The purpose of this article is not to attempt to explain the complex maze of defined terms, rules, and limits of Section 199A, but rather to present a number of “traps for the unwary” that taxpayers and their advisors need to be aware of, as well as a number of planning techniques that should be considered in order for taxpayers to maximize their ability to avail themselves of the new deduction for “qualified business income” (QBI), as defined in Section 199A(c)(1).
By now, you have probably read many articles about, and listened to many seminars about, the new 20 percent pass-through deduction of Section 199A. Assuming you have, you are likely aware that given the speed with which the 2017 tax act was passed, there are many ambiguities in this statutory provision, and hopefully, we will have many of our questions about the provision answered in the very near future pursuant to the issuance of regulations by the Treasury Department.
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Note that this article does not provide a comprehensive discussion of all potential traps and planning opportunities relating to the new QBI deduction, but simply reflects a limited number of observations that I have made in the months since Section 199A was enacted.
In addition, as mentioned above, until regulations are issued, there are many unanswered questions as to how the new rules will apply, and there is no way to know with any degree of certainty whether the Treasury Department will prohibit or limit some or all of the ideas discussed below. With those qualifiers, let us begin exploring some of the traps and opportunities embedded in Section 199A.
CONVERTING FROM EMPLOYEE TO INDEPENDENT CONTRACTOR
Wages Excluded from QBI
While wages received by an employee do not qualify for the QBI deduction, if the employee can instead provide the same or similar services as an independent contractor (IC) (rather than as an employee), compensation received by the IC can potentially qualify for the QBI deduction.
The divergent treatment of employee wages (typically reported on a Form W-2) vs. IC compensation (typically reported on a Form 1099) certainly creates a further incentive for service providers to classify themselves as ICs instead of employees.
Employee vs. IC Classification
It should be noted, however, that in order for a service provider to be properly classified as an IC, it is not enough to simply replace his or her Form W-2 with a Form 1099. Under the worker classification rules of the Internal Revenue Service (IRS), a service provider is generally considered an IC if the recipient of the services has the right to control or direct only the result of the work, not what will be done and how it will be done.
Businesses need to consider all evidence of the degree of control and independence in the employer/worker relationship. Under applicable IRS guidelines, the focus is on three categories: (1) behavioral control (the right of the business to direct and control the work performed by the worker), (2) financial control (the right of the business to direct or control the financial and business aspects of the worker’s job), and (3) the relationship of the parties (how the worker and business perceive their interaction with one another).
Cost/Benefit Analysis Required
In addition, in making the employee vs. IC decision, qualification for the QBI deduction for ICs needs to be weighed against the many other potential disadvantages of IC status, which include the loss of pre-tax employee benefits (e.g., health insurance, 401K, etc.), as well as the obligation of the IC to pay 100 percent of all self-employment taxes. (Payroll taxes paid with respect to an employee, in contrast, are generally split 50/50 between the employer and the employee.) Finally, while IC status may be appealing from the service provider’s perspective for QBI deduction purposes, the employer may prefer classifying the service provider as an employee in order to maximize its QBI deduction, which, as discussed below, is subject to limits based upon the amount of W-2 wages that are paid by the employer.
SPECIFIED SERVICE BUSINESS ‘SPIN-OFF’ OF QUALIFIED BUSINESSES
SSB Income Excluded from QBI
Under Section 199A(d)(3), income from a “specified service business” (SSB) in excess of certain taxable income thresholds ($207,000 for a single filer, and $415,000 for a married couple filing jointly) (upper thresholds) is completely disqualified from the QBI deduction. (Taxpayers with taxable incomes below the upper thresholds but above certain lower thresholds [$157,500 to for a single filer and $315,000 for a married couple filing jointly] (lower thresholds) can qualify for the QBI deduction even with respect to SSB income, but are subject to a gradual phase-out of the deduction under Section 199A(d)(3).)
Section 199A(d)(2) defines an SSB as a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or where the principal asset of the business is the reputation or skill of one or more of its employees; or which involves the performance of services that consist of investing and investment management, trading; or dealing in securities, partnership interests, or commodities.
`Spin-Off’ of Qualified Businesses
While income from an SSB for taxpayers in excess of the above thresholds is (wholly or partially) disqualified from the QBI deduction, can an SSB “spin off” portions of its business (e.g., its human resources [HR] or information technology [IT] departments) or certain of its assets (e.g., business-owned real estate or intellectual property) to an affiliated entity and thus convert non-QBI into QBI?
Example: Assume that the XYZ law firm (clearly, an SSB) is owned equally by ten partners and is generating annual profits of $10 million. Assume further that (1) XYZ owns (rather than rents) its own premises, (2) the XYZ “name” is a very valuable intangible asset, and (3) XYZ’s HR and IT departments are housed internally. Because each partner’s $1 million share of profit exceeds the applicable threshold, none of the partners will be able to receive any benefit of the QBI deduction.
