The IRS has issued proposed regulations (see REG-107892-18) regarding the deduction for qualified business income under new section 199A (commonly called the pass-through deduction). These proposed regulations contain six major sections, and provide computational, definitional and anti-abuse guidance on the new pass-through deduction.
These highly anticipated proposed regulations are very complex, addressing a myriad of topics and containing a number of clarifying rules. The regulations are generally effective for taxable years ending after their publication as final regulations; however, taxpayers may generally rely upon them in proposed form for tax years ended after Dec. 31, 2017. Some initial highlights are:
- Aggregating businesses
- One of the major areas of uncertainty surrounding the pass-through deduction was the question of if, and how, a business would be permitted to aggregate its operations for purposes of calculating the pass-through deduction and its relevant limitation factors. Under the proposed regulations, “aggregation is permitted, but not required.” Therefore, businesses under common control – and that meet the certain requirements for aggregation under the proposed regulations – would be able to aggregate. The proposed regulations do not follow the grouping rules under the passive activity loss rules (section 469), as some thought they might, however, the drafters suggests that these proposed aggregation rules may instead be applied for other purposes in the future, including potentially section 469.
- W-2 wages attributable to a trade or business
- Another key uncertainty surrounding the pass-through deduction was whether or not taxpayers could count W-2 wages (a limitation factor) for workers paid using third party payors (such as professional employer organizations (PEOs)). The proposed regulations confirm that these amounts may be taken into account. Specifically, the proposed regulations state that “in determining W-2 wages, a person may take into account any W-2 wages paid by another person and reported by the other person on Forms W-2 with the other person as the employer listed in Box c of the Forms W-2, provided that the W-2 wages were paid to common law employees or officers of the person for employment by the person.”
- Specified service trades or businesses
- The definition of a Specified Service Trade or Business (SSTB) – and in particular, the so-called principal asset test – were among the most discussed, and uncertain, areas of the new pass-through deduction. The proposed regulations address both of these issues at length.
- For purposes of defining the listed trade or business fields (such as health, law, accounting, etc.) the proposed regulations “generally follow the guidance issued under section 448(d)(2) [definition of a qualified personal service corporation] with some modifications” noting that “in certain cases, the principles of section 448(d)(2) proved useful analogies in defining the particular fields…”
- The proposed regulations then go on to address the second prong of the SSTB test – the so-called principal asset test – which includes “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners.” The proposed regulations limit the applicability of this provision to certain very specific fact patterns, including “receiving income from endorsing products or services…,” “licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or other symbol associated with the individuals identity…” and “ receiving appearance fees or income…”
- Reasonable compensation requirement
- Another area of uncertainty regarding the pass-through deduction was whether pass-through entities other than S corporations would be subject to the reasonable compensation requirements. The proposed regulations come down against this, stating that while “QBI does not include reasonable compensation paid by an S corporation…” the proposed regulations do “not extend [the reasonable compensation] rule to partnerships.”
In addition, the proposed regulations address a host of computational issues including the treatment of losses and specific items of income, including section 1231 gains and section 751 hot asset income (among others.) Interestingly, in addressing 1231 gains or losses, the preamble noted, “if gain or loss is treated as capital gain or loss under section 1231, it is not QBI,” a statement which itself raises interesting computational issues.
These proposed regulations will affect a multitude of taxpayers, and it will take time for all the implications of them to surface. Accordingly, taxpayers should stay tuned for more in-depth analyses of these proposed regulations.