199A Treasury Regulations
IRS Issues Regulations on 20% Pass-Through Deduction
On August 9, 2018, the IRS issued proposed Treasury Regulations to provide administrative guidance on one of the more drastic changes to the Internal Revenue Code contained in the Tax Cuts and Jobs Act, which was passed at the end of last year. Specifically, the newly proposed Treasury Regulations relate to the qualified trade or business income deduction, under Internal Revenue Code section 199A.
The section 199A deduction, which taxpayers will first be eligible to take in 2018, allows owners of pass-through business entities, such as sole proprietorships, partnerships, limited liability companies, and S corporations to deduct up to 20% of their qualified business income on their individual tax returns. Although the specific rules for this deduction are already highly complicated, many felt that section 199A left more questions unanswered than it did answered.
Fortunately, the newly proposed regulations address a number of questions that tax practitioners have been uneasy about since the text of section 199A was released last year.
What is a Qualified Trade or Business?
In order to be eligible for the section 199A deduction, a business has to be a “qualified trade or business.” Neither the statutory text of section 199A nor the legislative history provides a definition of what a “qualified trade or business” is for purposes of section 199A. To make matters worse, the term “trade or business” is defined in more than one provision of the Internal Revenue Code. While many tax advisors were eager in interpreting “qualified trade or business” to be any kind of pass-through income, thoughtful tax attorneys and CPAs were telling their clients with real estate investments to wait and see before assuming that section 199A would apply to them this year.
Unfortunately, the proposed regulations landed on a definition of “qualified trade or business” that will have a negative impact on many passive real estate investors hoping to take the 20% deduction on their rental income. The proposed regulations state that the IRS has decided to apply the definition of a “trade or business” contained in section 162(a) of the Internal Revenue Code. Section 162 requires a taxpayer to be continually and regularly involved in an activity for that activity to qualify as a trade or business. Moreover, the courts have come up with a very onerous series of factors to be considered for passive real estate activities to qualify as a trade or business. As a result, any individual hoping to take the section 199A deduction this year with respect to their real estate activities should see an experienced tax advisor soon.
Is it better to be an independent contractor than an employee?
When section 199A was first announced, many employees of businesses began inquiring if they could become independent contractors so as to take advantage of section 199A, since an employee is not eligible to take the section 199A deduction on his or her wage income. As predicted by many, the proposed regulations provide a framework to prevent abuse by taxpayers. If an individual was an employee of an employer but suddenly becomes an independent contract while providing substantially similar services directly or indirectly to the employer, that individual will be presumed to be an employee for purposes of section 199A, and, therefore, ineligible to take the section 199A deduction. While this presumption can be rebutted, the IRS’s intent to curb the one of the most obvious temptations of section 199A is clear.
Do taxpayers aggregate their qualified trade or business income prior to taking the section 199A deduction?
The plain language of section 199A states that the section 199A deduction is taken on a per business basis. That means an individual who receives pass-through income from two different businesses, would have to find the ideal blend of qualified business income, W-2 wages, and property basis to maximize the taxpayer’s section 199A deduction. The regulations provide a method for taxpayers with multiple sources of income to potentially become eligible to aggregate section 199A deduction.
In addition to the foregoing, the proposed regulations deal with many other issues surrounding section 199A and provide guidance for taxpayers looking for opportunities to tax plan around this important new provision in the Internal Revenue Code. With the new regulations being issued, Helsell Fetterman expects many businesses, especially those businesses with rental income or leases between related entities, will seek to do more sophisticated tax planning around section 199A.
Currently, the IRS is requesting comments on all of the proposed regulations. Although proposed regulations are not final until they are published in the Federal Register, the IRS has stated that taxpayers may rely on these regulations until final ones are published.