The new passthrough deduction created by section 199A has already unleashed plenty of havoc for both taxpayers and the government, and it seems a likely source of mischief through at least 2025, when it’s due to sunset.
Section 199A introduced a 20 percent deduction for domestic qualified business income from a partnership, S corporation, or sole proprietorship. Qualified business income comes from a qualified trade or business and from real estate investment trusts and publicly traded partnerships. Some service trades or businesses are ineligible for the deduction and are specified in section 1202(e)(3)(A). Other service trades or businesses that are ineligible include trades or businesses performing investment services and trading or dealing in securities, commodities, or partnership interests. However, if the taxpayer’s income is below the threshold set in the statute, the exclusion for services businesses does not apply.
Qualified business income includes items of income, gain, deduction, and loss if they are treated as effectively connected income and included or allowed in determining taxable income for the tax year. The deduction is capped at the greater of 50 percent of W-2 wages regarding the qualified trade or business, or 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property. Alternatively, some taxpayers can deduct 20 percent of their qualified cooperative dividends, which is causing confusion. (Prior analysis: Tax Notes, Jan. 22, 2018, p. 426.)
According to the 2017-2018 priority guidance plan, Treasury and the IRS will provide “computational, definitional, and anti-avoidance guidance” under section 199A, which is guidance plan-ese for “We are trying to figure out how to make the statute work.” That exercise will be challenging because there are many deficiencies to remedy and Treasury might not have the authority or time to fix some of them.
The difficulties in implementing guidance are exacerbated by the way the statute was drafted. “There was little outside input in section 199A, apart from the lobbyists,” said Steven M. Rosenthal of the Urban-Brookings Tax Policy Center. Thus, the framework is rough, and the edges need a lot of smoothing, he said. The tax reform package was adopted too quickly to address structural problems or make revisions, Rosenthal added.
There is some hope that problems might be addressed legislatively. Senate Finance Committee Chair Orrin G. Hatch, R-Utah, promised that Congress would stay involved in implementing the Tax Cuts and Jobs Act (P.L. 115-97) in a speech on February 13 at the Tax Policy Center, saying that when things are unclear in the law, Congress should explain them and correct the problems. There is a lot to be explained about the deduction for passthroughs, said Calvin H. Johnson of the University of Texas School of Law. “Section 199A is seven pages of rat’s nest of jumbled rationales,” he said.
Focus for Guidance
Further refinement will be needed regarding qualified services income, reasonable compensation, and when businesses and activities will be aggregated or disaggregated. Treasury and the IRS have several technical decisions to make in guidance to help taxpayers apply the statute, and little time to do it. Some sort of guidance must be out by the end of the year, and probably much sooner than that to allow other parts of the IRS to create the forms and publications necessary for taxpayers to file their returns.
The scope of services businesses is perhaps the largest issue to sort out for both the government and taxpayers. The cross-reference to section 1202(e)(3)(A) — which defines a specified service trade or business as including health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services — provides a starting point for developing guidance. Section 199A(d)(2)(A) excludes the fields of engineering and architecture. Rosenthal said Treasury should resist taxpayer requests to further relax the restrictions on what services are eligible.
It is an open question how well the existing section 1202(e)(3)(A) rules will work for defining the scope of services under section 199A. The exclusion of any trade or business whose “principal asset is the reputation or skill of one or more of its employees” begs for more attention. The IRS has issued letter rulings interpreting section 1202(e)(3)(A), but the rulings have been unable to offer clear guidance because of the provision’s arbitrary distinctions, said Alan D. Viard of the American Enterprise Institute. Consequently, there will probably be significant litigation over the services exclusion, particularly the “reputation or skill” aspect of the statutory scheme, because of the difficulties in consistently applying that rule.
The income to which the deduction applies does not include reasonable compensation paid to the taxpayer, but reasonable compensation is required only of S corporations, so partnerships and limited liability companies aren’t affected by section 199A(c)(4). Treasury has no plans right now to require reasonable compensation of entities other than S corporations, although the government could expand that requirement. (Related coverage: p. 1123.) However, the statute does not seem to authorize such an expansion. Viard said a more broadly applicable reasonable compensation requirement might help keep taxpayers from playing games, although it would be difficult to administer.
How to aggregate or disaggregate trades and businesses to determine whether a taxpayer is eligible for the deduction is a significant issue Treasury and the IRS should consider in guidance. Some sort of bifurcation would seem likely if a partnership has one business that qualifies and another that does not, for example, but the limits of separating and combining businesses must be established. Guidance should address questions such as how much of a “bad” activity is necessary to taint an otherwise “good” qualified trade or business and how to apply the rules to tiered partnerships. Taxpayers will have an incentive to split off qualified businesses from tainted ones, and the IRS must decide when it’s necessary to aggregate them.
Similarly, taxpayers may try to aggregate unrelated businesses to achieve a better result under section 199A, and there should be rules about when a combination will be disaggregated in applying the deduction. Rosenthal noted that the passive loss rules could be a model for how to combine or disaggregate businesses, but that the IRS has struggled with defining the scope of a business or activity in that context. “Aggregation and disaggregation rules are hard to draft because of the lack of a coherent theme,” he said. Such rules are always based on facts and circumstances, but taxpayers control the facts, which tends to make enforcement difficult, he said.
Rosenthal said another issue Treasury should consider is the definition of qualified business income and the expenses associated with it. The qualified business income amount is the net amount of qualified items of income, gain, deduction, and loss. Rosenthal noted that there might be arbitrage if taxpayers deduct interest expenses incurred to carry an interest in a REIT. Further, the statute leaves open questions regarding whether individuals can borrow to make an equity contribution and then have the business generate interest income, and whether expenses like retirement contributions are business expenses that reduce qualified business income.
The IRS and Treasury are also focused on the antiabuse rules. Subsection (h) tells them to use section 179(d)(2) as a model to prevent taxpayers from taking advantage of the depreciable period for qualified property, and to write rules for determining the unadjusted basis immediately after acquisition of qualified property in like-kind exchanges or involuntary conversions.
Effects, Intended and Otherwise
Divining the policy rationale for the new section 199A is a particular challenge. “To the extent that there is a coherent policy goal, I assume the intent was to try to increase capital investment by passthrough businesses,” Viard said. And the provision significantly lowers the effective tax rate on passthrough business investment, he said. But it is poorly designed, creating complexity and inviting taxpayer gamesmanship, Viard said.
The numbering of the provision points to what legislators may have intended it to do — or, less charitably, what legislators wanted to advertise it as being designed to do — because the former domestic production deduction of section 199 was also meant to reward companies for creating or keeping jobs in the United States. Johnson said the limitation of the deduction to the higher of 50 percent of the W-2 wages the business pays or 25 percent of W-2 wages plus 2.5 percent of original basis was a surprise. “The apparent rationale is that section 199A is supposed to have something to do with creating jobs,” he said. Johnson added that the limitation to 25 percent of W-2 wages plus 2.5 percent of original basis seems designed for a specific, and small, group of taxpayers. “Original basis is an indefensible thing to rely on” because equipment and buildings decline in value and there is no double tax on basis once it has been depreciated, he said.
In contrast to the eliminated domestic production activities deduction, which was 9 percent, the new qualified business income deduction is considerably more generous at 20 percent. Like its numerical predecessor, section 199A will keep the IRS and Treasury busy providing guidance and eventually litigating disputes with taxpayers. The new provision borrows some calculations and reporting from section 199. The similarities to section 199 were intentional and an attempt to win bipartisan support for the provision, according to Christopher Hanna, majority senior tax policy adviser for the Senate Finance Committee. (Prior coverage: Tax Notes, Jan. 29, 2018, p. 588.) But the attempt to please everyone doesn’t appear to have worked out well.
There’s a lot of picking winners in section 199A. Passive investments aren’t supposed to qualify — this is ostensibly about creating jobs, remember — and neither are services businesses in which the taxpayer’s income is above the threshold, although engineers and architects were deemed eligible. Preferring some industries to others is an acceptable legislative prerogative, although it makes the resulting legislation susceptible to the charge that lobbyists were too influential in the drafting process. When legislators decide to pick economic winners and losers in tax reform, they should at least attempt to articulate their reasoning.
The deduction should increase investment by passthrough businesses that qualify for the rate reduction in the same way that the corporate rate reduction should encourage investment by C corporations, Viard said. However, Viard added that if increasing investment was the sole goal of section 199A, the rate reduction should have been restricted to capital income and denied to labor income. “Looking at the motley array of rules in 199A, some seem intended to deny the rate reduction to labor income,” but that doesn’t explain the arbitrary distinctions between industries, he said. Viard questioned why the limits don’t apply to taxpayers below a specific income threshold. “If those are structurally sound distinctions, they should apply at all income levels,” Viard said.
The road ahead for section 199A will be long and hard as taxpayers and the government address how to make it function reasonably. And there is no guarantee it ever will.