On Aug. 8, the IRS released the highly anticipated proposed regulations addressing the new 20 percent pass-through deduction. The regulations generally are taxpayer friendly and contain a broad anti-abuse provision to prevent service providers that generally are ineligible for the deduction from restructuring their business to obtain the deduction for a portion of their business.
The pass-through deduction is a 20 percent deduction for the income of qualifying partnerships, LLCs, and S corporations that generally is referred to as a relevant pass-through entity (RPE). The deduction for each trade or business cannot exceed the greater of:
The proposed regulations clarified the following items:
The pass-through deduction is a 20 percent deduction for the income of qualifying partnerships, LLCs, and S corporations that generally is referred to as a relevant pass-through entity (RPE). The deduction for each trade or business cannot exceed the greater of:
- 50 percent of wages
- 25 percent of W-2 wages paid by the business plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the trade or business
- The sum of the combined amounts described for each trade or business
- 20 percent of the excess (if any) of taxable income over the net capital gain of the taxpayer for the taxable year
The proposed regulations clarified the following items:
- Wages. The proposed regulations clarify that an RPE generally can count wages toward the limitation even if the W-2 wages are reported by another entity as a payroll agent. The proposed regulations also allow a business to count wages paid by a certified professional employer organization provided that all federal tax filings are done in a manner consistent with the employees being treated as common law employees of the RPE.
- Specified Service Trades or Businesses. An SSTB is defined as a health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services trade or business, or any trade or business in which the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. In a taxpayer friendly move, the application of this provision to businesses involving the reputation or skill of one or more of its employees or owners generally will be limited to businesses that receive:
- Endorsement fees
- Licensing income from an individual’s image, likeness, name, signature, or similar items
- Appearance fees
The proposed regulations also limit the definition of a consulting business characterized as an SSTB to businesses that offer professional advice and counsel to clients to assist the client in achieving goals and solving problems. While these provisions offer relief to many human capital businesses, defining professional advice and counsel likely will be one of the most challenging determinations required by the proposed regulations.
- Aggregation of Activities. The proposed regulations allow taxpayers to aggregate multiple trades or businesses under common control with a 50 percent ownership threshold as a single activity if two of the following three conditions are satisfied:
- The trades or businesses provide products and services that are the same or customarily offered together.
- The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources.
- The trades or businesses are operated in coordination with, or reliant upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies).
Once an individual elects to aggregate two or more trades or businesses, the individual must consistently report the aggregated trades or businesses in all subsequent taxable years and annual tax return disclosures are required. The proposed regulations note that the grouping rules of the Section 469 passive activity rules were not adopted. In some cases, items will be aggregated for the pass-through deduction and not grouped under Section 469, or vice versa.
- Anti-Abuse Rules. The regulations adopt an anti-abuse rule that applies to an SSTB with related businesses with common ownership that generate at least 80 percent of their income from the entity that engages in the SSTB, such as when partners of a law firm that is an SSTB and the partners also own a building and the entire building is leased to the law firm. Under the anti-abuse rule, the rental income will be characterized as income from an SSTB.
- Reporting. RPEs are subject to the following reporting requirements on an annual basis:
- The RPE must determine if it is engaged in one or more trades or businesses. The RPE also must determine whether any of its trades or businesses is an SSTB.
- The RPE must determine and disclose the qualified business income for each trade or business engaged in directly.
- The RPE must determine and disclose the W-2 wages and UBIA of qualified property for each trade or business engaged in directly.
- Computation of pass-through deduction. The regulations provide a variety of computational examples, including scenarios in which a taxpayer has multiple pass-through entities, some of which have income and some of which have losses. The regulations also clarify that Section 1231 income that is characterized as capital gain is ineligible for the pass-through deduction.
