In-Depth Article: Long Awaited Section 199A Prop Regs Are Generally Favorable to Taxpayers

(Parker Tax Publishing August 2018)

On August 8, the IRS released proposed regulations on Code Sec. 199A, one of the major tax breaks enacted as part of the Tax Cuts and Jobs Act of 2017. The proposed rules, which run to 184 pages, address many issues that had been of concern to practitioners, such as the definition of a "specified trade or business," the calculation of qualified business income flowing through to multiple entities, the treatment of wages paid to employees through third parties, and the definition of "reputation or skill." The rules allow for grouping of related trades or businesses for purposes of applying Code Sec. 199A and provide for narrow applicability of Code Section 199A's "reputation or skill" clause. The IRS separately issued a proposed revenue procedure addressing the calculation of W-2 wages for purposes of the W-2 wage limitation on the deduction. REG-107892-18; Notice 2018-64.

I. Introduction

The Tax Cuts and Jobs Act of 2017 (TCJA), which is generally effective for tax years after 2017, was signed into law on December 22, 2017. One of the most significant provisions in TCJA is a new deduction under Code Sec. 199A - the qualified business income deduction.

Code Section 199A Deduction in General

Code Sec. 199A provides a deduction of up to 20 percent of income from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate (Code Sec. 199A deduction). The Code Sec. 199A deduction may be taken by individuals and by some estates and trusts. A Code Sec. 199A deduction is not available for wage income or for business income earned through a C corporation. For taxpayers whose taxable income exceeds a statutorily-defined amount (threshold amount), Code Sec. 199A may limit the taxpayer's Code Sec. 199A deduction based on:

(1) the type of trade or business engaged in by the taxpayer;

(2) the amount of W-2 wages paid with respect to the trade or business (W-2 wages); and/or

(3) the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the trade or business (UBIA of qualified property).

These limitations are subject to phase-in rules based upon taxable income above the threshold amount. The threshold amount is, for any tax year beginning before 2019, $157,500 (or $315,000 in the case of a taxpayer filing a joint return). In the case of any tax year beginning after 2018, the threshold amount is adjusted for inflation.

Code Sec. 199A also allows individuals and some trusts and estates (but not corporations) a deduction of up to 20 percent of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, including qualified REIT dividends and qualified PTP income earned through passthrough entities. This component of the Code Sec. 199A deduction is not limited by W-2 wages or UBIA of qualified property.

The Code Sec. 199A deduction is the lesser of (1) the sum of the combined amounts described in the prior two paragraphs or (2) an amount equal to 20 percent of the excess (if any) of taxable income of the taxpayer for the taxable year over the net capital gain of the taxpayer for the taxable year.

Additionally, Code Sec. 199A(g) provides that specified agricultural or horticultural cooperatives may claim a special entity-level deduction that is substantially similar to the domestic production activities deduction under former Code Sec. 199.

IRS Releases Highly Anticipated Proposed Regulations

While businesses cheered the passage of Code Sec. 199A, their enthusiasm was tempered by the logistics of actually applying it in real life. Due to poor drafting, the legislation left a myriad of questions unanswered. On August 8, the IRS issued proposed rules which attempt to answer many of those questions and assist taxpayers with the calculation of this deduction. In REG-107892-18 (8/8/18), the IRS set forth the following six proposed regulations:

(1) Prop. Reg. Sec. 1.199A-1, which covers operational rules;

(2) Prop. Reg. Sec. 1.199A-2, which covers the determination of W-2 wages and unadjusted basis immediately after the acquisition of qualified property;

(3) Prop. Reg. Sec. 1.199A-3, which covers qualified business income, qualified REIT dividends, and qualified publicly traded partnerships (PTP) income;

(4) Prop. Reg. Sec. 1.199A-4, which covers aggregation rules;

(5) Prop. Reg. Sec. 1.199A-5, which covers specified service trades or businesses and the trade or business of performing services as an employee; and

(6) Prop. Reg. Sec. 1.199A-6, which covers relevant passthrough entities (RPEs), PTPs, trusts, and estates.

Simultaneous with the issuance of the proposed regulations, the IRS issued Notice 2018-64, which contains a proposed revenue procedure that provides guidance on methods for calculating W-2 wages for purposes of the Code Sec. 199A deduction and the proposed regulations. Specifically, Notice 2018-64, which is discussed below, provides methods for calculating W-2 wages for purposes of the limitations on the Code Sec. 199A deduction in Code Sec. 199A(b)(2) and Code Sec. 199A(b)(7).

12 Key Takeaways from the Proposed Regs

(1) Reputation or Skill Clause. Perhaps the biggest surprise in the proposed regs is the IRS's narrow interpretation of the infamous "reputation or skill" clause. Prop. Reg. 1.199A-5 essentially limits its application to fact patterns in which the individual or relevant passthrough entity (RPE) receives income for endorsing products or services, receives appearance fees, or receives income for the use of an individual's image, likeness, trademark, etc.

(2) De Minimis Rule for a Specified Service Trade or Business. The proposed regs provide a de minimis rule for a specified service trade or business (SSTB) so that a trade or business is not considered a SSTB if gross receipts are $25 million or less and less than 10 percent of gross receipts of the trade or business is attributable to the performance of services in an SSTB.

(3) Restrictions on "Crack and Pack". Strategies to separate out parts of an SSTB in an attempt to qualify those separated parts for the Code Sec. 199A deduction were dealt a blow by the proposed regs, which provide that an SSTB includes any trade or business that provides 80 percent or more of its property or services to an SSTB if there is 50 percent or more common ownership of the businesses.

(4) Grouping of Commonly Controlled Trades or Businesses. Prop. Reg. 1.199A-4 allows for elective aggregation of commonly controlled businesses at the owner level for purposes of applying Code Sec. 199A. Eligibility requirements for aggregation are generally stricter than the ones applicable under Code Sec. 469.

(5) Allocation of W-2 wages to More Than One Trade or Business. For commonly controlled trades and business that are not aggregated, the proposed regs provide rules for allocating W-2 wages to more than one trade or business.

(6) Wages Paid Through a Third-Party. The proposed regs allow a business that pays wages to a common law employee through a third-party, such as a PEO, to count such wages as being paid by the business.

(7) Reasonable Compensation Paid to S Corporation Shareholders Included in Definition of W-2 Wages. Nothing in the proposed regs disturbs the general consensus that reasonable compensation paid to S corporation shareholders are included in definition of W-2 wages for purposes of calculating the W-2 wage limitation.

(8) Section 162 Standard Applies for Trade or Business Determinations. Prop. Reg. Sec. 199A-1 formally adopts the Code Sec. 162 definition of a "trade or business" for determining if an activity is eligible for the Code Sec. 199A deduction.

(9) Classification of Rental Real Estate Activities. The proposed regs do not provide any supplemental guidance on the circumstances under which a rental real estate activity rises to the level of a trade or business, other than to provide a special rule for self-rental activities (allowing for such activities to be considered part of the trade or business to which tangible or intangible property is rented or licensed).

(10) Alternative Minimum Tax. The proposed regulations make clear that the Code Sec. 199A deduction is allowed when calculating alternative minimum taxable income of individuals. Thus, the Code Sec. 199A deduction does not result in individuals being subject to the alternative minimum tax.

(11) Presumption Regarding Employee Reclassifications. To prevent employees from being arbitrarily reclassified as independent contractors or as taking an equity interest in a partnership or S corporation in order to benefit from the Code Sec. 199A deduction, Prop. Reg. Sec. 1.199A-5 creates a rebuttable presumption that a reclassified employee who provides substantially the same services to the former employer (or related person) continues to be in the trade or business of performing services as an employee.

(12) Examples, Examples, and More Examples. The proposed regs include extensive examples of the calculation of the Code Sec. 199A deduction for taxpayers both above and below the thresholds at which various restrictions on the deduction phase in, providing useful illustrations of numerous scenarios.

II. Qualified Trade or Business

The Code Sec. 199A deduction is calculated, in part, on the qualified business income amount for each qualified trade or business carried on by the taxpayer. Code Sec. 199A(d)(1) defines a "qualified trade or business" as any trade or business other than a specified service trade or business (SSTB), or the trade or business of performing services as an employee. However, as discussed below, there is an exception for an SSTB where the taxpayer's income is below a threshold amount.

Trade or Business Requirement

In order to be a qualified trade or business, an activity must rise to the level of being a trade or business. Neither Code Sec. 199A nor the legislative history provides a definition of "trade or business" for purposes of Code Sec. 199A.

In the preamble to the proposed regulations, the IRS said that it agreed with practitioners who commented that the definition of a "trade or business" under Code Sec. 162 provided the most appropriate definition for purposes of Code Sec. 199A. The IRS noted that the definition of a trade or business under Code Sec. 162 is derived from a large body of existing case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries. Thus, the IRS said, using the definition of a trade or business under Code Sec. 162 in Prop. Reg. Sec. 1.199A-1 provides for administrable rules that are appropriate for the purposes of Code Sec. 199A and which taxpayers have experience applying.

Observation: Many practitioners had hoped the IRS would provide specific guidance regarding when a rental real estate activity rises to the level of a trade or business for purposes of Code Sec. 199A, or at least something similar to the 500-hour safe harbor in the Net Investment Income Tax (NIIT) regulations. The proposed regs contain no such guidance. So, for now, practitioners will need to determine whether rental activities rise to the level of a trade or business on a case-by-case basis under the existing case law and IRS guidance under Code Sec. 162.

Relief for Self-Rentals. In one circumstance, Prop. Reg. Sec. 1.199A-1 extends the definition of a "trade or business" for purposes of Code Sec. 199A beyond Code Sec. 162. Solely for purposes of Code Sec. 199A, the rental or licensing of tangible or intangible property to a related trade or business is treated as a trade or business if the rental or licensing and the other trade or business are commonly controlled. It is not uncommon that, for legal or other non-tax reasons, taxpayers may segregate rental property from operating businesses. This rule allows taxpayers to aggregate their trades or businesses with the associated rental or intangible property if all of the requirements of the aggregation rules in Prop. Reg. Sec. 1.199A-4 are met (see discussion in "Aggregation Rules" section, below).

