IRS Issues Proposed Regulations on Pass- Through Deduction

Transcription

1 IRS Issues Proposed Regulations on Pass- Through Deduction Proposed Regulations Would Implement Several Anti-Abuse Rules and Provide Computational and Definitional Guidance SUMMARY On August 8, the Internal Revenue Service (the IRS ) and the Treasury Department issued proposed regulations (the Proposed Regulations ) addressing the deduction for owners of pass-through entities engaged in certain trades or businesses created by the recent federal tax reform legislation (the Pass- Through Deduction ). The Proposed Regulations provide guidance on which businesses would be eligible for the Pass-Through Deduction. Notably, the Proposed Regulations would allow a Pass-Through Deduction with respect to a lending business, real estate and insurance brokerage services, and direct management of real property. The Proposed Regulations would also narrowly limit the reputation or skill exception to the Pass- Through Deduction to certain endorsement, licensing, and appearance fees. On the other hand, the Proposed Regulations would exclude not only athletes but also sports team owners and managers from claiming the Pass-Through Deduction. The Proposed Regulations would also provide rules for calculating various components of the limitations on an individual s Pass-Through Deduction. In particular, the Proposed Regulations would (i) allow individuals to elect to aggregate qualified trades or businesses for purposes of applying the wage and property basis limitations and (ii) clarify how to take into account real estate investment trust ( REIT ) dividends, publicly-traded partnership ( PTP ) income, and like-kind exchange property. The Proposed Regulations do not address whether REIT dividends flowing through a regulated investment company would be eligible for the Pass-Through Deduction. New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Brussels Tokyo Hong Kong Beijing Melbourne Sydney

2 The Proposed Regulations contain several anti-abuse rules aimed at commonly discussed strategies for maximizing the Pass-Through Deduction for established trades or businesses. Significantly, the Proposed Regulations would aggregate commonly owned trades or businesses where one of the commonly owned trades or businesses that might otherwise be eligible for the Pass-Through Deduction provides services to another commonly owned trade or business that is not eligible for the Pass-Through Deduction, in effect precluding the crack-and-pack strategy. Similarly, the Proposed Regulations would disregard the division of assets among multiple trusts in order to obtain a Pass-Through Deduction. The Proposed Regulations also would add anti-abuse rules to prevent individuals from claiming the Pass- Through Deduction for certain incidental services and to prevent improper recharacterization of employees as independent contractors or as equity interest holders in partnerships or S corporations. BACKGROUND In December 2017, Congress enacted comprehensive tax reform legislation that, among other changes, created the new Pass-Through Deduction. 1 The Pass-Through Deduction rules allow a federal income tax deduction of up to 20 percent of income received from partnerships, sole proprietorships, S corporations, and other pass-through businesses engaged in certain trades or businesses, thus reducing the highest effective federal income tax rate on pass-through income from 37% to 29.6%. 2 The Pass-Through Deduction also applies to ordinary income dividends from REITs and PTP income. The Pass-Through Deduction may be taken by individuals and by some estates and trusts, but not by corporations, and currently may be taken for taxable years beginning after December 31, 2017 and before January 1, For simplicity, the remainder of this memorandum uses the term individual to refer to a taxpayer who is eligible to claim the Pass-Through Deduction and the term relevant passthrough entity ( RPE ) to refer to a pass-through entity that has an individual as a direct or indirect owner. The amount of the new Pass-Through Deduction varies depending on an individual s total taxable income for the taxable year. Individuals with taxable income up to a statutorily defined threshold amount are entitled to the full 20 percent deduction on income they receive from pass-through businesses, regardless of the nature of the pass-through businesses generating the income. 3 Individuals with taxable income greater than the threshold amount are allowed no deduction from income received from specified services trades or businesses (defined below) and are subject to certain limitations on Pass-Through See S&C publication of December 20, 2017, U.S. Tax Reform, for a description of the key provisions included in the enacted legislation. Unlike corporations, so-called pass-through businesses pass through income to the businesses owners without the businesses paying federal income tax on such income. The full 20 percent deduction is available to single filers with taxable income up to $157,500 and to joint filers with taxable income up to $315,000, in each case adjusted for inflation after See Section 199A(b)(3)(A), (d)(3), and (e)(2). -2-

