sec. 199A. For example, future regulations could require a partner to withdraw reasonable compensation from a partnership, but what form would this payment take? The IRS has long held the position that a partner cannot be paid W-2 wages.70 If reasonable compensation paid to a partner were instead categorized as a guaranteed payment, Sec. 199A, as currently constructed, would not include that amount in the W-2 limitation, potentially preventing partners with taxable income in excess of the threshold at which the W-2 limitations apply from claiming a deduction.

More importantly, expanding the reasonable-compensation requirement beyond shareholders in an S corporation would be a departure from current policy and would layer additional complexity onto an already nebulous reasonable-compensation standard. Over a half-century has passed since the reasonable-compensation standard was established for S corporations, and the issue continues to generate significant disputes between taxpayers and the IRS, often ending in litigation. Any attempt to apply such an imprecise standard to sole proprietors and partners would only exacerbate an already problematic provision of the law.

Definition of specified service business

The most troubling aspect of Sec. 199A over the coming months and years is likely to be the definition of the "specified service businesses" for which a taxpayer is generally ineligible to claim the deduction.71

As quoted and discussed earlier in this article, Sec. 199A defines a specified service business, in part and before modification, by reference to Sec. 1202(e)(3)(A), which provides that disqualified businesses include:

any trade or business involving the performance of services in the fields of health, law, engineering, architecture, 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.

While doctors, accountants, and attorneys will clearly fall victim to the specified fields found in this definition, many businesses will not fit so neatly into one of the disqualified categories. For example, while an actor is in the field of performing arts, is a director? A makeup artist? A producer?

Making matters worse, the history of Sec. 1202 offers little clarification, because while the provision has been in the Code since 1993, it has only recently become widely utilized.72 As a result, there is currently little guidance in the form of administrative rulings or judicial precedent to further elaborate on the types of activities that will disqualify a taxpayer.

Taxpayers and tax advisers desperate for additional clarity may look to other provisions of the Code. For example, Sec. 448 excludes "personal service corporations" from the general requirement that a C corporation use the accrual method of accounting once average gross receipts exceed a threshold.73 To qualify as a personal service corporation, one of the requirements is that more than 95% of the time spent by employeesmust be devoted to the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, a list of businesses that is nearly identical to that found in Sec. 1202(e)(3)(A).74

The Sec. 448 regulations provide additional guidance on what it means to provide services in certain disqualified fields. For example, performance of services in the field of health means "the provision of medical services by physicians, nurses, dentists, and other similar healthcare professions," but does not include "the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient," such as "the operation of health clubs or health spas."75 Additional guidance and case law provide that veterinarians,76 medical ambulance professionals,77 and radiation oncologists78 are engaged in the field of health. Similar clarification is provided in the Sec. 448 regulations for the fields of consulting and the performing arts.

While not controlling authority, the Sec. 448 regulations offer insight into what types of activities future regulations under Sec. 199A may earmark as specified service businesses. Caution is required, however, because while the list of specific disqualified fields is nearly identical between Secs. 199A and 448, only the former provision contains, by its reference to Sec. 1202(e)(3)(A), as modified, the concerning catch-all, that a disqualified business includes any trade or business of which the principal asset is the reputation or skill of one or more of its employees or owners.

The most obvious problem posed by the catch-all is that it threatens any taxpayer who is not engaged in one of the businesses specifically listed as a disqualified field. Consider the case of a "personal trainer to the stars": Using the definition of "specified service business" in Sec. 199A via Sec. 1202(e)(3)(A), the argument can be made that the trainer is not in the fields of health or athletics. The Sec. 448 regulations could support this position because, under them, a personal trainer likely would not be considered to be directly working in a medical field.

Application of the catch-all, however, would likely yield a different result. What is the principal asset of a celebrity personal trainer if not the reputation and expertise of that trainer? As one can see, until further guidance is issued that narrows the scope of the catch-all, it threatens to ensnare far more taxpayers than the specifically delineated disqualified fields.

Perhaps even more problematic is the fact that the catch-all may also disqualify taxpayers who are not engaged in a service business at all. While Sec. 199A uses the term specified service trade or business to describe its disqualified businesses, the language of the catch-all in Sec. 1202(e)(3)(A) does not require that the taxpayer be providing services; rather, it merely requires that the principal asset of the business be the reputation or skill of its employees or owners.

