On Friday, Jan. 18, 2019, the IRS released guidance on many Sec. 199A issues, including the final Sec. 199A regulations. The Sec. 199A deduction, commonly known as the qualified business income (QBI) deduction, provides a 20 percent deduction for owners of pass-through entities (with limitations). The final regulations provided clarity on many issues related to this deduction that was unclear in the August 2018 proposed regulations.
Sec. 199A provides that the QBI deduction is limited to the lesser of the taxpayer’s QBI or 20percent of the taxpayer’s taxable income, not including the taxpayer’s net capital gain. The proposed regulations did not define “net capital gain.” The final regulations provide guidance on this and define net capital gain as the excess of net long-term capital gain for the year over the net short-term capital loss for that year plus qualified dividend income.
The IRS also more clearly defined the definition of a trade or business, which was slightly reworded. A trade or business for 199A purposes is now defined as a trade or business under Sec. 162 other than a trade or business performing services as an employee. In the Supreme Court case Higgins v. Commissioner, the court established two requirements to determine the existence of a Sec. 162 trade or business. The first is the taxpayer must conduct their business with the intent to make a profit. The second is a taxpayer’s business must have considerable, regular and continuous activity.
The final regulations also clarified the definition of a specified service trade or business (SSTB). The proposed regulations issued in August 2018 highlighted the need to address the ambiguity of this definition, as these were broad categories that could have included many different industries. The final regulations provided further insight with specific examples, as agreed upon by the Treasury Department and the IRS:
- Health – The “performance of services in the field of health” is considered an SSTB, which can include medical services performed by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists and other similar healthcare professionals. However, ancillary services that are not directly related to the medical services field are not included in this definition (e.g. health clubs/spas, payment processing, or sales of pharmaceuticals or medical devices by a retail pharmacy).
- Consulting – The definition here means “the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.” It was clarified that lobbyists are considered consultants, whereas recruiters that refer job applicants are not. Additionally, services in the consulting field other than advice and counsel (such as sales) are not considered to be SSTBs, and services in the fields of architecture and engineering are excluded from the consulting definition.
- Brokerage Services – Services in this field include ones “in which a person arranges transactions between a buyer and a seller with respect to securities… for a commission or fee.” While this includes stockbrokers, it does not include services provided by real estate agents and brokers, or insurance agents and brokers.
Further clarity was provided in the final regulations regarding the treatment of services provided by independent contractors. In the August 2018 proposed regulations, independent contractors who were previously treated as employees are presumed to be performing services as an employee for the purposes of Sec. 199A if they are performing substantially the same services in both roles. The final regulations build on this by adding a three-year lookback rule for determination and allow for a rebuttal of the presumption if the individual can provide sufficient records corroborating the individual’s status as a non-employee.
The final regulations also provided guidance on an area that the proposed regulations did not address – disregarded entities. The final regulations define a disregarded entity as an entity with a single owner that is treated as disregarded as an entity separate from its owner. Thus, trades or businesses conducted by a disregarded entity are treated as being conducted directly by the owner.
The IRS issued new proposed regulations in addition to the final regulations that were released. Two revenue procedures (one proposed and one final) were also issued to provide additional guidance on the new proposed regulations.
The treatment of previously suspended losses under Sec. 199A is addressed in the newly proposed regulations. Since the “previously disallowed losses or deductions (including under sections 465, 469, 704(d), and 1366(d))” that were incurred in taxable years ending before January 1, 2018, are not to be used in the computation of QBI. The Treasury Department and IRS agreed on a first-in, first-out ordering rule when applying losses to offset taxpayer income. In addition, they are to be treated as a separate trade or business. To the extent that losses relate to a PTP, they must be treated as losses from a separate PTP, and the attributes of the disallowed loss are determined in the year the loss is incurred.
The August 2018 proposed regulations brought about many questions regarding the definition of a trade or business, specifically those in the rental real estate industry. To provide additional guidance on the new proposed regulations, the IRS issued Notice 2019-07, in which a proposed revenue procedure provides a safe harbor for taxpayers conducting rental real estate activities. Under the proposed safe harbor, a taxpayer conducting rental real estate activities will be considered a trade or business if:
- At least 250 hours of services are performed each taxable year by owners, employees, and independent contractors;
- Separate books and records are maintained for each rental real estate enterprise; and,
- The taxpayer maintains adequate records of hours and services performed.
If a rental real estate enterprise fails to satisfy the safe harbor requirements, the enterprise may still be treated as a trade or business if it otherwise meets the definition of a trade or business.
The final revenue procedure that the IRS issued was Rev. Proc. 2019-11. This revenue procedure provides three methods for calculation of W-2 wages for 199A purposes. W-2 wages must be calculated, as they are a factor in one of the limitations of 20 percent deduction for taxpayers that have taxable income above a certain threshold. The first method (the unmodified Box method) allows for a simplified calculation. The second and third methods (the modified Box 1 method and the tracking wages method) are more complex but provide greater accuracy.
While the Sec. 199A final regulations provide clarity on several important topics, the coinciding issuance of newly-proposed regulations demonstrates the ongoing complexity of this code section. The QBI deduction will be a powerful tool in tax planning and strategy and staying current on the latest guidance will be paramount. For more information, please contact your Windham Brannon tax advisor.