3 Deductions with respect to other pass-through businesses. 4 The Pass-Through Deduction with respect to REIT dividends and PTP income is not affected by an individual s taxable income. The remainder of this memorandum focuses on the rules applicable to individuals with taxable income in excess of the threshold amount. The Internal Revenue Code (the Code ) applies different limits to an individual s Pass-Through Deduction based on the type of income giving rise to the Pass-Through Deduction. A Pass-Through Deduction is allowed with respect to only (i) qualified business income ( QBI ) and (ii) certain dividends from real estate investment trusts ( qualified REIT dividends ) and certain income from publicly traded partnerships ( qualified PTP income ). 5 An individual s QBI is the individual s adjusted net income that is effectively connected with a U.S. trade or business 6 and that is with respect to any trade or business other than certain personal service trades or businesses ( specified service trades or businesses or SSTBs, singular, SSTB ) or the performance of services as an employee (any trade or business not described in these two exceptions, a qualified trade or business ). QBI does not include certain investment-related income (such as capital gains or losses), reasonable compensation paid to the individual for services rendered, or partnership payments to a partner for services rendered. 7 An individual s Pass-Through Deduction with respect to QBI cannot exceed an amount (the wage and UBIA limit ) equal to the greater of (x) 50 percent of the W-2 wages paid with respect to the qualified trade or business ( W-2 wages ) and (y) the sum of (a) 25 percent of the W-2 wages with respect to the qualified trade or business and (b) 2.5 percent of the unadjusted basis immediately after acquisition ( UBIA ) of certain property held for use in the qualified trade or business (such property, qualified property ). 8 The wage and UBIA limit does not apply to any individual s Pass-Through Deduction with respect to qualified REIT dividends and qualified PTP income Individuals with taxable income in excess of the amounts described in note 3 and up to $207,500 for single filers and $415,000 for joint filers are phased into these limitations. See Section 199A(b)(3)(B). The details of the phase-in rules are not discussed in this memorandum. Qualified REIT dividends are all REIT dividends that are not capital gain dividends or qualified dividend income. Qualified PTP income is the sum of (x) the net amount of an individual s allocable share of qualified items from a PTP and (y) any gain the individual recognizes with respect to hot assets of the PTP. See Section 199A(e)(3) and (4). Items of income, gain, deduction, and loss are includible in QBI only to the extent such items would be treated as effectively connected with a U.S. trade or business if earned by a nonresident alien individual or foreign corporation. See Section 199A(c)(3)(A)(i). See Section 199A(c). See Section 199A(b)(2)(B). -3-

4 Finally, an individual s total Pass-Through Deduction cannot exceed 20 percent of the excess of the individual s taxable income over the individual s net capital gain. 9 This overall limitation prevents an individual from taking a Pass-Through Deduction against income taxed at preferential capital gain rates. 10 DISCUSSION The Proposed Regulations would provide guidance on a wide range of issues with respect to the Pass- Through Deduction rules. This memorandum discusses some of the most important provisions of the Proposed Regulations and highlights the impact on potential strategies for maximizing the Pass-Through Deduction. The Proposed Regulations would: Address which types of trades or businesses are treated as SSTBs and add several anti-abuse rules that would prevent the use of strategies such as crack-and-pack to circumvent the Pass- Through Deduction limitations. For purposes of applying the wage and UBIA limit, provide guidance on determining W-2 wages, qualified property, and UBIA, including for like-kind exchange property. For purposes of applying the wage and UBIA limit, provide guidance on netting QBI across multiple qualified trades or businesses, including an elective aggregation rule. Add anti-abuse rules to prevent improper recharacterization of employees and use of multiple trusts or estates. Provide guidance on exclusions from QBI and allocating QBI items across multiple trades or businesses. Clarify how qualified REIT dividends and qualified PTP income relate to QBI. Clarify the impact of an individual s Pass-Through Deduction on calculations of other tax amounts for the individual. A. SSTB As discussed above, if a trade or business is an SSTB, none of its items are taken into account for calculating an individual s Pass-Through Deduction. The Proposed Regulations would (i) provide guidance on the types of trades or businesses treated as SSTBs, (ii) allow for a de minimis exception to the SSTB rules, (iii) add several anti-abuse rules, and (iv) clarify the effect of treating a trade or business as an SSTB See Section 199A(a)(1). Additional rules apply to the Pass-Through Deduction that an individual may claim with respect to income received from certain agricultural and horticultural cooperatives. See Section 199A(g). The details of those rules are not discussed in this memorandum. Under the Proposed Regulations, whether a trade or business is an SSTB would be determined (x) in the case of a trade or business conducted through an RPE, by the RPE, and (y) in the case of a trade or business conducted by an individual, by the individual. See Prop. Treas. Regs A- 6(b)(3)(B). -4-

5 1. Specified Service Activities The Code defines an SSTB as a trade or business involving the performance of services in any of the following fields (each, a specified service activity ): 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 the employees or owners of the trade or business (the reputation or skill category ). 12 The Proposed Regulations would provide guidance on determining the meaning and scope of each of these specified service activities. The preamble notes that the statutory definition of an SSTB substantially tracks definitions in other sections of the Code, such as the definition for qualified personal service corporations in the context of allowed accounting methods. However, the preamble distinguishes those other sections of the Code as having different scopes, objectives, and, in some respects, language. As a result, for purposes of providing guidance on the definition of an SSTB, the Proposed Regulations would generally follow existing interpretations and guidance under other sections of the Code, but also would include distinct guidance for the Pass-Through Deduction context. Under the Proposed Regulations, similar to prior case law on qualified personal service corporations, state licensing laws would not control whether a trade or business is an SSTB. The preamble notes that commenters requested guidance on what types of activities are included in each type of specified service activity. The Proposed Regulations would define several specified service activities narrowly. Notably, under the Proposed Regulations: 12 See Section 199A(d)(2). The statute defines an SSTB by reference to trades or businesses taken into account for the rules on excluding from gross income gain from a sale or exchange of qualified small business stock, plus the trades or businesses of investing or investment management, trading, and dealing. -5-

