Menu
Tax Notes logo

Miller & Chevalier Recommends Changes to Section 199A Regs

SEP. 26, 2018

Miller & Chevalier Recommends Changes to Section 199A Regs

DATED SEP. 26, 2018
DOCUMENT ATTRIBUTES

September 26, 2018

CC:PA:LPD:PR (REG-107892-18)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

Re: Comments to REG-107892-18, Qualified Business Income Deduction, 83 Fed. Reg. 40884 (Aug. 16, 2018)

To Whom It May Concern:

Pursuant to REG-107892-18, Qualified Business Income Deduction, 83 Fed. Reg. 40884 (Aug. 16, 2018), Miller & Chevalier Chartered respectfully submits two comments regarding the proposed regulations under section 199A (the “Proposed Regulations”).1 First, we recommend that the U.S. Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) modify the Proposed Regulations to provide that certain section 707(a) payments are not excluded from qualified business income (“QBI”). Second, we recommend that Treasury and the IRS modify the Proposed Regulations to clarify the consequences that occur if a relevant passthrough entity (“RPE”) fails to report certain information on a Schedule K-1 issued to a partner.2

I. INTRODUCTION

Section 199A allows an individual to deduct up to 20 percent of the individual's qualified business income (“QBI”). QBI generally means the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business (“QTB”) of the taxpayer. Section 199A(c)(1). A QTB is any trade or business other than a specified service trade or business (“SSTB”) or the trade or business of performing services as an employee. Section 199A(d)(1). The SSTB limitation does not apply to individuals with taxable income below a certain threshold. Section 199A(d)(3). The 20 percent deduction is limited by the greater of (1) 50 percent of the individual's allocable share of the QTB's W-2 wages or (2) the sum of 25 percent of the individual's allocable share of the QTB's W-2 wages plus 2.5 percent of the individual's allocable share of the unadjusted basis immediately after acquisition (“UBIA”) of qualified property. Section 199A(b)(2)(B). This limitation also does not apply to individuals with taxable income below a certain threshold. Section 199A(b)(3).

II. SECTION 707(A) PAYMENTS

A. Background

Section 199A(c)(4) contains exceptions to the definition of QBI. One such exception provides that “to the extent provided in regulations, any payment described in section 707(a) to a partner for services rendered with respect to the trade or business” is not QBI. Section 199A(c)(4)(C). In general, section 707(a) provides that transactions between a partner and a partnership other than in the partner's capacity as a partner of such partnership generally are treated as occurring between a partner and non-partner for all federal tax purposes.

The Proposed Regulations exercise the regulatory authority provided under section 199A(c)(4)(C) to exclude all section 707(a) payments from QBI. Specifically, Prop. Treas. Reg. § 1.199A-3(b)(2)(ii)(J) provides that “[a]ny payment described in section 707(a) received by a partner for services rendered with respect to the trade or business, regardless of whether the partner is an individual or an RPE,” is not taken into account in calculating QBI. The preamble to the Proposed Regulations explains the rationale for this rule:

Section 707(a) addresses arrangements in which a partner engages with the partnership other than in its capacity as a partner. Within the context of section 199A, payments under section 707(a) for services are similar to, and therefore, should be treated similarly as, guaranteed payments, reasonable compensation, and wages, none of which is includable in QBI. . . . Accordingly, proposed § 1.199A-3(b)(2)(ii)(J) provides that QBI does not include any payment described in section 707(a) to a partner for services rendered with respect to the trade or business, regardless of whether the partner is an individual or an RPE.

83 Fed. Reg. 40844, 40893. Notwithstanding the foregoing, the preamble to the Proposed Regulations requests comments on whether there are situations in which it is appropriate to include section 707(a) payments in QBI. Id.

B. Recommendation

In response to the preamble's request for comments, we recommend that Treasury and the IRS modify Prop. Treas. Reg. § 1.199A-3(b)(2)(ii)(J) to provide that certain section 707(a) payments are not excluded from QBI.3 Specifically, we recommend that final regulations provide that a section 707(a) payment is QBI only if the recipient partner (whether an individual or RPE) receives the payment in connection with the recipient partner's own QTB and the payment is not otherwise excluded from QBI under Prop. Treas. Reg. § 1.199A-3(b)(2)(ii).

