Section 199A – Big Changes, Important Questions

The 2017 tax legislation has significant implications for all businesses. That’s why KPMG has created this video series, Tax Reform: Big Changes, Important Questions to help you prepare.

Today’s question is, what’s all the buzz about a new 20 percent deduction for some business owners?

Hey, great question! The buzz is all about a new provision in the tax law that benefits some individuals as well as trusts and estates. The provision may allow for a 20 percent deduction against certain kinds of business income resulting in an effective federal tax rate of 29.6 percent on that income.

So, if you’re a sole proprietor or an owner of a passthrough business—like a partnership or an S corporation—you might be able to benefit. Notice we said, “might.” Whether or not you qualify, and to what degree you might benefit is complicated. 

Let’s look at some “if’s.”

The benefit is generally available:

IF the business is not what’s called a “specified service trade or business,” 

AND

IF it meets certain limitations based upon the amount of wages paid to employees and the amount of tangible depreciable property that counts as “qualified property.”

Like we said, complicated—and, until you’ve considered closely how the rules apply to your situation, you may be surprised at how much of a benefit you may or may not get.

The IRS released proposed regulations in August of 2018 and final regulations (along with other guidance) on January 18 of this year.

For 2018 returns, taxpayers can rely on either set of regulations—but they have to pick one or the other. They can’t pick and choose some provisions from the proposed regulations and other provisions from the final regulations. And, after 2018, the final regulations govern.

But, while there is more guidance, uncertainty still exists about certain aspects of the deduction.

Plus, determining the benefit for 2018 may involve gathering more information than in prior years—so understanding how the new rules apply to your business and what the requirements are needs to start now.

Also, keep in mind that the 20 percent deduction is only for federal income tax purposes. It’s not relevant for purposes of self-employment tax or net investment income tax. In addition, most states do not allow this deduction on resident or nonresident personal income tax returns.

And, here’s another important point. Although the benefit is available beginning in 2018, it’s scheduled to expire after 2025—unless Congress extends it. The fact that the benefit is temporary makes planning harder—especially as businesses are also trying to understand other provisions of the 2017 tax law and to wrestle with issues, like whether their current tax entity classification—such as partnership, S corporation, or C corporation—still makes the most sense for them.

So, the benefit is significant, but it’s temporary. The rules are complex, and many hurdles must be cleared.

Want to know more? Watch one of our other videos on 199A for more information or visit KPMG’s tax reform Web page: read.kpmg.us/tax-reform.

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This video is brought to you by KPMG’s Passthroughs Group, which is led by Debbie Fields. Contact Debbie for more information about the taxation of passthrough entities and KPMG’s services at dafields@kpmg.com.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

The 2017 tax legislation has significant implications for all businesses. That’s why KPMG has created this video series, Tax Reform: Big Changes, Important Questions, to help you prepare.

Today’s question is, does my trade or business generate the kind of “good” income that’s required for the new 20 percent deduction for some business owners . . .

Or, does it generate “bad” income that’s not eligible?

It’s not a simple question, so let’s break it down.

Unless the owner of a passthrough business has taxable income below certain thresholds, they’re going to want to know whether their trade or business is “good” or “bad”—that is, whether their income is from a qualified business or a specified service business.

Step one is to figure out if you have a “bad” specified service business. This is a relatively broad category and includes a number of service businesses.

“Bad” Specified Service Businesses

• Health
• Law
• Accounting
• Actuarial science
• Performing arts
• Consulting
• Athletics
• Financial services
• Brokerage services
• Investing and investment management
• Certain trading and dealing.

It may also be any trade or business where the principal asset is the reputation or skill of one or more of the employees or owners.

If you are in a specified service business, then the 20 percent deduction is generally not available for most taxpayers.

So, you can see that distinguishing “bad” specified services businesses from “good” qualified businesses is key—but you may not be done. Confusing as it may sound, certain rules may still treat a “good” qualified business as a “bad” specified service business.

Here are some rules to consider:

If only a de minimis amount of a business (generally 5 percent or 10 percent of gross receipts) is from “bad” activities, that doesn’t taint the good business. But be careful—if the de minimis amount is exceeded, the entire business is a “bad” specified service business. Said differently, if you have a trade or business that generates 80 percent good income and 20 percent bad income—the entire business is treated as a “bad” specified service business. This “cliff effect” has been surprising to some taxpayers.

Adding to the complexity, a “good” qualified business might be tainted by a “bad” specified service business if there’s sufficient common ownership of the two businesses. That is:

• Under the proposed regulations, if there is 50 percent or more common ownership of the businesses AND 80 percent or more of the sales from the “good” qualified business are to the “bad” specified service business, then the “good” business is treated as part of the bad business.
• Under the final regulations, however, if a “good” business provides property or services to a “bad” business with 50 percent or more common ownership, only a portion of the “good” trade or business is treated as a separate “bad” business.

There is also another rule in the proposed regulations that would force an incidental “good” business (generally 5 percent of gross receipts) to be treated as a “bad” business, but this rule is not in the final regulations.

To summarize, to better understand what this deduction might mean to your passthrough business, you’ll likely want to consider the following:

• Do I have one or more trades or businesses?
• Do they generate “good” or “bad” income?
• Will my “good” activity be treated as “bad” activity?
• And, is there any restructuring that can be done to protect the “good” activity?

Figuring this all out may require digging deeper into the relevant rules—which, for 2018 returns, may mean looking at both the proposed and final regulations. Remember, you can apply either the proposed regs or the final regs for your 2018 return—but you have to apply whichever you pick in its entirety. You can’t pick and choose provisions from each set of regs.

