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Treasury Clarifies 199A De Minimis Rules Have Cliff Effect

POSTED ON Oct. 10, 2018

A Treasury official confirmed that income from a prohibited service over the de minimis threshold bars the entire business from using the passthrough deduction, but that clarification creates more uncertainty.

Audrey Ellis, attorney-adviser, Treasury Office of Tax Legislative Counsel, clarified that if a business receives a small amount of income from a service that is statutorily barred from using the deduction over specified percentage thresholds listed in the proposed rules (REG-107892-18) released August 8, a “cliff effect” applies and the entire business is considered tainted.

Section 199A was enacted in the Tax Cuts and Jobs Act (P.L. 115-97) and allows a 20 percent deduction for passthrough business owners up to specific income thresholds, after which some owners are barred from using the deduction. Those who are eligible for the deduction are also subject to wage and basis limitations.

For those not barred from using the deduction above the income thresholds, the deduction is limited by W-2 wages paid to employees and 2.5 percent of the unadjusted basis in property immediately after acquisition — basically, the cost of the property.

To determine what’s a trade or business for calculating qualified business income, the IRS and Treasury relied on the section 162(a) definition based on case law and guidance on the provision, Ellis said at the October 5 Partnerships & LLCs session of the American Bar Association Section of Taxation meeting in Atlanta.

In comments on the proposed rules, however, taxpayers have voiced concerns that the definitions under section 162(a) are unclear and could create uncertainty in the tax community.

The proposed rules provide a de minimis test that says if a trade or business has gross receipts of $25 million or less for a taxable year, the business will not be treated as a specified service if less than 10 percent of its gross receipts are attributable to the barred services. If a trade or business has gross receipts of more than $25 million, the applicable percentage is lowered to 5 percent.

If a taxpayer’s receipts from banned services for a business that has less than $25 million of gross receipts is 11 percent, none of the income from that business is allowed to use the deduction, Ellis said.

One audience member took issue with that statement, saying in that scenario there might actually be two separate trades or businesses under section 162, so the majority of the business receipts from the services that aren’t specifically barred could still be subject to section 199A.

Ellis responded that the determination as to whether there would be separate trades or businesses in that scenario would be based on the facts and circumstances of each taxpayer, and added that under the proposed rules, if the businesses are split into one eligible business and one barred business, they could not be aggregated.

Commentators have also wondered whether rental real estate income qualifies for the deduction, pointing out that whether that type of income constitutes a trade or business under section 162 isn’t obvious.

Wendy Kribell, assistant to the branch 1 chief, IRS Office of Associate Chief Counsel (Passthroughs and Special Industries), said the IRS has received comments requesting clarification on whether income from a triple net lease would qualify. Kribell declined to say whether it would qualify, but added that the rental real estate question is being considered by regulation writers in drafting the final regulations.

Ellis added that the comment period for the proposed regulations has been extended to the hearing date, which is October 16.