Treasury issued the final rules on 199A earlier this month. You can read the rules and accompanying guidance here:
You can also read a terrific “how does it all work” review published in Forbes the other day. As the writer notes:
I believe in giving credit where credit is due, and I’ll be damned if the IRS doesn’t deserve some serious credit. It was less than 13 months ago that Congress dumped 500 pages of sloppy statutory language on the Service in the form of the Tax Cuts and Jobs Act, and somehow, in that span the IRS has managed to provide final regulations on the most controversial, convoluted and complicated provision of the new law: Section 199A, better known as the “20% pass-through deduction.” It required a Herculean effort, particularly when you consider that, you know…most of the government has been on unpaid leave since December 22nd.
We agree. Treasury did a great job of getting a workable set of rules based on a very complicated law out the door quickly. They also embraced some very taxpayer-friendly ideas, like the ability to aggregate multiple businesses together when calculating the deduction in certain circumstances, as well as the option to calculate the deduction at the entity, rather than the taxpayer, level. These are welcome and will help make the 199A deduction workable for most businesses.
That said, there were many details that we hoped Treasury would improve in the final rules. The aggregation rules are still too restrictive, and the imposition of a two-tiered de minimis threshold is simply too low and could give rise to needlessly complexities.
Our biggest objection to the final rules, however, is the starting point. How so? When Congress created 199A, it needed guardrails to distinguish between business income that would qualify for the deduction and wage income that would not. It’s the old “John Edwards, Newt Gingrich” dilemma all over again, only more so since the 199A tax benefit is potentially bigger.
But instead of a targeted approach that distinguished business income from wages, Congress chose a wholesale exclusion of entire industries (so-called Specified Service Trades or Businesses or SSTB’s) from the deduction. The idea was that since a law firm’s income is largely due to services, let’s just say that all law firm income is ineligible for the deduction and not mess around with difficult distinctions of business income and an owner’s wages.
The statute accordingly describes an SSTB as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, dealing in securities, partnership interests, or commodities, or 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.
It is an extensive list and a classic case of picking winners and losers. Obviously, litigating which trades or businesses get the deduction will be an issue for years to come. There’s not much Treasury could have done about that.
Where Treasury went wrong, in our opinion, is in defining the term “involving” narrowly to encompass any level of activity in those listed professions. They explicitly rejected arguments that they should define “involving” more broadly where substantially all the corporation’s activities for a taxable year must involve the performance of services in the listed fields in order to trip the exception.
Treasury argues “… section 199A looks to the trade or business of performing services involving one or more of the listed fields, and not the performance of services themselves in determining whether a trade or business is an SSTB.”
Yet it can be argued that the final rule does exactly the opposite. If “involving” means any level of activity in the listed services, then any trade or business that has even a modicum of revenue from one of the listed services would be precluded from getting the deduction. For example, banks may earn revenue from many listed services and so would be disqualified under Treasury’s narrow interpretation, even though Congress explicitly chose not to list banking as an SSTB. The rule effectively puts the emphasis on the service, not the business.
So how does Treasury get out of this conundrum? They embrace two “outs.”
First, they established a two-tiered de minimis threshold for SSTB revenue in a business that would otherwise qualify for the deduction. The threshold is 10-percent for businesses with gross receipts of $25 million or less, and 5-percent for those businesses above $25 million. Allowing a minimum level of disqualified income is obviously inconsistent with the notion that “involving” is triggered by one penny of specified service revenue, but it’s necessary. Otherwise, all businesses would be at risk of being characterized as SSTBs, which obviously isn’t what Congress intended.
Second, Treasury relies on the fact that there can be multiple trades or businesses within a single business entity. Treasury argues that an S corporation bank that would otherwise be disqualified as an SSTB under their strict interpretation can still get the deduction for their qualified lending and banking operations by segregating other, disqualified services into a separate “trade or business.”
The final rules say “… a subchapter S bank could segregate specified service activities from an existing trade or business and operate such specified service activities as an SSTB separate from its remaining trade or business, either within the same legal entity or in a separate entity.”
