Passthrough businesses may be unwilling to take full advantage of newly created tax cuts until the IRS issues guidance to clear up confusion about the law.
The 20 percent deduction for passthrough businesses provided in the Tax Cuts and Jobs Act (P.L. 115-97) was intended to allow those entities to maintain a tax rate comparable to the 21 percent corporate tax rate, but practitioners say questions about whether a taxpayer qualifies for the deduction present a roadblock.
Section 199A provides the deduction for business income, effective for tax years beginning after December 31, 2017, and calendar year taxpayers with passthrough businesses will begin applying it on their 2018 tax returns if they are eligible for the deduction.
“I definitely can see some questions around what may qualify for the section 199A deduction or even how you calculate it,” said James Calzaretta of Deloitte Tax LLP, who added that there are “unanswered questions as with any new legislation.”
Donald B. Susswein of RSM US LLP, in a letter to Treasury Assistant Secretary for Tax Policy David Kautter, urged the government to prioritize guidance to ensure small and middle-market passthrough taxpayers can take advantage of the new law. Section 199A “is a very important tax cut” for individuals making under $300,000 per year, and the government should make applying the new statute as easy as possible for individuals who qualify for the deduction, Susswein told Tax Analysts.
Susswein recommended that the government consider providing guidance in the form of a safe harbor that will allow taxpayers engaged in personal service activities to determine whether they are independent contractors or employees. Providing an example, Susswein suggested that a worker providing over 500 hours of personal services per year, with no single client providing more than 30 percent of revenue, would be presumed to be an independent contractor.
“Who knows if that’s the right number, but the question of whether a taxpayer is in a trade or business is very difficult” and the government should put it to rest, at least temporarily, so individuals can apply section 199A, Susswein said. This would avoid having individuals rush to recharacterize themselves as independent contractors when they’re really employees, he said, adding that improperly raising people’s expectations could create chaos in the marketplace.
The 20 percent deduction in section 199A is available to qualified trades or businesses, which are defined in section 199A(d)(1) as “any trade or business other than a specified service trade or business, or the trade or business of performing services as an employee.” Section 199A(d)(2)(A) defines “specified service trade or business” as the trades or businesses described in section 1202(e)(3)(A).
Those specified services include health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. Section 1202(e)(3)(A) also lists engineering and architecture, but those fields are not included under section 199A(d)(2)(A).
“There could be some ambiguity as to how some of those terms are defined,” Calzaretta said, adding that “people would welcome guidance on how to interpret the specified services listed in section 1202(e)(3)(A), as well as the other specified services listed in section 199A(d)(2)(B).”
Section 199A(d)(2)(B) includes as a specified service trade or business “the performance of services that consist of investing and investment management, trading, or dealing in securities . . . , partnership interests, or commodities.” It is unclear how these terms relate to “financial services” in section 1202(e)(3)(A). The IRS has not issued regulations defining the terms under that subsection.
Skill or Reputation
Susswein’s letter suggests that the government clarify the limitations applicable to businesses whose “principal asset” is the skill or reputation of employees or owners, which is a catchall provision in section 1202(e)(3)(A). The provision includes as a specified service trade or business “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees” or owners.
That raises questions about at what point does someone’s reputation or skill pull them onto the list when they do not fall into one of the specifically enumerated categories.
Eric B. Sloan of Gibson, Dunn & Crutcher LLP said it will be interesting to see how broadly the IRS will interpret "skill or reputation."
Susswein suggested that the government provide early guidance on how it will apply the limitation. His letter recommends several clarifications and examples that could serve as the basis of a safe harbor for relatively simple cases.
According to Sloan, taxpayers will need confirmation that gain on the sale of a partnership interest that is ordinary income under section 751(a) will benefit from the deduction to the same extent that it would if the partnership sold assets and allocated the gain. “It seems pretty clear from the text of the Code, but the specific rule in section 199A(e)(5) for publicly traded partnerships is making people concerned that there is a negative implication,” he said.
Sloan said another issue requiring guidance is whether different trades or businesses operated by a single partnership or S corporation will be required under section 199A to aggregate or disaggregate when the taxpayer receives only one Schedule K-1.
The government may not have a lot of time to issue guidance if it wants taxpayers to receive the benefits of section 199A as early as possible.
Calzaretta explained that estimated tax payments are due in April and taxpayers that are affected by section 199A will have to choose whether to take a position on how section 199A applies or rely on prior year calculations when making estimated payments. Section 6654 generally requires individuals making estimated tax payments to pay 100 percent of the tax shown on the prior year’s tax return, although 110 percent is required for individuals whose adjusted gross income exceeds $150,000 for the prior tax year.
According to Calzaretta, the lower individual rates in the tax reform law and the section 199A deduction mean that individuals may pay too much estimated tax in 2018 if they rely on taxes paid on the 2017 tax return. “It might be that people will try to use safe basis for the first quarter and hope to receive guidance at some point later in the year,” he said.