The Mixed Bag of Proposed §199A Regulations
By Thomas G. Hineman on August 23, 2018
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Thomas G. Hineman
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The IRS issued the eagerly awaited §199A proposed regulations on August 8, which will please some, but also leave others disappointed.
Definition of Trade or Business
As I discussed in an earlier blog post, since the §199A deduction must first be computed separately for each separate trade or business in which the taxpayer has an interest, it is very important that the guidelines for a trade or business be clear. Not surprisingly, the proposed regulations look to §162 and its body of authorities for defining a trade or business. The good news for many closely held businesses is that the proposed regulations define “trade or business” as including the rental or licensing of property that would otherwise not constitute a trade or business if the property is rented or licensed to a commonly controlled trade or business. Thus, a rental activity which otherwise may not be considered a trade or business may be aggregated with a commonly controlled business to which property is rented so long as new aggregation rules are satisfied. This provides welcome relief for closely held businesses which maintain separate entities, often with little or no employees, which lease assets to the operating entity, often on a triple net lease.
However, for other rental activities that do not involve a commonly controlled lessee the §162 case law generally does not provide clear answers as to whether the activity constitutes a trade or business. In particular, triple net leases to unrelated lessees likely will not qualify as a trade or business for purposes of §199A. There will likely be many other situations in which the body of law under §162 will not be particularly helpful.
Aggregation Rules
Because QBI and the W-2 wage and Unadjusted Basis of Qualified property limitations must be computed separately for each trade or business, many practitioners have asked the IRS for a grouping or aggregation rule. While the proposed regulations do not follow the §469 route, they do allow (but do not require) aggregation of separate trades or businesses if it can be demonstrated that:
Interestingly, multiple owners of a RPE are not required to aggregate in the same manner. The proposed regulations also make it clear that a minority owner of less than 50% interests in two or more partnerships which satisfy the remaining aggregation requirements may choose to aggregate his or her interests in some, or all, of the partnerships so long as he or she can demonstrate that the 50% ownership test is met by another partner, or partners as to the partnerships the minority partner desires to aggregate.
W-2 Wages and Reasonable Compensation
Continuing on with the good news first, the proposed regulations provide that for purposes of determining W-2 wages an individual or RPE may include W-2 wages paid and reported by a third party payor listed on box c of the W-2 form, so long as such W-2 wages are paid to a common law employee or officers of the individual or RPE. Prior to release of the proposed regulations there had been considerable speculation as to whether use of third party payors would qualify for purposes of determining §199A W-2 wages.
Notably, the proposed regulations also clarify that the §199A concept of “reasonable compensation” excludable from QBI applies to S corporations, but not partnerships, thereby continuing the IRS position that a partner cannot be an employee. Of course, guaranteed payments to a partner are also excluded from QBI. The proposed regulations also exclude from QBI §707(a) payments to a partner for services rendered to the partnership business in a capacity other than as a partner. QBI attributable to more than one trade or business must be allocated among such trades or businesses using a method that is consistent with §199A. Different reasonable methods may be used for different items of income, gain, deduction and loss provided that the overall combination of methods is also reasonable based on the facts and circumstances.
Specified Service Trades or Businesses (SSTBs)
Under §199A, unless an exception applies, none of the items of a specified service trade or business (“SSTB”) are included in computing QBI. In addition to the listed SSTBs, §199A contains a seemingly catchall category of SSTB that includes a trade or business the principal asset of which is the reputation or skill of one or more of its owners or employees. Once again there had been much speculation as to how broadly, or narrowly, this provision will be applied. Fortunately, the proposed regulations take a very narrow interpretation of the catchall clause, which will be welcome news to many taxpayers. As it turns out, the reputation or skill provision is not a catchall clause at all, but rather is essentially limited to trades or businesses of endorsement of products or services, licensing of an individual’s image, likeness, name, signature, voice, trademark or other symbols associated with such individual’s identity, and appearance fees.