This approach will work, albeit at a significant burden to the taxpayer. The approach also opens the door to gaming. As S-Corp argued in making the case for generous aggregation rules, gaming under 199A is more likely to come from disaggregation than aggregation. Treasury’s approach opens the door to disaggregation by law firms and other listed trades or businesses.
In our opinion, it would have been better to adopt a higher bar of activity in order to trip the SSTB definition. In practice, this higher bar would have established a single de minimis threshold that would have eased compliance and administration burdens, reduced the number of companies that are unintentionally tripped up, and limited the need for Treasury and the courts to continuously weigh in on what might and might not be an SSTB.
Of course, it would have been better still had Congress targeted wage income itself rather than whole trades or businesses for exclusion from the deduction, but that horse left the barn a long time ago.
One area where the Treasury did taxpayers a huge service was stomping on any expansive notions of the phrase “principal asset is the skill or reputation of one or more employees or owners.” This phrase is wholly unworkable (what exactly is a “principal asset” and how do you measure it?) and had the potential to open up a wide variety of trades or businesses to SSTB designation. Treasury correctly rejected that option and limited “the meaning of the reputation or skill clause to fact patterns in which an individual or RPE is engaged in the trade or business of receiving income from endorsements, the licensing of an individual’s likeness or features, and appearance fees.”
The bottom line is that S corporations and other pass-through businesses now have the rules in place to move forward. While the rules are not as broad as we had hoped, they are better than many possible alternatives and they now form the foundation from which we intend to build. Our agenda for 2019 is to continue to make the case for pass-through parity and working to make the 199A deduction broader and more permanent. Like so many S corporations, these final rules provide us with a starting point.
Board Member and Advisory Committee Chair Tom Nichols represented S-Corp in Tuesday’s IRS hearing on Section 199A.
Tom was one of 26 witnesses to testify. As Tax Notes summarized:
Thomas J. Nichols of Meissner, Tierney, Fisher & Nichols SC said when taxpayers have losses from one trade or business and income from another, they are required to aggregate those amounts to determine the deduction amount, even though aggregation isn’t mandated when determining whether Form W-2 wages and basis in property can be combined.
Instead, taxpayers must jump through several hoops to determine if they can aggregate those businesses, Nichols added. He also said it’s important to keep in mind the likelihood of gaming Form W-2 wage context is low because it wouldn’t make economic sense for a company to pay $100,000 in wages to get a tax benefit under the Form W-2 rule of around $18,500.
Nichols added that it would help the government to ensure that the same people benefiting from the 199A deduction are also burdened by the Form W-2s. That would enable them to relax the business relation requirements.
The proposed rules require business owners to pass a five-factor test when grouping together different legal entities to calculate their 199A deduction. Grouping or aggregating these separate business entities is critical because of the guardrails limiting a business owner’s access to the deduction. Absent aggregation, many businesses that should get the full deduction will see it reduced or eliminated completely.
As Tom made clear, however, the five factors included in the proposed rules go too far. Requiring there to be common ownership of at least 50 percent of the entities being grouped and that all the entities have a common tax year will needlessly limit aggregation opportunities without materially increasing the integrity of the process.
In addition to getting the aggregation rules right, a number of witnesses expressed concern regarding the Specified Service Trade or Business (SSTB) definition and accompanying de minimis thresholds in the proposed rules. While banks and energy companies highlighted their particular concerns, common to those industries was support of significantly higher de minimis thresholds. As one bank argued:
Joseph Frampton of Paducah Bank and Trust Co. said Congress added the passthrough deduction to the code to provide parity for the corporate income tax rate reduction from 35 percent to 21 percent. However, after reading the proposed rules, it may make more sense for some small banks to convert to a C corporation, he said.
Frampton took issue with the de minimis test laid out in the proposed regulations, which states that if a trade or business has gross receipts of $25 million or less for a tax year, it won’t be treated as a specified service if less than 10 percent of its gross receipts are attributable to the barred services. And if a trade or business has gross receipts of more than $25 million, the applicable percentage drops to 5 percent.
Since Frampton’s bank has more than $25 million in gross receipts and 7 percent of the services it provides are barred from using the deduction, shareholders will be adversely affected, he said. At the fall American Bar Association Section of Taxation meeting in Atlanta on October 5, a Treasury official clarified that the de minimis rules have a cliff effect and that once the de minimis amounts are exceeded, the entire business is potentially banned from using the deduction.
