Tax Reform Progress Report | August 2018

The Tax Cuts and Jobs Act (the Act or TCJA) became law approximately eight months ago, significantly transforming how we compute federal income taxes. This edition of the Tax Reform Progress Report focuses on the new pass-through deduction regulations, a proposed rule to eliminate a state and local tax deduction, depreciation changes, accounting method changes for small business taxpayers, federal payroll withholding and hardship distributions.

In this issue:

New pass-through deduction regulations on specified service trades or businesses

Earlier this month, the Treasury Department issued proposed regulations covering many aspects of the section 199A qualified business income deduction (aka the section 199A deduction or pass-through deduction). The new rules generally are taxpayer-friendly and address many of the key questions the tax community has been asking in the months since the passage of the Act.

This article discusses some key takeaways from the new regulations for specified service trades or businesses (SSTBs). Income from an SSTB is not eligible for the section 199A deduction, unless the taxpayer’s taxable income is below certain thresholds ($157,500 for single filers, $315,000 for joint filers). Taxpayers whose taxable income is over the threshold but within a phase-in range ($50,000 for single filers, $100,000 for joint filers) may claim a partial deduction based on the applicable percentage of qualified business income, etc. from the SSTB. Additionally, the trade or business of performing services as an employee is not a trade or business for purposes of section 199A. No taxpayer may claim a section 199A deduction for wage income, regardless of the level of his or her taxable income.

Perhaps the biggest area of uncertainty under section 199A was the definition of an SSTB. In particular, the statute says that an SSTB includes “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.” This vague language caused a lot of hand-wringing among taxpayers and tax professionals since most professions can be construed as being dependent on reputation or skill. Read broadly, it seemed like this clause could disqualify many small businesses from taking the pass-through deduction.

Fortunately, the IRS interpreted the “reputation or skill” clause narrowly. In general, only individuals who receive fees, compensation or other income 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) will fall into this category.

Other important takeaways include:

  • The regulations provide a de minimis rule under which a trade or business will not be considered an SSTB merely because it provides a small amount of services in a specified service activity. In other words, a small amount of gross income earned in a specified service will not taint the income from the overall trade or business.
  • The regulations include a rule designed to prevent employees from re-characterizing themselves as independent contractors, partners in a partnership or S corporation shareholders solely to benefit from the section 199A deduction. The regulations include a presumption that former employees who provide substantially the same services to a trade or business are in the trade or business or performing services as an employee, and thus ineligible for the deduction. This presumption is for purposes of the pass-through deduction and can be rebutted based on facts and circumstances.
  • SSTBs may not be aggregated with other trades or businesses.
  • The regulations implement rules to prevent the strategy of splitting up an SSTB into separate entities to circumvent limitations on or prohibition of the deduction for SSTB income. The so-called “crack-and-pack” strategy — which involves an SSTB spinning off a capital or administrative component of its business with a view to qualify income from these isolated functions for the deduction — is “inconsistent with the purpose of section 199A.”
  • Services provided by real estate agents and brokers, or insurance agents and brokers, are not considered “brokerage services” for purposes of section 199A and, therefore, are not SSTBs. In addition, real estate management — i.e., directly managing real property — is not included in the definition of investing and investment management and, therefore, is not an SSTB.
  • Pass-through entities must determine if their trades or businesses are SSTBs and must disclose this information to its partners, shareholders or owners.

IRS allows aggregation of trades or businesses for the 199A deduction

The section 199A analysis starts at the trade or business level. However, at the time the TCJA passed, there was no legislative history or guidance on what constitutes a trade or business specifically for purposes of the pass-through deduction. In addition, there was much discussion and commentary about the relationship between passive activity groupings under section 469 and the definition of a trade or business for section 199A purposes. Taxpayers wondered if multiple similar trades or businesses, or a single business activity conducted across multiple entities, could be combined for purposes of the section 199A calculation.

Fortunately, the proposed regulations provide more good news — taxpayers are permitted to aggregate trades or business for purposes of the section 199A deduction if they meet certain requirements.