6 Financial services would exclude taking deposits or making loans, 13 Brokerage services would exclude services provided by insurance and real estate agents and brokers, 14 and Investing and investment management would exclude directly managing real property. 15 On the other hand, the Proposed Regulations would define athletics broadly to include not only athletes themselves, but also coaches, team managers, and team owners. Thus, a partner in a partnership with the sole business of owning and operating a professional sports team would not be allowed to claim a Pass-Through Deduction for the partner s distributive share of the partnership s income, gain, loss, and deduction. 16 The Proposed Regulations would also narrowly define the reputation or skill category. The preamble describes several standards suggested by commenters for determining whether a trade or business is described within the reputation or skill category, ranging from an activity-based standard to a balance sheet test to a highly skilled services standard. The preamble rejects mechanical tests like those suggested by commenters as posing administrative difficulties, failing to provide taxpayers with needed certainty, and potentially including as SSTBs trades or businesses that Congress intended to be eligible for the Pass-Through Deduction. Instead, the Proposed Regulations would define the reputation or skill category using what the preamble describes as an objective and administrable test. The Proposed Regulations would limit the meaning of the reputation or skill clause to only three narrow categories of trades or businesses: trades or businesses in which the individual or RPE (1) receives income for endorsing products or services, (2) licenses or receives income for the use of any symbol associated with an individual s identity, such as the individual s name, or (3) receives appearance fees or income. For each category, income would include the receipt of a partnership interest or stock of an S corporation and the corresponding income, deduction, gain, or loss received with respect to such interest or stock The preamble, but not the Proposed Regulations, explicitly excludes taking deposits and making loans from financial services. Financial services would include services provided by financial advisors, investment bankers, wealth planners, retirement advisors, and other similar professionals. See Prop. Treas. Regs A-5(b)(2)(ix). See Prop. Treas. Regs A-5(b)(2)(x). Brokerage services would include services provided by stock brokers and other similar professionals. The Proposed Regulations would not provide new guidance on the level of involvement required for real estate activity to constitute a trade or business, an issue that historically has not been very clear. See Prop. Treas. Regs A-5(b)(2)(xi). Investing and investment management would include asset management and providing advice with respect to buying and selling investments. See Prop. Treas. Regs A-5(b)(2)(viii) and (b)(3), Ex. 2. See Prop. Treas. Regs A-5(b)(2)(xiv). -6-

7 2. De Minimis Exception The preamble acknowledges that the Code does not provide a minimum threshold for a specified service activity to cause a trade or business to be treated as an SSTB. However, the preamble notes that requiring a trade or business to be treated as an SSTB as a result of any amount of a specified service activity would create administrative complexity and undue burdens for both taxpayers and the IRS. As a result, the Proposed Regulations would not treat a trade or business as an SSTB if the percentage of the trade or business s gross receipts that are attributable to a specified service activity is less than (i) 10 percent, if the trade or business has gross receipts of $25 million or less for the taxable year, or (ii) 5 percent, if the trade or business has gross receipts exceeding $25 million for the taxable year No Crack-and-Pack Since Congress created the Pass-Through Deduction, some taxpayers have contemplated dividing what otherwise would be an integrated SSTB into multiple separate trades or businesses to allow one of the trades or businesses to qualify for the Pass-Through Deduction, a strategy commonly called crack-andpack. Under the crack-and-pack strategy, for example, a law firm would split into three commonly owned partnerships, one employing the firm s lawyers, another employing the firm s administrative staff, and another owning the firm s office space. The administrative staff partnership would perform administrative services for the lawyers partnership in exchange for a fee. The strategy would thereby shift income from an SSTB ineligible for the Pass-Through Deduction (the lawyers partnership) to separate, qualified trades or businesses (the administrative staff and office space partnerships). The preamble makes clear that the Treasury Department and the IRS are aware of the crack-and-pack strategy and believe such a strategy is inconsistent with the purpose of the Pass-Through Deduction. Accordingly, the Proposed Regulations would include anti-abuse rules to prevent separated trades or businesses from avoiding SSTB treatment. If a trade or business shares at least 50 percent common ownership with an SSTB and provides property or services to the SSTB, then the portion of the trade or business providing property or services to the commonly owned SSTB would be treated as part of the SSTB, except that the SSTB would include the entire trade or business if at least 80 percent of its property or services are provided to an SSTB. The common ownership would be determined by including direct and indirect ownership. 19 Thus, in the example above, the Proposed Regulations would treat the lawyers partnership and the administrative staff and office space partnerships as one SSTB, and none of the income earned by any of the entities would be taken into account for any individual s Pass-Through Deduction See Prop. Treas. Regs A-5(c)(1). See Prop. Treas. Regs A-5(c)(2). The Proposed Regulations would determine common ownership using the deemed ownership rules for related party transactions and controlled partnership transactions. See Prop. Treas. Regs A-5(c)(2)(iii) (referencing Sections 267(b) and 707(b)). -7-

