The passage of the tax reform law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, has created many questions for CPAs and their clients, but the IRS has now started to release guidance on key issues. For instance, over the summer of 2018 the IRS provided eagerly anticipated guidance on the new Sec. 199A proposed regulations (REG-107892-18), and the Office of Management and Budget is currently reviewing final regulations. To get more perspective, editors from The Tax Adviser recently sat down with Jeff Bilsky, CPA, senior practice leader for BDO’s national partnership taxation group, for a question-and-answer session on the guidance.
What is your overall reaction to the Sec. 199A proposed regulations?
Jeff Bilsky: These proposed regulations were some of the most anticipated guidance after tax reform, and we’ve spent about seven-and-a-half months looking at a statute that had an incredible number of open questions. There’s a huge potential benefit of a 20% deduction based on certain income generated by taxpayers, typically in passthrough entities, partnerships, and S corporations.
But for those seven-and-a-half months, we weren’t sure exactly what some of the specific terms meant and how certain rules would be applied, and we truly were in desperate need of proposed regulations or some guidance. During those months before we received the guidance, during discussions with representatives from Treasury and representatives from the Senate Finance Committee, it became clear that with these proposed regulations, Treasury and the IRS had an opportunity to create a set of rules that would either make this Sec. 199A 20% deduction very broadly applicable or narrowly applicable.
When I read through these regulations, I think they’re taxpayer-favorable on the whole. I’m sure we’ll get into some of the winners and losers, as people like to say, and there certainly are those, but in whole, I find these to be very taxpayer-favorable. Treasury clearly put a lot of thought and effort into developing the rules that we were looking for: the definitions of specified service trades or businesses [SSTBs], aggregation rules, how to actually compute what’s referred to as qualified business income [QBI]. And with a number of other very important questions that we had, at least they made a solid effort to answer them.
There’s not a lot of issues that have been reserved for further guidance. We don’t see that in these proposed regulations. What I also take from the proposed regulations is in the initial year of the Sec. 199A deduction, taxpayers and, initially, partnerships and S corporations are going to have to put in a lot of effort to make sure they’re properly capturing the various components that are needed to calculate this deduction and then properly reporting that information out to their shareholders or partners. And then, the partners and shareholders and individuals in the sole proprietorship will then need to apply the different sets of rules that are all contained within the same proposed regulatory package to figure out how various limits and phasing calculations and things of that nature apply.
The big picture is favorable, but there’s an awful lot of work to be done between now and the first tax filings.
One concept in Sec. 199A that I know practitioners were looking for guidance about was the meaning of SSTBs. Do you feel the proposed regulations provide enough guidance around the meaning of an SSTB?
Bilsky: I think, consistent with this, seeing that Treasury really did a good job putting together some solid rules, there’s an incredible amount of detail within the proposed regulations around the SSTB concept. There is, I’ll say, decent discussion defining each of the particular categories of an SSTB, and what I think would probably still need some work is what I’d refer to as those business activities that are maybe operating on the fringes of what’s defined. Take, for example, health care. We know doctors fall within that category, but there may be a number of ancillary services that you don’t have a medical doctor providing the service, and they don’t fit cleanly within the particular list. We might be uncertain as to whether those services are health care related. One example of this is assisted-living facilities. Where do you draw the line between a specified service trade or business and a non–specified service trade or business?
The regulations include a number of helpful examples, but what I’m finding out from conversations I’m having both internally and with clients is a taxpayer may initially be perceived to be a single trade or business, but, as we start drilling down, there will be a question as to whether the taxpayer is actually operating multiple trades or businesses. And, of course, the critical question is, “Is that trade or business an SSTB or not?” Making the distinction between the different lines of businesses rising to the level of a trade or business is going to be very important. And then understanding that the interaction of those potentially distinct trades or businesses will be another issue or hurdle that we need to get over. So those, I think, are some of the questions that are actually raised as a result of the thoroughness of the examples and the definitions themselves.
Do you think there were any surprises or any clear winners or losers as a result of the SSTB definitions?
