IRS Provides Guidance on Pass-Through Deduction
The new Section 199A “pass-through” deduction provides valuable tax benefits for owners of sole proprietorships, S corporations, partnerships and limited liability companies taxed as partnerships. But the original tax code section left many questions unanswered. Taxpayers, however, may rely on new IRS guidance on the pass-through deduction until the agency issues final regulations.
A quick recap
Under Sec. 199A, eligible taxpayers may deduct up to 20% of their qualified business income (QBI) from a pass-through entity. QBI is an owner’s share of the net of qualified items of income, gain, deduction and loss (excluding capital gains, dividends and nonbusiness interest income) from a qualified trade or business. It doesn’t include reasonable compensation received by S corporation shareholders or guaranteed payments received by partners. Eligible taxpayers also may deduct up to 20% of their combined real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
The amount of the deduction is the lesser of 1) 20% of the taxpayer’s QBI plus 20% of his or her qualified REIT dividends and qualified PTP income, or 2) 20% of the taxpayer’s taxable income minus net capital gains.
For high-income taxpayers, there are two additional limitations:
- The deduction for QBI (but not for REIT dividends and PTP income) is limited to a taxpayer’s share of the entity’s W-2 wages. Or, alternatively, this deduction is limited to 25% of W-2 wages plus 2.5% of the unadjusted basis of certain depreciable property.
- The deduction is unavailable for specified service trades or businesses (SSTBs). That includes those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing, investment management and trading (but not architecture or engineering). It also includes a “catchall” provision that encompasses “any trade or business where the principal asset . . . is the reputation or skill of one or more of its employees.”
These limitations don’t apply unless an owner’s taxable income exceeds $157,500 ($315,000 for joint filers). Then they are phased in gradually, under a complex formula, and reach full force when taxable income rises to $207,500 ($415,000 for joint filers).
Highlights of the proposal
The proposed regulations are nearly 200 pages long, so a complete discussion is beyond the scope of this article. Here are some of the key provisions:
SSTBs. When Sec. 199A was first enacted, many feared that its catchall provision would ensnare a wide range of service businesses. Fortunately, the proposal interprets this category narrowly to apply only to people who receive income for endorsing products or services; for licensing their images, likenesses, names, voices, and so on; or for making appearances on television, radio, social media, and such.
The proposed regulations also exclude traditional banking services from the list of SSTBs and establish a de minimis rule: A business won’t be deemed an SSTB if less than 10% of its gross receipts are attributable to one of the service areas listed above (5% for businesses whose gross receipts exceed $25 million). An antiabuse rule prevents SSTBs from qualifying for the deduction by spinning off their non-SSTB activities into a separate entity.
Aggregation of commonly controlled businesses. Under the proposal, taxpayers may elect to aggregate certain commonly controlled entities for purposes of Sec. 199A. For example, the rental or licensing of tangible or intangible property to a related trade or business may be treated as a single trade or business. That’s if the two entities are commonly controlled (50% or more common ownership). Certain other requirements also must be met. Aggregation allows taxpayers to maximize their deductions, for example by combining the entities’ W-2 wages and depreciable property investments.
W-2 wages defined. The proposed regulations clarify that W-2 wages include amounts paid by other entities. Among them, for example, are professional employer organizations or employee leasing firms. The IRS also issued a proposed revenue procedure outlining three alternative methods for calculating a business’s W-2 wages.
Converting to independent contractor status. Some commentators have discussed the idea of converting employees to independent contractor status, enabling them to claim the pass-through deduction as sole proprietors. The proposed regulations clarify that, under those circumstances, one who continues to perform substantially the same services is presumed to be an employee rather than an independent contractor.
The proposal contains numerous other provisions addressing the computation of QBI, netting and carryover rules, pass-through entity reporting obligations and other issues.
Keep an eye on regulatory developments in the coming months. Once the proposed regulations are finalized, consult with your tax advisor about their impact on your eligibility for the pass-through deduction. And plan your tax strategies accordingly.