The proposed regulations provide a de minimis exception to the definition of SSTBs for trades or businesses which have gross receipts of $25 million or less, in a taxable year, and less than 10% of the gross receipts of the trade or business are attributable to the performance of services in a SSTB. There is also an exemption for a trade or business with gross receipts in excess of $25 million in a taxable year if less than 5% of the gross receipts of the trade or business are attributable to the performance of services as an SSTB.
Despite these favorable positions with respect to SSTBs, the proposed regulations still leave uncertainty in some instances as to what is includible in the Listed SSTBs in §199A. On the one hand, the proposed regulations tend to draw upon existing authorities under §1202, as meager as they may be, for guidance. However, the proposed regulations are not consistent in their application of such prior authorities among each of the Listed SSTBs.
The proposed regulations throw up a roadblock to the so-called “crack and pack” technique for splitting off certain functions of a SSTB which, by themselves are arguably not part of a SSTB. Under the proposed regulations such tangential trade or businesses will be treated as part of the SSTB if:
The existence of common control between two or more businesses is determined under the proposed regulations in accordance with §§ 267(b) and 707(b). Finally, if a trade or business has 50% or more common ownership with a SSTB and has shared expenses (including shared wages or overhead expenses) that trade or business is considered incidental to, and thus, part of the SSTB, if its gross receipts do not exceed 5% of the combined gross receipts of those businesses. The proposed regulations give as an example a dermatologist (a SSTB) who also provides skin care products which constitute less than 5% of the combined gross receipts of both businesses. Under that example, we are told that the skin care products business is conducted using the same employees and office premises as the dermatology business and therefore would be treated as part of the SSTB. This shared expenses limitation will force commonly controlled businesses to have to terminate such expense sharing arrangements if one of the businesses is a SSTB and a §199A deduction is desired for another commonly controlled business with gross receipts below the 5% threshold.
Multiple Non-Grantor Trust Planning
Some advisors have suggested spreading the interest in a trade or business or RPE among multiple non-grantor trusts in order to maximize potential usage of the exemption for trusts with income below the threshold amount. However, the proposed regulations warn that trusts formed or funded with a significant purpose of receiving a deduction under §199A will not be respected for purposes of §199A. In conjunction with this anti-abuse provision, proposed Reg. §1.643(f)-1 provides that if two or more trusts have substantially the same grantor, or grantors, and substantially the same primary beneficiary, or beneficiaries, and a principal purpose for establishing such trusts or contributing additional cash or property to such trusts is the avoidance of Federal income tax, the trusts will be treated as a single trust.
Change in Classification of Employees
The proposed regulations take the position that performing services as an employee is never a trade or business for purposes of §199A. Some employees may be tempted to change their relationship to that of independent contractor, rather than employee, in order to qualify for a possible 199A deduction. However, the proposed regulations contain a presumption that an individual who was properly treated as an employee for Federal income tax purposes by the service recipient, but subsequently is treated as an independent contractor with regard to providing substantially the same services, directly or indirectly, to the same person (or a related person) is presumed to be in the trade or business of performing services as an employee as to such services. The presumption may be rebutted by showing that under Federal income tax law, regulations and other principals (including the common law employee classification rules) such person is performing services in a capacity other than as an employee. While this doesn’t appear to significantly change existing law, it does serve as notice that those attempting to change their status must be prepared to substantiate their position in support of the change of status.
If anyone has questions regarding the new §199A proposed regulations, please contact Tom Hineman at 214-744-3700 or thineman@meadowscollier.com.
Definition of Trade or Business
As I discussed in an earlier blog post, since the §199A deduction must first be computed separately for each separate trade or business in which the taxpayer has an interest, it is very important that the guidelines for a trade or business be clear. Not surprisingly, the proposed regulations look to §162 and its body of authorities for defining a trade or business. The good news for many closely held businesses is that the proposed regulations define “trade or business” as including the rental or licensing of property that would otherwise not constitute a trade or business if the property is rented or licensed to a commonly controlled trade or business. Thus, a rental activity which otherwise may not be considered a trade or business may be aggregated with a commonly controlled business to which property is rented so long as new aggregation rules are satisfied. This provides welcome relief for closely held businesses which maintain separate entities, often with little or no employees, which lease assets to the operating entity, often on a triple net lease.
