Article Highlights: Trade or Business Definition Qualified Business Income Limitation Thresholds Specified Service Trade or Business Reputation or Skill Wage Limitation Proper Wage Allocation Qualified Property Depreciable Period Bonus Depreciation and Sec 179 Negative QBI and Carryovers Multiple Activities REITS and Publicly Traded Partnerships Anti-Cracking Provisions Some of the major provisions of last year’s tax reform legislation were the many benefits provided for businesses, including cutting the C corporation tax rate to 21%. Not to leave out other forms of business, the bill also included what was termed the 20% pass-through deduction that applies to sole proprietorships, partnerships, s-corporations and the like. The short-hand title for this tax benefit is the Sec 199A deduction, and it is one of the more complicated pieces of tax legislation ever conceived by Congress. So complicated in fact that the legislation left a lot of unanswered questions, and for the most part the tax preparation community has sat back and waited for the IRS to release regulations, hoping they would explain the many grey areas of this new deduction. The Treasury Department and the IRS finally released the 184 page proposed regulations on August 8, 2018, explaining how they interpret and propose to apply the provisions and limitations included in the legislation. The regulations are “proposed” and the IRS is asking for feedback from stakeholders. So these are not the “final” regulations and have left some unanswered questions. One of the more important issues related of the legislation is the definition of a “trade or business” since that describes the kind of activity that can create income for purposes of the new 199A deduction. The tax code does not provide a definitive “bright line” definition of a trade or business and the new regulations simply adopted an existing subjective definition, that relies on the outcomes of past court cases and interpretive rules the IRS has issued under code section 162 which is the most familiar provision using the term “trade or business”. This leaves some room for interpretation; most notably whether or not rental real estate income qualifies for the Sec. 199A deduction. Our tentative research finds that except for totally passive rental real estate activities such as triple net leases, a rental real estate activity is a trade or business for purpose of section 199A. The Sec 199A deduction does apply to virtually all pass-through income, referred to as qualified business income (QBI), from all trades or businesses if the taxpayer receiving the income has a taxable income less than the threshold for the 32% tax bracket. For married couples filing a joint return the threshold is $315,000 and for all other filing statuses, the threshold is $157,500. So, if you are receiving QBI in the form of the net profit from a sole proprietorship, K-1 income from a partnership or S corporation, and hopefully the net profit from a rental, your Sec 199A deduction will be 20% of that QBI, figured separately for each business activity. The deduction is taken below the line, which means it does not change your adjusted gross income (AGI), which limits other tax benefits, and it does not reduce your self-employment tax. It is deducted in a manner similar to your itemized or standard deductions on your 1040 tax return. However, once your taxable income goes above those thresholds the computation of the deduction becomes more complicated and for those in a specified service trade or business (SSTB) it is the beginning of the end for the deduction. In the case of a SSTB, the deduction begins to phase out if your taxable income is between $315,000 and $415,000 for married couples filing jointly and between $157,500 and $207,500 for other filing statuses. Thus once your taxable exceeds the $415,000 and $207,500 levels there is no 199A deduction from a SSTB. Reputation or Skill - Although the original legislation provided a list of the type of businesses that were SSTBs there still remained a lot of uncertainty about some business types, especially regarding one very subjective definition of a SSTB which specified that where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners the business activity was an SSTB. Did this mean, for example, that a self-employed plumber who provided his skill for the business wouldn’t be eligible for the 199A deduction? In a taxpayer-friendly interpretation, the regulations clarify that the plumber and others like him would qualify by defining “reputation and skill” to mean: (1) Receiving income for endorsing products or services, including an individual’s distributive share of income or distributions from a relevant pass-through entity (RPE) for which the individual provides endorsement services; (2) Licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, including an individual’s distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual’s image; or (3) Receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players). The regulation also expanded on the list of business activities that are classified as SSTBs and provided several pages of detail that cannot be included here. The following is a general list of those businesses. Health (services by physicians, nurses, dentists, veterinarians, and other similar health care providers. But that does not apply to the businesses of spas and health clubs); Law; Accounting; Actuarial science; Performing arts (but does not apply to the services of others in the industry such as promoters and broadcasters); Consulting; Athletics; Financial services; Brokerage services (investing, investment management, trading, or dealing in securities, partnership interests, or commodities); Wage Limitation - The 199A deduction for business activities other than SSTBs is quite a bit different in that the deduction is available to higher income taxpayers but adds some limitations that complicate the calculations. For these, like an SSTB as discussed earlier, the deduction is 20% of QBI if your taxable income is below the thresholds. But once the threshold is exceeded the wage limitation begins to phase in and once your taxable income exceeds $415,000 for a married couple filing jointly or $207,500 for other filing statuses, the 199A deduction is the lesser of 20% of QBI or the “wage limit” amount. The wage limit amount is the greater of: a. 50% of the W-2 wages paid by the business activity or b. 25% of the W-2 wages plus 2.5% of the unadjusted basis of the qualified property of the business activity. So, if a business activity pays no W-2 wages during the year and has no qualified property, and the taxpayer’s taxable income exceeds the top of the threshold range, the 199A deduction would be zero. W-2 Wages – You would think determining the wages for the purposes of computing the Sec 199A wage limit would be a simple matter of just adding up the wages; unfortunately, it is not. The proposed regulations specify that wages for this purpose will only include wages paid during the calendar year. So wages earned in one year but paid in the next year would be used in the year paid. The wages include wages paid to employees, and if an S corporation, to the officers of the S corporation. Compensation paid to statutory employees (Form W-2 box 13 is checked), is not includible in the calculation of W-2 wages. However wages paid by another employer, such as a staffing agency, are included, but both businesses can’t claim the same wages. The proposed regulations provide 3 methods of determining the total W-2 wage amount. It would seem that what the regulations describe as the “Modified Box 1 Method” will be the one most frequently used by small and midsized employers. That method totals the W-2 box 1 wages, subtracts amounts that are not subject to income tax withholding, and adds the excludable pension contributions included in box 12 codes D, E, F, G, and S. Where the taxpayer is a shareholder in an S corporation or partnership the taxpayer will only use his or her prorated share of the wages from the business.