Extracted from Law360
This month brought good news for owners of banks organized as pass-through entities. On Aug. 8, 2018, the IRS issued new proposed Treasury Regulation Sections 1.199A-1 through 1.199A-6, specifically including banks in the list of businesses eligible for the 20 percent deduction for the qualified business income, or QBI, of pass-through entities.
The Tax Cuts and Jobs Act, which took effect on Jan. 1 of this year, famously slashed the tax rate on C corporations, which pay corporate income tax, from 35 percent to 21 percent. By itself, this may have been seen as unfair to small businesses, most of which are set up not as C corporations but rather as sole proprietorships, limited liability companies, partnerships and S corporations whose income passes through to be taxed at the level of their individual owners. To ensure that non-C corporations could also benefit, the act included Section 199A, which allows owners of sole proprietorships and pass-through entities a deduction of up to 20 percent of their QBI.
The 20 percent pass-through deduction was meant to benefit income derived from a business’ deployment of capital. Therefore, owners of “specified service businesses” with income over a low threshold are excluded from qualification. Specified service businesses are defined as “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” The inclusion of “financial services” caused confusion among owners of banks organized as flow-through entities, which were left wondering whether they could benefit from the deduction or would have to convert their banks to C corporations. Fortunately, the 199A regulations specifically exclude banking from the definition of specified financial services, meaning that owners of banks organized as flow-through entities qualify for the 20 percent deduction.
QBI is the net amount of qualified income, gain, deduction and loss for a qualified trade or business in the U.S. QBI does not include certain investment-related income, including capital gains, dividend or dividend-equivalent income, interest income, gains from foreign currency or commodities transactions, annuity income not connected to a business or any deductions or losses allocable to such items. If a gain or loss is treated as a capital gain or loss under Section 1231, it is excluded from QBI; however, if a loss is treated as ordinary under Section 1231, it reduces QBI.
To ensure that the 20 percent deduction is only used to benefit productive businesses, Section 199A contains a limitation based on the amount of a qualified business’ wages and depreciable property. For an owner with income over a low threshold, the 20 percent deduction is limited to the greater of 50 percent of a qualified business’ W-2 wages; or the sum of 25 percent of its W-2 wages and 2.5 percent of the original basis of all of its depreciable property.
Reasonable compensation paid to S corporation shareholder-employees is specifically included as W-2 wages for purposes of the above limitations, but excluded from QBI. Guaranteed payments to partners in LLCs and partnerships are excluded from both W-2 wages and QBI. This odd treatment of reasonable compensation and guaranteed payments leads to different results for S corporations, LLCs, partnerships and sole proprietorships at similar income levels. For example, if an S corporation’s W-2 wages are low enough that the W-2 wage limitation applies, the inclusion of reasonable compensation in W-2 wages would result in a greater deduction. By contrast, for a business that pays a large amount of wages but has little QBI, the exclusion of reasonable compensation or guaranteed payments from QBI results in a smaller deduction. Thus, depending on their particular circumstances, limited liability companies and partnerships might consider reorganizing as S corporations and single-owner S corporations might consider reorganizing as sole proprietorships, or vice versa, to maximize their future QBI deductions.
The 199A regulations also contain aggregation rules so that owners of multiple qualified businesses can potentially aggregate their QBI, W-2 wages and adjusted bases for purposes of the above limitations. To qualify for aggregation, the businesses must share the same tax year, they must not be specified service businesses and one person or group of persons must own at least 50 percent of each business to be aggregated for the majority of the year. For S corporations, ownership is measured by outstanding stock; for partnerships, it is measured by capital or profits in the partnership and in both cases, family and entity attribution rules apply for purposes of measuring ownership. The businesses to be aggregated must also either provide products or services that are the same or customarily offered together or they must share facilities or significant centralized business elements such as personnel, accounting, legal or information technology resources.
W-2 wages paid by a management company may also be allocated to commonly controlled operating companies to satisfy the wage limitations. An owner of a business may take into account any W-2 wages paid by another business, provided that the W-2 wages were paid to common law employees or officers of the business for which the taxpayer is claiming the deduction.
If certain businesses have negative QBI and others positive, the losses must be allocated to all of the businesses with positive QBI in proportion to their QBI amounts. The W-2 and basis limitations are applied after such losses are allocated and no part of the W-2 wages or basis of the loss businesses is taken into account by the positive-QBI businesses. Net QBI losses may be carried forward to future years but no W-2 or basis amounts may be carried forward with them.
The 199A regulations further clarify that businesses with fiscal year ends other than Dec. 31 may take the full amount of their QBI, W-2 wages and basis into account even though some might have been earned or incurred before 2018.
The 199A regulations also create a series of anti-abuse rules meant to prevent otherwise ineligible businesses from taking advantage of the 20 percent deduction. Before the issuance of the regulations, business owners and advisers considered whether it would be advantageous to convert employees into independent contractors so that they could each claim the 20 percent deduction or to engage in “cracking,” whereby a service business is split into two separate businesses with the qualified business paying a fee to the service business. The 199A regulations specifically crack down on these types of transactions to curtail abuse of the deduction.