8 4. Incidental Services Under the Proposed Regulations, an SSTB would include any incidental trade or business sharing expenses and at least 50 percent common ownership with the SSTB if the gross receipts of the incidental trade or business represent no more than 5 percent of the total combined gross receipts of the two trades or businesses in a taxable year. 20 For example, a dermatologist providing medical services to patients on a regular basis would have an SSTB of performing services in the field of health. If the dermatologist sells skin care products to patients using the same employees and office space as are used for medical services and the skin care product sales do not exceed 5 percent of the dermatologist s gross receipts, then the sale of the skin care products would be treated as part of the dermatologist s health services SSTB Impact of SSTB Determination As discussed above, if a trade or business is an SSTB, none of its items are taken into account for calculating an individual s Pass-Through Deduction. Accordingly, no income from an SSTB is QBI to any individual, regardless of whether the individual participates in the specified service activity, and no individual is allowed to take into account any W-2 wages or UBIA of qualified property from an SSTB. Furthermore, an individual would not be allowed to aggregate an SSTB with any other trade or business. 22 The Proposed Regulations would not prohibit an individual or an RPE from conducting both SSTBs and qualified trades or businesses, subject to the anti-abuse rules discussed above. Generally, treating a trade or business as an SSTB is unfavorable to an individual. However, in certain situations, treating a trade or business as an SSTB may be beneficial. Under the Proposed Regulations, losses from one trade or business could offset income from another qualified trade or business, either as a result of an aggregation election with respect to the two trades or businesses or as a result of the nonelective netting rules discussed below. However, a loss from an SSTB would not offset QBI from any qualified trade or business. Thus, if a trade or business has an overall loss, treating the trade or business as an SSTB could result in more QBI overall for an individual than if the trade or business were a qualified trade or business. For example, newly acquired sports teams often generate losses for their owners for many years as a result of amortization deductions in excess of operating income. Under the Proposed Regulations, the See Prop. Treas. Regs A-5(c)(3). Although the Proposed Regulations would not explicitly specify how to determine common ownership for purposes of the incidental services rule, presumably the same deemed ownership rules would apply as for the service provider rule discussed above. Under the Proposed Regulations, a trade or business sharing at least 50% common ownership with an SSTB would not be included in the SSTB if (i) such trade or business does not provide any services to the SSTB and (ii) the gross receipts of such trade or business exceed 5 percent of the total combined gross receipts of such trade or business and the SSTB. See Prop. Treas. Regs A-4(b)(1)(iv). -8-

9 sports team would be an SSTB. Thus, a sports team owner who owns other trades or businesses that generate positive income would not be required to offset such positive income with the losses generated by the sports team for purposes of determining the owner s total QBI. B. WAGE AND UBIA LIMIT CALCULATION 1. W-2 Wages The Proposed Regulations would provide guidance on calculating the amount of W-2 wages with respect to each qualified trade or business. The Proposed Regulations would generally follow the rules that were applicable to a domestic manufacturing deduction available under prior law that contained a W-2 wage limitation similar to the Pass-Through Deduction s wage and UBIA limitation Unlike the wage and UBIA limitation, the W-2 wage limitation on the domestic manufacturing deduction was not applied separately for each trade or business. Thus, unlike the domestic manufacturing deduction rules, the Proposed Regulations would require that W-2 wages allocable to more than one trade or business be allocated to each trade or business in the same proportion as the deductions associated with those wages. 24 In addition, the IRS issued a proposed revenue procedure contemporaneously with the Proposed Regulations that would provide for a simplified method for calculating W-2 wages, as well as two other, more complicated (but arguably more accurate) methods for calculating W-2 wages UBIA of Qualified Property a. Qualified Property Consistent with the statute, the Proposed Regulations would define qualified property for a taxable year to be tangible, depreciable property (i) that is held by, and available for use in, a trade or business at the close of the taxable year, (ii) that is used in the production of QBI, and (iii) for which the depreciable period has not ended before the close of the taxable year. Among other guidance, the Proposed Regulations would provide that if a qualified property is added to or improved after being placed in service, the additions or improvements would be treated as separate qualified property placed in service on the date such additions or improvements were placed in service. 26 In addition, the Proposed Regulations would clarify that qualified property does not include elective adjustments to the basis of a partnership s property when the partnership distributes property or when See Prop. Treas. Regs A-2(b). The tax reform legislation that created the Pass-Through Deduction also repealed Section 199, which provided for a deduction with respect to certain domestic production activities that was limited to 50 percent of the W-2 wages of the taxpayer claiming the deduction. See Prop. Treas. Regs A-2(b)(3). See Notice The Notice is effective August 27, 2018, and the revenue procedure is proposed to apply generally to taxable years ending after December 31, See Prop. Treas. Regs A-2(c)(1)(ii).

