Section 199A was added to the Internal Revenue Code (IRC) by the Tax Cuts and Jobs Act (TCJA or the Act). After months of waiting and speculation, the IRS released proposed regulations under section 199A in August 2018. These reliance regulations answer many questions about the new 20 percent deduction for qualified business income (aka the “QBI deduction” or the “section 199A deduction”) and generally are taxpayer-friendly.
Now that we have regulations, taxpayers can begin to plan for section 199A with a bit more certainty. This article will provide an overview of the section 199A rules and some high-level suggestions for ways to increase the deduction. As always, careful thought and analysis is required before implementing any planning strategies, especially when dealing with a new code section. It is also important to keep in mind that, while they can be relied upon, these regulations are still proposed, meaning, they can and most likely will be revised before being finalized. Taxpayers should exercise caution before making changes to their business structure designed solely to take advantage of the QBI deduction.
The section 199A deduction: overview
A section-by-section guided tour of the section 199A regulations would fill this entire year-end letter so, instead, we will limit ourselves to a quick review of the new law. Section 199A allows taxpayers other than C corporations — i.e., individuals, estates and trusts — a deduction of up to 20 percent of their QBI. The deduction is in effect for taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026. Various limitations are based on taxable income level, the type of trade or business, and the taxpayer’s share of W-2 wages and qualified basis from each trade or business. There is also an overall limitation based on the excess of taxable income over net capital gains for the year.
In general, qualified items of income, gain, deduction and loss with respect to each qualified trade or business are eligible for the deduction. The section 199A regulations do not define the term “trade or business,” rather, they fall back on the definition of a “section 162 trade or business.” Despite more than 100 years of income tax law, the term “trade or business” is not defined in either the code or regulations. Therefore, each situation has to be analyzed based on facts and circumstances, taking into account existing case law. There is no one-size-fits-all definition of trade or business.
We do know, however, that for taxpayers above the limitation phase-in range ($207,500 for single filers, $415,000 for joint filers), income from specified service trades or businesses (SSTBs) is not eligible for the section 199A deduction. Specified services include health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading and dealing. Further, specified service income includes fees, compensation or other income received by an individual for endorsing products or services, licensing fees for the use of their name, image, voice, personal trademarks, etc., or appearance fees (in person, on TV or in any other another media format).
Qualifying income must come from U.S. sources and excludes various investment-related items such as capital gains and losses, section 1231 gains, dividends and nonbusiness interest income. Reasonable compensation paid to the taxpayer, as well as guaranteed payments for services rendered to a partnership, also are excluded from QBI (in other words, taxpayers do not get the section 199A deduction against their own compensation).
Each relevant pass-through entity (RPE) will report the taxpayer’s allocable share of income or loss; the taxpayer will then calculate the deduction separately for each trade or business. The regulations allow taxpayers to aggregate trades or businesses if certain requirements are met. If the taxpayer’s overall QBI is less than zero, the loss will be carried to the next taxable year. If a taxpayer with multiple qualifying trades or businesses has positive overall QBI, but losses from one or more businesses, the losses offset the positive QBI from the other businesses pro rata.
The section 199A deduction is a deduction from taxable income and does not reduce adjusted gross income (AGI). Therefore, it does not affect limitations that are based on AGI. Further, the deduction does not reduce net investment income or self-employment income; however, it is allowed for alternative minimum tax (AMT). Finally, the deduction can be taken regardless of whether a taxpayer itemizes his or her deductions.
Increasing your section 199A deduction
You may be able to increase your section 199A deduction a number of ways. The following examples are conceptual and must be examined in light of your specific facts and circumstances.
Manage taxable income to stay under the threshold. For taxpayers with taxable income at or below the threshold amount — the 2018 thresholds are $157,500 for single filers, $315,000 for joint filers — the W-2 wage limitation, wage/basis limitation and SSTB limitation do not apply. For these taxpayers, the QBI component of the section 199A deduction is simply 20 percent of their QBI. If your projected taxable income is above the threshold and you are in a position to defer income, accelerate deductions and/or make additional retirement plan contributions, you may be able to claim the full 20 percent deduction and spare yourself the complexity of the limitation calculations.
Aggregate trades or businesses. The aggregation rules are one of the best features of the new section 199A regulations. These rules allow taxpayers to combine their trades or businesses, if they meet certain requirements, and treat them as a single trade or business for purposes of the section 199A calculation. This can result in a larger deduction than if the calculations were done separately for each business. Aggregation can help taxpayers overcome the wage limitations that are part of the computations.