To illustrate the complications caused by the catch-all, compare two restaurants — the first a prominent chain, the second a stand-alone bistro with a world-renowned, five-star chef. Neither restaurant is in a listed disqualified service field under Sec. 199A, and so the initial presumption is that both eateries generate qualified business income eligible for the Sec. 199A deduction.

Now, consider the application of the catch-all. The principal asset of the chain restaurant is clearly not the skill of its employees or owners; after all, if the chef at one of the locations leaves the restaurant, he or she will be replaced and life will go on. As a result, the chain restaurant should not fall victim to the catch-all.

The bistro, however, may not be so fortunate. In this scenario, it is much more likely that the business's principal asset is the skill and reputation of the five-star chef who prepares its food. Put in simple terms, if that chef leaves the bistro, the business probably shutters its doors, adding further evidence that it is the expertise of the chef that drives the business. Thus, based on the current structure of Sec. 199A, it would not be unreasonable to conclude that the second restaurant is a specified service business. But why should the owners of the two restaurants be treated differently when they both provide the same mix of food and services to customers?

Thus, the "principal asset" aspect of the catch-all is certain to create considerable confusion and uncertainty as practitioners begin to implement Sec. 199A. Without specific and detailed guidance, this issue will lead to countless disputes between taxpayers and the IRS. The Service could prevent a great number of these disputes by quickly issuing guidance providing that a specified service business is meant to be just that, a service business. Regulations could provide a quantitative test similar to the one found in the Sec. 448 regulations, providing that a business can be a "specified service business" for the purposes of Sec. 199A only if more than 95% of the activities of the business during the year involve the performance of services by owners and employees. This would remedy the disparate treatment between the two restaurants reflected above, as neither would likely meet the definition of a service business under this standard.

Additional guidance is also needed regarding the meaning of the term "principal asset" and how the various assets of a business are to be measured and compared for purposes of the catch-all.79 For example, assume that a service business — one that is not engaged in one of the disqualified fields in Sec. 1202(e)(3)(A) — pays more than 50% of its gross revenue to employees in the form of wages. Does this mean the "principal asset" of the business is attributable to the skill of the employees? If this were the case, the employer might be incentivized to replace employees with automation, a move that runs contrary to one of the stated goals of the Act (job creation) as well as an apparent incentive behind Sec. 199A's W-2 wages limitation (to encourage employers to pay higher wages).

To avoid these mixed messages, regulations governing the principal-asset test should clarify that the focus of the test is on the expertise or reputation of the owner of the business, rather than that of its employees. This would accomplish the desired effect of the prohibition on specified service businesses — to prevent the owner of a business from converting personal service income into qualified business income eligible for a 20% deduction — without inadvertently incentivizing business owners to reduce wages or eliminate employees.

Structuring to avoid personal service business designation

Until further guidance is issued, taxpayers in a disqualified specified service business will likely aggressively search for ways to make their businesses eligible for a Sec. 199A deduction. One strategy that has been discussed is to infuse a qualified business into a disqualified business — for example, a law firm might acquire commercial real estate that it rents to tenants, or a famous actor might launch a clothing line — in the hopes that it "muddies the waters" enough to convert the entire enterprise into a qualified business.

This strategy faces two significant hurdles. First, because Sec. 199A requires that the deduction be determined on a business-by-business basis, the IRS may force a taxpayer to distinguish among multiple lines of business within the same entity, denying a deduction attributable to any disqualified business line.

But even if the businesses could be commingled, Sec. 1202(e)(3)(A) treats as a disqualified specified service business any business involving the performance of services in the fields of health, law, etc. Thus, as opposed to Sec. 448, which requires that more than 95% of the time spent by a corporation's employees be spent performing certain services for the corporation to qualify as a personal service corporation, the language in Sec. 1202(e)(3)(A) suggests that even a small amount of services provided in a disqualified field could taint an entire business.

Thus, in the examples above involving the law firm/real estate company or actor/clothing line scenarios, because each business would continue to provide some element of personal services in a disqualified field, those services could taint the entire business, potentially preventing the rental income or the income from the clothing line from being treated as qualified business income.