  • The proposed regulations allow, but do not require, aggregation of similar trades or businesses. However, rather than rely on the existing passive activity grouping rules, the IRS introduced a completely new set of requirements for section 199A purposes. Despite the additional complexity, the rules are fairly straightforward and generally (but not completely) taxpayer-friendly.
  • There are four requirements to aggregate trades or businesses.
    • First, each trade or business in the aggregated group must rise to the level of a trade or business (under section 162) on its own. For example, rental activities in separate entities involving triple net leases likely do not rise to the level of a trade or business on their own.
      1. While the net investment income rules under section 1411 provide a safe harbor for rental activities when there are 500 hours of material participation in the combined rental activity, there is no similar safe harbor under the section 199A regulations. Therefore, rental activities involving triple net leases generally may not be aggregated for section 199A purposes. However, there is an exception for rental or licensing of tangible or intangible property if the property is rented or licensed to a trade or business which is commonly controlled (see discussion below).
    • Second, only trades or businesses with 50 percent or more common ownership by a person or group of persons can be aggregated. Note: “Group of persons” is not defined or otherwise limited by the regulations. Therefore, it does not appear that aggregation is limited to a finite number of persons, provided there is common ownership. However, the regulations do not have any reporting requirement to provide shareholders or partners information regarding common ownership. Consequently, taxpayers will likely have to obtain such information on their own.
    • Third, SSTBs are not eligible for aggregation.
    • Finally, the trades or businesses must meet at least two of the following three factors, which demonstrate that the businesses are, in fact, part of a larger, integrated trade or business:
      1. The businesses provide products and services that are the same (for example, a restaurant and a food truck) or they provide products and services that are customarily provided together (for example, a gas station and a car wash);
      2. The businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources); or
      3. The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).

PEOs get relief under the new pass-through deduction regulations

In an effort to reduce the disparity between the amount of tax paid on business income earned in pass-through entities to the 21 percent rate now being paid by corporations, the Act included a 20 percent tax deduction on income from a relevant pass-through entity (RPE). This deduction is subject to many limitations, thresholds and restrictions. One limitation is that the deduction may be limited to 50 percent of the W-2 wages with respect to the qualified trade or business. In this article, we focus our attention on the wage limitation used in calculating the deduction. Specifically, one concern shared by many taxpayers was, prior to newly released regulations, whether they could use wages paid via a professional employer organization (PEO) when computing this wage limitation.

Generally, employers can outsource to a PEO certain employee-related functions, such as payroll and related taxes, worker’s compensation, benefits administration and training. For a fee, the PEO becomes the employer of its client’s individual employees while the client continues to direct daily tasks and responsibilities. PEOs tend to be used by small and midsize businesses.

Under the proposed regulations issued earlier this month, an RPE is defined as a partnership, S corporation or sole proprietorship owned directly or indirectly by at least one individual, estate or certain trusts. The first limitation in computing the pass-through deduction is based on wages paid by the RPE. Wages are defined as amounts paid for employment by the taxpayer related to a trade or business. The wage limitation applies separately for each trade or business.

An RPE using a PEO to handle its payroll-related function will be permitted to use such wages paid by the PEO toward its pass-through deduction limitation. In a favorable development, the proposed regulations do not limit taxpayers from applying the deduction simply because they use a third-party employer organization to technically hire, pay and report wages to their employees. This rule also applies to statutory employers and certain fiduciary agents.

Three methods were established to calculate wages for purposes of the pass-through deduction: the unmodified box method, the modified box 1 method and the tracking wages method. Each method generally uses the total of all wages reported to the Social Security Administration (SSA) with the latter two methods making adjustments for certain elective salary deferrals.

If a major portion of a trade or business is acquired or disposed of during the tax year, W-2 wages are allocated between each individual or entity based on the period such employees were employed, regardless of the calculation method used. During a short tax year, the W-2 wages include only those paid to employees of the taxpayer during the short year. In addition, if using either the modified box 1 or tracking wages method, only related amounts of aforementioned elective deferrals can be subtracted from the total wage calculation. If the short year does not include Dec. 31, taxpayers can only include those wages that would otherwise be reported to the SSA using one of the methods listed above. Amounts treated as W-2 wages for one tax year cannot be considered W-2 wages by any other trade or business.

Once total wages are determined, the amount must be allocated among trades or businesses of the RPE generating such wages. Each RPE then identifies the amount of wages attributable to qualified business income (QBI) for each trade or business. Finally, the wage expense is then allocated and reported to each partner or shareholder of the RPE, generally in proportion to their allocation of income. If the RPE fails to report such amounts, the presumption is the allocable share of W-2 wages is zero.

Treasury moves to eliminate benefit of SALT limitation workaround

Several states tried to circumvent the $10,000 cap on state and local tax (SALT) deductions by enacting programs allowing individuals to make payments in lieu of taxes to a variety of government-operated public purpose foundations. This, in theory, would allow taxpayers to deduct those payments as charitable contributions for federal income tax purposes while simultaneously satisfying their SALT liabilities.