However, for other rental activities that do not involve a commonly controlled lessee the §162 case law generally does not provide clear answers as to whether the activity constitutes a trade or business. In particular, triple net leases to unrelated lessees likely will not qualify as a trade or business for purposes of §199A. There will likely be many other situations in which the body of law under §162 will not be particularly helpful.
Aggregation Rules
Because QBI and the W-2 wage and Unadjusted Basis of Qualified property limitations must be computed separately for each trade or business, many practitioners have asked the IRS for a grouping or aggregation rule. While the proposed regulations do not follow the §469 route, they do allow (but do not require) aggregation of separate trades or businesses if it can be demonstrated that:
- The same person or group of persons own, directly or indirectly, more than 50% of each trade or business;
- Such ownership exists for the majority of the taxable year of each trade or business;
- All items attributable to each of the trades or businesses are reported on returns with the same taxable year (not taking into account short years); and
- None of such trades or businesses is a specified service trade or business (“SSTB”).
- Each trade or business provides products and services which are the same or customarily provided together (such as a restaurant and a food truck);
- Each trade or business shares facilities or centralized business elements (such as personnel, accounting, legal, manufacturing, purchasing, human resources or information technology resources);
- Each trade or business is operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (such as supply chain interdependencies).
Interestingly, multiple owners of a RPE are not required to aggregate in the same manner. The proposed regulations also make it clear that a minority owner of less than 50% interests in two or more partnerships which satisfy the remaining aggregation requirements may choose to aggregate his or her interests in some, or all, of the partnerships so long as he or she can demonstrate that the 50% ownership test is met by another partner, or partners as to the partnerships the minority partner desires to aggregate.
W-2 Wages and Reasonable Compensation
Continuing on with the good news first, the proposed regulations provide that for purposes of determining W-2 wages an individual or RPE may include W-2 wages paid and reported by a third party payor listed on box c of the W-2 form, so long as such W-2 wages are paid to a common law employee or officers of the individual or RPE. Prior to release of the proposed regulations there had been considerable speculation as to whether use of third party payors would qualify for purposes of determining §199A W-2 wages.
Notably, the proposed regulations also clarify that the §199A concept of “reasonable compensation” excludable from QBI applies to S corporations, but not partnerships, thereby continuing the IRS position that a partner cannot be an employee. Of course, guaranteed payments to a partner are also excluded from QBI. The proposed regulations also exclude from QBI §707(a) payments to a partner for services rendered to the partnership business in a capacity other than as a partner. QBI attributable to more than one trade or business must be allocated among such trades or businesses using a method that is consistent with §199A. Different reasonable methods may be used for different items of income, gain, deduction and loss provided that the overall combination of methods is also reasonable based on the facts and circumstances.
Specified Service Trades or Businesses (SSTBs)
Under §199A, unless an exception applies, none of the items of a specified service trade or business (“SSTB”) are included in computing QBI. In addition to the listed SSTBs, §199A contains a seemingly catchall category of SSTB that includes a trade or business the principal asset of which is the reputation or skill of one or more of its owners or employees. Once again there had been much speculation as to how broadly, or narrowly, this provision will be applied. Fortunately, the proposed regulations take a very narrow interpretation of the catchall clause, which will be welcome news to many taxpayers. As it turns out, the reputation or skill provision is not a catchall clause at all, but rather is essentially limited to trades or businesses of endorsement of products or services, licensing of an individual’s image, likeness, name, signature, voice, trademark or other symbols associated with such individual’s identity, and appearance fees.