Perhaps a more prudent alternative to maximizing the Sec. 199A deduction involves the opposite approach: having a disqualified business "spin off" the activities of a potentially qualifying business into a separate entity. For example, a group of doctors may choose to house all of their required administrative and support services in a separate entity, which then charges the doctor group a fee, stripping earnings from the disqualified business and moving the earnings to a qualified business. The group would take the position that because this new business is not in the field of health, it is not a specified service business.

Such a structure is not without peril, however. The IRS could craft regulations similar to those under Sec. 448, which provide that administrative and support services provided to a personal service business are treated as the provision of services in that same personal service business.80 If this were the case, rendering administrative and support services to a doctor group would be treated as services provided in the field of health, converting that business from a qualified to a disqualified business.

Perhaps a safer alternative is for a specified service business — for example, a law firm — to form a new LLC that purchases the building it currently leases, which then rents the building to the law firm at the highest justifiable rate. It is unlikely future regulations similar to those under Sec. 448 would deny such a structure, provided the rent were fairly valued, because, in this example, it is property, rather than services, that is being provided to a disqualified field.

Employee versus independent contractor

Sec. 199A prohibits an employee from taking a 20% deduction against his or her wage income. A deduction is available, however, to an independent contractor, subject to the W-2 wage limitations if taxable income exceeds the thresholds.

This advantageous treatment of independent contractors has led many to speculate that the advent of Sec. 199A will lead to a flurry of taxpayers fleeing their role as employees in favor of being self-employed, placing a heavy burden on the IRS to properly classify workers for both income and payroll tax purposes. Consider the following example:

Example 20: A is the CEO of a manufacturing company who earns wages of $800,000 annually. In search of a Sec. 199A deduction, A terminates his employment and forms an S corporation to provide "consulting services" to his former employer. The manufacturing company pays $800,000 to the S corporation in 2018, which in turn pays $200,000 of reasonable compensation to A, with the remaining $600,000 passed through as qualified business income.

A is entitled to a deduction in 2018 of $100,000, the lesser of $120,000 (20% of $600,000) or $100,000 (50% of W-2 wages of $200,000).

Even taxpayers engaged in a disqualified service business could use this strategy until taxable income reaches the thresholds at which owners of such businesses can no longer claim the deduction.

Example 21: A, B, and C are associates in a law firm. Each is married, each is paid a salary of $300,000, and taxable income for each is less than $315,000. In search of a Sec. 199A deduction, A, B, and C terminate their employment with the law firm and form a new partnership, which then provides services to the law firm in exchange for a $900,000 consulting fee, which is allocated equally to A, B, and C as passthrough income.

Because neither the prohibition on specified service businesses nor the W-2 wage limitation applies at this level of taxable income, A, B, and C would each be entitled to a deduction of $60,000.

While at first blush, the occurrence of these types of shifts in workplace arrangement seem to be a foregone conclusion, safeguards and ancillary considerations may prevent them from becoming a reality. For example, while an employer and employee may agree on a shift to independent contractor status, the IRS continues to have at its disposal a 20-factor worker classification test that it will use to determine the appropriate treatment of the arrangement.81 Thus, if the service recipient continues to hold a strong degree of control over the service provider, the arrangement may be reclassified as one between an employer and an employee. This may be all the IRS needs to treat the CEO in Example 20 as an employee ineligible for the Sec. 199A deduction.

Safeguards exist within Sec. 199A as well. As discussed earlier, Sec. 199A contains a rule providing that qualified business income does not include reasonable compensation. If this reasonable-compensation standard is newly applied to sole proprietors and partners, while it would introduce many complexities and challenges, it would also eliminate the advantage of many proposed worker shifts. For example, each of the attorneys in Example 21 was earning wages of $300,000 before forming their own partnership and converting the wages into passthrough income of $300,000. If the IRS is able to recharacterize the $300,000 of income as reasonable compensation, the qualified business income of each associate would be reduced to zero.

Lastly, certain non-income tax advantages remain available only to employees: for example, worker protections such as overtime pay, health and safety protections, and anti-discrimination guarantees. In addition, employees enjoy a reduced payroll tax burden and the ability to receive tax-free employer-provided fringe benefits.

Despite these advantages, the lure of a 20% deduction may prove too great to resist, particularly if an employee-turned-consultant can convince his or her former employee to gross up his or her pay by the amount of any lost benefits. For the reasons discussed above, however, a taxpayer should give careful consideration to the potential pros and cons of independent contractor status, while acknowledging the uncertain nature of the Sec. 199A deduction.