10 partnership interests are transferred The preamble notes that treating such basis adjustments as qualified property could result in inappropriate duplication of UBIA of qualified property in situations in which the fair market value of qualified property has not increased and its depreciable period has not ended. b. UBIA As discussed above, the limitation on an individual s Pass-Through Deduction may be determined by reference to the unadjusted basis immediately after acquisition of qualified property. The Proposed Regulations would define UBIA of qualified property to be the basis of such property as of the property s placed in service date and as determined under the general basis rules. However, under the Proposed Regulations, UBIA would not be adjusted for (i) any claimed tax credits, (ii) any portion of the basis treated as an expense, or (iii) depreciation, amortization, and depletion with respect to the property. 28 However, UBIA would reflect basis reductions for use of the property in a trade or business other than the qualified trade or business for which UBIA is being determined. 29 In addition, a partnership or S corporation that receives qualified property in a tax-free contribution would determine its UBIA by reference to the adjusted tax basis of the property as of the date of contribution, and not by reference to the transferor s UBIA. 30 c. Like-Kind Exchange Property The Proposed Regulations would provide rules for determining the UBIA for qualified property acquired in a like-kind exchange or an involuntary conversion. Under the Proposed Regulations, the UBIA of the replacement property would be determined as of the date of the like-kind exchange. As a result, the UBIA of the replacement property would be the individual s adjusted basis in the relinquished property carried over to the replacement property, as determined under the like-kind exchange rules, and the UBIA of the replacement property would take into account depreciation already taken on the relinquished property. 31 Moreover, whether and for how long the replacement property is qualified property would be determined by treating the depreciable period of the replacement property as beginning on the date when the relinquished property was first placed in service. 32 The Proposed Regulations would allow an exception to this rule when the individual or RPE has made an election to treat the replacement property as newly That is, basis adjustments under Sections 734(b) and 743(b) are not treated as qualified property. See Prop. Treas. Regs A-2(c)(1)(iii). See Prop. Treas. Regs A-2(c)(3) and (c)(4), Ex. 1. See Prop. Treas. Regs A-2(c)(3) and (c)(4), Ex. 3. See Prop. Treas. Regs A-2(c)(4), Ex. 3. See Prop. Treas. Regs A-2(c)(4), Ex. 2. See Prop. Treas. Regs A-2(c)(2)(iii)(A) and (B), and (c)(4), Ex. 2.

11 placed in service for depreciation purposes. The depreciable period of replacement property subject to such an election would be treated as beginning on the date of the like-kind exchange, thereby extending the time period during which the replacement property could contribute to the individual s wage and UBIA limit. 33 Taxpayers considering making such an election would need to weigh the benefits of extending the replacement property s UBIA credit period against the tax cost of restarting the replacement property s depreciation lifespan. 3. Netting Rules a. Election to Aggregate Trades or Businesses Generally, the wage and UBIA limitations apply separately to each trade or business of an individual or RPE. The Proposed Regulations would permit, but not require, aggregation of separate trades or businesses meeting certain requirements for purposes of applying the wage and UBIA limit. The preamble notes that the Treasury Department and the IRS received comments requesting that, for purposes of the Pass-Through Deduction, individuals be permitted to aggregate trades or businesses using the rules for grouping an individual s trade or business activities and rental activities under the passive activity loss and credit limitation rules (the passive activity grouping rules ). The preamble states that the passive activity grouping rules would not be appropriate in the Pass-Through Deduction context because the passive activity grouping rules (i) focus on activities and a taxpayer s involvement in a trade or business, neither of which concepts is used in determining an individual s Pass-Through Deduction and (ii) do not separate SSTBs from qualified trades or businesses as required for determining an individual s Pass-Through Deduction. Nevertheless, the preamble acknowledges that some aggregation of trades or businesses should be allowed for determining an individual s Pass-Through Deduction, because single trades or businesses may in fact be operated across multiple entities for non-tax reasons and combining those entities could be costly or impermissible under non-tax law requirements. Accordingly, the Proposed Regulations would allow individuals, but not RPEs, to elect to aggregate trades or businesses for purposes of applying the wage and UBIA limit if four requirements are met: 1. The trades or businesses are majority owned, directly or indirectly, by the same person(s) for the majority of the taxable year All of the items attributable to the trades or businesses are reported on returns with the same taxable year (not including short taxable years). 3. None of the trades or businesses is an SSTB See Prop. Treas. Regs A-2(c)(2)(iii)(C). The Proposed Regulations would not require the majority owner(s) to provide information about all of the other pass-through entities in which the majority owner(s) hold a majority interest, but the Treasury Department and the IRS request comments on whether such a requirement or any other information sharing requirement should be implemented. -11-

