By: John Carpenter, Principal and Rick Schneider, Partner
The Treasury Department and the Internal Revenue Service recently issued proposed regulations on the new Section 199A pass-through deduction created by the Tax Cuts and Jobs Act, available for tax years beginning after December 31, 2017, and before January 1, 2026. Section 199A is a wholly new regime established to generate a non-cash tax deduction to alleviate the disparity between the 37% individual tax rate and the new 21% corporate tax rate.
Section 199A permits a deduction of up to 20% of qualified business income (“QBI”) from a domestic pass-through business, plus 20% of qualified REIT dividends and 20% of qualified PTP income, if applicable. These highly anticipated and robust proposed regulations define and provide guidance on a number of items identified within Section 199A, including the items noted below.
W-2 Wages and Qualified Property
The Section 199A deduction is calculated based on the lower of 20% of QBI or the “W-2 wages/qualified property limitation.” The proposed regulations expanded upon these items and clarified a number of questions that emerged from the initial Section 199A language.
The W-2 wages and qualified property limitations are defined as the lower of:
(1) 50% of the W-2 wages of the business or
(2) 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of depreciable property used in the trade or business.
W-2 wages attributed to QBI are identified by calculating all W-2 wages for the taxable year, allocating between each of your trades or businesses, and then analyzing to determine if they are allocable to QBI within each trade or business. One key item clarified in the proposed regulations was that wages paid by third parties on your behalf (e.g., by professional employer organizations) qualify for purposes of calculating W-2 wages attributable to QBI. It was noted earlier by the IRS that salaries paid to 1099 subcontractors do NOT qualify as W-2 wages, and thus companies who have a sizable base of 1099 subcontractors will want to evaluate how that affects their ability to benefit from the 199A deduction.
With regard to the limitation above calculated as 25% of W-2 wages plus 2.5% of the UBIA of tangible depreciable property used in the trade or business, most government contractors do not own enough fixed assets to make this method worthwhile. The proposed regulations also provide guidance on the definition of unadjusted basis immediately after acquisition in regards to tangible depreciable property. Essentially, the proposed regulations provide that UBIA equals the acquisition cost of the property without regard to any adjustments (such as Section 179) with the exception of a reduction for the percentage of time the qualifying property is used outside the qualifying trade or business (if not used 100% in the business).
Specified Service Trade or Business (“SSTB”)
All pass-through businesses should be scrutinized or evaluated to determine if there is one, or more than one, trade or business within the company – particularly if one of those businesses is consulting or meets another of the “Specified Service Trade or Business” definitions. If the pass-thru business owner’s taxable income exceeds certain threshold amounts, income from SSTBs would not be treated as income from a qualified trade or business. The proposed regulations further define what constitutes an SSTB, and provide specific guidance on the 13 listed SSTBs, including definitions and examples of what is and is not included in such definitions. One notable clarification in the proposed regulations that can work in your favor came within the final listed SSTB – “trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owners.” The proposed regulations clarify that this is specifically limited to situations where employees or owners receive compensation for product endorsements, licensure associated with an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, or appearance fees. This will not likely impact any government contractors.
One area that has potential to impact a lot of government contractors is whether a business meets the definition of “consulting” business. The IRS recently released guidance on the definition of “consulting,” which states:
“Consulting” is defined as “the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems” but states that consulting “does not include the performance of services other than advice and counsel, such as sales or economically similar services or the provision of training and educational courses.”
Many government contractors would say that they always want to be considered as “helping the client in achieving goals and solving problems.” The difficulty becomes how to draw the line between providing technical services or support and providing “professional advice and counsel.” Even drawing this distinction is not difficult enough, contractors may also look forward to having to make this analysis on a contract by contract (or even task order by task order) basis. Tax preparers are faced with the task or either forcing clients to provide this distinction, or passing the data to individual owners and advising them to make their own individual determination as they perform an overall analysis of 199A eligibility.
Most tax advisors still consider the “consulting” definition to be a gray area and are pressing IRS to provide further clarification prior to end of year. Cherry Bekaert will provide further updates as they become available.
If there are multiple businesses within an entity, then the owner of such pass-thru entity should consider making an aggregation election. To aide with this, the company should begin evaluating the multiple businesses or begin record keeping set-up to track the separate business lines for tax purposes. The proposed regulations permit but do not require you to aggregate if you have multiple qualified trades or businesses. Aggregation requires, among other things, that your businesses must be under common ownership, have shared services or related transactions between the businesses, and not include any SSTBs. Once aggregated, QBI, W-2 wages and UBIA of qualified property are also aggregated for purposes of the formula to calculate the Section 199A deduction, which can be favorable to you, as some standalone deductions may be significantly limited by W-2 or UBIA limitations. The aggregation must be consistent from year-to-year (i.e., you cannot evaluate annually whether aggregation or disaggregation would be more favorable).
As we approach year-end, companies will commonly engage in certain tax planning activities and may frequently be asked by shareholders to provide an estimate of K-1 income and other information so that owners may do proper tax planning. With the dawn of the 199A deduction, companies should be careful in providing guidance on how the 199A deduction will impact each owner. Owners can expect that additional detailed information will be provided with each Schedules K-1 distributed to owners so they can claim the deduction on their personal returns. When it comes to assessing the impact of the 199A deduction, individual owners can have very different results from each other under Section 199A based on their personal tax situations, including the effect of other partnerships and businesses on their individual tax return. Companies should exercise more than usual care in advising their owners as to the impact of 199A on personal tax returns.
These multifaceted proposed regulations provide guidance on a number of items within Section 199A, including clarifying or expanding upon certain definitions, assisting with the rules in determining what income may qualify, and analyzing how to treat each aspect of the calculation. Additional guidance will continue to be released as further implications of the new Section 199A and proposed regulations are analyzed and considered.
Your business will need guidance and a practical approach to navigate these new proposed regulations. Our dedicated team of tax experts at Cherry Bekaert can explain the details of these changes specific to your situation and help you determine which actions are best for your business.