Long-awaited and highly anticipated proposed regulations for Code Section 199A, the new 20 percent deduction on “qualified business income” of pass-through entities, were released August 8 by the Treasury Department and the Internal Revenue Service, and experts are saying they're broadly taxpayer-friendly.
“The government did a good job of responding to practitioner concerns during the comment period,” said Jerry August, shareholder and chair of Philadelphia Federal Tax Practice at law firm Chamberlain Hrdlicka. “The regulations cover important definitional, computational and anti-avoidance guidance. There are still open issues, and the government has requested comments and scheduled a public hearing for Oct. 18, 2018.”
“The proposed regs are impressive in scope, but there are still a handful of areas that will prove tricky for taxpayers,” said Dustin Stamper, managing director at Grant Thornton’s Washington National Tax Office. “We were very pleased to see how narrowly construed the interpretations were for disqualified specified services.”
“The rules are broadly very taxpayer-favorable,” said Jeff Bilsky, technical practice leader for BDO’s National Tax Office Partnership Taxation group. “The Treasury really had some significant decisions to make regarding how the rules would impact taxpayers claiming the deduction and following congressional intent as best they could. They could have been much more restrictive.”
“But when you read through the rules, it’s not as simple as saying, ‘You’re entitled to this,’” he said. “Instead, there’s a lot of nuance that companies will have to consider as they calculate qualified business income.”
The new proposed regulations will help clarify an issue that’s been under consideration all year, according to Bilsky: “Now, the choice of entity has become a little more clear. Companies should now be able to finish their analysis as to whether to remain a pass-through or become a C corporation.”
“Of course, the analysis is driven by other factors in addition to Section 199A,” he noted. “Other factors are whether the company will be distributing available cash, the growth potential of the company, and the ultimate exit timing and value. And because a lower corporate tax rate results in more after tax cash inside the entity, being a C corporation will result in more after-tax cash, and to the extent not currently distributed may allow the corporation to generate a larger growth multiple compared to a pass through.”
Who’s excluded?
The new rules clarify a number of questions and in many cases answer them in a taxpayer-friendly manner, according to Timothy Oberst, tax partner at Top 100 Firm Bennett Thrasher.
“Banking and insurance business are winners,” he said. “Brokerage services is one of the excluded specified services, but it is defined to include only services in which a person arranges transactions between a buyer and a seller with respect to securities. This means that the category of excluded services does not include service provided by insurance agents and brokers, so those activities qualify for the deduction.”
The proposed regulations contain some of the “crack and pack” anti-abuse provisions expected by many practitioners, according to Howard Wagner, national tax services managing director at Top 10 Firm Crowe.
“These anti-abuse provisions prevent service providers who are ineligible for the 20 percent deduction from separating their businesses into separate entities to take advantage of the 20 percent deduction,” he said. “For example, the owners of an accounting firm can’t get the 20 percent deduction for income generated by leasing a building from a separate entity back to the accounting firm.”
The proposed regulations allow require individuals to aggregate related businesses into one activity for purposes of the 20 percent deduction, but do not require it. Individuals are permitted to aggregate trades or businesses operated directly and trades or businesses operated through pass-through entities, Wagner explained: “Assume a taxpayer owns two pass-through entities that are an integrated business. Each one on its own is a business that qualifies for the pass-through entity deduction. One pass-through entity has high profits and low wages. The other pass-through entity has low profits and high wages. The aggregation rules allow the individual to aggregate the two separate trades or businesses to maximize the benefits of the 20 percent deduction.”
“The proposed regulations also clarify that you can count wages paid for your employees even if the wages are reported by someone else under a payroll agent relationship,” he said. “This is favorable to taxpayers and not provided for in the statute.”
The proposed regs also attempt to narrow the scope of service businesses ineligible for the pass-through deduction, Wagner said. “The definition of an ineligible consulting business has been limited to businesses that provide advice and counsel. Along the same lines, the definition of a business that is ineligible for the 20 percent deduction has been narrowed to include only those businesses that provide endorsement services or receive income from licensing an individual’s image, likeness, voice, etc.”
One of the “tricky” areas is going to be when an activity rises to the level of a trade or business, according to Grant Thornton’s Stamper. “The IRS basically relies on existing rules under Section 162 for what is considered a trade or business,” he said. “There is a large body of administrative guidance and case law on that issue, but it’s ambiguous in some areas. It’s particularly difficult to determine when a rental real estate business rises to the level of a trade or business.”
“Another tricky area may be banking,” he said. “The proposed regs rightly hold that core banking activities like lending money and paying interest on deposits is not a disqualified financial service, but there are a lot of banks that have multiple activities – there’s no longer a clear line between traditional banking activities and other financial services.”
Stamper expects “a deluge” of comments before the October 18 hearing on the proposed regulations: “There could be some modifications. They have already sent out a separate notice with a proposed Revenue Procedure on how to count W-2 wages. It’s possible they’ll do some more pieces on mechanical guidance outside of the proposed regulations.”