Definition of a Specified Service Trade or Business (SSTB)

The term "specified trade or business" means any trade or business involving the performance of services in one or more of the following fields:

(1) health;

(2) law;

(3) accounting;

(4) actuarial science;

(5) performing arts;

(6) consulting;

(7) athletics;

(8) financial services;

(9) brokerage services;

(10) investing and investment management;

(11) trading;

(12) dealing in securities, partnership interests, or commodities; or

(13) 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 or owners.

Observation: Under Code Sec. 199A(e)(2)(A), the rule disqualifying specified service trades or businesses from being considered a qualified trade or business does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). Code Sec. 199A(d)(3) provides that, after an individual reaches the threshold amount, which is indexed for inflation, the restriction is phased in over a range of $50,000 in taxable income ($100,000 for joint filers). The exclusion from the definition of a qualified business for SSTBs is fully phased in for a taxpayer with taxable income in excess of the threshold amount plus $50,000 ($100,000 in the case of a joint return).

The proposed regulations spell out what types of activities constitute the performance of services in the various fields of a trade or business that is classified as an SSTB.

Services in Health Field. The performance of services in the health field refers to the provision of medical services by individuals such as physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists and other similar healthcare professionals performing services in their capacity as such who provide medical services directly to a patient (service recipient). The performance of services in the field of health does not include the provision of services not directly related to a medical services field, even though the services provided may purportedly relate to the health of the service recipient. For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or the research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.

Services in the Field of Law. The performance of services in the field of law means the performance of services by individuals such as lawyers, paralegals, legal arbitrators, mediators, and similar professionals performing services in their capacity as such. The performance of services in the field of law does not include the provision of services that do not require skills unique to the field of law, for example, the provision of services in the field of law does not include the provision of services by printers, delivery services, or stenography services.

Services in the Field of Accounting. The performance of services in the field of accounting means the provision of services by individuals such as accountants, enrolled agents, return preparers, financial auditors, and similar professionals performing services in their capacity as such.

Services in the Field of Actuarial Science. The performance of services in the field of actuarial science means the provision of services by individuals such as actuaries and similar professionals performing services in their capacity as such.

Services in the Field of Performing Arts. The performance of services in the field of the performing arts means the performance of services by individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors, and similar professionals performing services in their capacity as such. The performance of services in the field of performing arts does not include the provision of services that do not require skills unique to the creation of performing arts, such as the maintenance and operation of equipment or facilities for use in the performing arts. Similarly, the performance of services in the field of the performing arts does not include the provision of services by persons who broadcast or otherwise disseminate video or audio of performing arts to the public.

Example: Adele, a singer, records a song. Adele is paid a mechanical royalty when the song is licensed or streamed. She is also paid a performance royalty when the recorded song is played publicly. Adele is engaged in the performance of services in an SSTB in the field of performing arts. The royalties she receives for the song are not eligible for a deduction under Code Sec. 199A.

Services in the Field of Consulting. The performance of services in the field of consulting means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems. Consulting includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such. The performance of services in the field of consulting does not include the performance of services other than advice and counsel, such as sales or economically similar services or the provision of training and educational courses. For this purpose, the determination of whether a person's services are sales or economically similar services will be based on all the facts and circumstances of that person's business. Such facts and circumstances include, for example, the manner in which the taxpayer is compensated for the services provided. Performance of services in the field of consulting does not include the performance of consulting services embedded in, or ancillary to, the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB (such as typical services provided by a building contractor) if there is no separate payment for the consulting services.

Example: Charles is in the business of providing services that assist unrelated entities in making their personnel structures more efficient. Charles studies his client's organization and structure and compares it to peers in its industry. Charles then makes recommendations and provides advice to clients regarding possible changes in the client's personnel structure, including the use of temporary workers. Charles is engaged in the performance of services in an SSTB in the field of consulting and is not eligible for a Code Sec. 199A deduction.

Example: Donna is in the business of licensing software to customers. She discusses and evaluates the customer's software needs with the customer and advises the customer on the particular software products it licenses. Donna is paid a flat price for the software license. After the customer licenses the software, she helps to implement the software. Donna is engaged in the trade or business of licensing software and not engaged in an SSTB in the field of consulting.

Services in the Field of Athletics. The performance of services in the field of athletics means the performance of services by individuals who participate in athletic competition such as athletes, coaches, and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing. The performance of services in the field of athletics does not include the provision of services that do not require skills unique to athletic competition, such as the maintenance and operation of equipment or facilities for use in athletic events. Similarly, the performance of services in the field of athletics does not include the provision of services by persons who broadcast or otherwise disseminate video or audio of athletic events to the public.

Example: Barry is a partner in ABC Partnership, which solely owns and operates a professional sports team. ABC employs athletes and sells tickets to the public to attend games in which the sports team competes. Therefore, ABC is engaged in the performance of services in an SSTB in the field of athletics. Barry is a passive owner in ABC and does not provide any services with respect to ABC or the sports team. However, because ABC is engaged in an SSTB in the field of athletics, Barry's distributive share of the income, gain, loss, and deduction with respect to ABC is not eligible for a Code Sec. 199A deduction.

Services in the Field of Financial Services. The performance of services in the field of financial services means the provision of financial services to clients including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings (including in title 11 or similar cases), and raising financial capital by underwriting, or acting as a client's agent in the issuance of securities and similar services. This includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals performing services in their capacity as such.

Services in the Field of Brokerage Services. The performance of services in the field of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities (as defined in Code Sec. 475(c)(2)) for a commission or fee. This includes services provided by stock brokers and other similar professionals, but does not include services provided by real estate agents and brokers, or insurance agents and brokers.

Services in Investing and Investment Management. The performance of services that consist of investing and investment management refers to a trade or business involving the receipt of fees for providing investing, asset management, or investment management services, including providing advice with respect to buying and selling investments. The performance of services of investing and investment management does not include directly managing real property.

Services in Trading. The performance of services that consist of trading means a trade or business of trading in securities (as defined in Code Sec. 475(c)(2)), commodities (as defined in Code Sec. 475(e)(2)), or partnership interests. Whether a person is a trader in securities, commodities, or partnership interests is determined by taking into account all relevant facts and circumstances, including the source and type of profit that is associated with engaging in the activity regardless of whether that person trades for the person's own account, for the account of others, or any combination thereof. A taxpayer, such as a manufacturer or a farmer, who engages in hedging transactions as part of their trade or business of manufacturing or farming is not considered to be engaged in the trade or business of trading commodities.

Services in Dealing. The performance of services that consist of dealing in securities (as defined in Code Sec. 475(c)(2)) means regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. For this purpose, however, a taxpayer that regularly originates loans in the ordinary course of a trade or business of making loans but engages in no more than negligible sales of the loans is not dealing in securities.

"Reputation or Skill" Catch-All. Code Sec. 199A provides that SSTBs include 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 or owners.

Observation: Prior to the release of the proposed regulations, this SSTB category was widely regarded as a catch-all with the potential to ensnare a broad array of trades or businesses, including some that might not even be considered service businesses. As discussed immediately below, the IRS's interpretation of the "reputation or skill" clause in the proposed regs renders it narrowly applicable - more of a niche category than a catch-all.

"Reputation or Skill of One or More Employees" Narrowly Defined

In determining the meaning of "reputation or skill of one or more employees," the IRS noted that Congress enacted Code Sec. 199A to provide a deduction from taxable income to trades or businesses conducted by sole proprietorships and passthrough entities that do not benefit from the income tax rate reduction afforded to C corporations under the TCJA. The IRS said it was concerned that a broad definition of the "reputation or skill" phrase that relied on a balance sheet test or numerical ratios would have several consequences inconsistent with the intent of Code Sec. 199A. The IRS stated that testing businesses based on metrics, some of them subjective, that change over time could result in inappropriate year-over-year tax consequences and lead to distorted decision-making.

According to the IRS, the "reputation or skill" clause as used in Code Sec. 199A was intended to describe a narrow set of trades or businesses, not otherwise covered by the enumerated specified services, in which income is received based directly on the skill and/or reputation of employees or owners. Additionally, the IRS said that "reputation or skill" must be interpreted in a manner that is both objective and administrable. Thus, Prop. Reg. 1.199A-5(b)(2)(xiv) limits the meaning of the "reputation or skill" clause to fact patterns in which the individual or RPE is engaged in the trade or business of:

(1) receiving income for endorsing products or services, including an individual's distributive share of income or distributions from an RPE for which the individual provides endorsement services;

(2) licensing or receiving income for the use of an individual's image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual's identity, including an individual's distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual's image; or

(3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players).

For purposes of the above fact patterns, "fees" and "income" include the receipt of a partnership interest and the corresponding distributive share of income, deduction, gain or loss from the partnership, or the receipt of stock of an S corporation and the corresponding income, deduction, gain or loss from the S corporation stock.

Example: Harry is a well-known chef and the sole owner of multiple restaurants each of which is owned in a disregarded entity. Due to Harry's skill and reputation as a chef, he receives an endorsement fee of $500,000 for the use of his name on a line of cooking utensils and cookware. Harry is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, Harry is also in the trade or business of receiving endorsement income. Harry's trade or business consisting of the receipt of the endorsement fee for his skill and/or reputation is an SSTB.

Example: Julie is a well-known actor. She entered into a partnership with Shoe Company, in which she contributed her likeness and the use of her name to the partnership in exchange for a 50 percent interest in the capital and profits of the partnership and a guaranteed payment. Julie's trade or business consisting of the receipt of the partnership interest and the corresponding distributive share with respect to the partnership interest for her likeness and the use of her name is an SSTB.