Want to know more? Watch one of our other videos on 199A for more information or visit KPMG’s tax reform web page: read.kpmg.us/tax-reform.

_________________

This video is brought to you by KPMG’s Passthroughs Group, which is led by Debbie Fields. Contact Debbie for more information about the taxation of passthrough entities and KPMG’s services at dafields@kpmg.com.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

The 2017 tax legislation has significant implications for all businesses. That’s why KPMG has created this video series, Tax Reform: Big Changes, Important Questions, to help you prepare.

Today’s question is, once you have a qualified trade or business, how much do you benefit from the new deduction for certain business owners?

This seems like a fairly straightforward question, but the answer requires some deeper digging.

Taxpayers will also need to consider two sets of regulations—proposed regulations that were released in August of 2018 and final regulations (along with other guidance) that were just released on January 18 of this year. For their 2018 returns, taxpayers can rely on either set of regulations, but they have to pick one or the other. They cannot pick and choose rules from each set of regulations. After 2018, taxpayers have to use the final regulations.

And, while there is more guidance, uncertainty still exists about certain aspects of the deduction.

So, even if you previously considered how section 199A might apply to your situation, it is a good time to revisit if you are eligible for a section 199A deduction in light of the final regulations.

If you do have a qualified trade or business, the benefit may be 20 percent of the amount of qualified business income.

But, of course, it’s not that simple.                                          

The good news is that both sets of regulations provided some specific answers to some specific questions.

First, with respect to the qualified trade or business, both sets of regulations address whether certain amounts will be considered qualified business income or not.

For instance, ordinary income on the sale of a partnership interest may be qualified business income. However, the list of items excluded from qualified business income is longer and includes:

• Section 1231 gains
• Interest on working capital, and
• Certain payments to partner for capital or services.

And, even if you have qualified business income, limitations for wages and qualified property (certain tangible depreciable property) must be met for each trade or business (subject to specific aggregation rules).

So, you will need to determine the amount of wages and qualified property attributable to a trade or business (and the owner’s share). This will require additional work—particularly the amount of your qualified property, which requires you to determine the unadjusted basis immediately after acquisition of certain property. The work is important as it will determine if there is a cap on your ability to benefit from the 20 percent deduction.

There may be dramatic differences in the determination of an owner’s share of qualified property based upon the proposed and final regulations. So, additional time may be needed for 2018 tax return preparation to compare the various outcomes.

As an important side note—there are special rules with respect to income from certain publicly traded partnerships and real estate investment trusts that generate qualified business income without limitation. It will be important to isolate these numbers for purposes of determining the 20 percent benefit.

Bottom line: It’s complicated. Information will need to be gathered. Determinations made. Benefit quantified. New investor reporting will be required.

Want to know more? Watch one of our other videos on 199A for more information or visit KPMG’s tax reform web page: read.kpmg.us/tax-reform.

_________________

This video is brought to you by KPMG’s Passthroughs Group, which is led by Debbie Fields. Contact Debbie for more information about the taxation of passthrough entities and KPMG’s services at dafields@kpmg.com.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.

The 2017 tax legislation has significant implications for all businesses. That’s why KPMG has created this video series, Tax Reform: Big Changes, Important Questions, to help you prepare.

Today’s question is, given the changes made by the 2017 law, does it make more sense for your business to be a C corporation rather than a passthrough or sole proprietorship for federal tax purposes?

This is a critical question and the answer is complicated. And, even if you’ve done the analysis before, you might want to think some more in light of the final regulations on the new deduction that were just issued on January 18 of this year.

For 2018 returns, taxpayers can rely on either these regulations or the proposed regulations that were issued in August of 2018—but, after 2018, the final regulations govern.

Some owners of passthroughs may benefit a lot from the new deduction for qualified business income, while others may benefit a little or not at all, depending on their particular facts. Under current law, any benefit is only available through 2025. Legislation would need to be enacted to extend the deduction beyond its scheduled expiration.

The 2017 law made permanent a reduction in the general corporate rate—the so-called “C corporation” rate—to 21 percent. This benefit is not scheduled to expire, but there is still a double layer of tax on C corporation earnings.

With this is mind, how do you decide how to proceed?

The answer is very fact specific and requires an understanding of both present and expected future business activity. It also may require thinking about how stable you think the current tax provisions might be. Keep in mind that future legislation could be enacted changing the relevant tax rules.

But, as a starting point, here are some key questions that may influence the conclusion:

• Is any of your trade or business able to benefit from the 20 percent deduction?
• Is there a cost of getting into a C corporation?
• What is the anticipated exit strategy for the business?
• Will cash be retained or distributed by the business?
• Is there a state tax deduction that would be available for a C corporation but not for an individual?
• Is there a state tax difference between being classified as a passthrough and a C corporation?
• Are there any “nontax” drivers to the decision, such as complexity of reporting or investor attractiveness or other drivers?
• Are there any international considerations?

The decision must be made carefully. C corporations can be a “roach motel”—once you get in you may never get out—at least not without paying a significant toll charge.

Want to know more? Watch one of our other videos on 199A for more information or visit KPMG’s tax reform web page: read.kpmg.us/tax-reform.

_________________

This video is brought to you by KPMG’s Passthroughs Group, which is led by Debbie Fields. Contact Debbie for more information about the taxation of passthrough entities and KPMG’s services at dafields@kpmg.com.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation.