How do we get tax law? It’s not just Congress proposing a bill, voting on it, getting the Senate to pass it and the President to sign. That just gets us an Act, describing what will happen in broad strokes. We need to wait for the Treasury Department to give us the Treasury Regulations that tell us the detail of HOW to put the Tax Code into place.
Then there will be still more clarification needed and that’s where Revenue Procedures, Revenue Rulings and Private Letter Rulings are needed. And, of course, there will be times when the IRS and the taxpayer don’t agree and so the issue gets sent to Tax Court. Sometimes it even makes it all the way to the US Supreme Court.
Tax law isn’t simply Congress proposing a bill and it getting passed. That’s just the beginning of the process.
The Treasury Department issued 184 pages of proposed regulations regarding ONE section of the Trump Tax Plan, the Section 199A 20% pass-through income reduction. That’s ONE section of a massive tax plan and the Treasury Dept took 184 pages to lay out how and when you can use it.
I will be covering these regulations in the next set of blogs here at USTaxAid.com. I’ll also be talking about it Wednesday, August 15th at 5 pm during the Coaching session. For more information on coaching, please go to: https://www.ustaxaid.com/coaching-program/
Let’s start with what Section 199A actually is. It’s a deduction of up to 20% of income from a sole proprietorship or through a partnership, S Corporation, trust or estate. It is not available for wage income or for C Corporation income. If the individual taxpayer’s taxable income is over a threshold amount, the amount of the pass-through income reduction may be limited based on the type of trade or business (service or non-service) and the wage limitation.
We knew that.
But we just got an expansion of what’s covered. According to the Regs, Section 199A also allows individuals and some trusts and estates a deduction of up to 20% of their combined qualified real estate investment trust dividends and qualified publicly traded partnership income.
The Act did not define what a trade or business is, the Dept of Treasury and the IRS have agreed to use section 162(a) as the definition of a trade or business, according to the Regulations. There is a problem, however. Although “trade or business” is one of the most widely used terms in the Internal Revenue Code (IRC), neither the Code nor the Treasury Regulations provide a definition. The definition of a “trade or business” comes from common law, where the concepts have been developed and refined by the courts. The Supreme Court has interpreted “trade or business” for purposes of IRC § 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making profit.
There is one additional group that has been added beyond Section 162. This is the rental or licensing of tangible or intangible property related to a trade or business. The Regs further state that if you have similar real estate properties that are held in different entities (for example, separate LLCs for asset protection purposes) that these should be aggregated for calculation of the pass-through reduction. That’s another important change that has come from the Regulations. Change (or clarification) #2, if you’re keeping track.
For businesses that are not passive real estate, though, the income or loss is calculated separately. If you have multiple trades or businesses, you must calculate the qualified business income (QBI) from each activity separately. If one of the businesses has a loss, the amount of the loss will not be impacted by Section 199A. In other words, there is no 20% reduction on losses. The loss will carryover to subsequent years and be used to offset income for that trade or business for purposes of Section 199A. It does not effect your ability to take the loss against income in the current year, however.
If there is a loss from qualified REIT dividends and qualified publicly traded partnership (PTP), it is rolled forward and offset against qualified REIT dividends and qualified PTP in subsequent years. It isn’t netted together with the other income.
This was discussed somewhat in the Act, but the Regulations have clarified it. Let’s call that Change #3, although it’s not completely a new thing. It’s just more clear now.
So far all we’ve done is talk about the definition of the basics of 199A, just 11 pages of 184 pages today. We have a lot more pages to go!
Now, let’s look at what happens if your taxable income is over the taxable income threshold. The threshold is $315K for married, filing jointly and $157.5K for single. Remember the threshold is based on taxable income, not adjusted gross income which is what we usually see.
The first question is whether you have an SSTB, defined as a specified service trade or business. There is a second income threshold, $415K for married, filing jointly and $207.5K for single. Between the two taxable income thresholds ($315K – $415K, married, filing jointly and $157.5K – $207.5, single), the amount may be limited based on the amount of 50% of W-2 wages paid or 25% of W-2 wages paid plus 2.5% of UBIA (unadjusted basis immediately after acquisition).
This part of the calculation is the same as originally discussed in “Taxmageddon 2018: How to Brace for the Trump Tax Plan.” Please see this book for examples of how the basis amount might work in your particular case.
And now we come to Change #4 that is applicable if you are over the taxable income threshold. If you have QBI (qualified business income) that is actually a loss in one business, but your overall QBI has income when added together, then you must follow some additional rules. You must offset the net income with the net loss from each trade or business that produced net loss before you apply the wage limitations.
You must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the limitation based on W-2 wages and UBIA of qualified property, the net gain or income with respect to each trade or business (as offset by the apportioned losses) is the taxpayer’s QBI with respect to that trade or business. The W-2 wages and UBIA of qualified property from the trades or businesses which produced negative QBI are not taken into account and are not carried over into the subsequent year.
One more clarification that’s we’ll call #5, and the final item in today’s blog: basis.
The Section 199A pass-through reduction is applied by individual, not by business such as with a partnership or an S Corporation. The reduction has no effect on the partner’s or shareholder’s basis. That’s change #5.