A bounty, with bewilderments

Sec. 199A provides a tremendous benefit to owners of sole proprietorships, S corporations, and partnerships. As the preceding discussion makes clear, however, granting a 20% deduction to these business owners is far easier in concept than it is in execution. Questions abound in implementing Sec. 199A, from seemingly simple concepts such as the treatment of fiscal-year businesses and the netting of income and losses, to much more meaningful aspects like the definition of a specified service business.

Tax advisers are understandably eager for answers, but unfortunately, Sec. 199A is just one small piece of the most significant overhaul of the tax law in 31 years. The IRS is now charged with the Herculean task of providing guidance for a host of new and changed statutory provisions, and, as a result, it may be some time before tax advisers have answers to many of the questions posed in this article. Until that guidance arrives, Sec. 199A will best be approached cautiously, particularly in light of the reduced threshold for a substantial-understatement penalty that comes with claiming a deduction under this provision.  

Footnotes

1An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018, P.L. 115-97, introduced as the Tax Cuts and Jobs Act.

2Before taking into account the 3.8% net investment income tax imposed under Chapter 2A by Sec. 1411.

3Before corporate rate reduction: [35% corporate tax + (20% individual dividend rate × 65% remaining earnings after corporate tax that are paid as dividends)] = 48%. After rate reduction: [21% corporate tax + (20% individual dividend rate × 79% remaining earnings after corporate tax that are paid as dividends)] = 36.8%.

437% top individual rate × 80% of income remaining after the 20% deduction.

5Compare 48% (C corporation) to 39.6% (sole proprietorship, S corporation, or partnership) (8.4 percentage points difference) prior to the Act with 36.8% to 29.6% (7.2 percentage points difference) after the Act.

6See Sec. 199A(i). The provision, along with nearly every other individual tax change in the Act, expires on Dec. 31, 2025.

7Sec. 199A(b)(2)(A). A deduction is also allowed for 20% of qualified real estate investment trust dividends, publicly traded partnership income, and cooperative dividends, but discussion of these items is beyond the scope of this article.

8Sec. 199A(b)(2)(B)(i).

9Sec. 199A(b)(2)(B)(ii).

10Sec. 199A(a)(1)(B).

11Sec. 199A(a).

12Sec. 199A(f)(4)(B).

13Joint Explanatory Statement of the Committee of Conference (available at docs.house.gov, at 28, incorporated into Conference Report to Accompany H.R. 1, H.R. Rep't No. 115-466, 115th Cong., 1st Sess. (Dec. 15, 2017).

14Id., at 40.

15Sec. 199A(d)(1)(B).

16Sec. 199A(d)(1)(A).

17Sec. 199A(d)(2)(A). But advisers should explore whether architects and engineers might fall victim to the "principal asset" test discussed later.

18Id.

19Sec. 199A(d)(2)(B).

20Sec. 199A(c)(3)(A).

21Sec. 199A(c)(3)(A)(i). For these purposes, "effectively connected with the conduct of a trade or business within the United States" has the same meaning as in Sec. 864(c), but substituting "qualified trade or business (within the meaning of Sec. 199A)" for "nonresident alien individual or foreign corporation" or for "a foreign corporation" each place it appears.

22Sec. 199A(c)(3)(B).

23Sec. 1231(b)(1).

24Sec. 1221(a)(2).

25Sec. 1231(a)(1).

26Sec. 1231(a)(2).

27Joint Explanatory Statement of the Committee of Conference, at 30.

28Id.

29Sec. 199A(c)(4).

30Sec. 199A(b)(2)(B)(i).

31Sec. 199A(b)(2)(B)(ii). These limitations accomplish the policy goal of preserving the Sec. 199A deduction for business owners who provide capital — used either to pay employees or purchase property — to their business rather than merely personal services. The House version of what would become Sec. 199A sought to accomplish this goal by affording its preferential 25% rate only upon pure "passive" investors; any owner who materially participated in the business was generally limited to claiming the benefit of the preferential rate on only 30% of his or her income from the business. This 30% was intended to reflect his or her return on capital, rather than labor. Logically, if a business pays no wages and owns no qualified property, the only possible source of the revenue earned by the business is the services of the owner, and this personal services income should not be eligible for a Sec. 199A deduction.