Consider an individual engaged in a QTB. As part of that QTB, the individual provides services to unrelated parties, one of which is a partnership. Service fees from the partnership constitute QBI for the individual and are eligible for the section 199A deduction. Assume now that the individual contributes cash to the partnership in exchange for a small equity interest. The individual's new status as a partner means the service fee is now a section 707(a) payment that Prop. Treas. Reg. § 1.199A-3(b)(2)(ii)(J) excludes from QBI. In other words, the individual's small equity interest in the partnership has converted what was otherwise QBI into non-QBI. We submit that this result is inappropriate. Our proposed modification to Prop. Treas. Reg. § 1.199A-3(b)(2)(ii)(J) would preserve the QBI characterization of the service fee. Specifically, the individual received the section 707(a) payment in connection with the individual's own QTB. As such, under our proposed modification, the section 707(a) payment would constitute QBI.

Consider the same example as above but assume instead that the individual engaged in a SSTB and has taxable income above the relevant threshold in section 199A(b)(3). Under these revised facts, the individual receives the section 707(a) payment with respect to the individual's SSTB. Because the individual does not receive the section 707(a) payment with respect to a QTB of the individual, our proposed modification would not characterize the section 707(a) payment as QBI.

Arrangements analogous to the above examples are quite common. A recent comment letter on the Proposed Regulations identified such arrangements in the commercial lending and real-estate management industries.4 We note that such arrangements also exist in the construction industry. For example, two construction companies (potentially with different areas of expertise) may enter into a joint venture to bid on a large-scale construction project (e.g., municipal infrastructure). This joint-venture approach allows the companies to negotiate more competitively for the project. If the joint venture wins the project, the joint venture enters into a contract with the client and may then decide to subcontract all of some of the associated work to its construction-company partners (typically based on each company's area of expertise). Payments from the joint venture to the construction-company partners under the subcontracts may be section 707(a) payments. Without our proposed modification to the Proposed Regulations, such payments would not be QBI (even though such payments would be QBI if the construction companies had not formed the joint venture and each contracted with the client separately). In contrast, under our proposed modification to the Proposed Regulations, such payments would be QBI because the construction companies receive the payments in connection with their own respective QTBs. In other words, our proposed modification to the Proposed Regulations would achieve the same result that the construction companies would have achieved had they forgone the joint-venture arrangement.

As another example, frequently a special purpose vehicle (“SPV”) (treated as a partnership for federal tax purposes) will be formed to own and operate a facility that will require construction (e.g., a power plant). To be awarded the associated construction contract, a construction company may agree to make a small equity investment in the SPV, thereby becoming a partner. Due to this equity interest, payments under the construction contract from the SPV to the construction-company partner may be section 707(a) payments. Again, without our proposed modification to the Proposed Regulations, such payments would not be QBI (even though such payments would be QBI if the construction company had not taken the small equity interest in the SPV). In contrast, our proposed modification to the Proposed Regulations would preserve the QBI characterization of such payments because the construction company receives the payments in connection with the company's own QTB.

Our proposed modification to the Proposed Regulations is appropriate for several reasons. First, our proposed modification draws a clear and administrable distinction between section 707(a) payments that constitute QBI and section 707(a) payments that do not.

Second, our proposed modification is consistent with the stated intention of Treasury and the IRS to promulgate regulations that (1) make the section 199A deduction broadly available and (2) encourage economically efficient decision making based on market incentives rather than tax consequences. Treasury's news release accompanying the Proposed Regulations states that the Proposed Regulations “ensure that this historic tax cut will be available to the broadest spectrum of American businesses.” Press Release, Treasury Issues Proposed Regulations on New 20 Percent Deduction for Pass-Through Businesses (Aug. 8, 2018). Additionally, the preamble to the Proposed Regulations contains numerous references to implementing the section 199A deduction in an economically efficient manner that reduces incentives to make choices based on tax consequences rather than business judgment. See, e.g., 83 Fed. Reg. 40884, 40904. Our proposed modification aligns with the foregoing intentions by ensuring that a payment that otherwise constitutes QBI does not lose that characterization simply because the recipient takes an equity interest in the entity making the payment. Any other result would narrow the section 199A deduction's availability and drive taxpayers to restructure their affairs in what may be an economically inefficient manner.

