Recently, proposed regulations were issued to provide some clarity concerning the new Section 199A deduction.
As part of the Tax Cuts and Jobs Act, which became effective as of the beginning of this year, this new deduction generally provides a 20 percent deduction for a pass-through businesses (primarily partnerships and LLCs taxed as partnerships, S Corporations, Sole Proprietorships and single member LLCs) that generate Qualified Business Income (QBI). This deduction is taken at the individual level and is allowable after one takes the greater of their itemized deductions or the standard deduction.
QBI does not include wages earned by an employee, guaranteed payments paid to a partner or reasonable compensation paid to an S Corporation shareholder.
It also does not include certain types of investment income and income earned from a Specified Service Trade or Business (SSTB). A SSTB generally provides services in the fields of health, law, accounting, consulting, financial services and others. Single taxpayers who work in these areas with income in excess of $157,500 and married couples earning more than $315,000 can potentially get this deduction, but there are limitations.
The proposed regulations include new anti-abuse rules and some important definitions.
One of the new rules states an individual who was classified as an employee, who is now being treated as an independent contractor, cannot qualify for the pass-through deduction. However, if this worker should really be treated as an independent contractor, which may have to be proven to IRS due to the relationship between the worker and the company, they may qualify. The various rules pertaining to the employee versus independent contractor status should be examined closely in this case.
Another new rule dictates that breaking apart a SSTB into other separate business(es) may not necessarily qualify them for the new deduction. This would entail the transfer of part of a SSTB that does not earn “tainted” service income into a new business entity. For example, a law firm may provide not only legal services, but also certain administrative services. If they now create a new entity to conduct the administrative services function (not a SSTB), they may very well have to include this new entity’s income with the income of the law firm when computing the potential eligibility for the pass-through deduction. The new common ownership rules would have to be examined, in order to determine if this exercise of aggregation needs to be conducted.
Also, the proposed regulations state that a non-SSTB can consider the rental of an office building (for use in conducting its business, also known as a “self-rental”) a separate business for the purposes of qualifying for the pass-through deduction, whereas, a SSTB cannot, and would have to potentially include the rental income in computing the total income from the SSTB. This is the case even if the building is held in a separate entity, i.e., an LLC.
There are income thresholds that apply to these new aggregation rules, which should be examined in order to determine their applicability. In certain circumstances, it may actually be beneficial to aggregate income in order to maximize the 199A deduction, but describing these examples are beyond the scope of this article.
The above rules are only a part of the new Section 199A proposed regulations. Such proposals are issued in order to provide guidance, however there are typically hearings held that may result in changes to these rules. Stay tuned.
In the meantime, please consult your tax team at Zinner & Co. if you would like to discuss any of these issues.
