Despite being in the midst of a government shutdown, the Internal Revenue Service (IRS) was just able to release a 247 page document describing and cementing final rules around section 199A. For those of you who are unfamiliar with 199A, the section provides for a new deduction of up to 20 percent of qualified domestic business income for pass through entities such as sole-proprietorships, partnerships, S-corporations, trusts, or estates. 199A was solidified as part of the tax reform legislation that was passed late in 2017 on December 22nd. Much like the official title of the tax cut act itself, entitled “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2019” – and less formally known as the Tax Cuts and Jobs Act (TCJA) – it fell short on the original message of simplification. While 199A remains extremely complex, the new regulations help to explain a lot of the questions that arose from the original legislation. Let’s look at how the law stands now after the new regulations.
Like most of the individual tax code provision passed in the TCJA, they went effective for the tax year 2018 and expire after 2025. While all laws are somewhat temporary in nature as they can be changed, this one goes away unless further action is taken, which could occur before 2025. However, with 2018 in the books, we know that 199A is at least applicable to last year. The 199A deduction allows for up to a “20% deduction” of qualified business income for certain business owners, trusts, and estates. However, the deduction comes with significant qualifications. First, you need to determine if your business entity qualifies for the deduction. Remember, this is only for pass-through entities. Additionally, the deduction is only on qualified business income (discussed more later), and not available for wage income (i.e. W-2 reported income). The deduction could also be limited by the type of business in which you are engaged, your taxable income, W-2 wages paid, and the unadjusted basis immediately after acquisition (UBIA) of qualified property.
To be a section 162 business that receives the 199A deduction you need to be engaged in the activity with some regularity. Generally, if you think you are running a business you probably are running a business. One area of concern with 199A had been if rental property qualified as a business. Under the new regulations, Revenue Procedure 2019-7, the IRS offered a safe harbor in determining what is rental activity. For instance, if separate books and records are maintained for each rental activity, and if 250 hours or more of rental services are provided for the year. You lose the rental safe harbor if you use the rental for yourself for more than 14 days a year (think your beach house or mountain cabin). If you rent it most of year but spend three weeks there, it’s not available. Further complicating the matter is that generally the 199A deduction requires you to treat each trade or business (even within a single entity) as separate for reporting purposes. For each trade or business, you must be able to compute qualified business income.
You also must know the business owner’s taxable income. The income-based limitations are as follows:
Single individual $157,500 to $207,500 (2018) $160,700 to $210,700 (2019)
Married Filing Jointly $ 315,000 to $415,000 (2018) $ 321,450 to $421,450 (2019)
If the business owner has less than the threshold amounts, it is then fairly straightforward. Take the QBI and deduct 20 percent of it against that specific trade or business. If the business owner’s taxable income is above the income limits you will need to determine if the business is a specified service trade or business (SSTB). Under 199A a specified service trade or business is defined as: any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees. . The new regulations did help define a few areas of what it means to be a SSTB for purposes of 199A. For example, whether a business identifies as a SSTB is a factual determination, and several examples were provided by the IRS to clarify this. Additionally, for any trade or business with gross receipts of $25 million or less, if more than 10 percent of gross revenue comes from a SSTB activity then the entire business will be treated as a SSTB and subject to the 199A limitations. For businesses above the $25 million mark in gross revenue, if just 5 percent or more of the revenue comes from a SSTB activity then the entire business is treated as such. The de minimis rule could hinder a large number of companies from taking advantage of the 199A deduction.
The IRS provided an example of a landscaping company that does design services as part of its business. Design services can be considered consulting services and if the receipts were 10 percent or more from the consulting, the entire business would be treated as a SSTB. It is the consulting side that could entangle a lot of businesses. So be aware of your business bills and the specified services you offer. Think of a technology company that sells computers and software, but also does consulting. This could pull the company back into the SSTB limitations for 199A and cost the business owner the entire 199A deduction. If a trade of business provides services or property back to a SSTB that has 50 percent or more common ownership, the trade or services provided back to the SSTB will also be treated as a SSTB. The example provided by the IRS shows a Law Firm that provides legal services, a SSTB, that owns a partnership that owns an office building that it rents back to the law firm.
Since both partnerships are owned by the same owners of the SSTB, both businesses would be treated as a SSTB even though typically a rental company is not a SSTB. So, let’s now look at what happens if you are an owner of a SSTB with taxable income over the income-limitation thresholds. Between the threshold of $157,500 to $207,500, the deduction gets phased out. So, if you go over the $207,500 you cannot get a 199A deduction for a single filer with a SSTB. However, let’s say instead you have $182,500 of taxable income in 2018. You would then be entitled to 50 percent of the 199A deduction for your SSTB because you were only half of the way through the phase-out range. Now, if you are not a SSTB but go over the phase-in range of $157,500 or $315,000, your deduction could be limited by your W-2 wages paid, or the UBIA of qualified property held by the trade or business. For a non-SSTB owner, that earns over the income ranges, a potential limitation on the 199A deduction will phase in, and you will only be able to deduct the lesser of 20 percent of QBI or the greater of 50 percent of W-2 wages paid or 25 percent of W-2 wages plus 2.5 percent of the UBIA of qualified property. So, if you are not a SSTB business owner making more than the upper end of the ranges, rent your building, and pay no W-2 wages, you will lose out on the 199A deduction completely.
These limitations of W-2 and basis phase-in over the income limitation ranges of $157,500 to $207,500 for married filers and $315,000 to $415,000 for joint-filers. To meet the W-2 and UBIA limitations for high-earning business owners, the owner is allowed to aggregate together businesses under the new IRS regulations. However, the businesses cannot be aggregated if they are SSTBs. Furthermore, any business that is aggregated with another must be able to qualify alone as a Section 162 trade or business. The same people or groups must own 50 percent or more of each business for the majority of the tax year, including the last day of the tax year, to aggregate. Additionally, the businesses must satisfy at least two of three other factors in that the businesses:
- Provide products, services, or property that are “customarily” provided together (i.e. offering a car wash at a gas station)
- Share facilities or a significant centralized business element (i.e. accounting, legal, human resources, etc.)
- Operate in coordination with, or reliance on, the other aggregated businesses
This can be a very powerful tool for those trying to overcome the potential limits of the W-2 and UBIA limitations for a 199A deduction. The new IRS rules help tremendously in answering a lot of the outstanding questions around the 199A deduction. While more questions are still left unanswered – and more are likely to arise – 199A planning will remain complex and uncertain in some situations for the foreseeable future. One thing to keep in mind, as the IRS noted, is that 95 percent of business owners fall below the 95-percent thresholds and won’t have to worry about the limitations, aggregation, buying up property, or the W-2 limits. For the 5 percent that do fall above the income thresholds, it is imperative you work with your financial advisor, accountant, and attorney to make sure you are not losing a valuable deduction or incorrectly filing your taxes.