De Minimis Test

While Code Sec. 199A does not have a de minimis test for businesses qualifying as an SSTB, the IRS decided to incorporate one into the proposed regulations. Analogous to the regulations under Code Sec. 448, the proposed regulations provide a de minimis rule under which a trade or business will not be considered an SSTB merely because it provides a small amount of services in a specified service activity. Under Prop. Reg. Sec. 1.199A-5(c)(1), a trade or business (determined before applying the aggregation rules in Prop. Reg. Sec. 1.199A-4) is not an SSTB if the trade or business has gross receipts of $25 million or less (in a tax year) and less than 10 percent of the gross receipts of the trade or business is attributable to the performance of services in an SSTB. For trades or business with gross receipts greater than $25 million (in a tax year), a trade or business is not an SSTB if less than 5 percent of the gross receipts of the trade or business are attributable to the performance of services in an SSTB.

Proposed Regs Deal a Blow to "Crack and Pack" Strategy; SSTBs Include a Trade or Business with Common Ownership

The IRS noted that some taxpayers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the Code Sec. 199A deduction. According to the IRS, such a strategy is inconsistent with the purpose of Code Sec. 199A. Therefore, in accordance with Code Sec. 199A(f)(4), in order to carry out the purposes of Code Sec. 199A, Prop. Reg. 1.199A-5(c)(2) provides that an SSTB includes any trade or business with 50 percent or more common ownership (directly or indirectly) that provides 80 percent or more of its property or services to an SSTB. Additionally, if a trade or business has 50 percent or more common ownership with an SSTB, to the extent that the trade or business provides property or services to the commonly-owned SSTB, the portion of the property or services provided to the SSTB will be treated as an SSTB (meaning the income will be treated as income from an SSTB).

Example: Green & Green Law Firm is a partnership that provides legal services to clients and owns its own office building and employs its own administrative staff. Green & Green divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and through a contract with Partnership 1 provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Green & Green). Because there is 50 percent or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 will be treated as one SSTB.

Example: A dentist owns a dental practice and also owns an office building. The dentist rents half the building to the dental practice and half the building to unrelated persons. Under Prop. Reg. Sec. 1.199A-5(c)(2), the renting of half of the building to the dental practice will be treated as an SSTB.

Additionally, Prop. Reg. Sec. 1.199A-5 provides a rule that if a trade or business (that would not otherwise be treated as an SSTB) has 50 percent or more common ownership with an SSTB and shared expenses, including wages or overhead expenses with the SSTB, it is treated as incidental to an SSTB and, therefore, as an SSTB, if the trade or business represents no more than 5 percent of gross receipts of the combined business.

III. W-2 Wage Limitation

If a taxpayer's taxable income exceeds a statutorily-defined amount (threshold amount), Code Sec. 199A may limit the taxpayer's Code Sec. 199A deduction based on the following:

(1) the type of trade or business engaged in by the taxpayer;

(2) the amount of W-2 wages paid with respect to the trade or business (W-2 wages); and/or

(3) the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the trade or business (UBIA of qualified property). These statutory limitations are subject to phase-in rules based upon taxable income above the threshold amount.

The threshold amount, for any tax year beginning in 2018, is $157,500 (or $315,000 in the case of a taxpayer filing a joint return).

Under Code Sec. 199A, individuals and some trusts and estates (but not corporations) can deduct up to 20 percent of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, including qualified REIT dividends and qualified PTP income earned through passthrough entities. This component of the Code Sec. 199A deduction is not limited by W-2 wages or the UBIA of qualified property.

However, if an individual's taxable income exceeds the threshold amount, Code Sec. 199A(b)(2)(B) imposes a limit on the Code Sec. 199A deduction based on the greater of either:

(1) the W-2 wages paid, or

(2) the W-2 wages paid and UBIA of qualified property attributable to a trade or business.

In Prop. Reg. Sec. 1.199A-2, the IRS sets forth rules that generally follow the rules under former Code Sec. 199 with respect to the above calculation. Code Sec. 199, which was repealed by the TCJA, provided for a deduction with respect to certain domestic production activities and contained a W-2 wage limitation similar to the one in Code Sec. 199A. The legislative text of the W-2 wage limitation in Code Sec. 199A is modeled on the text of former Code Sec. 199, a provision that both taxpayers and the IRS have developed experience in applying.

Wages Paid by PEOs and Other Third Party Payors

One of the main concerns practitioners had in this area was whether amounts paid to workers who receive Forms W-2 from third party payors (such as professional employer organizations (PEOs), certified professional employer organizations (CPEOs), or agents under Code Sec. 3504) that pay these wages to workers on behalf of their clients and report wages on Forms W-2, with the third party payor being listed as the employer in Box c of the Forms W-2, are includible in the W-2 wages of the clients of third party payors.

In order for wages reported on a Form W-2 to be included in the determination of W-2 wages of a taxpayer, the Form W-2 must be for employment by the taxpayer. The regulations under former Code Sec. 199, specifically Reg. Sec. 1.199-2(a)(2), addressed this issue, providing that, since employees of the taxpayer are defined in the regulations as including only common law employees of the taxpayer and officers of a corporate taxpayer, taxpayers may take into account wages reported on Forms W-2 issued by other parties provided that the wages reported on the Forms W-2 were paid to employees of the taxpayer for employment by the taxpayer.

Prop. Reg. Sec. 1.199A-2(b)(2)(ii) provides a rule for wages paid by a person other than the common law employer that is substantially similar to the rule in Reg. Sec. 1.199-2(a)(2). In determining W-2 wages, a person may take into account any W-2 wages paid by another person and reported by the other person on Forms W-2 with the other person as the employer listed in Box c of the Forms W-2, provided that the W-2 wages were paid to common law employees or officers of the person for employment by the person. In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person. Persons that pay and report W-2 wages on behalf of or with respect to others can include certified professional employer organizations under Code Sec. 7705, statutory employers under Code Sec. 3401(d)(1), and agents under Code Sec. 3504. Under this rule, persons who otherwise qualify for the deduction under Code Sec. 199A are not limited in applying the deduction merely because they use a third party payor to pay and report wages to their employees.

Observation: The IRS reminded taxpayers that, with respect to individuals who taxpayers assert are their common law employees for purposes of Code Sec. 199A, such individuals have a duty to file returns and apply the tax law on a consistent basis.

W-2 Wage Limitation Applies Separately for Each Trade or Business

Unlike former Code Sec. 199, the W-2 wage limitation in Code Sec. 199A applies separately for each trade or business. Accordingly, Prop. Reg. Sec. 1.199A-2 provides that, in the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined to be in the same proportion to total W-2 wages as the deductions associated with those wages are allocated among the particular trades or businesses. Code Sec. 199A(b)(4) also requires that to be taken into account, W-2 wages must be properly allocable to QBI. W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.

W-2 Wage Limitation for Business Conducted by an RPE

In the case of a trade or business conducted by an RPE, a partner's or shareholder's allocable share of wages must be determined in the same manner as the partner's allocable share or a shareholder's pro rata share of wage expenses.

W-2 Wage Limitation Where a Business Is Acquired or Disposed

For purposes of applying the W-2 wage limitation in cases in which the taxpayer acquires, or disposes of, a trade or business, the major portion of a trade or business, or the major portion of a separate unit of a trade or business during the year, Prop. Reg. Sec. 1.199A-2(b)(2)(iv)(B) provides rules that apply in the case of an acquisition or disposition of a trade or business. That regulation provides that, in the case of an acquisition or disposition of a trade or business, the major portion of a trade or business, or the major portion of a separate unit of a trade or business that causes more than one individual or entity to be an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity, regardless of which permissible method is used for reporting predecessor and successor wages on Form W-2. For this purpose, the period of employment is determined consistently with the principles for determining whether an individual is an employee described in Prop. Reg. Sec. 1.199A-2(b).

Proposed Revenue Procedure on Calculating W-2 Wages

Simultaneously with the issuance of the proposed regulations, the IRS issued Notice 2018-64, which contains a proposed revenue procedure that provides guidance on methods for calculating W-2 wages for purposes of Code Sec. 199A and the proposed regulations. In Notice 2018-64, the IRS provides three methods for calculating W-2 wages and those methods are substantially similar to the methods provided in Rev. Proc. 2006-47, relating to the calculation of wages under former Code Sec. 199. The first method (the unmodified Box method) allows for a simplified calculation while the second and third methods (the modified Box 1 method and the tracking wages method) provide for greater accuracy.

IV. Alternative Limitation Based on W-2 Wages and Qualified Property

Code Sec. 199A(b)(2)(B)(ii) provides an alternative deduction limitation based on 25 percent of W-2 wages with respect to the qualified trade or business and 2.5 percent of the UBIA of qualified property.

Prop. Reg. Sec. 1.199A-2(c)(1) restates the definition of qualified property in Code Sec. 199A(b)(6)(A), which provides that "qualified property" means tangible property of a character subject to depreciation that is held by, and available for use in, a trade or business at the close of the tax year, and which is used in the production of QBI, and for which the depreciable period has not ended before the close of the tax year.

Prop. Reg. Sec. 1.199A-2(c)(2) also restates the definition of depreciable period in Code Sec. 199A(b)(6)(B), which provides that "depreciable" period means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of:

(1) the date 10 years after that date, or

(2) the last day of the last full year in the applicable recovery period that would apply to the property under Code Sec. 168(c), regardless of the application of Code Sec. 168(g).

UBIA Determined Based on Placed In Service Date

Prop. Reg. Sec. 199A-2(c)(3) provides a definition of UBIA. The IRS said it believes that "immediately after acquisition" in UBIA means as of the date the property is placed in service because Code Sec. 199A provides that "qualified property" must be used in the production of QBI.

