IRS Releases Proposed Guidance on 20 Percent Deduction for Pass-Through Entities

By:
Chris Gaetano
Published Date:
Aug 9, 2018
IRS

The IRS has released technical guidance for a key part of the Tax Cuts and Jobs Act, the 20 percent deduction for pass-through entities, which had been the source of much confusion for preparers and taxpayers alike since the law went into effect. The deduction is generally available to eligible taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns and $157,500 for other taxpayers. It’s generally equal to the lesser of 20 percent of their qualified business income plus 20 percent of their qualified real estate investment trust dividends and qualified publicly traded partnership income or 20 percent of taxable income minus net capital gains. Deductions for taxpayers above the $157,500/$315,000 taxable income thresholds may be limited. Those limitations are fully described in the proposed regulations.

While this provision may seem simple on its face, in its wake has come questions regarding when taxpayers who earn above the $157,500/$315,000 thresholds qualify for the deduction, and how it should be calculated. For instance, one NYSSCPA member in a recent Trusted Professional article on the subject, noted that those in a "specified service trade or business," which includes fields such as accounting, law, medicine and anything where the principal asset is the reputation or skill of at least one employee, cannot take the deduction. Yet, imagine two restaurants that are both pass-through entities, one owned by a regular chef and the other owned by a celebrity chef. While both are in exactly the same trade, which is more likely to get the deduction? 

Agreeing that the term is overly broad and subject to too many interpretations, the proposed guidance limits the meaning of the "reputation or skill" clause to cases where the entity is: receiving income for endorsing products or services; licensing or receiving income for the use of an individual's likeness, image, name, signature, voice, trademark or any other symbol associated with their identity; or receiving appearance fees or income, such as going on a reality TV show or engaging with social media. The IRS determined that such an interpretation fit Congress's intent on the statute. 

Another question that has come up is what happens when a pass-through entity has multiple types of income, some of which fit under a "specified service trade or business (SSTB)" and some of which does not. The IRS has proposed that, in such cases, income from the prohibited categories would not be counted as qualified business income (QBI) regardless of whether the entity was actively or passively involved in it. The agency gave the example of a partnership that also owns a professional sports team, which falls under the category of an SSTB. In this case, all income from that sports team would not be counted toward the deduction, and cannot be aggregated with other trades or business. 

In general, though, aggregation is allowed (but not required), so long as the individual can demonstrate that the income comes from a qualified trade or business, that the same person or group of persons directly or indirectly owns a majority interest in each of the businesses to be aggregated, that none of the aggregated trades or businesses are an SSTB, and finally that the trades or businesses meet two of three of the following conditions: They provide products and services that are the same or are customarily provided together; they share facilities or significant centralized business elements like common personnel or IT resources; or they are operated in coordination with, or reliance on, other businesses in the aggregated group. 

The IRS noted that certain commentators have said that some entities might be tempted to make their employees who earn below the threshold amounts independent contractors as a way to lower their costs and allow the workers to qualify for the pass-through deduction. The Trusted Professional article noted that this is one way that, while counting as an SSTB, accounting firms might still be able to take advantage of the deduction. The IRS proposal, though, would not allow such maneuverings. Any individual who had been treated as an employee but is then reclassified to a contractor, despite doing substantially the same services, is still presumed to be an employee with regard to these services. This presumption can be rebutted only if the entity shows that the employee is performing services in a capacity other than as an employee (the IRS said this would apply solely to Section 199A and does not otherwise change employment tax classification as an individual). 

The proposed regulations have a number of other anti-abuse provisions as well. For instance, taxpayers would be prohibited from establishing multiple nongrantor trusts or contributing additional capital to multiple existing nongrantor trusts in order to avoid federal income tax. Trusts formed or funded with a significant purpose of receiving the deduction will not be respected with respect to this statute. 

The IRS also shut down an idea that the agency said it has heard some taxpayers contemplating: separating out parts of what would otherwise be an integrated SSTB to try to qualify them for the deduction, which it said is inconsistent with the purpose of the statute. Under the proposed regulation, an SSTB includes any trade or business with 50 percent or more common ownership, directly or indirectly, that provides 80 percent or more of its property to services to an SSTB. Additionally, if an entity has a 50 percent or more common ownership with an SSTB, the portion of the property or services provided to that entity will be treated as income from an SSTB. Meanwhile, if a trade or business that would not otherwise be treated as an SSTB has 50 percent or more of common ownership with an SSTB and shares expenses like wages and overhead, then it is treated as an SSTB itself if it represents no more than 5 percent of gross receipts of the combined business. 

The proposal also contains the general calculation for the deduction: It is calculated as the deduction of the lesser of, either, 20 percent of the taxpayer’s QBI, plus 20 percent of the taxpayer’s qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income; or, 20 percent of the taxpayer’s taxable income minus net capital gains.

If the taxpayer’s taxable income is above the $315,000/$157,500 thresholds, the deduction may be limited based on whether the business is an SSTB, the W-2 wages paid by the business and the unadjusted basis of certain property used by the business. These limitations are phased in for joint filers with taxable income between $315,000 and $415,000, and all other taxpayers with taxable income between $157,500 and $207,500. The threshold amounts and phase-in range are for tax-year 2018 and will be adjusted for inflation in subsequent years.

The IRS said that taxpayers may rely on the rules in these proposed regulations until final regulations are published in the Federal Register. Written or electronic comments and requests for a public hearing on this proposed regulation must be received within 45 days of publication in the Federal Register.

Click here to see more of the latest news from the NYSSCPA.