On January 17, 2019, the IRS delivered final regulations on one of the most complicated provisions of the new tax law, Section 199A, commonly referred to as the 20% pass-through deduction. The regulations provide clarity and much needed guidance on Section 199A that was enacted on December 22, 2017, as part of the Tax Cuts and Jobs Act. Along with the final regulations the IRS also issued two significant rulings; one allows a safe harbor for certain rental properties and the other a method of determining W-2 wages.
While the guidance is welcome, its timing is challenging. Taxpayers and tax preparers be warned that the new set of rules will add complexity, and will require additional work performed at both the pass-through entity and individual level to ensure the maximum deduction is correctly taken.
The deduction is applicable for tax years beginning after December 31, 2017, and ending before January 1, 2026. It applies to S-corporations, partnerships, sole proprietorships, estates and trusts (not C-corporations). It is limited based on the amount of qualified trade or business W-2 wages and unadjusted basis in qualified property immediately after acquisition. It only applies to income connected with a “qualified trade or business” within the United States.
The deduction cannot exceed 20% of a taxpayer’s share of qualified business income (QBI) from a relevant pass-through entity (RPE). The term “qualified trade or business” is any trade or business other than a specified service trade or business (SSTB) or the trade or business of performing services as an employee. For taxpayers over certain levels of income it is limited to the greater of:
- 50% of a RPE’s W-2 wages paid by the business, or
- 25% of those same wages plus 2.5% of the owner’s share of unadjusted basis immediately after acquisition (UBIA) of qualified property
Overall, the deduction is limited to 20% of the taxpayer’s taxable income less net capital gain, which includes qualified dividend income, unrecaptured section 1250 gain and collectibles gain.
Generally, the calculation is relatively simple for taxpayer’s whose taxable income is less than the phase-in range, $315,000 for married filing joint and $157,500 for all other filers. The deduction becomes complicated for taxpayer’s whose taxable income is within the phase range, between $315,000 to $415,000 for married filing joint and $157,500 to $207,500 for all other filers. Once taxable income is over $415,000 or $207,500, the deduction is limited to owners of non-SSTB’s and is subject to the W-2 wage limitation and UBIA limitation.
The final regulations largely adopted the proposed regulations issued in August 2018 but did make substantial modifications. A few key items from the final regulations include:
- Taxpayers may aggregate multiple trades or businesses at the individual level that qualify under common control and that meet certain other requirements, not including SSTB’s
- An aggregation of trades or businesses can also be made at the entity level, partnership or S-corporation
- The aggregation election is permanent unless there is a change in facts
- Section 1231 capital gain is not included in QBI
- Prior suspended passive, basis and/or at-risk losses are taken on a first-in-first-out basis for the 20% limitation in the year which they become deductible
- The deduction is not applicable to reasonable compensation paid to an S-corporation owner and guaranteed payments paid to partners
- Employee’s cannot change their status to an independent contractor solely for the purpose of taking the deduction, however individuals are allowed to prove that they are performing services in the capacity other than an employee
- Requires netting of income and losses before computing the 20% deduction
- A safe harbor election can be made for certain rental properties to be automatically treated as a trade or business (Notice 2019-07)
- Certain rental properties considered self-rental are automatically treated as a trade or business
- Partnership gain attributable to the sale of ‘hot assets’ under Section 751 is included in QBI
- Partner basis adjustments under section 743 per a section 754 election are included in the definition of UBIA, with some adjustments
- The accuracy related penalty for those claiming the deduction is reduced
Owners of SSTB’s cannot take the deduction if their income is over the phase-out limitation. A summarized list of disqualified SSTB’s include:
- Actuarial Science
- Performing Arts
- Financial, brokerage services, investment management and trading
- Individuals receiving income for endorsing products or services, appearance fees or use of an individual’s image or likeness
The regulations provide specific terms and examples for each SSTB listed above.
Other businesses that may be disqualified are those that provide services to a SSTB and businesses that generate more than a de minimus amount of SSTB revenue.
A pass-through entity is required to allocate and disclose QBI, W-2 wages and UBIA of property to its owners. If any one item is not disclosed then it is presumed to be zero. In addition a pass-through entity is required to disclose multiple trades or businesses and whether any of those businesses are an SSTB.
A taxpayer may need to consider including election statements with their return. Two of which are a rental property safe harbor election statement (Notice 2019-7) and an aggregation election statement at the pass-through and/or taxpayer level.
If you have any questions or if you would like to further discuss the new regulations and guidance, please contact one of RubinBrown’s Tax Services Group professionals.
Readers should not act upon information presented without individual professional consultation.
Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.
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