In order to be used in the production of QBI, the IRS said, the qualified property necessarily must be placed in service. According to the IRS, determining UBIA as of the date the property is placed in service ensures consistency between purchased and produced qualified property, and reduces compliance costs, burden, and administrative complexity because taxpayers are already required to determine that amount. Accordingly, Prop. Reg. sec. 1.199A-2 provides that the term "UBIA" means the basis as determined under Code Sec. 1012 or other applicable provisions, including the rules relating to gain or loss on dispositions of property, the rules relating to corporate distributions and adjustments, the rules relating to partners and partnerships, and the rules relating to capital gains and losses. UBIA is determined without regard to any adjustments described in Code Sec. 1016(a)(2) or (3), any adjustments for tax credits claimed by the taxpayer, or any adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense (for example, under Code Secs. 179, 179B, or 179C). Therefore, for purchased or produced qualified property, UBIA generally will be its cost under Code Sec. 1012 as of the date the property is placed in service.

For qualified property contributed to a partnership in a Code Sec. 721 transaction and immediately placed in service, UBIA generally will be its basis under Code Sec. 723. For qualified property contributed to an S corporation in a Code Sec. 351 transaction and immediately placed in service, UBIA generally will be its basis under Code Sec. 362. Further, for property inherited from a decedent and immediately placed in service by the heir, the UBIA generally will be its fair market value at the time of the decedent's death under Code Sec. 1014. However, Prop. Reg. Sec. 1.199A-2(c)(3) provides that UBIA does reflect the reduction in basis for the percentage of the taxpayer's use of property for the tax year other than in the taxpayer's trade or business.

Partnership Special Basis Adjustments Aren't Separate Qualified Property

In response to questions as to whether partnership special basis adjustments under Code Sec. 734(b) or Code Sec. 743(b) constitute qualified property for purposes of Code Sec. 199A, the IRS noted that treating partnership special basis adjustments as qualified property could result in inappropriate duplication of UBIA of qualified property (if, for example, the fair market value of the property has not increased and its depreciable period has not ended). Accordingly, Prop. Reg. Sec. 1.199A-2(c)(1)(iii) provides that partnership special basis adjustments are not treated as separate qualified property.

Property Transferred with a Principal Purpose of Increasing Code Sec. 199A Deduction

Qualified property includes depreciable property used during the tax year in the production of QBI and held by, and available for use in, the trade or business at the close of the tax year. However, the IRS said it would be inconsistent with the purposes of Code Sec. 199A to permit trades or businesses to transfer or acquire property at the end of the year merely to manipulate the UBIA of qualified property attributable to the trade or business. Therefore, Prop. Reg. Sec. 1.199A-2(c)(1)(iv) provides that property is not qualified property if the property is acquired within 60 days of the end of the tax year and disposed of within 120 days without having been used in a trade or business for at least 45 days before disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the Code Sec. 199A deduction.

Like-kind Exchanges and Involuntary Conversions

Code Sec. 199A does not provide rules to determine UBIA for qualified property in the case of an exchange of property under Code Sec. 1031 (like-kind exchange) or involuntary conversion under Code Sec. 1033. However, Code Sec. 199A(h)(2) authorized the IRS to do so. The IRS said that existing general principles used for like-kind exchanges and involuntary conversions under Reg. Sec. 1.168(i)-(6) provide a useful analogy for administrable rules that are appropriate for the purposes of Code Sec. 199A and that their use would reduce compliance costs, burden, and administrative complexity because taxpayers have experience applying them.

Prop. Reg. Sec. 1.199A-2(c)(2)(iii) generally follows the rules of Reg. Sec. 1.168(i)-6 to provide that qualified property that is acquired in a like-kind exchange, as defined in Reg. Sec. 1.168(i)-6(b)(11), or in an involuntary conversion, as defined in Reg. Sec. 1.168(i)-6(b)(12), is treated as replacement Modified Accelerated Cost Recovery System (MACRS) property whose depreciable period generally is determined as of the date the relinquished property was first placed in service.

Subject to one exception, Prop. Reg. Sec. 1.199A-2(c)(2)(iii) provides that, for purposes of determining the depreciable period, the date the exchanged basis in the replacement qualified property is first placed in service by the trade or business is the date on which the relinquished property was first placed in service by the individual or RPE and the date the excess basis in the replacement qualified property is first placed in service by the individual or RPE is the date on which the replacement qualified property was first placed in service by the individual or RPE. As a result, the depreciable period under Code Sec. 199A for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.

The exception is that Prop. Reg. Sec. 1.199A-2(c)(2)(iii)(C) provides that, for purposes of determining the depreciable period, if the individual or RPE makes an election under Reg. Sec. 1.168(i)-6(i)(1) (the election not to apply Reg. Sec. 1.168(i)-6), the date the exchanged basis and excess basis in the replacement qualified property are first placed in service by the trade or business is the date on which the replacement qualified property is first placed in service by the individual or RPE, with UBIA determined as of that date. In this case, the depreciable periods under Code Sec. 199A for the exchanged basis and the excess basis of the replacement qualified property will end on the same date. Thus, unless the exception applies, qualified property acquired in a like-kind exchange or involuntary conversion will have two separate placed in service dates under the proposed regulations: for purposes of determining the UBIA of the property, the relevant placed in service date will be the date the acquired property is actually placed in service; for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the relinquished property was first placed in service.

Example: On January 5, 2012, Alex purchases for $1 million and places in service Real Property X in Alex's trade or business. Alex's trade or business is not an SSTB. Alex's basis in Real Property X under Code Sec. 1012 is $1 million. Real Property X is qualified property for purposes of Code Sec. 199A. As of December 31, 2018, Alex's basis in Real Property X, as adjusted under Code Sec. 1016(a)(2) for depreciation deductions, is $821,550. Alex's UBIA of Real Property X is its $1 million cost basis, regardless of any later depreciation deductions and resulting basis adjustments.

Example: The facts are the same as the example above, except that on January 15, 2019, Alex enters into a like-kind exchange under Code Sec. 1031 in which Alex exchanges Real Property X for Real Property Y. Real Property Y has a value of $1 million. No cash or other property is involved in the exchange. As of January 15, 2019, Alex's basis in Real Property X, as adjusted under Code Sec. 1016(a)(2) for depreciation deductions, is $820,482. Alex's UBIA in Real Property Y is $820,482 as determined under Code Sec. 1031(d) (Alex's adjusted basis in Real Property X carried over to Real Property Y). Real Property Y is first placed in service by Alex on January 5, 2012, which is the date on which Property X was first placed in service by Alex.

Other Nonrecognition Transactions

In response to practitioners' request for guidance on the application of the qualified property rules to nonrecognition transfers involving transferred basis property, such as how to determine the depreciable period of the property if a partnership conducts a trade or business and qualified property is contributed to that trade or business in a nonrecognition transfer under Code Sec. 721(a), the IRS said that existing general principles used for transferred basis transactions under Code Sec 168(i)(7) provide a useful analogy for administrable rules that are appropriate for the purposes of Code Sec. 199A.

Prop. Reg. Sec. 1.199A-2(c)(2)(iv) provides that, for purposes of determining the depreciable period, if an individual or RPE (the transferee) acquires qualified property in a transaction described in Code Sec. 168(i)(7)(B), the transferee determines the date on which the qualified property was first placed in service using a two-step approach. First, for the portion of the transferee's UBIA of the qualified property that does not exceed the transferor's UBIA of such property, the date such portion was first placed in service by the transferee is the date on which the transferor first placed the qualified property in service. Second, for the portion of the transferee's UBIA of the qualified property that exceeds the transferor's UBIA of such property, if any, such portion is treated as separate qualified property that the transferee first placed in service on the date of the transfer.

Qualified property acquired in these non-recognition transactions will have two separate placed in service dates under the proposed regulations: for purposes of determining the UBIA of the property, the relevant placed in service date will be the date the acquired property is placed in service by the transferee (for instance, the date the partnership places in service property received in a Code Sec. 721 transaction); for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the transferor first placed the property in service (for instance, the date the partner placed the property in service in his or her sole proprietorship).

Redetermination of UBIA and Subsequent Improvements to Qualified Property

Practitioners requested guidance on the treatment of subsequent improvements to qualified property, which are generally treated as a separate item of property under Code Sec. 168(i)(6). The IRS said it did not believe a different approach was necessary for purposes of Code Sec. 199A. Accordingly, Prop. Reg. Sec. 1.199A-2(c)(1)(ii) provides that, in the case of any addition to, or improvement of, qualified property that is already placed in service by the taxpayer, such addition or improvement is treated as separate qualified property that the taxpayer first placed in service on the date such addition or improvement is placed in service by the taxpayer for purposes of determining the depreciable period of the qualified property.

Example: Brad acquired and placed in service a machine on March 26, 2018, and then incurred additional capital expenditures to improve the machine in May 2020. When he places such improvements in service on May 27, 2020, Brad has two qualified properties: the machine acquired and placed in service on March 26, 2018, and the improvements to the machine incurred in May 2020 and placed in service on May 27, 2020.

Allocation of UBIA of Qualified Property by RPEs

In the case of a trade or business conducted by an RPE, a partner's or shareholder's allocable share of the UBIA of qualified property is determined in the same manner as the partner's allocable share or shareholder's pro rata share of depreciation.

Prop. Reg. Sec. 1.199A-2(a)(3) provides that, in the case of qualified property held by an RPE, each partner's or shareholder's share of the UBIA of qualified property is an amount that bears the same proportion to the total UBIA of qualified property as the partner's or shareholder's share of tax depreciation bears to the entity's total tax depreciation attributable to the property for the year. In the case of qualified property of a partnership that does not produce tax depreciation during the year (for example, property that has been held for less than 10 years but whose recovery period has ended), each partner's share of the UBIA of qualified property is based on how gain would be allocated to the partners pursuant to Code Sec. 704(b) and Code Sec. 704(c) if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property. In the case of qualified property of an S corporation that does not produce tax depreciation during the year, each shareholder's share of the UBIA of the qualified property is a share of the UBIA proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.