The proposed regulations provide a de minimis exception to the definition of SSTBs for trades or businesses which have gross receipts of $25 million or less, in a taxable year, and less than 10% of the gross receipts of the trade or business are attributable to the performance of services in a SSTB. There is also an exemption for a trade or business with gross receipts in excess of $25 million in a taxable year if less than 5% of the gross receipts of the trade or business are attributable to the performance of services as an SSTB.
Despite these favorable positions with respect to SSTBs, the proposed regulations still leave uncertainty in some instances as to what is includible in the Listed SSTBs in §199A. On the one hand, the proposed regulations tend to draw upon existing authorities under §1202, as meager as they may be, for guidance. However, the proposed regulations are not consistent in their application of such prior authorities among each of the Listed SSTBs.
The proposed regulations throw up a roadblock to the so-called “crack and pack” technique for splitting off certain functions of a SSTB which, by themselves are arguably not part of a SSTB. Under the proposed regulations such tangential trade or businesses will be treated as part of the SSTB if:
- There is 50% or more common ownership (directly or indirectly) between the tangential trade or business and the SSTB; and
- The tangential trade or business provides 80% or more of its property or services to the SSTB.
The existence of common control between two or more businesses is determined under the proposed regulations in accordance with §§ 267(b) and 707(b). Finally, if a trade or business has 50% or more common ownership with a SSTB and has shared expenses (including shared wages or overhead expenses) that trade or business is considered incidental to, and thus, part of the SSTB, if its gross receipts do not exceed 5% of the combined gross receipts of those businesses. The proposed regulations give as an example a dermatologist (a SSTB) who also provides skin care products which constitute less than 5% of the combined gross receipts of both businesses. Under that example, we are told that the skin care products business is conducted using the same employees and office premises as the dermatology business and therefore would be treated as part of the SSTB. This shared expenses limitation will force commonly controlled businesses to have to terminate such expense sharing arrangements if one of the businesses is a SSTB and a §199A deduction is desired for another commonly controlled business with gross receipts below the 5% threshold.
Multiple Non-Grantor Trust Planning
Some advisors have suggested spreading the interest in a trade or business or RPE among multiple non-grantor trusts in order to maximize potential usage of the exemption for trusts with income below the threshold amount. However, the proposed regulations warn that trusts formed or funded with a significant purpose of receiving a deduction under §199A will not be respected for purposes of §199A. In conjunction with this anti-abuse provision, proposed Reg. §1.643(f)-1 provides that if two or more trusts have substantially the same grantor, or grantors, and substantially the same primary beneficiary, or beneficiaries, and a principal purpose for establishing such trusts or contributing additional cash or property to such trusts is the avoidance of Federal income tax, the trusts will be treated as a single trust.
Change in Classification of Employees
The proposed regulations take the position that performing services as an employee is never a trade or business for purposes of §199A. Some employees may be tempted to change their relationship to that of independent contractor, rather than employee, in order to qualify for a possible 199A deduction. However, the proposed regulations contain a presumption that an individual who was properly treated as an employee for Federal income tax purposes by the service recipient, but subsequently is treated as an independent contractor with regard to providing substantially the same services, directly or indirectly, to the same person (or a related person) is presumed to be in the trade or business of performing services as an employee as to such services. The presumption may be rebutted by showing that under Federal income tax law, regulations and other principals (including the common law employee classification rules) such person is performing services in a capacity other than as an employee. While this doesn’t appear to significantly change existing law, it does serve as notice that those attempting to change their status must be prepared to substantiate their position in support of the change of status.
- Other provisions of the proposed regulations not covered in this blog post include:
- Rules explaining the determination of UBIA, including basis determinations;
- Extensive examples regarding application of the new aggregation rules;
- Examples explaining the SSTB rules, and
- Rules for determining W-2 wages on the acquisition or disposition of a trade or business.
If anyone has questions regarding the new §199A proposed regulations, please contact Tom Hineman at 214-744-3700 or thineman@meadowscollier.com.
