ABA Staff Analysis : Internal Revenue Code Section 199A Proposed Pass-through Regulations Information Summary

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1 ABA Staff Analysis : Internal Revenue Code Section 199A Proposed Pass-through Regulations Information Summary September 17, 2018 Background On December 22, 2017, President Trump signed comprehensive tax reform legislation. This legislation, known as the Tax Cuts and Jobs Act (TCJA), made significant changes to the taxation of individuals and business activities. Section 199A is a new section of the Internal Revenue Code (IRC) that was added through the TCJA. Section 199A provides that an individual taxpayer generally can deduct 20% of qualified business income from a partnership, S corporation or sole proprietorship. Qualified business income is determined for each qualified trade or business of the taxpayer. A qualified trade or business generally means any trade or business other than a specified service trade or business (SSTB) and other than the trade or business of being an employee. There are 5,670 banks in the U.S. as of December 31, Of that number, approximately 2,000 have elected Subchapter S status under the IRC and of these S banks, approximately 96% have total assets of $1B or less. Accordingly, application of Section 199A is very important to a significant number of banks and their shareholders. ABA, in cooperation with other trade associations, worked with policy makers as the TCJA was being drafted in an attempt to ensure S Bank income would fully qualify for the deduction. Since the statute was enacted late in 2017, there has been a significant amount of questions surrounding the operation of the law generally and to some extent, its applicability to banking. There was significant pressure for the Internal Revenue Service (IRS) and the Department of Treasury (Treasury) to issue guidance on how to apply the new law. ABA, working with ICBA and Subchapter S Bank Association wrote a comment letter, held meetings with congressional staff, Treasury and the Administration. The main focus of our advocacy was to encourage Treasury to issue guidance that would recognize regulated banking as a qualified business, and accordingly, all banking income would qualify for the deduction. ABA believes policy maker intent was income from regulated S banks to generally qualify for the 20% deduction, while income from many individual financial service providers, including hedge funds, would not. On August 8, 2018, proposed regulations relating to Section 199A were issued. The interpretative package is significant (183 pages) and covers a variety of matters. Since these are proposed regulations, there is a 45 day comment period. The comment period ends on October 1, In addition, there is scheduled to be a public hearing on October 16, The main issues related to the proposed regulations concern what kind of income is considered qualified business income and also the implications to S banks of income that could be deemed not qualified. Proposed Regulations 1

2 The proposed regulations contain a variety of definitions and computational details. While different sections of the proposed regulations may apply to shareholders of banks, the principal areas of focus are with respect to the definition of qualified trade or business and its application to banking. To be eligible for the 20% deduction, a shareholder must receive qualified business income. Qualified business income is generated only from a qualified trade or business. Section 199A(d)(1) defines a qualified trade or business as any trade or business other than a SSTB or the trade or business of performing services as an employee. A SSTB is defined in Sections 199A(d)(2)(A) and (B). Section 199A(d)(2)(A) cross references Section 1202(e)(3)(A) and generally provides the businesses enumerated in that section, including financial services, as SSTBs. Financial services are, however, clearly something other than banking, which is a separate business activity listed in Section 1202(e)(3)(B). Accordingly, for the first part of the SSTB test, it is ABA s position that banking is a qualified trade or business. This position was generally confirmed in the preamble to the proposed regulations: h. Financial services Commenters requested guidance as to whether financial services includes banking. These commenters noted that section 1202(e)(3)(A) includes the term financial services, but that banking in separately listed in section 1202(e)(3)(B) which suggests that banking is not included as part of financial services in section 1202(e)(3)(A). The Treasury Department and the IRS agree with such commenters that this suggests that financial services should be more narrowly interpreted here. Therefore, proposed 1.199A-5(b)(2)(ix) limits the definition of financial services to services typically performed by financial advisors and investment bankers and provides that the field of financial services includes the provision of financial services to clients including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings (including in title 11 or similar cases), and raising financial capital by underwriting, or acting as the client s agent in the issuance of securities, and similar services. This includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals, but does not include taking deposits or making loans. The second part of the test for potential SSTB treatment, however, is found in Section 199A(d)(2)(B). This section includes the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. ABA members and other industry participants have identified a variety of activities that, absent clarification, potentially could fall under this second part of the definition. While we continue to believe that policy makers intended for banks to have the deduction for all their activities, there are at least two activities deserving of further analysis. The category and the relevant text from the proposed regulation follow: 2