For example, assume Taxpayer T has taxable income above the limitation phase-in range and is the sole owner of two qualified trades or businesses. Business A generates $1 million QBI and pays $600,000 of W-2 wages. Business B generates $1 million QBI but pays no wages. Since the taxpayer is above the limitation phase-in range, T’s deduction is 20 percent of QBI, or 50 percent of W-2 wages, whichever is less. On a standalone basis, A’s QBI deduction is $200,000 (the lesser of [20% x $1,000,000] or [50% x $600,000]). B’s QBI deduction is $0 (the lesser of [20% x $1,000,000] or [50% x $0]). But if the taxpayer aggregates A and B, and treats them as a single trade or business for purposes of the calculation, the section 199A deduction will increase to $300,000 (i.e., the lesser of [20% x $2,000,000] or [50% x $600,000]). In this simple scenario, a portion of the wages paid by Business A is applied against the income earned by Business B, resulting in a larger deduction.
Adjust owner wages. Reasonable compensation paid to S corporation employee/owners is not QBI and is not eligible for the section 199A deduction. (However, this compensation is included in the wage limitation computation.) The key phrase here is “reasonable compensation,” but this is another one of those critical terms that is not defined. If owners that receive high wages can support reducing wages (perhaps with a compensation study), thus moving income to the QBI bucket, they may be able to get a larger section 199A deduction.
Make a priority allocation of income versus a guaranteed payment. Guaranteed payments to partners are not QBI and are not eligible for the section 199A deduction, nor are they factored into the wage limitation computation. However, there is no requirement that partnerships make guaranteed payments. In the right fact pattern, reducing guaranteed payments and shifting partner income to QBI in the form of a priority allocation of profits can increase the section 199A deduction. A word of caution, though: this is not something that can be accomplished simply by moving a number to a different line on the tax return. The partnership agreement will have to be amended, and the new allocation must have substantial economic effect. This may involve renegotiating the economic arrangement among partners.
Ramp up activity to the trade or business level. The trade or business question is particularly vexing when it comes to rental real estate. The regulations allow property leased to a commonly controlled trade or business (i.e., self-rentals) to be treated as a trade or business for section 199A purposes, even if the rental does not rise to the level of a trade or business on its own. However, there is no such accommodation for standalone rentals. Nor is there a safe harbor, similar to the safe harbor under the net investment income tax rules, which treats rental income of real estate professionals as trade or business income based on a 500-hour participation test.
Can rental real estate owners increase their day-to-day involvement to such an extent that the rentals rise to the level of a trade or business? It may be difficult, but not impossible, in the right circumstances. The answer will depend on many factors, including the type of rental property (commercial real estate versus apartment building versus single-family home or condo), type of lease (triple net versus traditional), the nature and extent of services provided, specific individuals providing the services (direct involvement of the owner versus management company), etc.
Two other considerations: First, the section 199A regulations are proposed regulations. The IRS is requesting comments and held a public hearing Oct. 16. We expect the IRS will receive feedback on the treatment of rental real estate as a trade or business for section 199A purposes. Perhaps the final regulations will include a safe harbor for rental real estate similar to what happened with the net investment income tax regulations. Second, remember that if the real estate entity is paying no wages, the deduction will be limited to 20 percent of QBI, or 2.5 percent of qualified basis, whichever is less. So, it is important to run the numbers to see if the additional time commitment, day-to-day work, etc., is worth the effort for what could be a relatively small deduction.
Examine U.S. and foreign operations. QBI must be effectively connected with a U.S. trade or business in order to be eligible for the section 199A deduction. For businesses with both U.S. and foreign operations, it is critical (for many reasons) to ensure the right amount of income is being reported in the right jurisdiction. A transfer pricing study can help taxpayers determine if U.S. income is being under- (or over-) reported and, if so, how to adjust intercompany transactions to report the proper amount of U.S. income.
Invest in REITs/PTPs. Qualified real estate investment trust dividends and qualified publicly traded partnership income are not subject to the W-2 wage limitation, the basis limitation or the SSTB limitation. Income from these investments is eligible for a straight 20 percent deduction; the only limit on this component of the section 199A deduction is the overall limit based on the excess of taxable income over net capital gains.
While the new regulations answer many questions, they do not (and cannot) address every possible fact pattern. Section 199A is a new and untested code section — expect the IRS to be on the lookout for abusive situations. Any planning ideas should be implemented only after careful analysis; the new section 199A deduction is just one piece of the overall tax-planning puzzle.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.