V. Qualified Business Income

Code Sec. 199A(c)(1) provides that qualified business income (QBI) means, for any tax year, the net amount of qualified items of income, gain, deduction, and loss attributable to any qualified trade or business of the taxpayer. QBI does not include any qualified REIT dividends or qualified PTP income. Code Sec. 199A(c)(3)(A) provides that the term "qualified items of income, gain, deduction, and loss" means items of income, gain, deduction, and loss to the extent such items are:

(1) effectively connected with the conduct of a trade or business within the United States (within the meaning of Code Sec. 864(c), determined by substituting "qualified trade or business (within the meaning of Code Sec. 199A)" for "nonresident alien individual or a foreign corporation" or for "a foreign corporation" each place it appears), and

(2) included or allowed in determining taxable income for the tax year.

Prop. Reg. Sec. 1.199A-3 describes what qualifies as QBI as long as the other requirements of Code Sec. 199A and the regulations thereunder are satisfied. The IRS evaluated numerous types of income to determine whether each type of income qualified as QBI.

Items Includible in QBI

The following are either includible in QBI or partially includible in QBI:

Section 751 Gain. With respect to a partnership, if Code Sec.751(a) or (b) applies, then gain or loss attributable to assets of the partnership giving rise to ordinary income under Code Sec. 751(a) or (b) is considered attributable to the trades or businesses conducted by the partnership, and is taken into account for purposes of computing QBI.

Guaranteed Payments for the Use of Capital. Income attributable to a guaranteed payment for the use of capital is not considered to be attributable to a trade or business, and thus is not taken into account for purposes of computing QBI. However, the partnership's deduction associated with the guaranteed payment will be taken into account for purposes of computing QBI if such deduction is properly allocable to the trade or business and is otherwise deductible for federal income tax purposes.

Section 481 Adjustments. Code Sec. 481 adjustments (whether positive or negative) are taken into account for purposes of computing QBI to the extent that the applicable requirements udner Code Sec. 199A and the regulations are otherwise satisfied, but only if the adjustment arises in tax years ending after December 31, 2017.

Previously Disallowed Losses. Generally, previously disallowed losses or deductions (including under Code Secs. 465, 469, 704(d), and 1366(d)) allowed in the tax year are taken into account for purposes of computing QBI. However, losses or deductions that were disallowed, suspended, limited, or carried over from tax years ending before January 1, 2018 (including under Code Secs. 465, 469, 704(d), and 1366(d)), are not taken into account in a later tax year for purposes of computing QBI.

Net Operating Losses. Generally, a deduction under Code Sec. 172 for a net operating loss is not considered with respect to a trade or business and, therefore, is not taken into account in computing QBI. However, to the extent that the net operating loss is disallowed under Code Sec. 461(l), the net operating loss is taken into account for purposes of computing QBI.

Items of Gross Income, Gain, Deduction, and Loss to the Extent Effectively Connected with the Conduct of a Trade or Business. The term "qualified items of income, gain, deduction, and loss" means items of gross income, gain, deduction, and loss to the extent such items are -

(1) effectively connected with the conduct of a trade or business within the United States (within the meaning of Code Sec. 864(c), determined by substituting "trade or business (within the meaning of section 199A)" for "nonresident alien individual or a foreign corporation" or for "a foreign corporation" each place it appears); and

(2) included or allowed in determining taxable income for the tax year.

Code Sec. 199A(c)(3) provides a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, amounts received from an annuity other than in connection with a trade or business, certain items described in Code Sec. 954, and items of deduction or loss properly allocable to these items.

Section 199A(c)(4) provides that QBI does not include reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business, any guaranteed payment described in Code Sec. 707(c) paid to a partner for services rendered with respect to the trade or business, and to the extent provided in regulations, any payment described in Code Sec. 707(a) to a partner for services rendered with respect to the trade or business.

Items Excludible from QBI

The proposed regulations provide that the following items are generally excludible from QBI:

Code Sec. 1231 Gains and Losses. Code Sec. 199A(c)(3)(B)(i) excludes capital gains or losses from QBI, regardless of whether those items arise from the sale or exchange of a capital asset. The legislative history of Code Sec. 199A provides that QBI does not include any item taken into account in determining net long-term capital gain or net long-term capital loss. Thus, Prop. Reg. Sec. 1.199A-3(b)(2)(ii)(A) clarifies that, to the extent gain or loss is treated as capital gain or loss, it is not included in QBI. Specifically, if gain or loss is treated as capital gain or loss under Code Sec. 1231, it is not QBI. Conversely, if Code Sec. 1231 provides that gains or losses are not treated as gains and losses from sales or exchanges of capital assets, Code Sec. 199A(c)(3)(B)(i) does not apply and the gains or losses must be included in QBI (provided all other requirements are met).

Interest Income. Code Sec. 199A(c)(4)(C) provides that QBI does not include any interest income other than interest income that is properly allocable to a trade or business. According to the IRS, interest income received on working capital, reserves, and similar accounts is not properly allocable to a trade or business, and therefore should not be included in QBI, because such interest income, although held by a trade or business, is simply income from assets held for investment. Accordingly, Prop. Reg. Sec. 1.199A-3(b)(2)(ii)(C) provides that interest income received on working capital, reserves, and similar accounts is not properly allocable to a trade or business. In contrast, interest income received on accounts or notes receivable for services or goods provided by the trade or business is not income from assets held for investment, but income received on assets acquired in the ordinary course of trade or business.

Reasonable Compensation. Code Sec. 199A(c)(4)(A) provides that QBI does not include reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business. Similarly, guaranteed payments for services under Code Sec. 707(c) are excluded from QBI. The IRS said the legislative history of Code Sec. 199A confirms that the reasonable compensation rule was intended to apply to S corporations. It also noted that it had received requests for guidance on whether the phrase "reasonable compensation" within the meaning of Code Sec.199A extends beyond the context of S corporations for purposes of Code Sec. 199A. The term "reasonable compensation," the IRS said, is best read as limited to the context from which it derives: compensation of S corporation shareholders-employees. According to the IRS, if reasonable compensation were to apply outside of the context of S corporations, a partnership could be required to apply the concept of reasonable compensation to its partners, regardless of whether amounts paid to partners were guaranteed. Such a result, the IRS said, would violate the principle set forth in Rev. Rul. 69-184 that a partner of a partnership cannot be an employee of that partnership. The IRS found no indication that Congress intended to change this long-standing federal income tax principle. Accordingly, Prop. Reg. Sec. 1.199A-3(b)(2)(ii)(H) provides that QBI does not include reasonable compensation paid by an S corporation but does not extend this rule to partnerships. Because the trade or business of performing services as an employee is not a qualified trade or business under Code Sec. 199A(d)(1)(B), wage income received by an employee is never QBI. The rule for reasonable compensation, the IRS said, is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in QBI.

Guaranteed Payments. Code Sec. 199A(c)(4)(B) provides that QBI does not include any guaranteed payment described in Code Sec. 707(c) paid by a partnership to a partner for services rendered with respect to the trade or business. Prop. Reg. Sec. 1.199A-3(b)(2)(ii)(I) restates this statutory rule and clarifies that the partnership's deduction for such guaranteed payment is an item of QBI if it is properly allocable to the partnership's trade or business and is otherwise deductible for federal income tax purposes. The IRS noted that it may be unclear whether a guaranteed payment to an upper-tier partnership for services performed for a lower-tier partnership is QBI for the individual partners of the upper-tier partnership if the upper-tier partnership does not itself make a guaranteed payment to its partners. Since Code Sec. 199A(c)(4)(B) does not limit the term "partner" to an individual, for purposes of the guaranteed payment rule, a partner may be an RPE. Accordingly, Prop. Reg. Sec. 1.199A-3(b)(2)(ii)(I) clarifies that QBI does not include any guaranteed payment described in Code Sec. 707(c) paid to a partner for services rendered with respect to the trade or business, regardless of whether the partner is an individual or an RPE. Therefore, for the purposes of this rule, a guaranteed payment paid by a lower-tier partnership to an upper-tier partnership retains its character as a guaranteed payment and is not included in QBI of a partner of the upper-tier partnership regardless of whether it is guaranteed to the ultimate recipient.

Code Sec. 707(a) Payments. Code Sec. 199A(c)(4)(C) provides that QBI does not include, to the extent provided in regulations, any payment described in Code Sec. 707(a) to a partner for services rendered with respect to the trade or business. Code Sec. 707(a) addresses arrangements in which a partner engages with the partnership other than in its capacity as a partner. Within the context of Code Sec. 199A, payments under Code Sec. 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. In addition, consistent with the tiered partnership rule for guaranteed payments described previously, to the extent an upper-tier RPE receives a Code Sec. 707(a) payment, that income should not constitute QBI to the partners of the upper-tier entity. Accordingly, Prop. Reg. sec. 1.199A-3(b)(2)(ii)(J) provides that QBI does not include any payment described in Code Sec. 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. The IRS is requesting comments on whether there are situations in which it is appropriate to include Code Sec. 707(a) payments in QBI.

Allocation of Items Not Clearly Attributable to a Single Trade or Business. Prop. Reg. Sec. 1.199A-3(b)(5) provides that, if an individual or an RPE directly conducts multiple trades or businesses, and has items of QBI that are properly attributable to more than one trade or business, the taxpayer or entity must allocate those items among the several trades or businesses to which they are attributable using a reasonable method that is consistent with the purposes of Code Sec. 199A. The chosen reasonable method for each item must be consistently applied from one tax year to another and must clearly reflect the income of each trade or business. There are several different ways to allocate expenses, such as direct tracing or allocating based on gross income, but whether these are reasonable depends on the facts and circumstances of each trade or business. The IRS is considering whether the term "reasonable method" should be defined to include the direct tracing method, allocations based on gross income, or other methods, within appropriate parameters. The IRS is requesting comments on reasonable methods for the allocation of items not clearly attributable to a single trade or business and whether any safe harbors may be appropriate.

VI. Aggregation Rules

Prop. Reg. Sec. 1.199A-4 allows taxpayers to group or aggregate trades or business for purposes of determining the Code Sec. 199A deduction. It incorporates the rules under Code Sec. 162 for determining whether a trade or business exists for purposes of Code Sec. 199A. A taxpayer can have more than one trade or business for purposes of Code Sec. 162 but, in most cases, a trade or business cannot be conducted through more than one entity.