Third, anti-abuse rules in the Proposed Regulations and elsewhere are already sufficient to prevent potentially abusive transactions:

  • Prop. Treas. Reg. § 1.199A-5(c)(2) provides that a partner engaged in a trade or businesses that provides more than 80 percent of its property or services to an SSTB with which the partner shares common ownership (50 percent or greater) will be treated as engaged in an SSTB. This rule prevents a partner from deriving QBI by providing otherwise qualifying services to a partnership he or she controls that is engaged in an SSTB in exchange for a section 707(a) payment.

  • Prop. Treas. Reg. § 1.199A-5(d)(3) provides that when a former employee becomes a partner of a partnership and continues to provide substantially the same services to that partnership, the former employee will be presumed to continue to be in the trade or business of being an employee. This rule prevents former employees from disguising their employment compensation as section 707(a) payments.

  • Section 482 and the regulations thereunder provide broad authority for the IRS to allocate income among related taxpayers in a manner that clearly reflects income and is consistent with an arm's-length standard. These rules prevent a partner and a partnership from using noneconomic payments to inappropriately inflate or otherwise distort the partner's section 199A deduction.

  • Treas. Reg. § 1.702-2 gives the IRS broad authority to disregard a purported partnership or partners, or a specific partner's allocation of partnership income, gain, loss, deduction, or credit, in cases where the partnership is formed with the principal purpose of reducing a partner's federal taxes in a manner inconsistent with subchapter K. This rule prevents partners and partnerships from engaging in certain transactions that are solely motivated by obtaining or increasing the section 199A deduction.

Fourth, our proposed modification is consistent with section 707(a)'s language and intent. Regarding the language, Section 707(a)(1) provides that “[i]f a partner engages in a transaction with a partnership other than in his capacity as a member of such partnership, the transaction shall, except as otherwise provided in this section, be considered as occurring between the partnership and one who is not a partner.” (emphasis added). Thus, if a payment falls within section 707(a)'s ambit, the payment is treated as occurring between a partnership and a non-partner for all federal tax purposes. It is therefore wholly consistent with section 707(a)(1)'s language to apply the QBI test of section 199A(c) to a section 707(a) payment received by a partner for services provided to the partnership just as if the payment were received from an unrelated party.

Our proposed modification is also consistent with congressional intent regarding section 707(a). That section was first enacted as part of the Revenue Act of 1954. The House Ways & Means Committee Report for that legislation states the following:

When a partner sells property to, or performs services for the partnership, the problem arises whether the transaction is to be treated in the same manner as though the partner were an outsider dealing with the partnership (the “entity” approach). An alternative (“aggregate” approach) is to view the partner as dealing with himself to the extent of his own balance of the transaction. The present code fails to cover the problem and judicial decisions on the subject go in either direction. Because of its simplicity of operation, the “entity” rule has been adopted.

H. Rep. No. 1337, at 67 (1954). Hence, Congress intended that federal tax law apply with respect to section 707(a) payments “as though the partner were an outsider dealing with the partnership.” Allowing partners to claim the section 199A deduction for section 707(a) payments received from the partnership where the payments would have been QBI if received from an unrelated party aligns with this approach.

In summary, our recommendation to modify the Proposed Regulations to provide that certain section 707(a) payments are not excluded from QBI is clear and administrable, consistent with the Proposed Regulations' overall goals, backstopped by applicable anti-abuse provisions, and consistent with section 707(a)'s language and legislative history.

III. REPORTING REQUIREMENTS

A. Background

The Proposed Regulations provide that for any trade or business in which an RPE directly engages, the RPE must include certain information on the Schedule K-1 the RPE issues to its owners. Specifically, the RPE must separately identify and report (1) each owner's allocable share of QBI, W-2 wages, and UBIA of qualified property attributable to each of the RPE's trades or businesses and (2) whether any of the RPE's trades or businesses is an SSTB. Prop. Treas. Reg. § 1.199A-6(b)(3)(i). If an RPE fails separately to identify or report any required information on the Schedule K-1 that the RPE issues to an owner, then “the owner's share . . . of positive QBI, W-2 wages, and UBIA of qualified property attributable to trades or businesses engaged in by that RPE will be presumed to be zero.” Prop. Treas. Reg. § 1.199A-6(b)(3)(iii).

