Section 199A Final Regulations Deeper Dive
Posted Mon, April 29, 2019
On January 18, 2019 the IRS and the Treasury Department released the Section 199A final regulations, including some related guidance such as IRS Notice 2019-7 for rental property owners. We apologize upfront that this blog post is delayed since there are some material changes to previous blog posts, but here we are… post-tax season. The Section 199A final regulation summary is over 240 pages. However, given our attention to small business owners and reviewing our current clients’ needs, we truncated this massive Section 199A document into about 70 pages that you can zip through in an hour.
The Tax Cuts and Jobs Act of 2017 created a new tax deduction for business owners (and others) called the Section 199A Qualified Business Income Deduction. Later in August 2018, the IRS released Proposed Regulations 1.199A to offer some additional insight to Section 199A. The Treasury Department and the IRS held a public hearing on the proposed regulations on October 16, 2018 and later issued Section 199A final regulations summaries on January 18, 2019. Some of the major provisions of the 1986 tax code upheaval took over four years to resolve (such as passive activities).
Before we run through some of those finer details, here are some pertinent blog posts and other information that you might find useful.
Ok, here we go-
Trade or Business Defined
This Section 199A deduction for small businesses is great, right?! But what the heck constitutes a business? This seemingly simple issue bogged down accountants, taxpayers and the IRS. On page 12 of final Section 199A summary, it reads “for purposes of section 199A and the regulations thereunder, 1.199A-1(b)(14) defines trade or business as a trade or business under Section 162(section 162 trade or business) other than the trade or business of performing services as an employee.”
Make sense? No, of course not. Stay with us here… the Treasury Department and the IRS also use the phrase “activity rises to the level of a Section 162 trade or business” when determining the binary decision of Yes or No. Understanding this nomenclature helps you choose your words wisely.
Commenters in reference to August 2018’s proposed Section 199A regulations asked for a regulatory definition, a bright-line test, a factor-based test or a safe harbor. Something that can be pointed to on a chart. The Treasury declined to do so and relied on the Higgins and Groetzinger tax court cases to help shape the definition. This is good; while we nerdy accountants want 1 + 1 to equal 2, this squishy definition allows for wiggle room.
In Higgins v. Commissioner, 312 U.S. 212 (1941), the Supreme Court noted that determining whether a trade or business exists is a factual determination. Because there is no statutory or regulatory definition of a Section 162 trade or business, courts have established elements to determine the existence of a trade or business.
- One, in relation to profit motive, is said to require the taxpayer to enter into and carry on the activity with a good faith intention to make a profit or with the belief that a profit can be made from the activity.
- Second, in relation to the scope of the activities and is said to require considerable, regular, and continuous activity.
Along came Commissioner v. Groetzinger, 480 U.S. 23 (1987) where the Supreme Court stated, “[w]e do not overrule or cut back on the Court’s holding in Higgins when we conclude that if one’s gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the statutes with which we are here concerned.” This is re-affirming a 1941 holding in 1987; no narrowing; no re-shaping.
Review those two elements again; fairly straightforward, right? Intend to make a profit, and perform your activities regularly and continuously. Got it… easy!
In terms of rental activities rising to the level of a trade or business, the summary of the Section 199A final regulations read on page 16,
In determining whether a rental real estate activity is a section 162 trade or business, relevant factors might include, but are not limited to (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner’s or the owner’s agents day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).
The operable word is “might.” Read it again… “relevant factors might include…” Might and must are wholly different just like may and shall. Certainly using the relevant factors including the wording as you pitch your “Higgins” argument will bolster your position. Having said this, the IRS released Notice 2017-9 which creates a rental safe harbor; the massive takeaway is this- your rental activities may rise to the level of a trade or business without complying with the IRS Notice per the preamble.
What is also a bit noteworthy is that the Section 199A proposed regulations summary released in August 2018 for rental activities had an example of a landowner who leased unimproved land to an airport for parking lots. People got hung up on the use of land this way, and leaped to the argument that all land rental activities rise to the level of a trade or business. The final regulations for Section 199A removed the land examples and stated that land rental activities might or might not be a trade or business depending on the facts and circumstances. Like Peyton Manning in his SNL UnitedWay skit, “I’m not saying I’ve killed a snitch; I’m not saying I haven’t.”