12 4. The trades or businesses are part of a larger, integrated trade or business, demonstrated by satisfying at least two of the following three factors: The trades or businesses provide products and services that are the same or customarily offered together. The trades or businesses share facilities or significant centralized business elements. The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group. 35 The Proposed Regulations would allow individuals to aggregate trades or businesses operated directly or through RPEs as long as the requirements above are met. In the case of trades or businesses directly operated by an individual, the Proposed Regulations would require the individual to compute QBI, W-2 wages, and UBIA of qualified property for each trade or business before any aggregation The wage and UBIA limit would then be applied with respect to the combined QBI, W-2 wages, and UBIA of qualified property. 37 The Proposed Regulations would not require individual owners of an RPE to aggregate trades or businesses in the same manner, but would require each individual to report aggregation consistently in all taxable years subsequent to the first taxable year of aggregation. An individual would be allowed to add newly created or newly acquired trades or businesses to an existing aggregation, but would be required to reapply the aggregation requirements if any of the aggregation requirements ceased to be met. 38 The preamble explains that the Treasury Department and the IRS decided against allowing RPEs to aggregate trades or businesses in a tiered structure because the reporting requirements would be overly complex to administer. Furthermore, the preamble notes that since the Pass-Through Deduction is always taken at the individual level, aggregation only at the individual level would not be detrimental to the individual and in fact may provide individuals with more flexibility. The Treasury Department and the IRS have requested comments on permitting aggregation by RPEs and the reporting necessary for individuals. b. Netting and Carryover of Negative QBI Amounts Even if an aggregation election is not made or is unavailable, the Proposed Regulations would require netting QBI from different trades or businesses in certain situations. First, if an individual s QBI from at least one trade or business is less than zero (i.e., at least one trade or business generates a loss), the Proposed Regulations would require the negative QBI from that trade or business to offset the QBI from those trades or businesses with positive QBI. However, the W-2 wages and UBIA of qualified property from trades or business with negative QBI would not be taken into account and would not be carried over See Prop. Treas. Regs A-4(b)(1). See Prop. Treas. Regs A-4(b)(2). See Prop. Treas. Regs A-1(d)(2)(ii). See Prop. Treas. Regs A-4(b)(2) and (c).

13 to any subsequent year. 39 Second, if an individual s QBI from all trades or businesses combined is less than zero, the Proposed Regulations would treat the individual as having zero QBI for the taxable year and would require the individual to carry over the negative QBI amount to the next taxable year as negative QBI from a separate trade or business. However, no W-2 wages or UBIA of qualified property would be carried over. Under the Proposed Regulations, the carryover of the negative QBI amount would not affect the deductibility of the loss for any other tax purposes. 40 C. ADDITIONAL ANTI-ABUSE RULES 1. Former Employees As discussed above, a trade or business of providing services as an employee is not a qualified trade or business, and an individual may not claim a Pass-Through Deduction with respect to any income with respect to such trade or business. The preamble observes that taxpayers and practitioners have noted that employees could benefit from the Pass-Through Deduction by treating themselves as independent contractors or as equity interest holders in partnerships or S corporations. Accordingly, the Proposed Regulations would include an anti-abuse rule to prevent employers from improperly recharacterizing employees and to ensure individuals properly substantiate their status. If an employer reclassifies an employee individual as a non-employee for federal employment tax purposes, the Proposed Regulations would nevertheless presume the individual to be performing services as an employee if the individual continues to provide substantially the same services directly or indirectly to the employer (or a related person) that the individual provided while classified as an employee. 41 For example, a partnership employee who quits and becomes an independent contractor providing substantially the same services to the partnership would be presumed still to be an employee of the partnership and would not be able to treat any income received from the partnership as QBI for purposes of the Pass-Through Deduction rules. 42 An individual would be allowed to rebut this presumption by showing the individual is not an employee under federal tax law, regulations, and principles. For example, a partnership employee who becomes a See Prop. Treas. Regs A-1(d)(2)(iii)(A) and (d)(4), Ex. 11. As a result of this netting rule, an individual would generally be able to claim a greater Pass-Through Deduction by electing to aggregate trades or businesses whenever possible. See Prop. Treas. Regs A-1(d)(2)(iii)(B). See Prop. Treas. Regs A-5(d)(3)(i). The preamble notes the Proposed Regulations would not provide any new or different standards for properly classifying an individual as an independent contractor or owner of a business because an individual s prior employment history should not cause the individual to be less likely to be respected as an independent contractor. See Prop. Treas. Regs A-5(d)(3)(ii), Ex