Frampton suggested treating all bank income as qualified business income, raising the de minimis cap from 5 percent to 25 percent, or considering net income instead of gross receipts when calculating the de minimis rule.
For next steps, the IRS and Treasury will review the comments they received during the comment period and produce a final rule. With the clock ticking on calendar year 2018, we expect them to move quickly and produce something either prior to Thanksgiving or just after. Taxpayer’s need clarity, and the authors of the proposed rules understand that fully.
You can read S-Corp’s full comments on the proposed 199A rules here.
Everything has its season, and for tax reform, this is the season of sending comments to Treasury. This week, the S Corporation Association submitted comments on Treasury’s proposed rules implementing the so-called “toll charge” repatriation tax under Section 965.
To recap, one of the selling points of tax reform was the move from a system that taxed all the income of U.S. taxpayers, regardless of where it was earned, with a system that focused primarily on taxing income earned with our borders. This new territorial approach was supposed to make U.S. businesses more competitive overseas. Only time will tell whether that proves to be the case.
What is most certainly the case is that individuals and S corporations were blocked from the territorial treatment yet subjected to the new taxes that accompanied it. These taxes include the toll charge under Section 965, the GILTI tax to help shore up the territorial treatment, and the BEAT tax to protect against base erosion. So, S corporations don’t get the good international stuff in tax reform, but they must pay the extra taxes anyway. Not the best outcome.
These general concerns are outside the scope of Treasury’s regulatory process, however. In the proposed rules, S-Corp focused its recommendations to two specific items:
- Treasury needs to clean up the mess about overpayments and deferred taxes under Section 965; and
- Treasury needs to discard new language that would needlessly accelerate payment of the Section 965 toll charge on S corporations.
Those S corporations with overseas operations should pay attention, as these items will affect you in the coming months and years. You can read the full comments here.
S-Corp and U.S. Chamber Join Forces on Overpayments
S-Corp co-authored a separate letter with the U.S. Chamber of Commerce on the toll-charge tax and the question of what should happen to overpayment by taxpayers. Signed by 30 trade groups, the letter highlights business community concerns on the overpayment issue and why the IRS needs to revisit its position. As the letter states:
Taxpayers often overpay their tax liabilities, either through excessive estimated tax payments or through amendments to earlier returns. The policy articulated in FAQ 13 and 14 would require that these overpayments be applied to any outstanding §965 liabilities, even if the taxpayer had elected to defer those liabilities under §965(h) and (i). That result is simply not consistent with the clear reading of §965(h) and (i) nor with the policy goals Congress articulated when it adopted the deferral election.
An accompanying press release included the following quotes:
- “The current IRS guidance creates a sweeping, negative impact on business operations of all sizes and across all sectors,” said U.S. Chamber Vice President for Tax Policy and Economic Development and Chief Tax Counsel Caroline Harris. “This new tax code is designed not to pick winners and losers, but the IRS’s current guidance for overpayments does just that. We urge the IRS to change course and to implement this provision the way Congress intended – to grow and strengthen American businesses.”
- “S corporations were excluded from the new territorial system, so Congress reasonably exempted them from the toll charge tax as well,” S Corporation Association President Brian Reardon said. “A policy of applying tax overpayments to these deferred 965 liabilities effectively undermines congressional intent and should be reversed. S corporation owners should not have to pay a ticket for a ride they don’t get.”
The overpayment issue is obviously a big deal to C corporations with overseas operations. It’s a bigger deal to S corporations. For them, it’s the difference between paying no tax and paying the full tax.
You can read the full letter here. Expect to hear lots more on this issue as Treasury finalizes its Section 965 rules and tax overpayments.
The S Corporation Association today submitted comments on Treasury’s proposed rules implementing the new, 20-percent pass-through deduction.
S-Corp readers know the 20-percent deduction was designed to preserve rate parity between pass-through businesses and the new, 21-percent rate on S corporations. But how is the deduction going to be calculated? How many pass-through businesses will qualify? Our comments kick off by emphasizing just how important the deduction is to keeping Main Street competitive.
