When Congress enacted tax reform in 2017, the new tax law permanently lowered the tax rate for corporations from 35% to 21%. To make sure that other business owners weren’t left behind, Congress provided a new deduction—Section 199A—for sole proprietors and owners of pass-through businesses. Section 199A offers eligible business owners a lower effective tax rate by allowing for a deduction of up to 20% on qualified business income (QBI) for tax years 2018 - 2025. Due to a lack of initial guidance, there has been much difficulty and speculation regarding how this deduction works.
Fortunately, in August 2018, the IRS quelled those uncertainties by releasing proposed regulations that have answered many burning questions. As of this January, those proposed regulations, with some clarifications and changes, have become final. The new regulations offer clarification regarding specified service trade or business (SSTB) guidelines, calculation of QBI, anti-abuse rules, and application of W2 wages and aggregate rules. Below are some highlights of the final regulations:
End of Year Acquisitions. The new regulations have included an anti-abuse rule designed to disincentivize buying properties solely for the purpose of gaining a larger deduction. The rule excludes property that is purchased and sold within 60 days of the end of the tax year in the calculation of unadjusted basis. While acquiring assets can be part of building a business, estate planners should exercise caution to avoid disqualifying those new assets.
Aggregation Rules. Besides individuals, the final regulations allow clients to aggregate W-2 wages, QBI, and UBIA of qualified property, so long as they satisfy five criteria: 1) the same person(s) own 50% or more of each trade/business that are to be aggregated; 2) the ownership is held for a majority of the year, including the last day of the taxable year; 3) all aggregated items are reported on returns with the same taxable year; 4) the business in question is not an SSTB; 5) at least two of these final factors considering all the facts and circumstances: A) the businesses to be aggregated provide products and/or service that are offered in tandem, B) the businesses share facilities or other business elements, such as personnel, accounting, human resources, or C) the businesses are operated as an aggregated group, such as through supply chain interdependencies.
Multiple Trusts. The new regulations have an additional anti-abuse rule concerning the treatment of multiple trusts that attempt to get around QBI limits. In circumstances where two or more trusts have substantially the same grantor and beneficiaries, Section 1.643(f)-1 states that the trusts will be treated as a single trust for federal income tax purposes if a principal purpose for establishing the multiple trusts was avoidance of federal income tax. Estate planners should revisit any plans that may be affected by this rule and should carefully document non-tax reasons for multiple trusts if they have an impact on the 199A deduction.
SSTB Guidelines. The regulations increased the clarity of what businesses count as a SSTB. Many different types of service or professional businesses can be SSTBs, including health care, law, actuarial, and accounting practices. Additionally, consultants, performers, and financial advisory service providers are considered SSTBs. The final regulations provide a variety of illustrative examples.
For example, the term “brokerage services” does not include taking deposits or making loans. It does, however, include arranging lending transactions between a lender and borrower. Regarding health care services, the final regulations have removed the requirement from the proposed regulations that health services be provided directly to patients; thus, increasing the number of entities—like businesses that provide lab reports and medical supplies—that are considered to be an SSTB. However, the final regulations concluded that architecture, engineering, and staffing services will not be treated as consulting services for purposes of Section 199A. Why is the SSTB definition so important? It can limit or even eliminate the 199A deduction. SSTB owners above the threshold income level have their deduction limited, and those with income above the phase-in range do not get a 199A deduction at all.
Calculation of QBI. The final regulations contain several important modifications to assist in the calculation of QBI. For example, the final regulations stipulate that deductions such as the tax on self-employment income, self-employed health insurance, and contributions to qualified retirement plans (as described in Sections 164(f), 162(l), and 404 respectively) are allowable, so long as the business’ gross income is taken into account when calculating the deduction on a proportionate basis.
The final regulations also define capital gain as net capital gain including any qualified dividend income. To determine whether something should be treated as a capital gain or ordinary loss, the final regulations say that taxpayers must first net their Section 1231 gains and losses. If the result is an excess gain, then it is considered a capital gain and must be considered in the calculation. If the result is an excess loss, then it is considered an ordinary loss and is used to reduce the QBI of the business.
To take advantage of the new regulations, it’s important to review your business owner clients’ situations and determine whether any changes need to be made to their choice of entity or operations. As these rules are complex and easy to mishandle, this may be one area in which “going it alone” is not likely to yield optimum results. Learn how a WealthCounsel membership can give you the information and support you need to continue to provide your estate and business planning clients with comprehensive legal strategy and advice. If you’d like to get the help you need to take your practice to the next level, click here.