This is the first year that individuals, estates, and trusts ("owners") holding these pass-through businesses will be able to claim the 199A deduction. The Tax Act of 2017 (PL115-97) included this deduction to level the playing field with companies that have benefited from the significant reduction in the corporate tax rate. The deduction is valid for tax years beginning in 2018 and is available till December 31, 2025. It enables owners to deduct up to 20% of their QBI (qualified business income) earned by the business on the owner's tax refunds, subject to other important limitations. The government published the final regulations for this deduction in February 2019.
But those who have begun to wonder what it takes to qualify for the deduction may realize that 199A is both a tax benefit and a compliance challenge. Unlike a simple tax cut, which is neat and easy to calculate, this deduction is a bit complex. It requires multiple calculations and assessments, new information collected and shared by each pass-through with its owners, and is subject to several important limitations. The provision may also cause some entrepreneurs to consider changes to how certain businesses are structured to better position themselves to benefit from the deal.
In short, the compliance burden is complex and mandatory – all pass-through entities must now provide this essential information to their owners on a going-forward basis.
Claiming the Pass-Through Deduction: Three Main Issues
Even at a basic level, those wishing to claim a deduction under Section 199A should be able to answer three main questions:
Is the trade or business a qualified trade or a specified business or service trade?
The information required to calculate the deduction under Section 199A is not based on a legal entity but at the business or enterprise level. Each business must first determine if it has a trade or business, then determine if each is considered a qualifying trade or business (QTB) or a specific service trade or business (SSTB).
The distinction is important because the new Section 199A deduction only applies to qualifying business income from a QTB. In addition to some specific examples, Section 199A defines a QTB by explaining what it is not. All trade or business is eligible, except if it is SSTB or services provided as employees and not as a company.
On the other hand, an SSTB is any business involved in healthcare, law, accounting, consulting, performing arts, commerce, financial services, and a few others. An SSTB is also defined as any business whose primary asset is the "reputation or skill" of one or more employees or owners. The fact that a business is an SSTB does not mean that disclosure is not required, as the revenue it generates can still generate profits at the owner level if its revenue falls below certain thresholds.
The more assets or underlying assets an organization has, the more difficult it may be to collect the necessary and relevant data for its owners and may even require some planning considerations as the contributor has QTB and SSTB activities within the framework of its trade or business.
What income qualifies?
What makes the task particularly burdensome for businesses is the need to obtain specific information for each transaction or activity to calculate the Section 199A deduction.
Each pass-through must determine the qualifying trading income for each transaction or underlying transaction. Qualifying income generally includes qualifying income or loss for each QTB as long as it is not canceled or suspended under other rules and is effectively related to the conduct of a domestic QTB. Non-qualifying income includes capital gains, dividends, net foreign exchange gains, and certain interest and other items listed by law.
Finally, there is the allocation of expenses. This is a challenge as the current rules do not define how to do this but allow any "reasonable" method. Once you have chosen a method, there is no going back. The final rule specifies that taxpayers must consistently apply the reasonable method chosen for each item in all subsequent years. This means they need to think critically and plan the approach they want to take to allocating expenses as part of their tax filing process.
Once these calculations are made for each QTB and SSTB, this information is shared with each owner as a part of the tax filing process.
What income can be deducted?
After sharing this information, each business owner must determine how much they can deduct. At that point, they might be tempted to take only 20% of eligible income to claim as a deduction. Not so fast. Even after all this work, the amount of the deduction may still be limited by salary and asset considerations.
These limits include a number of "greater than" calculations involving W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of assets used by the business or company. These calculations require more than just pulling a number from payroll or amortization reports. Instead, it involves one of three permitted W-2 salary limit methods and various manual UBIA adjustments.
Because the pass-through deduction is calculated at the owner level, the pass-through entities will not always know which limitation would benefit the individual or the trust most. Therefore, you may need to report your W-2 salary and your UBIA to give owners all the information they need to calculate the pass-through deduction at their level. As part of the final regulations, the undeclared item will be considered void if a pass-through fails to report an item of QBI, wages, or UBIA.
There is also the question of aggregation. Owners will need to consider adding eligible yet related trades or businesses. If two or more businesses or trades meet certain conditions, the respective Section 199A activities may be added to increase the benefit of the deduction. The rules provide that the assignor or its individual owners may elect to combine separate transactions or operations. If the pass-through entity combines certain businesses or trades, the owners of these entities retain the entity combination. As with the expenditure methodology above, the choice to aggregate is locked in once made. Once the decision to aggregate has been made, it is necessary to consistently report the aggregated trades or businesses in all subsequent taxable years. This puts pressure upon the business and its individual owners to exercise foresight when deciding to make the election.
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Dennis Jao