Bilsky: From my perspective, the biggest surprise is the definition of reputation or skill. There had been a lot of discussion preceding the issuance of these proposed regulations around what does it mean to operate a trade or business that has as a principal asset the reputation or skill of an employee or owner. The potential breadth of that definition could have captured virtually all businesses. The simple example of plumbers and electricians had been talked about at a number of seminars. I’ve heard Treasury representatives discuss that certainly a plumber is likely to be captured, but that’s not at all what happened. The reputation or skill category is limited to product endorsements, use of a personal likeness, appearance fees, and that type of situation, and so the plumbers and the electricians and people that are clearly skilled in some particular line of business aren’t captured within that definition. Again, that was a huge surprise, but very consistent with the general theme that I mentioned earlier. I view these rules as taxpayer-favorable and not an attempt to create a wide breadth of applicability of the rules.
I think, additionally, from the definition of an SSTB, real estate could probably be considered a winner because management-type services don’t seem to be captured within any of the definitions of consulting or investment management or things of that nature.
From a loser perspective, a big surprise, at least to me and some others that I’ve spoken with, relates to the definition of athletics and, in particular, professional sports teams. And if you look at the performing arts definition and athletics, you see that actors, athletes, coaches, and directors — the people who are actively involved in putting on those productions or entertainment — are clearly captured within the definition of performance of services in the field of athletics.
There’s an example that’s included within the regulations that pulls ownership of professional sports teams into the definition, so it’s not only the people providing the service but the ownership that is included, and that was certainly a surprise.
The proposed regulations allow taxpayers to aggregate certain trades or businesses, but they don’t adopt a Sec. 469 approach. Do you see any positives or negatives from that decision and the manner in which the aggregation rules have been structured?
Bilsky: I think my initial reaction to the Sec. 199A aggregation rules is they’re generally straightforward and relatively simple, and in tax we use that term loosely. But as compared to the Sec. 469 rules, they seem much more manageable. I understand and can appreciate why Treasury felt a Sec. 469 construct wouldn’t work in the case of Sec. 199A, and I also found it interesting that there’s a comment in the preamble looking for comments as to whether this type of approach used in Sec. 199A ought to be an approach that’s also used in Sec. 469, so we’ll see where that goes. But specific to the Sec. 199A rules, all in all, it should be favorable.
One particular area that creates some concern, at least in my mind, is real estate when real estate activities are conducted through multiple regarded entities. And I think if we have a situation where we have a holding partnership, for example, that has a number of triple net lease properties, each of which is held within a separate single-member LLC, that all rolls up and is treated as held directly by that holding partnership. It’s not at all uncommon, and I’ve had a number of discussions over the last couple of weeks, where you have a structure with, instead of single-member LLCs, multiple regarded partnerships or S corporations that hold one triple net lease asset. And as I read through the regulations, it seems clear, based on the language, that the determination of a trade or business will occur at the entity level.
But the aggregation rules occur at the individual level, and there’s some conflicting language within the preamble itself, but I think, just focusing on the regulations, in these situations where we have real estate held within a regarded partnership, and the activities may not rise to the level of a trade or business, there’s no ability to aggregate. Now, if we were applying a Sec. 469 construct, we would probably be able to pull those activities together and create a grouping at the individual owner level. Based on the approach adopted within the Sec. 199A regulations, these single-asset entities could have a very difficult time reaching the conclusion that they’re actually engaged in a trade or business, which is a necessary step to the creation of qualified business income, which we would need to generate a deduction and trade aggregation, etc., at the individual level.
The proposed regulations also have reporting rules. What are your thoughts around the reporting rules they contain? And do they appear reasonable?
Bilsky: As I read the rules, I think they’re reasonable from the perspective that if a partnership or an S corporation chooses to not report information, then there’s a presumption that qualified business income and wages and unadjusted basis immediately after acquisition (UBIA) and qualified property are all zero. And so a partnership that either can’t obtain the information or isn’t comfortable in its ability to obtain the information properly reported out, and if the partnership chooses to not report, the only penalty is that individual shareholders and partners won’t be eligible for the deduction.