Treatment of Other Section 199A Deductions
This issue is simple and we’ve discussed in other blog posts, but to reiterate the proposed regulations, the Section 199A final regulations on page 44 read, “Section 1.199A-3(b)(1)(vi) provides that, in general, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of Section 199A and §1.199A-3 are otherwise satisfied.” For example, the following items will reduce qualified business income when computing the Section 199A deduction-
- The deductible portion of self-employment taxes under Section 164(f).
- The self-employed health insurance deduction under Section 162(l).
- The deduction for contributions to qualified retirement plans under Section 404.
Section 199A Reasonable Compensation
When the proposed Section 199A regulations were released in August, the IRS received well over 300 comments. One of the comments concerned itself with the interplay of qualified business income deduction, W-2 wage limitations and S Corp reasonable shareholder salary. Furthermore the concern was that this interplay would cause disparities between different entity structures and elections.
For example, let’s assume a business makes a $100,000 net business income after expenses and deductions. As a garden-variety LLC, the entire $100,000 would be eligible for the Section 199A deduction. However, if the business owner elects S Corp status on the LLC he or she must pay a reasonable salary; let’s assume a shareholder salary of $45,000 which includes the employer’s portion of payroll taxes. Now this same $100,000 is reduced to $55,000 and as such the Section 199A is nearly halved (spoiler alert: the reduction of Section 199A deduction is eclipsed by the savings of self-employment taxes).
The converse problem occurs where a garden-variety LLC makes $500,000 net income after expenses and deductions. Let’s also assume taxable income is $500,000 for the sake of illustration. Since an LLC cannot pay wages to its owner, this $500,000 would not be eligible for the Section 199A deduction because of the W-2 wage limitation. Furthermore, let’s assume this business operates in New York City or Tennessee, and the local S Corp taxation rate kills whatever federal tax savings are in play. In this case, the business owner would be compelled to elect S corporation status and pay wages just to receive a Section 199A deduction.
The Treasury Department and the IRS recognized this issue, but declined to make any changes.
Specified Service Trade or Business (SSTB)
The dreaded specified service trade or business definitions continues to be the bulk of discussion around Section 199A campfires. The proposed regulations released last year expanded the SSTB definition including a dirty baker’s dozen list-
- Actuarial science
- Performing arts
- Financial services
- Brokerage services
- Investing and investment management
- Dealing in securities or commodities
- 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
From our perspective, the biggest news between the Section 199A proposed regs and the Section 199A final regs were in the health, performing arts and consulting. In some ways, these three have similarities in the sense that the Treasury Department and the IRS parsed out non-SSTB activities from SSTB activities. We’ll blast thru these…
The general gist here is that if you sell medical devices and other related equipment you are not a “trade or business performing services in the field of health.” (page 79) There is a subtle difference however with pharmacy; Yes, pharmacists sell stuff… drugs and other “retail” items that are used for administration of health but they are wholly snagged in the health specified service trade or business.
Veterinarians wanted it both ways. “Yes… we’re cool, we’re doctors! But… on this Section 199A deduction, No we are not medical providers… we are simply animal lovers who want to help other animal lovers provide care to their pets.” All kidding aside, veterinarians argued that pets are retail property and are not patients in the truest sense. The Treasury Department and the IRS relied on Revenue Ruling 91-30 from 1991, and other nuggets of code and case law to “to continue the long-standing treatment of veterinary services as the performance of services in the field of health for purposes of section 199A and these final regulations.” (pages 80-81)
Also, some doctors got hung up on the phrase that was in the proposed Section 199A regulations that read in part that the “medical services be provided directly to the patient.” For example, a radiologist might be reading X-rays for another doctor, and not directly providing services to a patient. As such, the phrase “medical services be provided directly to the patient” was removed in the Section 199A final regulations since proximity to a patient is not a necessary component for providing services in the field of health. (page 81)
To reiterate code, “for purposes of section 199A(d)(2) and paragraph (b)(1)(v) of this section only, 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.” What about writers? Good question… hang on for a bit.