3 Investing and investment management Proposed Regulation Section 1.199A- 5(b)(2)(xi) (xi) Meaning of the provision of services in investing and investment management. For purposes of section 199A(d)(2) and paragraph (b)(1)(x) of this section only, the performance of services that consist of investing and investment management refers to a trade or business involving the receipt of fees for providing investing, asset management, or investment management services, including providing advice with respect to buying and selling investments. The performance of services of investing and investment management does not include directly managing real property. Dealing in securities, partnership interests, and commodities Proposed Regulation Section 1.199A-5(b)(2)(xiii) (xiii) Meaning of the provision of services in dealing--(a) Dealing in securities. For purposes of section 199A(d)(2) and paragraph (b)(1)(xii) of this section only, the performance of services that consist of dealing in securities (as defined in section 475(c)(2)) means regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. For purposes of the preceding sentence, however, a taxpayer that regularly originates loans in the ordinary course of a trade or business of making loans but engages in no more than negligible sales of the loans is not dealing in securities for purposes of section 199A(d)(2) and this section. See 1.475(c)-1(c)(2) and (4) for the definition of negligible sales. Investment Management and Trust Operations With respect to investing and investment management, as part of their banking activities, many of our members conduct fiduciary or trust activities. Some portion of these activities may fall under the broad definition noted above. For example, some of our members may have trust powers to manage investments that are held in trust accounts and are compensated based on a certain percentage of assets under management. Another example of income in this category may be fees for simply disbursing funds at the direction of a customer from a trust or other entity. In the absence of the recognition of an umbrella set of activities by a bank, it will be necessary to evaluate these and other activities for potential SSTB status and potentially perform required calculations (as discussed below in the de minimis section). Dealing in Securities With respect to dealing in securities, inquiries have been received about another common activity related to banking. Banks originate loans and after origination, there may be circumstances where the loan is wholly or partially sold for a variety of reasons, including credit risk diversification, liquidity, interest rate risk, capital management, etc. These sales all occur in connection with common integrated banking activities. The question is whether these types of transactions would generate SSTB income. A common example is a bank that originates mortgage loans. Depending on the circumstances, the bank may decide to sell the loan to one of the Government Sponsored Entities (GSE s) such 3

4 as Freddie Mac or Fannie Mae and retain the mortgage servicing rights. The bank may record a gain on the sale of the loan; depending on the specific circumstances. While the statute and the proposed regulations refer to Section 475 for definitional purposes, as stated in the proposed regulation above, we believe that purchasing securities from and selling securities to customers in the ordinary course of a trade or business should not include these types of transactions, for it seems incongruous to consider a GSE a customer. These entities are a financing counterparty that, as noted above, provide a critical piece of integrated banking activities. Accordingly, we believe these activities should not be considered a SSTB. De Minimus Rule An additional area for clarification is the operation of the de minimis rule. In order to avoid having minor amounts of SSTB activity impact the classification of an otherwise qualified trade or business that generates qualified business income, the proposed regulations include the following de minimis rule: Proposed Regulation Section 1.199A-5(c)(1) (c) Special rules. (1) De minimis rule.--(i) Gross receipts of $25 million or less. For a trade or business with gross receipts of $25 million dollars or less for the taxable year, a trade or business is not an SSTB if less than 10 percent of the gross receipts of the trade or business are attributable to the performance of services in a field described in paragraph (b) of this section. For purposes of determining whether this 10 percent test is satisfied, the performance of any activity incident to the actual performance of services in the field is considered the performance of services in that field. (ii) Gross receipts of greater than $25 million. For a trade or business with gross receipts of greater than $25 million for the taxable year, the rules of paragraph (c)(1)(i) of this section are applied by substituting 5 percent for 10 percent each place it appears. The uncertainty generated by this section could be illustrated by a hypothetical example. Although it is ABA s position that any activity in a regulated bank generates qualified business income, an IRS agent may have a different interpretation. For example, assume that a community bank has gross interest income of $34 million and non-interest income of $14 million for total gross income of $48 million. Assume further that the bank has income from fiduciary activities of $4 million (roughly 8% of gross receipts) due to its presence in the community. If an IRS agent took the position that there is a single trade or business present in this bank, the de minimis threshold would be around $2 million (5% of $48 million). If the agent further made a determination that all the fiduciary activities of the bank were SSTB, the bank would fail the de minimis test, potentially resulting in none of the bank s income being considered qualified business income. We believe this not to be a reasonable answer, as this relatively minor (roughly 8%) of gross receipts would effectively taint the activities of the bank. This is obviously, a poor, punitive and nonsensical result. Since banks normally keep records of various activities and could, perhaps with some effort, determine the net income from the fiduciary activities, we believe the more logical requirement would be, in the absence of allowing all regulated bank income as qualified business income, to 4

5 calculate and report the alleged SSTB net income separately to the shareholder. While this would reduce the 20% deduction allowable to the shareholder, it appears to be more in line with the overall intent of the statute. Further, this appears to be anticipated in the reporting requirements included in the proposed regulations. ABA Advocacy In meetings with Treasury and other policy makers, as well as in ABA s joint comment letter with ICBA and Subchapter S Bank Association, ABA will reiterate the following: 1. Policy makers intended for banking to be eligible for the 20% deduction. The final regulations should simply and clearly state that. 2. All business activities that are performed in a regulated bank should generate qualified business income. 3. If a simple exemption is not made, additional guidance narrowing the definition of SSTB should be included that does not capture typical banking activities such as trust operations and loan sales. 4. The de minimis thresholds of 5% and 10% are very low and may capture insignificant activities. 5. It should be clarified that, upon failure to meet the de minimis test, other qualified business activities will not be completely tainted and lose all of the 20% deduction. 6. The dealing in securities definition should be clarified with respect to the definition of customer and should not include activities such as sales to GSE s, loan aggregators, etc. Questions? Contact ABA s John Kinsella or Curtis Dubay for more information American Bankers Association, Washington D.C. All rights reserved. This is for use by ABA Member Banks only for their educational and reference purposes. All other use, distribution, reproduction, or public display is strictly prohibited. Please contact BANKERS for order inquiries. 5

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