Proposed regulations issued: On Aug. 23, 2018, the IRS and Treasury Department issued proposed regulations stating that if a taxpayer receives a state credit in return for a payment to an approved entity (including government and private charities), it would constitute a quid pro quo. The taxpayer must reduce the charitable deduction by the amount of any state or local credit received for the donation. Exceptions are provided for dollar-for-dollar state tax deductions as well as tax credits of no more than 15 percent of the payment amount or of the fair market value of the property transferred.

The IRS and Treasury said that although deductions could be considered quid pro quo benefits in the same manner, sound policy considerations warrant making an exception to these quid pro quo principles in the case of dollar-for-dollar SALT deductions. The proposed regulations state: “Because the benefit of a dollar-for-dollar deduction is limited to the taxpayer’s state and local marginal rate, the risk of deductions being used to circumvent section 164(b)(6) is comparatively low.”

The proposed regulations theorize that since the benefit of a dollar-for-dollar deduction is limited to the taxpayer’s state and local marginal tax rate, the risk of circumventing this new restriction on SALT deductions is fairly low.

Thus, the proposed rules allow taxpayers to disregard dollar-for-dollar SALT deductions. However, if the taxpayer receives a SALT deduction exceeding either the amount of the payment or the fair market value of the property transferred, the taxpayer’s charitable contribution deduction must be reduced.

Example: If a state grants a 70 percent state tax credit and the taxpayer pays $1,000 to an eligible entity, the taxpayer receives a $700 state tax credit. The taxpayer would have to reduce the $1,000 contribution by the $700 state tax credit, leaving an allowable contribution deduction of $300 on the taxpayer's federal income tax return.

These proposed regulations are not limited in nature to newly enacted legislation by certain states to circumvent the federal $10,000 SALT cap. Rather, they will likely affect many state tax credit programs, such as conservation easements that previously allowed a federal charitable deductions. We will provide additional guidance as we continue reviewing these regulations. 

Further guidance issued for bonus depreciation

Earlier this month, Treasury released additional guidance related to the bonus depreciation changes wrought by the Act. The proposed regulations affect taxpayers deducting depreciation for qualified property both acquired and placed in service after Sept. 27, 2017. Qualified property must meet four criteria in order to be eligible for bonus depreciation.

First, qualified property must be of a specific type:

  • MACRS property with a recovery period of 20 years or less
  • computer software
  • water utility property
  • qualified television or film production
  • qualified live theatrical production
  • specified plant
  • qualified improvement property acquired after Sept. 27, 2017, and before Jan. 1, 2018.

Second, the original use must begin with the taxpayer or used depreciable property must meet certain acquisition requirements. There are special rules for lessees, consolidated groups and partnerships.

Third, the taxpayer must place the property in service after Sept. 27, 2017, and before Jan. 1, 2027.

Fourth, the qualified property must be acquired by the taxpayer after Sept. 27, 2017.

In addition, should the taxpayer choose to apply a 50 percent allowance instead of the 100 percent allowance for qualified property acquired after Sept. 27, 2017, and placed in service in the tax year including Sept. 28, 2017, this election applies for all asset classes of depreciable property.

Please see our recent alert “Bonus depreciation proposed regulations released” for additional information.

IRS provides procedures on TCJA small business taxpayer accounting methods

The Act favorably amended certain tax provisions applicable to eligible small business taxpayers. On Aug. 3, 2018, the IRS issued guidance permitting eligible small business taxpayers to obtain automatic IRS consent to implement those provisions, generally effective for tax years beginning after Dec. 31, 2017. Key provisions of the four new accounting method changes are highlighted below.

New automatic method changes for small business taxpayers

Change to overall cash method: Small business taxpayers (defined as a taxpayer with average annual gross receipts for the three prior taxable years of no more than $25 million) may change its overall method of accounting from the accrual method of accounting to the cash method of accounting for a trade or business. Taxpayers precluded from making this change to the overall cash method include:

  • tax shelters described in section 448(d)(3)
  • taxpayers otherwise prohibited from using the overall cash method or required under the Code or regulations to use another method of accounting (e.g., sections 475 and 1272)
  • certain banks
  • certain farmers

Exception from capitalizing costs into inventory: Small business taxpayers, described above currently capitalizing costs under the UNICAP rules, may change to a method of accounting that no longer capitalizes these costs.