The code continues with, “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.” Writers argued that writing does not require a unique skill, which is true if you recall that last bad movie you watched. The Treasury Department and the IRS said No with “to the extent that a writer is paid for written material, such as a song or screenplay, that is integral to the creation of the performing arts, the writer is performing services in the field of performing arts.” (page 84).
Here is an example from page 229-
Gordon Lightfoot, a singer and songwriter, writes and records a song while driving on a highway. Gordon is paid a mechanical royalty when the song is licensed or streamed. Gordon is also paid a performance royalty when the recorded song is played publicly. Gordon is engaged in the performance of services in an SSTB in the field of performing arts within the meaning of section 199A(d)(2) or paragraphs (b)(1)(v) and (b)(2)(vi) of this section. The royalties that Gordon receives for the song are not eligible for a deduction under section 199A.
Consulting had some problems in the proposed Section 199A regulations since it defined consulting as “provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.” Isn’t that every business transaction? You build a custom house; your builder provides advice and counsel to achieve your goals. Usually not good advice or counsel, but provided nonetheless. Your barista at the local coffee shop might even be providing counsel on solving your latte problems.
In response to commenters regarding the proposed regulations, the Treasury Department and the IRS threw their hands up in the air with a “what do want us to do here?” look, and therefore the “provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems” phrase remains. At issue is whether advice or counsel in context of selling goods or services that are not otherwise specified service trades or businesses in themselves is consulting; the answer is No. Your builder and barista are selling goods and services with embedded or ancillary counsel and advice, and as such are not providing services in the field of consulting. (page 86) Think of it this way; the primary purpose of a builder is to provide a home… a tangible deliverable.
Software developers and engineers are in a unique situation. Far too often we see small business owners suggesting they are software consultants when in fact they are software developers and sellers. Here is an example from page 231-
Bill Gates is in the business of licensing software to customers. Bill discusses and evaluates the customer’s software needs with the customer. Bill advises the customer on the particular software products it licenses. Bill is paid a flat price for the software license. After the customer licenses the software, Bill helps to implement the software (in real life, Paul Allen would have). Bill is engaged in the trade or business of licensing software and not engaged in an SSTB in the field of consulting within the meaning of section 199A(d)(2) or paragraphs (b)(1)(vi) and (b)(2)(vii) of this section.
As a quick side bar, some states or regulatory agencies require certain professions to bill separately for consulting services. Those separate billings might be considered an SSTB.
Reputation or Skill
A lot of business owners believe their reputation or skill is the primary factor in their success, and they are probably correct. But that is a literal interpretation of the reputation or skill definition with regards to a specified service trade or business. The Section 199A final regulations summarize the reputation or skill issue fairly well-
If Congressional intent was to exclude all service businesses, Congress clearly could have drafted such a rule. Accordingly, the final regulations retain the proposed rule limiting the meaning of the reputation or skill clause to fact patterns in which an individual or RPE (relevant pass-thru entity) is engaged in the trade or business of receiving income from endorsements, the licensing of an individual’s likeness or features, and appearance fees. (page 98)
Two wonderful examples exist on page 232-
Gordon Ramsay is a well-known chef and the sole owner of multiple restaurants each of which is owned in a disregarded entity. Due to Gordon’s skill and reputation as a chef, Gordon receives an endorsement fee of $500,000 for the use of his name on a line of cooking utensils and cookware. Gordon is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, Gordon is also in the trade or business of receiving endorsement income. Gordon’s trade or business consisting of the receipt of the endorsement fee for Gordon’s skill and/or reputation is an SSTB within the meaning of section 199A(d)(2) or paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.
Demi Moore is a well-known actor. Demi entered into a partnership with Shoe Company, in which Demi contributed her likeness and the use of her name to the partnership in exchange for a 50% interest in the partnership and a guaranteed payment. Demi’s trade or business consisting of the receipt of the partnership interest and the corresponding distributive share with respect to the partnership interest for Demi’s likeness and the use of her name is an SSTB within the meaning of section 199A(d)(2) or paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.
