The IRS has released the final regulations interpreting the new Section 199A deduction for the qualified business income (QBI) of certain pass-through entities.
While the final regulations largely follow the proposed regulations, they do contain some twists that may come as a surprise to clients who are currently in the midst of calculating their 2018 tax liability. Importantly, small business clients have the surprise option of relying on either the proposed regulations or the final regulations in finishing their 2018 taxes—although the final regulations become mandatory beginning in 2019. Despite this, clients must take an all-or-nothing approach to choosing which set of regulations to follow for 2018, making it important that they understand the important aspects of both the proposed and the final regulations now.
One of the more confusing aspects of new IRC Section 199A was the limitation on the ability of specified service trades or businesses (SSTBs) to claim the deduction. The regulations provided clarity as to which types of businesses qualify as SSTBs that were specifically enumerated in the statute itself (for example, with respect to the field of “law”, lawyers, paralegals, arbitrators and mediators are specifically included as SSTBs, while other services related to law, such as printing, stenography and delivery services, are specifically excluded).
The final regulations generally declined to provide significant new guidance in the area, but did provide guidance for health care professionals—under the proposed regulations, SSTB characterization was generally dependent upon whether patient services were provided directly. The final regulations remove this patient service requirement, so that a more facts-and-circumstances approach applies in determining whether health care providers are SSTBs.
Both the final and proposed regulations contain the “de minimis” exception, so that if the business has gross receipts of less than $25 million for the year, it is not considered an SSTB if 10 percent or less of its gross receipts are derived from performing services that would otherwise cause the business to be characterized as an SSTB (the threshold is lowered to 5 percent for larger businesses). The final regulations also acknowledge that a business entity may contain multiple “trades or businesses”, increasing the potential for splitting SSTB-businesses apart from non-SSTB businesses.
‘Crack and Pack’ Strategies
Prior to release of the proposed regulations, many SSTBs had contemplated spinning off separate business units that would not be SSTBs, such as administrative and non-professional functions, in order to take advantage of the QBI deduction. The proposed regulations limited this strategy by providing that if (1) the “spun off” business provides more than 80 percent of its property or services to an SSTB and (2) the two businesses share 50 percent or more common ownership, the “spun off” entity will be characterized as an SSTB. In other words, the separate entity will be ignored for Section 199A purposes under the proposed regulations.
The final regulations depart from this hard-line rule by eliminating the 80 percent threshold. Under the final regulations, the entire business will not be disqualified and characterized as a SSTB, but only the income from the related entity that is an SSTB will be disqualified, potentially opening up significant planning opportunities for businesses that serve multiple functions.
Shifting Income to Independent Contractors
QBI specifically excludes income that is earned from the trade or business of being an employee. Because of this, many employees would now rather be characterized as independent contractors in order to access the deduction. However, current employees will not be able to simply ask their employers to re-classify them as independent contractors to take advantage of the QBI deduction.
The proposed regulations limit the value of converting to independent contractor status by providing that if an individual was classified as an employee for tax purposes and, while continuing to perform the same services for the employer, was re-classified as an independent contractor, the IRS will presume that the individual remains an employee for Section 199A purposes. However, the presumption contained in the proposed regulations is a rebuttable presumption—if the individual can show that he or she is, in fact, properly classified as an independent contractor, Section 199A will be available.
Under the final regulations, taxpayers are required to provide records to establish their status as non-employee independent contractors for a three-year period after the business began treating them as independent contractors. Basically, this means that if an employee shifts to independent contractor status, he or she will have to wait three years before taking advantage of the QBI deduction for income earned in that independent contractor role.
Many taxpayers own interests in more than one pass-through trade or business that may qualify for the 199A deduction, so that it may be more advantageous to aggregate wages and unadjusted basis of qualified property (UBIA) from multiple businesses when calculating the deduction. Aggregation for Section 199A purposes takes place at the owner level only under the proposed regulations. This means that one partner may choose to aggregate businesses, while another partner with ownership interests in the same businesses may not choose to aggregate those same businesses.
Under the final regulations, aggregation of non-SSTB businesses is also permitted at the entity level if the businesses are commonly controlled. Aggregation is only permitted if the same person or group of people own 50 percent or more of each business for the majority of the tax year, including the last day of the year. If the entity chooses to aggregate, this does not mean that individual owners are required to aggregate in the same manner.
It is notable that taxpayers can choose to rely on either the proposed or final regulations for the 2018 tax year, but also important to remember that the final regulations do not clarify every potential issue that has arisen in the 199A context.
- Read previous coverage of planning under the 199A proposed regulations in Advisor’s Journal.
- For in-depth analysis of the choice of entity question, see Advisor’s Main Library.
- Your questions and comments are always welcome. Please post them at our blog, AdvisorFYI, or call the Panel of Experts.