IRS Proposed Regulations Code Section 199A Deduction Tax Act Background QBI Qualified REIT Dividends Qualified PTP Income SSTB

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1 On Aug. 8, the United States Internal Revenue Service (IRS) and Department of the Treasury released proposed regulations (the Proposed Regulations) on the deduction pursuant to Section 199A of the Internal Revenue Code of 1986, as amended (the Code), for income from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust or estate (the Section 199A Deduction), which was added to the Code as part of the recently enacted tax legislation known as the Tax Cuts and Jobs Act (the Tax Act). The Proposed Regulations generally include rules that provide operational guidance on the meaning of trade or business for determining qualified business income eligible for the Section 199A Deduction, the meaning of specified service trade or business and certain categories of specified service trades or businesses, including an anti-abuse rule addressing the separation of certain businesses from specified service trades or businesses, the aggregation of qualified business income with respect to multiple trades or businesses of a single taxpayer, the calculation of the limitation based on W-2 wages and tangible depreciable assets, the treatment of real estate investment trust (REIT) dividends and publicly traded partnership income, considerations relevant to entities treated as partnerships for tax purposes, the computation of the Section 199A Deduction special rules that certain entities, including trusts and estates, are required to follow for purposes of calculating the Section 199A Deduction of the entity or its owners. Background. Section 199A generally allows non-corporate sole proprietors and owners and shareholders of pass-through entities to take a deduction equal to (i) 20 percent of their domestic qualified business income (QBI); plus (ii) 20 percent of the taxpayer s (A) qualified dividends from real estate investment trusts (Qualified REIT Dividends) (i.e., those that are not capital gains dividends or otherwise constitute qualified dividend income) and (B) allocable share of qualified income from a publicly traded partnership, including gain recognized upon the sale of an interest in such partnership that would otherwise be taxed as ordinary income (Qualified PTP Income). For this purpose, QBI includes items of income, gain, deduction and loss (excluding certain investment type items) with respect to any qualified trade or business of the taxpayer. Income from certain specified service trades or businesses (an SSTB) is generally not entitled to the deduction unless the owner s income is below certain thresholds (subject to phase-out). Once certain income thresholds are met, the Section 199A Deduction for QBI is limited to the lesser of (i) 20 percent of QBI of the qualified trade or business or (ii) the greater of (A) 50 percent of the W-2 wages paid by such business, or (B) 25 percent of the W-2 wages paid by such business plus 2.5 percent of the cost of tangible depreciable assets (Qualified Property) used in such trade or business (the Wages and Property Limitation).

2 Proposed Regulations. The following summary discusses selected issues addressed by the Proposed Regulations that may be of particular interest to taxpayers. Trade or Business for Purposes of Calculating QBI. The Proposed Regulations define trade or business for purposes of calculating QBI as a Section 162 trade or business other than the trade or business of performing services as an employee. The preamble explains that Code Section 162(a), which addresses deductible trade or business expenses, provides the most appropriate definition of a trade or business because the definition under Section 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. Definitions and Operating Rules for SSTBs. The Proposed Regulations include definitions for the SSTB professions that are listed in the Code (health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services) and additional operating rules relating to SSTBs: o Lending Businesses, Banks and Insurers. The trade or business of financial services is included in the statutory list of SSTB professions. Under the Proposed Regulations, the definition of financial services is limited to services typically performed by financial advisers and investment bankers, or the provision of financial services to clients such as wealth management, retirement planning, wealth transition planning, advising regarding valuations, mergers, acquisitions, dispositions or restructurings, and underwriting or acting as agent to issue securities. Notably, because the definition does not include taking deposits or making loans, lending businesses and banks would generally still be entitled to the Section 199A Deduction (subject to meeting the other requirements). In addition, insurers are not included in the definition of financial services or any of the other listed SSTB professions. o Reputation or Skill Exclusion. The Proposed Regulations narrowly interpret the meaning of 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 included in the statutory list of SSTBs. Under the Proposed Regulations, this would include only trades or businesses in which a person (1) receives income for endorsing products or services; (2) licenses or receives income for use of such individual s image, likeness, name, signature, voice, trademark or other symbols associated with such individual s identity; or (3) receives income for appearing at an event or on radio, television or another media format. o De Minimis Exception. The Proposed Regulations provide a de minimis exception under which a trade or business is not an SSTB if the trade or business has gross receipts of