While practitioners had encouraged the IRS to allow taxpayers to aggregate trades or businesses under Code Sec. 199A using the grouping rules described in Reg. Sec. 1.469-4, the IRS said such grouping rules were not appropriate for determining a trade or business for Code Sec. 199A purposes. Thus, the proposed regulations did not adopt the Code Sec. 469 grouping rules as the means by which taxpayers can aggregate trades or businesses for purposes of applying Code Sec. 199A. However, the IRS did agree that some amount of aggregation should be permitted, noting that it is not uncommon for what are commonly thought of as single trades or businesses to be operated across multiple entities. Trades or businesses may be structured this way for various legal, economic, or other non-tax reasons, the IRS observed.

The fact that businesses are operated across entities raised the question of whether, in defining trade or business for purposes of Code Sec. 199A, Code Sec. 162 trades or businesses should be permitted or required to be aggregated or disaggregated, and if so, whether such aggregation or disaggregation should occur at the entity level or the individual level. The IRS found that allowing taxpayers to aggregate trades or businesses offered taxpayers a means of combining their trades or businesses for purposes of applying the W-2 wage and UBIA of qualified property limitations and potentially maximizing the deduction under Code Sec. 199A. If such aggregation was not permitted, the IRS said, taxpayers could be forced to incur costs to restructure solely for tax purposes. In addition, business and non-tax law requirements could restrict taxpayers from restructuring their operations. Therefore, under Prop. Reg. Sec. 1.199A-4, the IRS permits the aggregation of separate trades or businesses, provided certain requirements are satisfied.

Observation: The IRS noted that, in comments on guidance under Code Sec. 199A, many practitioners were concerned with having multiple regimes for grouping (that is, under Code Secs. 199A, 1411, and 469). Accordingly, the IRS is requesting comments on the aggregation method described Prop. Reg. Sec. 1.199A-4, including whether it would be an appropriate grouping method for purposes of Code Sec. 469 and Code Sec. 1411, in addition to Code Sec. 199A.

Elective Aggregation Permitted Where Requirements Are Satisfied

Under Prop. Reg. Sec. 1.199A-4, aggregation is permitted but is not required. However, an individual may aggregate trades or businesses only if the individual can demonstrate that certain requirements are satisfied.

First, each trade or business must itself be a trade or business.

Second, the same person, or group of persons, must directly or indirectly, own a majority interest in each of the businesses to be aggregated for the majority of the tax year in which the items attributable to each trade or business are included in income. All of the items attributable to the trades or businesses must be reported on returns with the same tax year (not including short years). The proposed regulations provide rules allowing for family attribution. Because the proposed rules look to a group of persons, non-majority owners may benefit from the common ownership and may also aggregate.

Third, none of the aggregated trades or businesses can be an SSTB.

Fourth, individuals and trusts must establish that the trades or businesses meet at least two of three factors, which demonstrate that the businesses are in fact part of a larger, integrated trade or business. These factors include:

(1) the businesses provide products and services that are the same (for example, a restaurant and a food truck) or they provide products and services that are customarily provided together (for example, a gas station and a car wash);

(2) the businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources); or

(3) the businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).

Observation: While the IRS had considered certain reporting requirements in which the majority owner or group of owners would be required to provide information about all of the other pass-through entities in which they held a majority interest, the IRS determined that this would be too complex and burdensome on taxpayers. However, the IRS is requesting comments on whether a reporting or other information sharing requirement should be required.

An individual is permitted to aggregate trades or businesses operated directly and trades or businesses operated through RPEs. Individual owners of the same RPEs are not required to aggregate in the same manner.

Implications of Aggregation

An individual directly engaged in a trade or business must compute QBI, W-2 wages, and UBIA of qualified property for each trade or business before applying the aggregation rules. If an individual has aggregated two or more trades or businesses, then the combined QBI, W-2 wages, and UBIA of qualified property for all aggregated trades or businesses is used for purposes of applying the W-2 wage and UBIA of qualified property limitations.

Similarly, with respect to RPEs, the proposed regulations required that RPEs compute QBI, W-2 wages, and UBIA of qualified property for each trade or business. An RPE must provide its owners with information regarding QBI, W-2 wages, and UBIA of qualified property attributable to its trades or businesses.

Observation: The IRS said that it considered permitting aggregation by an RPE in a tiered structure and looked at several approaches to tiered structures, including permitting only the operating entity to aggregate the trades or businesses or permitting each tier to add to the aggregated trade or business from a lower-tier, provided that the combined aggregated trade or business otherwise satisfied the requirements of Prop. Reg. Sec. 1.199A-4(b)(1) if the businesses were all owned by the lower-tier entity. The IRS aid it was concerned that the reporting requirements needed for either of these rules would be overly complex for both taxpayers and the IRS to administer. In addition, because the Code Sec. 199A deduction is in all cases taken at the individual level, it should not be detrimental, and in fact may provide flexibility to taxpayers, to provide for aggregation at only one level. The IRS is requesting comments on the proposed approach to tiered structures and the reporting necessary to allow an individual to demonstrate to which trades or businesses his or her QBI, W-2 wages, and UBIA of qualified property are attributable for purposes of calculating the Code Sec. 199A deduction.

Consistency Requirement

Once multiple trades or businesses are aggregated into a single aggregated trade or business, individuals must consistently report the aggregated group in subsequent tax years. Prop. Reg. Sec. 1.199A-4(c)(1) provides rules for situations in which the aggregation rules are no longer met as well as rules for when a newly created or acquired trade or business can be added to an existing aggregated group. Prop. Reg. Sec. 1.199A-4(c)(2) provides reporting and disclosure rules.

VII. Computing the Code Section 199A Deduction

An individual with income attributable to one or more domestic trades or businesses, other than as a result of owning stock of a C corporation or engaging in the trade or business of being an employee, and with taxable income (before computing the Code Sec. 199A deduction) at or below the statutorily-defined amount (threshold amount), is entitled to a Code Sec. 199A deduction equal to the lesser of:

(1) 20 percent of the QBI (generally defined as the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business of the taxpayer) from the individual's trades or businesses plus 20 percent of the individual's combined qualified REIT dividends and qualified PTP income, or

(2) 20 percent of the excess (if any) of the individual's taxable income over the individual's net capital gain.

For taxpayers whose taxable income exceeds the threshold amount, Code Sec. 199A may limit the taxpayer's Code Sec. 199A deduction based on the type of trade or business engaged in by the taxpayer; the amount of W-2 wages paid with respect to the trade or business (W-2 wages); and/or the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the trade or business (UBIA of qualified property). For an in-depth discussion of these limitations, see sections II though IV of this report.

The threshold amount at which the various limitations phase in, for any tax year beginning in 2018, is $157,500 (or $315,000 in the case of a taxpayer filing a joint return).

The following examples illustrate the calculation of the Code Sec. 199A deduction for individuals with taxable income below the threshold amount:

Example: Alan is single and owns and operates a computer repair shop as a sole proprietorship. The business generated $100,000 in net taxable income from operations in 2018. Alan has no capital gains or losses. After allowable deductions not relating to the business, Alan's total taxable income for 2018 is $81,000. The business's QBI is $100,000, the net amount of its qualified items of income, gain, deduction, and loss. Alan's Code Sec. 199A deduction for 2018 is equal to $16,200, the lesser of 20 percent of his QBI from the business ($100,000 x 20% = $20,000) and 20 percent of his total taxable income for the tax year ($81,000 x 20% = $16,200).

Example: Assume the same facts as the example above except that Alan also has $7,000 in net capital gain for 2018 and that, after allowable deductions not relating to the business, Alan's taxable income for 2018 is $74,000. Alan's taxable income minus net capital gain is $67,000 ($74,000 - $7,000). Alan's Code Sec. 199A deduction is equal to $13,400, the lesser of 20 percent of his QBI from the business ($100,000 x 20% = $20,000) and 20 percent of his total taxable income minus net capital gain for the tax year ($67,000 x 20% = $13,400).

Example: Bob and Carol are married and file a joint tax return. Bob earned $500,000 in wages as an employee of an unrelated company in 2018. Carol owns 100 percent of the shares of X, an S corporation that provides landscaping services. X generated $100,000 in net income from operations in 2018. X paid Carol $150,000 in wages in 2018. Bob and Carol have no capital gains or losses. After allowable deductions not related to X, Bob and Carol's total taxable income for 2018 is $270,000. Bob's and Carol's wages are not considered to be income from a trade or business for purposes of the Code Sec. 199A deduction. Because X is an S corporation, its QBI is determined at the S corporation level. X's QBI is $100,000, the net amount of its qualified items of income, gain, deduction, and loss. The wages paid by X to Carol are considered to be a qualified item of deduction for purposes of determining X's QBI. The Code Sec. 199A deduction with respect to X's QBI is then determined by Carol, X's sole shareholder, and is claimed on the joint return filed by Bob and Carol. Bob and Carol's Code Sec. 199A deduction is equal to $20,000, the lesser of 20 percent of Carol's QBI from the business ($100,000 x 20% = $20,000) and 20% of Bob and Carol's total taxable income for the tax year ($270,000 x 20% = $54,000).

Example: Assume the same facts as the above example except that Bob also earns $1,000 in qualified REIT dividends and $500 in qualified PTP income in 2018, increasing taxable income to $271,500. Bob and Carol's Code Sec. 199A deduction is equal to $20,300, the lesser of (i) 20% of Carol's QBI from the business ($100,000 x 20% = $20,000) plus 20% of Bob's combined qualified REIT dividends and qualified PTP income ($1500 x 20% = $300) and (ii) 20% of Bob and Carol's total taxable income for the tax year ($271,500 x 20% = $54,300).

If an individual's combined QBI is negative or combined qualified REIT dividends and PTP income is less than zero, Prop. Reg. 1.199A-1(c)(2) provides rules for the carryover of the losses.