14 partner as a career milestone and subsequently shares in the overall net profits of the partnership could be respected as a partner under the Proposed Regulations Multiple Trusts As discussed above, the Pass-Through Deduction is available to some estates and trusts. Under the Proposed Regulations, the threshold amount for an eligible estate or trust would be determined at the trust level without taking into account any distribution deductions. 44 The preamble states that, as commenters noted, taxpayers could circumvent the threshold amount by dividing assets among multiple trusts, each of which would claim its own threshold amount a result that the preamble states would be inappropriate and inconsistent with the purpose of the Pass-Through Deduction. To prevent such abuse, the Proposed Regulations would not respect any trust formed or funded with a significant purpose of obtaining a Pass-Through Deduction. 45 In addition, for taxable years ending after August 16, 2018, the date the Proposed Regulations were published in the Federal Register, the Proposed Regulations would treat two or more trusts as a single trust if (i) the trusts have substantially the same grantor(s) and substantially the same primary beneficiary or beneficiaries, and (ii) a principal purpose for establishing the trusts or for contributing property to the trusts is the avoidance of federal income tax. 46 The Proposed Regulations would presume a principal purpose of tax avoidance if establishing or funding a trust would result in a significant income tax benefit, unless creating a separate trust was necessary for a significant non-income tax purpose. 47 The Proposed Regulations would not define what it means for trusts to have substantially the same primary beneficiary or beneficiaries. However, the Proposed Regulations include an example aggregating three trusts where all the beneficiaries of the trusts are siblings and several of the siblings are beneficiaries of multiple trusts. 48 D. OTHER RULES RELATING TO QBI 1. Reasonable Compensation Exclusion Limited to S Corporations As discussed above, the Code excludes several items from QBI, including reasonable compensation paid by a qualified trade or business for services rendered by an individual with respect to the trade or business. The Code does not specify whether the reasonable compensation exclusion applies to all or only some contexts See Prop. Treas. Regs A-5(d)(3)(i). See Prop. Treas. Regs A-6(d)(3)(iii). See Prop. Treas. Regs A-6(d)(3)(v). See Prop. Treas. Regs (f)-1(a). See Prop. Treas. Regs (f)-1(b). See Prop. Treas. Regs (f)-1(c), Ex

15 The preamble states that the Treasury Department and the IRS believe the reasonable compensation exclusion is best read as applying only to compensation of S corporation shareholder-employees, for several reasons. First, the preamble notes that the phrase reasonable compensation is a well-known standard in the context of S corporations. Second, the preamble cites the legislative history as confirming the reasonable compensation exclusion was intended to apply to S corporations. Finally, the preamble states that applying the reasonable compensation exclusion more broadly could require a partnership to apply the concept of reasonable compensation to its partners, regardless of whether amounts paid to partners are guaranteed payments. The preamble states such a result would violate the long-standing principle that a partner of a partnership cannot be an employee of that partnership. Accordingly, the Proposed Regulations would exclude from QBI reasonable compensation paid by an S corporation, but would not extend this rule to partnerships, although guaranteed payments for services made by a partnership would also be excluded from QBI. 49 The preamble notes that since QBI does not include any wage income received by an employee, the reasonable compensation exclusion is merely a clarification that S corporation shareholder-employees cannot include in QBI an amount equal to reasonable compensation even if the S corporation fails to pay a reasonable wage to shareholderemployees. 2. Allocation of Items Among Trades or Businesses The Proposed Regulations would provide that if QBI items are properly attributable to more than one trade or business of an individual or RPE, the individual or RPE may use any reasonable method based on all the facts and circumstances to allocate such items among the trades or businesses. The Proposed Regulations would allow an individual or RPE to use different reasonable methods for different items, but the overall combination of methods would be required to also be reasonable based on all facts and circumstances. In addition, the Proposed Regulations would require that the method chosen for each item clearly reflect the income and expenses of each trade or business and be consistently applied from one taxable year to another. 50 E. QUALIFIED REIT DIVIDENDS AND QUALIFIED PTP INCOME 1. Qualified PTP Income Subject to QBI Requirements The Proposed Regulations would clarify that although the wage and UBIA limit does not apply to qualified PTP income, qualified PTP income would still be required to meet the other QBI requirements, such as the requirement that the relevant income be income that would have been treated as income effectively See Prop. Treas. Regs A-3(b)(2)(ii)(H) and (I); see also Prop. Treas. Regs A- 3(b)(1)(ii). However, under the Proposed Regulations, a partnership s related expense for making a guaranteed payment could constitute QBI if the other QBI requirements are satisfied. See Prop. Treas. Regs A-3(b)(2)(ii)(I). See Prop. Treas. Regs A-3(b)(5). -15-