3 $25 million or less (in a taxable year) and less than 10 percent of the gross receipts of the trade or business is attributable to the performance of services in a field that is included in the list of SSTB professions. A trade or business with gross receipts greater than $25 million (in a taxable year) is not an SSTB if less than 5 percent of the gross receipts of such trade or business are attributable to the performance of such SSTB services. o Reporting Obligation For Entities. Entities such as partnerships (other than PTPs), certain trusts and S corporations are required to determine whether they conduct an SSTB and disclose that information to their partners, shareholders or owners. Anti-Abuse Rule Relating to the Separation of Certain Businesses from SSTBs. Under the Proposed Regulations, SSTBs will generally be unable to spin off their non-sstb functions into separate entities to take advantage of the Section 199A Deduction. For example, assume a group of doctors operates a partnership that provides medical services to patients, owns its own clinical building and employs its own administrative staff. The partners might consider dividing the business into three separate partnerships: Partnership One to perform medical services to patients, Partnership Two to own the clinical building and rent the building to Partnership One, and Partnership Three to employ the administrative staff and contract with Partnership One to provide administrative services in exchange for fees. The partners might take the position that only Partnership One is an SSTB. The anti-abuse rule in the Proposed Regulations precludes that position by providing that if there is at least 50 percent common ownership between the two trades or businesses (SSTB and non-sstb), both businesses are SSTBs if the non-sstb provides 80 percent or more of its property or services to the SSTB. If the non-sstb provides less than 80 percent of its property or services to the SSTB, then the portion of the non-sstb s trade or business that provides property or services to the SSTB is treated as a part of the SSTB. Finally, if the non-sstb has shared expenses with the SSTB, then the non-sstb is treated as part of the SSTB if the gross receipts of the non-sstb represent no more than 5 percent of the combined gross receipts of the two trades or businesses. Aggregation Rules. A taxpayer may be engaged in, or own an interest in an entity that is engaged in, multiple trades or businesses. Generally, the Wages and Property Limitation is applied separately with respect to each individual trade or business. However, the Proposed Regulations allow (but do not mandate) the aggregation of multiple trades or business if the taxpayer can demonstrate that: (i) The same person or group of persons (including by family attribution), directly or indirectly, owns 50-percent or more of each trade or business to be aggregated for a majority of the taxable year in which the items attributable to each trade or business to be aggregated are included in income.

4 (ii) All of the items attributable to each trade or business to be aggregated are reported on returns with the same taxable year, not taking into account short taxable years. (iii) None of the trades or businesses to be aggregated is an SSTB. (iv) The trades or businesses to be aggregated satisfy at least two of the following factors (based on all of the facts and circumstances): (A) The trades or businesses provide products and share services that are the same or are customarily offered together. (B) The trades or businesses share facilities or significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources or information technology resources. (C) The trades or businesses are operated in coordination with, or with reliance upon, one or more of the businesses in the aggregated group (e.g., supply chain interdependencies). When allowed, the aggregation of trades or businesses may help taxpayers achieve a higher Wages and Property Limitation than would apply with respect to each separate trade or business. Calculating W-2 Wages for Purposes of the Wages and Assets Limitation. o Third-Party Payors. The Proposed Regulations provide that for purposes of calculating W- 2 wages, 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 under common law principles and the reporting party does not take into account the same W-2 wage amounts for its own Section 199A QBI calculations. o Methods for Calculating W-2 Wages. Notice , which was issued concurrently with the Proposed Regulations, provides three methods for calculating W-2 wages. The three methods are (1) the Unmodified Box Method (e.g., adding up Box 1 amounts in all W-2s issued), (2) the Modified Box 1 Method and (3) the Tracking Wages Method. The Unmodified Box Method provides for a simplified calculation, while the other two methods provide for a more accurate calculation (by accounting for certain nonwage payments subject to income tax withholding such as supplemental unemployment compensation benefits, sick pay and annuity payments as well as certain elective deferrals and employee salary reduction contributions).

5 Separate Calculation of QBI From Qualified REIT Dividends and Qualified PTP Income. The Proposed Regulations clarify that a taxpayer is required to calculate income or loss from QBI, on the one hand, and income or loss from Qualified REIT Dividends and Qualified PTP Income, on the other, separately. A loss from one is not netted against income from the other. Instead, each loss is carried forward and must be used to offset QBI or combined Qualified REIT Dividends and Qualified PTP Income in the succeeding taxable year or years. Subchapter K Considerations/Observations. o Outside Basis Calculations. The Proposed Regulations clarify that because the Section 199A Deduction is applied at the partner level (or shareholder level for S corporations), the deduction has no effect on the adjusted basis of the partner s interest in the partnership (or shareholder s stock in an S corporation or the S corporation s accumulated adjustments account). o Special Basis Adjustments and Qualified Property. The Proposed Regulations clarify that partnership special basis adjustments under Code Sections 734(b) or 743(b) do not constitute separate Qualified Property for purposes of calculating the Wages and Property Limitation. Therefore, if a partner sold an interest in a partnership that held depreciated assets, the new partner would be restricted to using the carryover tax basis attributable to the selling partner to calculate the Wages and Property Limitation applicable to such partner s income from the partnership. o Section 751 Gain. The Proposed Regulations clarify that any gain attributable to assets of a partnership giving rise to ordinary income under Code Section 751(a) or (b) (so-called hot assets) is considered attributable to the trades or businesses conducted by the partnership and, therefore, may constitute QBI. o Guaranteed Payments for Use of Capital. The Proposed Regulations state that guaranteed payments for the use of capital under Code Section 707(c) are not considered attributable to a trade or business and are not taken into account in calculating QBI. However, the partnership s related expense for making the guaranteed payments may reduce QBI if other requirements are satisfied. Non-U.S. Persons Claiming the Section 199A Deduction. The Proposed Regulations clarify that the Section 199A Deduction applies to all noncorporate taxpayers, including nonresident aliens that have QBI (since QBI must be effectively connected with the conduct of a trade or business within the United States ). The Proposed Regulations are generally proposed to apply to taxable years ending after the date that final regulations are published in the Federal Register, with the exception of certain anti-abuse rules

6 (including the rule addressing the separation of certain businesses from SSTBs) that are proposed to apply to taxable years ending after Dec. 22, 2017 the date of enactment of the Tax Act. However, taxpayers may rely on the Proposed Regulations, in their entirety, until final regulations are published in the Federal Register.