As our recent EY study made clear, pass-through businesses receiving the full deduction still will pay an effective tax rate that is 1.3-percent higher than the rate paid by the average C corporation. Pass-through businesses not receiving the full deduction, or those precluded from receiving any deduction, will pay rates significantly higher.
Broad access to the Section 199A deduction is also pivotal in order for Tax Reform to achieve its fundamental goals of job creation and economic growth. Pass-through businesses represent 95-percent of all business entities, employ over half of private sector workers in the United States, and contribute a majority of business income to our gross domestic product. Much of the economic potential of Tax Reform will be lost if the Main Street community is not a full partner in the reforms.
So the rules out of Treasury on how to calculate the new 199A deduction are critical. How did they do? Generally, the S-Corp comments paint a positive picture of the proposed rules. Treasury made a good-faith effort to get the new regime right. But with any new proposal this big, there are lots of details to work out, and the S-Corp comments include a number of recommendations as to how Treasury can improve the final rules.
You can click here to read the full S-Corp comments. And stay tuned for more on this topic. These rules have to be in place before the New Year, so we expect Treasury to move fast.
It’s not late Friday afternoon, so why is Treasury releasing important new rules on the pass-through deduction? We’re not sure, but we like it!
The rules themselves look pretty good too, and our members’ initial reaction to the rules was mostly positive. Here’s the statement S-Corp released earlier today:
“Treasury’s proposed rules are a good start to making the pass-through deduction workable for Main Street businesses. There are many important details to clarify and we have specific concerns about some of the definitions and reporting requirements, but the overall approach taken by Treasury is positive and should be applauded. Our goal is to make certain the 20-percent deduction is available to real businesses with real employees. We think these rules are a good beginning, and we will use the comment period to clarify our remaining concerns.”
Today’s release was broader than what we expected, and appears to be designed to give most businesses the details they need to file next year, including a refined definition of “trade or business,” clarification on which industries are “specified services” and therefore precluded from the deduction, and a new approach to when business owners may aggregate or group together separate legal entities to calculate the deduction.
S-Corp has championed the aggregation issue since the beginning of the year and the proposed rules are generally consistent with our recommendations. They cut a middle ground between a narrow interpretation severely limiting the ability of owners to aggregate and a broad approach with few limitations, as under Section 469. The resulting approach looks like a good-faith effort to allow owners to aggregate groups of businesses when it is appropriate.
Here are some of the details:
- The rule defines what qualifies as a trade or business, and then requires that any aggregated group only include trades or businesses.
- The same group of owners must own a majority stake of each business in the aggregated group. Owners are allowed to apply family attribution rules to measure their ownership stake, and minority owners may rely on the ownership of the entire group to qualify for aggregation.
- None of the aggregated businesses may be a “specified services” business.
- Each business in the aggregated group must meet at least two of the following three factors:
- Provides products and services that are the same or customarily provided together;
- Shares facilities or centralized business elements (personnel, accounting, purchasing etc.); and
- Operates in coordination with, or reliance upon, other businesses in the aggregated group (supply chain, vertical integration, etc.).
- Owners of the same businesses are not required to coordinate their aggregation approach, so each may choose different groups.
- Aggregated groups must be consistent year to year, with proposed rules on when owners are allowed to adjust a group.
Left out of the rule was guidance on how to address tiered ownership and how to stop owners from gaming the rules by disaggregating their businesses. Moreover, while the proposed rules better defined the population of “specified services” that don’t qualify for the deduction, many business activities remain in limbo, not sure which side of the line they fall. That’s not Treasury’s fault – it’s the concept of a specified services that’s problematic, not the rules that follow. One bit of good news is that Treasury narrowly defined when a business’ “principal asset is the reputation or skill of one or more of its employees.” That language has always been impossible and should be discarded by Congress.
In other good news, the proposed rules clarify that Electing Small Business Trusts get the deduction, just like any other owner of a pass-through business.
Treasury has set a 45-day comment period on the rules and scheduled a public hearing at the IRS on October 16th. S-Corp will be providing detailed comments on the rules and expects to testify on the 16th as well. Getting these rules right is our number one priority for the year. The proposals out of Treasury today are a good start – we will be working with them and the Hill over the next two months to make sure the details are just as good.