32Sec. 199A(b)(4)(A).

33E.g., Form W-2, Wage and Tax Statement.

34Sec. 199A(f)(1)(A)(iii).

35Sec. 1377.

36Sec. 199A(f)(1)(A). Additional guidance will be necessary for determining the allocation of wages when the partnership agreement provides for an allocation based on targeted capital accounts.

37Sec. 199A(f)(1)(A).

38Sec. 199A(b)(6)(A).

39Sec. 199A(b)(2)(B)(ii).

40Regs. Sec. 1.743-1(j)(4)(i)(B).

41Secs. 199A(b)(6)(A)(i) and (ii).

42Sec. 199A(b)(6)(A)(iii).

43Sec. 199A(b)(6)(B)(i).

44Sec. 199A(b)(6)(B)(ii).

45Joint Explanatory Statement of the Committee of Conference, at 38.

46Secs. 199A(b)(3)(A) and (e)(2)(A).

47Sec. 199A(e)(1).

48Sec. 199A(b)(3)(B).

49Secs. 199A(d)(3) and (e)(2)(A). For tax years beginning after 2018, the thresholds will be indexed for inflation (Sec. 199A(e)(2)(B)).

50Sec. 199A(d)(3).

51Sec. 62(a), flush language.

52Sec. 63(d)(3).

53Sec. 63(b)(3).

54Sec. 199A(f)(2).

55Sec. 199A(f)(3).

56Sec. 172(d)(8).

57Sec. 6662(d)(1)(A).

58Sec. 6662(d)(1)(C).

59Groetzinger, 480 U.S. 23 (1987).

60Preamble, T.D. 9644.

61Joint Explanatory Statement of the Committee of Conference, at 29.

62Id.

63Sec. 199A(c)(2).

64P.L. 115-97, §13305(a).

65Sec. 199(b)(1).

66Regs. Sec. 1.199-2(a)(2).

67Rev. Rul. 59-221 provides that undistributed income of an S corporation required to be included in the gross income of a shareholder — unlike similar income earned by a sole proprietor or most partners — is not subject to self-employment tax. As a result, shareholders are motivated to forgo salary in exchange for distributions to reduce the corporate and shareholder payroll tax liability. To prevent abuses of Rev. Rul. 59-221, the IRS has long required any officer of an S corporation who renders significant services to it to be paid "reasonable compensation."

68Joint Explanatory Statement of the Committee of Conference, at 25.

69Id. The 25% rate was also a feature of the House bill not included in the Senate bill or engrossed Act.

70Rev. Rul. 69-184.

71But see the discussion above regarding the exception when the taxpayer's taxable income is below the threshold.

72Qualified small business stock issued before Feb. 17, 2009, was eligible for only a 50% exclusion, with the remaining 50% of gain taxed at 28% under Sec. 1(h). As a result, Sec. 1202 was little used. The law was amended to provide that stock issued after Feb. 17, 2009, and before Sept. 28, 2010, was eligible for a 75% exclusion, with stock issued after Sept. 27, 2010, eligible for a 100% exclusion after the five-year holding period was met. Thus, Sec. 1202 exploded in popularity in September 2010, but the first tranches of 100% excludable stock were not sold until September 2015. As a result, there is limited judicial precedent at this time.

73As part of the Act, the average-gross-receipts test was raised from $5 million to $25 million.

74Temp. Regs. Sec. 1.448-1T(e)(4).

75Temp. Regs. Sec. 1.448-1T(e)(4)(ii).

76Rev. Rul. 91-30.

77IRS Letter Ruling 9309004.

78W.W. Eure, M.D., Inc., T.C. Memo. 2007-124.

79See IRS Letter Ruling 201717010. To date, this is the only private letter ruling that has been published on the issue, and it holds that the skills of an employee group are not the principal asset of a business when those skills are unique to that business and would not be valuable to other employers.

80Temp. Regs. Sec. 1.448-1T(e)(4)(i).

81Rev. Rul. 87-41.

 

Contributor

Tony Nitti is a partner with WithumSmith+Brown in Aspen, Colo. For more information about this article,contact thetaxadviser@aicpa.org
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