Since reading through these regulations after they came out, I have commented that the easy days of Sec. 199A, as frustrating as the first seven-and-a-half months of the year may have been, those are over, and we’re going to have a pretty tough time. And companies are going to have a fairly tough time really diving into these rules and performing the appropriate analyses they need to do, such as identifying trade or businesses, determining what items are included or excluded from qualified business income, and identifying what wages are for purposes of Sec. 199A. There’s a whole host of potential issues that arise in the determination of this, and all of that information is what has to be reported.
Developing that information is going to be a challenge, and being able to report it out shouldn’t be overly complicated for those partnerships that are properly maintaining capital accounts and have relatively straightforward allocation provisions. The more complicated the allocations become, the more risk there may be as far as incorrectly allocating some of this information out to the partners.
That being said, I think once we get through this first year and taxpayers have gone through and answered the questions about what are their trades or businesses, are each of those a specified service trade or business or not, and the other different types of questions they need to answer, then outside of changes in facts, it should be fairly repetitive. So I think the key will be putting in the time and effort during this first year to make sure the process and procedures are in place and the different issues, like identification of the trade or business, are well-documented and supported.
You mentioned the challenge of determining QBI. Were there any surprises or key issues resolved in terms of the definition of QBI?
Bilsky: Well, I think they go a long way to answering a number of questions. For example, Sec. 1231 gains. We know that a Sec. 1231 gain is treated as capital gain income, and we also know that Sec. 199A says qualified business income doesn’t include capital gains but is something that’s treated as a capital gain, such as a Sec. 1231 gain, or taxed at capital gain rates, the same as a long-term capital gain for purposes of Sec. 199A. And I think that’s much clearer now that we have these proposed regulations. Similarly helpful are rules about how certain losses should be netted or carried forward. And different ordering rules have been clarified.
The rules are very helpful, but now that we have guidance, we need to take a step back and carefully evaluate, for example, what items of income are being generated and whether they should be part of qualified business income or not. And the same, of course, goes for expenses.
The other area I think was helpful within these proposed regulations is the concept that qualified business income should be domestic. And by domestic, what we’re talking about is effectively connected income. I think the proposed regulations provide a good road map for us to make sure that we’re applying the appropriate non-U.S. or effectively connected income rules correctly. In my practice, I focus primarily on partnership acts that can involve international partnerships and structuring. But I think this is clearly an area where different specialists will need to be brought in and considered just to make sure that a particular bucket of income, or expense, using this effectively connected income example, meets the required definitions, or doesn’t, and should either be included or excluded.
What would you say taxpayers should be doing now that we have guidance under Sec. 199A?
Bilsky: There are a couple of directions. We have the opportunity to go through the proposed regulations. First, for those taxpayers that may feel they are not going to be able to benefit as much as they think they should, or as much as other taxpayers are — for example, real estate, where a number of regarded entities are being used and there may not be a trade or business — one step ought to be to discuss the provision of comments to Treasury. These regulations are only proposed. They’re not final, and so they certainly give us a clear indication of where Treasury intends to go. They’re certainly not perfect, and there’s room for improvement.
Putting that piece aside, any of these partnerships or S corporations or individuals operating sole proprietorships really need to take a step back and think about what these rules mean and what they’re going to have to do to be certain that whatever number they reflect on their individual tax returns for 2018 is the right number. That starts with identifying every trade or business operated by the entity or the individual taxpayer, then determining and documenting whether each of those trades or businesses is a specified service trade or business.
There are a number of de minimis and anti-abuse rules that will need to be considered, especially in the context of specified service trades or businesses. Review the reporting capabilities and identify the different financial components that are going to need to be reported out to the partners or shareholders.
Start thinking about and developing a process, with internal accounting, for example, or financial reporting, to make sure we’re able to properly capture each of the items that fit within QBI or don’t, the W-2 wages, the UBIA of a qualified property. And not just doing that in total because all of that information has to be reported on a trade or business by trade or business basis. But for a partnership, especially partnerships using targeted allocation agreements, it’s going to be very important to make sure our Sec. 704(b) and tax basis capital accounts are up to date, and the allocations that are being made accurately reflect the partner’s interests in the partnership or otherwise satisfy those substantial economic effect rules.