If an individual has multiple trades or businesses, the individual must calculate the QBI from each trade or business and then net the amounts. Under Code Sec. 199A(c)(2), if the net QBI with respect to qualified trades or businesses of the taxpayer for any taxable year is less than zero, such amount is treated as a loss from a qualified trade or business in the succeeding taxable year. Prop. Reg. Sec. 1.199A-1(c)(2)(i) repeats this rule and provides that the Code Sec. 199A carryover rules do not affect the deductibility of the losses for purposes of other provisions of the Code.

In the preamble to the proposed regulations, the IRS addressed practitioner uncertainty as to whether, if a taxpayer has an overall loss from combined qualified REIT dividends and qualified PTP income (because a loss from a PTP exceeds REIT dividends and PTP income), the negative amount should be netted against any net positive QBI (regardless of source), or whether the negative amount should be segregated and subject to its own loss carryforward rule distinct from but analogous to the QBI loss carryforward rule.

According to the IRS, Code Sec. 199A contemplates that qualified REIT dividends and qualified PTP income are computed and taken into account separately from QBI and should not affect QBI. If overall losses attributable to qualified REIT dividends and qualified PTP income were netted against QBI, the IRS said, these losses would affect QBI. Therefore, a separate loss carryforward rule is needed to segregate an overall loss attributable to qualified REIT dividends and qualified PTP income from QBI.

Further, as a result of practitioner concern that losses in excess of income could create a negative Code Sec. 199A deduction, which would be incompatible with Code Sec. 199, the proposed regulations provide that if an individual has an overall loss after qualified REIT dividends and qualified PTP income are combined, the portion of the individual's Code Sec. 199A deduction related to qualified REIT dividends and qualified PTP income is zero for the tax year. In addition, the overall loss does not affect the amount of the taxpayer's QBI. Instead, such overall loss is carried forward and must be used to offset combined qualified REIT dividends and qualified PTP income in the succeeding tax year or years for purposes of Code Sec. 199A.

Prop. Reg. Sec. 1.199A-1(d) addresses the calculation of the Code Sec. 199A deduction for individuals with taxable income above the threshold amount and provides that all of the rules relating to the REIT/PTP component of the Code Sec. 199A deduction applicable to individuals with taxable income at or below the threshold amount also apply to individuals with taxable income above the threshold amount.

For individuals with taxable income above the threshold amount, the Code Sec. 199A deduction is determined by adding the QBI component and 20 percent of the combined amount of qualified REIT dividends and qualified PTP income (including the individual's share of qualified REIT dividends and qualified PTP income from RPEs). That sum is then compared to 20 percent of the amount by which the individual's taxable income exceeds net capital gain. The lesser of these two amounts is the individual's Code Sec. 199A deduction.

An individual with taxable income that exceeds the threshold amount determines the QBI component using the following computational rules, which must be applied in the following order:

(1) SSTB Exclusion: If the individual's taxable income is within the phase-in range, then only the applicable percentage of QBI, W-2 wages, and UBIA of qualified property for each SSTB is taken into account for purposes of determining the individual's Code Sec. 199A deduction. If the individual's taxable income exceeds the phase-in range, then none of the individual's share of QBI, W-2 wages, or UBIA of qualified property attributable to an SSTB may be taken into account for purposes of determining the individual's Code Sec. 199A deduction.

(2) Aggregated Trade or Business: If an individual chooses to aggregate trades or businesses under the rules of Prop. Reg. Sec. 1.199A-4, the individual must combine the QBI, W-2 wages, and UBIA of qualified property of each trade or business within an aggregated trade or business prior to applying the W-2 wages and UBIA of qualified property limitations described in (4) below.

(3) Netting and Carryover: If an individual's QBI from at least one trade or business is less than zero, the individual must offset the QBI attributable to each trade or business that produced net positive QBI with the QBI from each trade or business that produced net negative QBI in proportion to the relative amounts of net QBI in the trades or businesses with positive QBI. The adjusted QBI is then used in (4), below. The W-2 wages and UBIA of qualified property from the trades or businesses which produced net negative QBI are not taken into account for purposes of the calculation in Prop. Reg. Sec. 1.199A-1(d) and are not carried over to the subsequent year. If an individual's QBI from all trades or businesses combined is less than zero, the QBI component is zero for the tax year. This negative amount is treated as negative QBI from a separate trade or business in the individual's succeeding tax year. This carryover rule does not affect the deductibility of the loss for purposes of other provisions of the Code. The W-2 wages and UBIA of qualified property from the trades or businesses which produced net negative QBI are not taken into account for purposes of the calculation in Prop. Reg. Sec. 1.199A-4(d) and are not carried over to the subsequent year.

Generally, the QBI component is the sum of the following amounts for each trade or business:

(1) the lesser of 20 percent of the QBI for that trade or business, or

(2) the greater of 50 percent of W-2 wages with respect to that trade or business, or the sum of 25 percent of W-2 wages with respect to that trade or business plus 2.5 percent of the UBIA of qualified property with respect to that trade or business.

However, if the individual's taxable income is within the phase-in range and the amount that is (1) the greater of 50 percent of W-2 wages with respect to that trade or business, or the sum of 25 percent of W-2 wages with respect to that trade or business plus 2.5 percent of the UBIA of qualified property with respect to that trade or business, is less than (2) 20 percent of the QBI for that trade or business, then the QBI component amount for that trade or business is modified. As modified, the QBI component amount for the trade or business is 20 percent of the QBI for that trade or business reduced by the reduction amount as defined in Prop. Reg. Sec. 1.199-1(b)(8). Under that provision, the reduction amount is, with respect to any taxable year, the "excess amount" multiplied by the ratio that the taxable income of the individual for the tax year in excess of the threshold amount, bears to $50,000 (or $100,000 in the case of a joint return). The "excess amount" is 20 percent of QBI over the greater of 50 percent of W-2 wages or the sum of 25 percent of W-2 wages plus 2.5 percent of the UBIA of qualified property. This reduction amount does not apply if the amount determined by taking the greater of 50 percent of W-2 wages with respect to that trade or business, or the sum of 25 percent of W-2 wages with respect to that trade or business plus 2.5 percent of the UBIA of qualified property with respect to that trade or business is greater than 20 percent of the QBI for that trade or business. In that case, the QBI component for the trade or business will be the unreduced amount (i.e., 20 percent of the QBI for that trade or business).

If the combined amount of REIT dividends and qualified PTP income is less than zero, the portion of the individual's Code Sec. 199A deduction related to qualified REIT dividends and qualified PTP income is zero for the tax year. The negative combined amount must be carried forward and used to offset the combined amount of REIT dividends/qualified PTP income in the succeeding tax year of the individual for purposes of Code Sec. 199A. This carryover rule does not affect the deductibility of the loss for purposes of other provisions of the Code.

The following examples illustrate the rules above and assume that all of the trades or businesses are qualified trades or businesses and that none of the trades or businesses are SSTBs, and all tax items associated with the trades or businesses are effectively connected to a trade or business within the United States.

Example: Dan is single and owns several parcels of land that he manages and which are leased to several suburban airports for parking lots. The business generated $1,000,000 of QBI in 2018. The business paid no wages and the property was not qualified property because it was not depreciable. After allowable deductions unrelated to the business, Dan's total taxable income for 2018 is $980,000. Because Dan's taxable income exceeds the applicable threshold amount, Dan's Code Sec. 199A deduction is subject to the W-2 wage and UBIA of qualified property limitations. Dan's Code Sec. 199A deduction is limited to zero because the business paid no wages and held no qualified property.

Example: Assume the same facts as the example above, except that Dan developed the land parcels in 2019, expending a total of $10,000,000 to build parking structures on each of the parcels, all of which is depreciable. During 2020, Dan leased the parking structures and the land to the suburban airports. Dan reports $4,000,000 of QBI for 2020. After allowable deductions unrelated to the business, Dan's total taxable income for 2020 is $3,980,000. Because Dan's taxable income is above the threshold amount, the QBI component of his Code Sec. 199A deduction is subject to the W-2 wage and UBIA of qualified property limitations. Because the business has no W-2 wages, the QBI component of Dan's Code Sec. 199A deduction is limited to the lesser of 20 percent of the business's QBI or 2.5 percent of its UBIA of qualified property. Twenty percent of the $4,000,000 of QBI is $800,000. Two and one-half percent of the $10,000,000 UBIA of qualified property is $250,000. The QBI component of Dan's Code Sec. 199A deduction is thus limited to $250,000. Dan's Code Sec. 199A deduction is equal to the lesser of (1) 20% of the QBI from the business as limited ($250,000) or (2) 20% of Dan's taxable income ($3,980,000 x 20% = $796,000). Therefore, Dan's Code Sec. 199A deduction for 2020 is $250,000.

Example: Ellen is single and is a 30% owner of a limited liability company (LLC), which is classified as a partnership for tax purposes. In 2018, the LLC has a single trade or business and reported QBI of $3,000,000. The LLC paid total W-2 wages of $1,000,000, and its total UBIA of qualified property is $100,000. Ellen is allocated 30 percent of all items of the partnership. For the 2018 tax year, Ellen reports $900,000 of QBI from the LLC. After allowable deductions unrelated to LLC, Ellen's taxable income is $880,000. Because Ellen's taxable income is above the threshold amount, the QBI component of Ellen's Code Sec. 199A deduction will be limited to the lesser of (1) 20% of Ellen's share of LLC's QBI, or (2) the greater of the W-2 wage or UBIA of qualified property limitations. Twenty percent of Ellen's share of QBI of $900,000 is $180,000. The W-2 wage limitation equals 50% of Ellen's share of the LLC's wages ($300,000) or $150,000. The UBIA of qualified property limitation equals $75,750, the sum of (1) 25% of Ellen's share of LLC's wages ($300,000) or $75,000 plus (2) 2.5% of Ellen's share of UBIA of qualified property ($30,000) or $750. The greater of the limitation amounts ($150,000 and $75,750) is $150,000. The QBI component of Ellen's Code Sec. 199A deduction is thus limited to $150,000, the lesser of (1) 20% of QBI ($180,000) and (2) the greater of the limitations amounts ($150,000). Ellen's Code Sec. 199A deduction is equal to the lesser of (1) 20% of the QBI from the business as limited ($150,000) or (2) 20% of her taxable income ($880,000 x 20% = $176,000). Therefore, Ellen's Code Sec. 199A deduction is $150,000 for 2018.