Services or Property Provided to an SSTB
The proposed regulations for Section 199A had a provision where a trade or business that provides more than 80% of its property or services to an SSTB is treated as an SSTB if there is 50% or more common ownership of the trades or businesses. This kills the self-rental income where an accountant, for example, owns the office building and leases it back to the accounting firm. Yuck. This seems silly since if the accounting firm rented from anyone else, the landlord would enjoy a Section 199A deduction. So, why not make an arms-length and fair market rent requirement? We digress…
One takeaway on this is the final regulations for Section 199A remove the 80% binary threshold-
Accordingly, the final regulations provide that if a trade or business provides property or services to an SSTB and there is 50 percent or more common ownership of the trade or business, the portion of the trade or business providing property or services to the 50 percent or more commonly-owned SSTB will be treated as a separate SSTB with respect to related parties. (pages 104-105)
Trade or Business of Performing Services as an Employee
The main problem here is a lot of employees might want to convert to an independent contractor status with their former employer so they can qualify for the Section 199A deduction. For example, you make $100,000 as a W-2 employee. This probably costs your employer around $25,000 in payroll taxes, vacation, sick pay, 401k contributions and other benefits for a total of $125,000. You stroll up to the boss and say “Hey, make me a contractor; you save $25 large and I deduct $20 large, and everyone wins.” This could be abused, right?
But what about the legitimate relationships where an employee retires but is retained as a contractor? Or a company’s risk department and other departments believe it is better to have more independent contractors than employees. Section 199A holds a presumption that if you are performing substantially the same services as a contractor as you were as an employee, you will be considered an employee for the purposes of Section 199A qualified business income deduction.
So, theoretically you could be on the hook for self-employment taxes since that is how one part of the tax code is defining you but also not be eligible for the Section 199A deduction because that part of the tax code reads No. Not cool. Here is a blurb from the final regulations-
The final regulations provide that an individual may rebut the presumption by showing records, such as contracts or partnership agreements, that are sufficient to corroborate the individual’s status as a non-employee for three years from the date a person ceases to treat the individual as an employee for Federal employment taxes.(page 108)
Ok, so read that again… a 3-year look back? How does that get administered? You file a tax return in 2019, you get audited in 2020 based on some silly presumption and you have to wait until you have a 3-year look back to rebut the presumption? What happens when after two years you stop being an independent contractor and get hired as an employee doing something totally different? This has problems as you can see. Most taxpayers will probably make decisions based on the assumption of qualifying.
Here is an example from page 237-
Jack Northrop is an engineer employed as a senior project engineer in an engineering firm, Engineering Firm. Engineering Firm is a partnership for Federal tax purposes and structured such that after 10 years, senior project engineers are considered for partner if certain career milestones are met. After 10 years, Jack meets those career milestones and is admitted as a partner in Engineering Firm. As a partner in Engineering Firm, Jack shares in the net profits of Engineering Firm, and also otherwise satisfies the requirements under Federal tax law, regulations, and principles (including common-law employee classification rules) to be respected as a partner.
Jack is presumed (solely for purposes of section 199A(d)(1)(B) and paragraphs (a)(3) and (d) of this section) to be in the trade or business of performing services as an employee with respect to the services Jack provides to Engineering Firm. However, Jack is able to rebut the presumption by showing that Jack became a partner in Engineering Firm as a career milestone, shares in the overall net profits in Engineering Firm, and otherwise satisfies the requirements under Federal tax law, regulations, and principles (including common-law employee classification rules) to be respected as a partner.
There you have it folks… a deeper dive into the final regulations for Section 199A. More guidance is surely coming and more problems are lurking around the corner. All we can do is brace for impact and hope for the best.
Jason Watson, CPA is the Managing Partner of WCG (formerly Watson CPA Group), a business consultation and tax preparation firm, and is the author of Taxpayer’s Comprehensive Guide on LLC’s and S Corps which is available online.