One ancillary topic that’s always floating around in my mind is new partnership audit rules that are now applicable. One of the areas that the IRS is going to be able to look at is the allocation of income, loss, and presumably these other items as well. So I think there’s an additional level of importance added to the accuracy of those allocations. To the extent necessary, start thinking about whether any sort of restructuring might need to occur.
Take my real estate example, where there may be multiple regarded partnerships that have one triple net lease property in each entity. If there’s not a change in the proposed regulations, there may be no Sec. 199A deduction attributable to their activities if they don’t rise to the level of a trade or business. And so, although Treasury has been very clear in the preamble that it tried to put together rules that don’t require restructuring, restructuring may be necessary in this case. And there’s a few other examples as you work through the regulations, where modifications to a taxpayer’s structure might be helpful to maximize the deduction.
Those are probably the big steps to think about, and, of course, as you get into the details, there’s a whole host of different avenues you can veer off on to make sure you’re able to document and support the requisite information.
Ever since the TCJA was passed with its lower corporate tax rate and other changes, there has been a lot of talk about choice-of-entity issues. Do you think these Sec. 199A rules are going to impact passthrough entities’ decisions to incorporate?
Bilsky: Choice of entity certainly has been a significant consideration throughout this year. I’ve spent quite a bit of time helping companies analyze their after-tax cash flow, comparing continued existence of an S corporation or a partnership as compared to a C corporation, and there are certainly a number of factors that go into that analysis. One of the key factors, though, is whether or not the individuals will ultimately be able to benefit from the Sec. 199A deduction. And I don’t think it’s very difficult to imagine that, if you’re entitled to a 20% deduction, that has a significant reducing effect on your overall individual effective tax rate, and that lowering of the tax rate would make an incorporation transaction less likely.
As we look at these rules and see that they do appear to be intended to provide for broad applicability, so more taxpayers are likely to be able to benefit from Sec. 199A, there’s less likelihood of the need or desire to incorporate and change choice of entity from a passthrough to a corporate structure.
Now that we have some clarity, I do believe those taxpayers who have been thinking they could get the deduction or may reap some benefit might take the next steps and actually go ahead and incorporate. I know I’ve had a number of conversations with taxpayers where we’ve performed the analysis, and a corporate structure clearly would provide some benefit in the event that Sec. 199A won’t be applicable, but we weren’t exactly sure how the rules would bear out. Now that we have at least in proposed form these answers, those entities now have enough information that taxpayers can make their final decisions to either go ahead and incorporate where they’re not going to be able to benefit from this deduction, or if they are, they will just remain as passthroughs.
What appear to be the greatest complexities related to the Sec. 199A deduction?
Bilsky: The greatest complexity that I’m seeing is going to be the practical application of these rules. If we read the rules in a vacuum, they’re fairly straightforward. They make sense. We can logically follow them. We’ll read through the reporting rules, and it makes sense. When I start having conversations with real taxpayers that have real facts, their facts are messy because they may operate multiple trades or businesses. Using an example of a partnership that has profits-interest members that are receiving wages, well, those wages probably don’t qualify as wages, and so a whole host of practical things that are going on within companies is going to make the actual implementation of these rules difficult and challenging.
But to be somewhat positive, because ultimately there’s a 20% deduction at stake … this is a huge benefit. I do believe that once we get through that first year, once taxpayers have put in the effort to make sure they’re capturing the information and understanding that it’s going to be painful this first year, once they’re set up, rolling forward each year should be relatively painless. Then it’s just another item to be reported without a huge capital investment on the part of internal employees and external service providers as well.
To comment on this article or to suggest an idea for another article, contact Alistair M. Nevius, J.D., The Tax Adviser’s editor-in-chief, at Alistair.Nevius@aicpa-cima.com.