Example: Frank is single and owns a 50% interest in Z, an S corporation for tax purposes that conducts a single trade or business. In 2018, Z reported QBI of $6,000,000. Z paid total W-2 wages of $2,000,000, and its total UBIA of qualified property is $200,000. For the 2018 tax year, Frank reports $3,000,000 of QBI from Z. Frank is not an employee of Z and receives no wages or reasonable compensation from Z. After allowable deductions unrelated to Z and a deductible qualified net loss from a PTP of ($10,000), Frank's taxable income is $1,880,000. Because Frank's taxable income is above the threshold amount, the QBI component of Frank's Code Sec. 199A deduction is limited to the lesser of (1) 20% of Frank's share of Z's QBI or (ii) the greater of the W-2 wage and UBIA of qualified property limitations. Twenty percent of Frank's share of QBI of $3,000,000 is $600,000. The W-2 wage limitation equals 50% of Frank's share of Z's W-2 wages ($1,000,000) or $500,000. The UBIA of qualified property limitation equals $252,500, the sum of (1) 25% of Frank's share of Z's W-2 wages ($1,000,000) or $250,000 plus (2) 2.5% of Frank's share of UBIA of qualified property ($100,000) or $2,500. The greater of the limitation amounts ($500,000 and $252,500) is $500,000. The QBI component of Frank's Code Sec. 199A deduction is thus limited to $500,000, the lesser of (1) 20% of QBI ($600,000) and (2) the greater of the limitations amounts ($500,000). Frank reported a qualified loss from a PTP and has no qualified REIT dividend. Frank does not net the ($10,000) loss against QBI. Instead, the portion of Frank's Code Sec. 199A deduction related to qualified REIT dividends and qualified PTP income is zero for 2018. Frank's Code Sec. 199A deduction is equal to the lesser of (1) 20% of the QBI from the business as limited ($500,000) or (2) 20% of Frank's taxable income over net capital gain ($1,880,000 x 20% = $376,000). Therefore, Frank's Code Sec. 199A deduction is $376,000 for 2018. Frank must also carry forward the $(10,000) qualified loss from a PTP to be netted against Frank's qualified REIT dividends and qualified PTP income in the succeeding taxable year.

Example: Bob and Carol are married and file a joint tax return. Bob is a shareholder in M, an entity taxed as an S corporation for tax purposes that conducts a single trade or business. M holds no qualified property. Bob's share of M's QBI is $300,000 in 2018. Bob's share of the W-2 wages from M in 2018 is $40,000. Carol earns wage income from employment by an unrelated company. After allowable deductions unrelated to M, Bob and Carol's taxable income for 2018 is $375,000. Bob and Carol are within the phase-in range because their taxable income exceeds the applicable threshold amount, $315,000, but does not exceed the threshold amount plus $100,000, or $415,000. Consequently, the QBI component of Bob and Carol's Code Sec. 199A deduction may be limited by the W-2 wage and UBIA of qualified property limitations but the limitations will be phased in. The UBIA of qualified property limitation amount is zero because M does not hold qualified property. Bob and Carol must apply the W-2 wage limitation by first determining 20% of Bob's share of M's QBI. Twenty percent of Bob's share of M's QBI of $300,000 is $60,000. Next, Bob and Carol must determine 50% of Bob's share of M's W-2 wages. Fifty percent of Bob's share of M's W-2 wages of $40,000 is $20,000. Because 50% of Bob's share of M's W-2 wages ($20,000) is less than 20% of Bob's share of M's QBI ($60,000), Bob and Carol must determine the QBI component of their Code Sec. 199A deduction by reducing 20% of Bob's share of M's QBI by the reduction amount.

Continued: Bob and Carol are 60% through the phase-in range (that is, their taxable income exceeds the threshold amount by $60,000 and their phase-in range is $100,000). Bob and Carol must determine the excess amount, which is the excess of 20% of Bob's share of M's QBI, or $60,000, over 50% of Bob's share of M's W-2 wages, or $20,000. Thus, the excess amount is $40,000. The reduction amount is equal to 60% of the excess amount, or $24,000. Thus, the QBI component of Bob and Carol's Code Sec. 199A deduction is equal to $36,000, 20% of Bob's $300,000 share M's QBI (that is, $60,000), reduced by $24,000. Bob and Carol's Code Sec. 199A deduction is equal to the lesser of (1) 20% of the QBI from the business as limited ($36,000) or (2) 20% of Bob and Carol's taxable income ($375,000 x 20% = $75,000). Therefore, Bob and Carol's Code Sec. 199A deduction is $36,000 for 2018.

VIII. Miscellaneous

Other issues addressed by the proposed regulations include the following:

Alternative Minimum Tax

The proposed regulations also make clear that the Code Sec. 199A deduction is allowed when calculating alternative minimum taxable income of individuals. Thus, the Code Sec. 199A deduction does not result in individuals being subject to the alternative minimum tax. Prop. Reg. Sec. 1.199A-1(e)(4) provides that, for purposes of determining alternative minimum taxable income, the Code Sec. 199A deduction is equal in amount to the deduction allowed under Code Sec. 199 in determining taxable income for that tax year.

Presumption for Former Employees

Code Sec. 199A provides that the trade or business of providing services as an employee is not eligible for the Code Sec. 199A deduction.

To prevent employees from treating themselves as independent contractors or as having an equity interest in a partnership or S corporation in order to benefit from the Code Sec. 199A deduction, Prop. Reg. Sec. 1.199A-5(d)(3) provides that if an employer improperly treats an employee as an independent contractor or other non-employee, the improperly classified employee is in the trade or business of performing services as an employee notwithstanding the employer's improper classification.

This issue is particularly important in the case of individuals who cease being treated as employees of an employer, but subsequently provide substantially the same services to the employer (or a related entity) but claim to do so in a capacity other than as an employee. Prop. Reg. 1.199A-5(d)(3) does not provide any new or different standards to be properly classified as an independent contractor or owner of a business. Instead, it contains a presumption that applies in certain situations to ensure that individuals properly substantiate their status.

Specified Agricultural or Horticultural Cooperatives

Special rules apply with respect to the Code Sec. 199A deduction in the case of specified agricultural and horticultural cooperatives. In the preamble to the proposed regulations, the IRS noted that it is continuing to study this area and intends to issue separate proposed regulations later this year describing rules for applying Code Sec. 199A to specified agricultural and horticultural cooperatives and their patrons.

As provided in Code Sec. 199A(g)(6), such regulations will generally be based on the regulations applicable to cooperatives and their patrons under former Code Sec. 199 (as in effect before its repeal). The IRS anticipates that the regulations will provide that Code Sec. 199A(g) applies only to the patronage business of a relevant cooperative. When issued, the future proposed regulations will also provide more information on the application of the reduction under Code Sec. 199A(b)(7), which is a special rule with respect to income received from cooperatives.

IX. Effective Date

Prop. Reg. Sec. 1.199A-1 through Prop. Reg. Sec. 1.199A-6 generally are proposed to apply to tax years ending after the date the regulations are adopted as final in the Federal Register. However, taxpayers may rely on the rules set forth in proposed Reg. Sec. 1.199A-1 through Prop. Reg. Sec. 1.199A-6, in their entirety, until the date the date the regulations are finalized. In addition, to prevent abuse of Code Sec. 199A and the regulations thereunder, the anti-abuse rules in Prop. Reg. Sec. 1.199A-2(c)(1)(iv), Prop. Reg. Sec. 1.199A-3(c)(2)(B), Prop. Reg. Sec. 1.199A-5(c)(2), Prop. Reg. Sec. 1.199A-5(c)(3), Prop. Reg. Sec. 1.199A-5(d)(3), and Prop. Reg. Sec. 1.199A-6(d)(3)(v) are proposed to apply to tax years ending after December 22, 2017, the date of enactment of the TCJA. Finally, the provisions of Prop. Reg. Sec. 1.643-1, which prevents abuse of the Code generally through the use of trusts, are proposed to apply to tax years ending after August 8, 2018.

In the preamble to the proposed regulations, the IRS notes that Code Sec. 199A(f)(1) provides that Code Sec. 199A applies at the partner or S corporation shareholder level, and that each partner or shareholder takes into account such person's allocable share of each qualified item. Code Sec. 199A(c)(3) provides that the term "qualified item" means items that are effectively connected with a U.S. trade or business, and "included or allowed in determining taxable income from the taxable year." Code Sec. 199A applies to tax years beginning after December 31, 2017. However, there is no statutory requirement under Code Sec. 199A that a qualified item arise after December 31, 2017.

Code Sec. 1366(a) generally provides that, in determining the income tax of a shareholder for the shareholder's tax year in which the tax year of the S corporation ends, the shareholder's pro rata share of the corporation's items is taken into account. Similarly, Code Sec. 706(a) generally provides that, in computing the taxable income of a partner for a tax year, the partner includes items of the partnership for any tax year of the partnership ending within or with the partner's tax year. Therefore, income flowing to an individual from a partnership or S corporation is subject to the tax rates and rules in effect in the year of the individual in which the entity's year closes, not the year in which the item actually arose.

Accordingly, for purposes of determining QBI, W-2 wages, and UBIA of qualified property, the effective dates provisions provide that if an individual receives QBI, W-2 wages, or UBIA of qualified property from an RPE with a tax year that begins before January 1, 2018, and ends after December 31, 2017, such items are treated as having been incurred by the individual during the individual's tax year during which such RPE tax year ends

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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