The provision in the Proposed Regulations regarding the consequences of failing to identify or report required information could be read to mean that if an RPE fails separately to identify or report any required information (i.e., QBI, W-2 wages, UBIA of qualified property, and whether there is an SSTB), then the RPE's owners' share of all positive QBI, W-2 wages, and UBIA of qualified property is presumed to be zero. We do not believe Treasury and the IRS intended this broad result. Rather, we believe Treasury and the IRS intended to provide that if an RPE fails separately to identify or report QBI, W-2 wages, or UBIA of qualified property, then only the unidentified or unreported amount is presumed to be zero.

B. Recommendation

We recommend that Treasury and the IRS modify Prop. Treas. Reg. § 1.199A-6(b)(3)(iii) to make clear that if an RPE fails separately to identify or report each owner's allocable share of QBI, W-2 wages, or UBIA of qualified property, then only the unidentified or unreported amount is presumed to be zero. Our proposed change is consistent with Treasury's stated goal of “minimizing compliance costs and streamlining the process for claiming the [section 199A] deduction.” Press Release, Treasury Issues Proposed Regulations on New 20 Percent Deduction for Pass-Through Businesses (Aug. 8, 2018). For example, an RPE may have sufficient W-2 wages to ensure that each of the RPE's owners will be allowed a full section 199A deduction with respect to QBI from the RPE. In this situation, there would be no need for the RPE to track UBIA of qualified property, an exercise which, depending on the facts, could be costly and time consuming. If the RPE chooses not to track UBIA of qualified property and, therefore, does not separately identify and report UBIA of qualified property, then the RPE's owners' share of the RPE's UBIA of qualified property should be presumed to be zero. However, if the RPE does separately identify and report QBI and W-2 wages, then the RPE's owners' share of the RPE's QBI and W-2 wages should not be presumed to be zero.

We recognize that a different rule may be appropriate if an RPE fails separately to identify and report whether any of the RPE's trades or businesses is an SSTB. This is a key piece of information which could make some or all of the RPE's QBI, W-2 wages, and UBIA of qualified property irrelevant (i.e., if the RPE is engaged in one or more SSTBs). For this reason, we acknowledge that it may be appropriate for the final regulations to retain a rule providing that if an RPE fails to report whether any of the RPE's trades or businesses is an SSTB, then the RPE's owners' share of each of the RPE's QBI, W-2 wages, and UBIA of qualified property is presumed to be zero.

* * *

Thank you for the opportunity to submit this comment letter. We appreciate the chance to work with Treasury and the IRS as they move to finalize the Proposed Regulations. Should you have any questions about our comments, we would welcome the opportunity to discuss them with you in greater detail.

Sincerely,

Marc J. Gerson

James R. Gadwood

Andrew L. Howlett

Miller & Chevalier Chartered
Washington, DC

cc:
Hon. David J. Kautter, Assistant Secretary for Tax Policy, Department of the Treasury
Thomas West, Tax Legislative Counsel, Department of the Treasury
Krishna Vallabhaneni, Deputy Tax Legislative Counsel, Department of the Treasury
Hon. William M. Paul, Acting Chief Counsel, Internal Revenue Service

FOOTNOTES

1All “section” references are to the Internal Revenue Code of 1986, as amended and currently in effect.

2An RPE is a partnership (other than a publicly traded partnership) or an S corporation that is owned, directly or indirectly, by at least one individual, estate, or trust. Prop. Treas. Reg. § 1.199A-1(b)(9). Estates and trusts may be RPEs in some circumstances. Id.

3Section 199A(c)(4)(C) provides that QBI does not include section 707(a) payments to the extent provided in regulations. In contrast, Prop. Treas. Reg. § 1.199A-3(b)(2)(ii)(J) provides that qualified items of income, gain, deduction, or loss do not include section 707(a) payments. This in turn means that section 707(a) payments cannot be QBI.

4See Michel P. Spiro, Finn, Dixon & Herling LLP, Comments to Proposed Regulations Concerning the Deduction for Qualified Business Income Under Section 199A of the Code (Reg-107892-18) (the “Proposed Regulations”) (Aug. 30, 2018). This comment letter recommends modifying the Proposed Regulations in a manner that is similar to our recommendation: “[I]n general, and subject to a general anti-abuse rule, all payments described in Code Section 707(a) should be treated as QBI to the extent such amounts would be treated as QBI if earned by a person that was not a partner in the paying partnership.” Id. at 1.

END FOOTNOTES

DOCUMENT ATTRIBUTES
Copy RID