Exception from accounting for inventories: Small business taxpayers, described above, may change their method of accounting for inventory to either:

  • treat inventory as non-incidental materials and supplies, or;
  • conform to the taxpayer’s method of accounting used in its applicable financial statements (AFS) or, if the taxpayer does not have an AFS, in the books and records prepared in accordance with the taxpayer’s accounting procedures

Certain long-term contracts exempt from PCM: Small business taxpayers, described above, may either:

  • change its method of accounting for exempt long-term construction contracts from PCM or
  • stop capitalizing certain inventory-related costs for specific home construction contracts

Cutoff method required: Unlike the other small taxpayer changes discussed above, the changes under this section are implemented on a cutoff basis (i.e., only for eligible long-term construction contracts entered into after Dec. 31, 2017, in taxable years ending after Dec. 31, 2017). Conversely, exempt long-term contracts entered into prior to that time continue to be accounted for using the taxpayer’s former method of accounting.

Reduced compliance burden: The issued guidance includes several favorable provisions intended to provide flexibility and to simplify and reduce the compliance burden of implementing tax changes related to the new small business taxpayer provisions.

Please see “New procedures on small business taxpayer accounting methods” for additional information.

Are you being underwithheld for federal income tax purposes?

You do not want to experience an unwelcome surprise come April 15, 2019, by finding out that an insufficient amount of federal income taxes were withheld from your wages, resulting in a large tax bill. However, many people may find this happening based upon a recent report by a government watchdog.

In a report released July 31, the Government Accountability Office said a Treasury Department recommendation for a $4,150 withholding allowance would “result in a slightly lower proportion of overwithheld taxpayers and a slightly higher proportion of underwithheld taxpayers under the Tax Cuts and Jobs Act than would have been the case under prior law.”

Earlier this year, the IRS issued an updated Form W-4 to reflect changes made by the TCJA. It also issued News Release 2018-36 and a withholding calculator that can be used to assist in determining the appropriate amounts that should be withheld from employees’ paychecks.

The Form W-4 provides for employees to claim a personal allowance for:

  • themselves,
  • their spouse if filing jointly,
  • filing as head of household,
  • an additional allowance depending on filing status as well as their/their spouse’s employment situation, and
  • various tax credits for which the employee may be eligible (examples include the child and dependent care, child tax and earned income credits).

Similar to the prior version of Form W-4, worksheets are available to assist the employee with accounting for itemized and above-the-line deductions or exclusions, second jobs and/or their spouse’s jobs, and unearned income in determining the proper withholding amounts.

The calculator is an online tool “to help taxpayers make sure that their withholding is appropriate.” The calculator requires a substantial amount of information available for proper use, including:

  • anticipated filing status and certain credits for which the employee may be eligible,
  • spouse’s wage information and projected withholding,
  • the most recently received paystub,
  • estimates of the following items anticipated for 2018:
    • bonuses
    • contributions to tax-deferred retirement plans, such as a 401(k)
    • contributions to cafeteria or other pre-tax plans, such as for health insurance
    • nonwage income, such as interest, dividends and capital gains
    • itemized deductions

The information is inputted via a series of worksheets, and the result is an estimated total 2018 tax liability, which is compared to the estimate of total withholding for the tax year. Recommendations are then made for how an updated Form W-4 should be completed in order to satisfy the tax liability by way of withholding.

We strongly recommend that the calculator results be independently verified, particularly with the assistance of the employee’s tax advisor. We suggest a separately prepared taxable income projection for the year be compared against the projected federal tax liability computed by the calculator.

Hardship distributions from retirement plans

Hardship withdrawals from 401(k) and 403(b) retirement plans became easier under the Bipartisan Budget Act of 2018 (BBA).

The BBA removed the six-month prohibition on deferrals after a participant takes a hardship withdrawal. It also eliminated the requirement that participants first take a loan from their plan account before taking a hardship withdrawal. These provisions could help an individual with a financial need continue saving for retirement without interruption as well as not having to forgo the employer matching contribution.

Elimination of the six-month suspension of deferrals is not mandatory and retaining it does not disqualify the plan. However, it may create potential nondiscrimination issues. In addition, hardship withdrawals, unlike plan loans, do not have to be repaid, but they are subject to a 10 percent early withdrawal penalty plus income tax.

The BBA also expanded the types of funds available for a hardship distribution from a 401(k) plan to include earnings on elective deferrals as well as qualified non-elective contributions (QNECs), qualified matching contributions (QMACs), and their respective earnings. Previously, a hardship withdrawal could only be made from the participant’s elective deferrals.

Although 403(b) retirement plans are intended to follow the rules for 401(k) plans, the BBA did not expand the additional types of funds available for hardship distributions out of 403(b) retirement plans. Therefore, until further legislation is passed, a hardship distribution from a 403(b) plan is limited to the amount of the participant’s elective deferrals in the participant’s 403(b) account.

Effective date

These provisions of the BBA are effective for plan years beginning after Dec. 31, 2018.

Please visit our Tax Reform Resource Center for additional information. 

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.