16 connected with a U.S. trade or business if the income had been earned by a nonresident alien individual or foreign corporation. 51 In addition, the Proposed Regulations would require each PTP to determine its qualified PTP income for each trade or business and report to each of the PTP s owners its allocable share of QBI, W-2 wages, and UBIA of qualified property attributable to each trade or business. 52 If an individual owns interests in multiple PTPs, some of which allocate income to the individual and others of which allocate losses to the individual, the amounts are netted, and the netted amount is combined with the individual s qualified REIT dividends, for purposes of determining the individual s Pass-Through Deduction with respect to qualified PTP income and qualified REIT dividends REIT Dividend Stripping Anti-Abuse Rule The preamble expresses concern over individuals engaging in transactions to capture qualified REIT dividends without economic exposure to the corresponding REIT stock for a meaningful period of time. Accordingly, the Proposed Regulations would not allow a Pass-Through Deduction with respect to any dividend received on REIT stock held for fewer than 45 days, taking into account the generally applicable rules that suspend a holding period for dividends on stock that is hedged or part of a straddle transaction Separate Loss Carryforward for Qualified REIT Dividends and Qualified PTP Income For purposes of calculating an individual s Pass-Through Deduction, the Proposed Regulations would implement a separate loss carryforward rule for qualified REIT dividends and qualified PTP income. As discussed above, qualified REIT dividends and qualified PTP income are not included in QBI and are taken into account separately from QBI when calculating an individual s Pass-Through Deduction. Under the Proposed Regulations, if an individual s combined qualified REIT dividends and qualified PTP income is less than zero, that combined loss would not offset any amount of the individual s QBI. Instead, the individual would not be allowed to claim any Pass-Through Deduction with respect to qualified REIT dividends and qualified PTP income for the taxable year of the combined loss. The Proposed Regulations would require the individual to carry forward the combined loss and use the combined loss to offset any positive amount of qualified REIT dividends or qualified PTP income in later years. 55 For example, if in a given taxable year, an individual has a deductible qualified net loss from a PTP of $10,000 and no qualified REIT dividends, the individual would not net the $10,000 loss against QBI but See Prop. Treas. Regs A-3(c)(3)(ii). See id. and Prop. Treas. Regs A-6(b)(3). See Prop. Treas. Regs A-3(c)(1). See Prop. Treas. Regs A-3(c)(2)(B). See Prop. Treas. Regs A-1(d)(3). -16-

17 must carry forward the $10,000 loss to be netted against the individual s qualified REIT dividends and qualified PTP income in the following taxable year. 56 F. IMPACT ON OTHER TAX AMOUNTS The Proposed Regulations would clarify the impact of an individual s Pass-Through Deduction on calculations of other tax amounts for the individual: In the case of a partnership, the Pass-Through Deduction would be applied at the partner level and would have no effect on the adjusted basis of a partner s interest in the partnership. 57 Similarly, in the case of an S corporation, the Pass-Through Deduction would be applied at the shareholder level and would have no effect on either the adjusted basis of the shareholder s stock in the S corporation or the S corporation s accumulated adjustments account. 58 The Pass-Through Deduction would not be taken into account for purposes of calculating either an individual s 3.8% tax on net investment income or an individual s 3.8% FICA tax on net earnings from self-employment. 59 G. EFFECTIVE DATE AND COMMENT PERIOD If finalized, the Proposed Regulations would generally apply to taxable years ending after the date the Proposed Regulations are finalized. Anti-abuse rules in the Proposed Regulations would apply to taxable years ending after either December 22, 2017 (the date the Pass-Through Deduction statute was enacted) or August 16, 2018 (the date the Proposed Regulations were published in the Federal Register). However, the preamble to the Proposed Regulations provides that taxpayers may rely on the Proposed Regulations in their entirety until the Proposed Regulations are finalized. Written comments to the Proposed Regulations must be received by the IRS by October 1, * * * See Prop. Treas. Regs A-1(d)(4), Ex. 4. See Prop. Treas. Regs A-1(e)(1). Id. See Prop. Treas. Regs A-1(e)(2). Copyright Sullivan & Cromwell LLP

18 ABOUT SULLIVAN & CROMWELL LLP Sullivan & Cromwell LLP is a global law firm that advises on major domestic and cross-border M&A, finance, corporate and real estate transactions, significant litigation and corporate investigations, and complex restructuring, regulatory, tax and estate planning matters. Founded in 1879, Sullivan & Cromwell LLP has more than 875 lawyers on four continents, with four offices in the United States, including its headquarters in New York, four offices in Europe, two in Australia and three in Asia. CONTACTING SULLIVAN & CROMWELL LLP This publication is provided by Sullivan & Cromwell LLP as a service to clients and colleagues. The information contained in this publication should not be construed as legal advice. Questions regarding the matters discussed in this publication may be directed to any of our lawyers listed below, or to any other Sullivan & Cromwell LLP lawyer with whom you have consulted in the past on similar matters. If you have not received this publication directly from us, you may obtain a copy of any past or future publications by sending an to SCPublications@sullcrom.com. CONTACTS New York Ronald E. Creamer Jr creamerr@sullcrom.com David P. Hariton haritond@sullcrom.com Jeffrey D. Hochberg hochbergj@sullcrom.com Andrew S. Mason masona@sullcrom.com Andrew P. Solomon solomona@sullcrom.com David C. Spitzer spitzerd@sullcrom.com Davis J. Wang wangd@sullcrom.com S. Eric Wang wangs@sullcrom.com Isaac J. Wheeler wheeleri@sullcrom.com Daniel J. Bleiberg bleibergd@sullcrom.com Michelle H. Lu lum@sullcrom.com London Ronald E. Creamer Jr creamerr@sullcrom.com S. Eric Wang wangs@sullcrom.com -18- SC1: J