Assume, however, that (1) XYZ’s partners establish another “brother-sister” entity, (2) XYZ transfers the XYZ name to the other entity, and (3) XYZ pays a fair market royalty for the use of the XYZ name in its legal practice. Assume further that a similar approach is used with respect to XYZ’s real estate, with a fair market rent being paid by XYZ to its affiliated real estate entity for use of the transferred real estate; and XYZ decides to “outsource” its IT and HR departments and it thus moves these departments as well to another affiliated entity, and pays a fair market “cost-plus” fee to its affiliate for these services. Finally, assume that the sum of all rental payments, royalty payments, and HR and IT fees paid by XYZ to its affiliates is $4 million. If (and I emphasize “if”) this structure were to be respected by the IRS, XYZ would have successfully converted $4 million of SSB non-QBI into QBI, resulting in a potential $800,000 deduction (20% of $4 million = $800,000).
While this proposed structure, in the simplified form described above, could of course (and likely would) be challenged by the IRS on “economic substance” and/or “sham transaction” theories, it should be possible to create a structure that would be difficult for the IRS to challenge. One important factor would be significant differentiation of ownership between XYZ and its affiliates. If XYZ and its affiliates have identical or near-identical ownership, it will be difficult to withstand an IRS challenge on economic substance grounds. It would thus be helpful for there to be significant ownership of the affiliates by, ideally, outside investors. If that isn’t feasible, it may be helpful for the affiliates to be owned by spouses and/or children of the partners, or, alternatively, trusts for the benefit of their spouses or children. In addition, given the extra scrutiny that generally applies to related party transactions, ensuring that the amount of rent, royalties, and fees paid by XYZ to its affiliates is consistent with prevailing “market” transactions would also be crucial in being able to withstand IRS challenge. Transfer pricing studies establishing the appropriateness of the amounts paid would be helpful in this regard.
One final word of caution for SSBs considering using the “spin-off” approach: if the pass-through entity that operates the SSB is an S corporation, it would not be possible to “spin off” appreciated assets (e.g., real estate or IP with a value in excess of tax basis) without triggering built-in gain under Section 311(b).
Multiple Lines of Business
What happens if a pass-through entity engages in two distinct businesses, one an SSB, and the other a “qualified trade or business,” as defined in Section 199A(d)(2)? Assume, for example, that in addition to providing medical services to patients, a medical practice also derives substantial revenues from the sale of medical products to patients.
Although the income from providing medical services to patients would clearly be “tainted” as non-QBI SSB income, can the income derived from product sales, which arguably qualifies as QBI, be “separated” from the medical service business income and thus qualify for the QBI deduction?
While the statute does not provide a clear answer, it appears that QBI qualification is determined at the activity level, rather than at the entity level. As such, it should be possible to separately calculate the income from each business, and take the QBI deduction with respect to the qualified business.
The medical practice, however, may not have historically maintained separate “books and records” for its medical services and products sales (as prior to the QBI deduction, there was no need to do so), but in order for this approach to succeed, it would need to do so going forward.
AVOIDING GUARANTEED PAYMENTS
Section 707(c) recognizes two types of “guaranteed payments” in the partnership context, (1) guaranteed payments for services, and (2) guaranteed payments for the use of capital. Each of these types of guaranteed payments presents unique challenges and opportunities with respect to the QBI deduction.
Guaranteed Payments for Services
Before beginning to address the treatment of guaranteed payments for services under Section 199A, a basic understanding of the important role that W-2 wages play in qualifying for the QBI deduction is necessary. Section 199A(b)(2) and Section 199A(b)(3) applies a limit on the use of the QBI deduction for taxpayers with taxable incomes over the upper thresholds, and a phase-in of the limit for taxpayers with taxable income between the lower thresholds and the upper thresholds. Under the limit, the QBI deduction generally cannot exceed the greater of (1) 50 percent of the W-2 wages paid with respect to the business, or (2) 25% of the W-2 wages paid with respect to the business, plus 2.5 percent of the unadjusted basis (i.e., original cost basis) of the business’ “qualified property” (generally, depreciable tangible property). Thus, owners of a business that has invested little in depreciable tangible property will be unable to fully benefit from the QBI deduction to the extent the business pays little or no W-2 wages.
Guaranteed Payments for Services Disfavored
Guaranteed payments for services, which, like wages, are designed to compensate a partner for services rendered to the partnership, are severely disfavored in the QBI deduction context. From the partner/payee perspective, guaranteed payments received for services are explicitly and completely excluded from QBI under Section 199A(c)(4)(B). At the same time, such guaranteed payments, which are not technically classified as W-2 wages, do not “count” for purposes of the limit because the IRS’s position is that compensation paid by a partnership to any of its partners can never be classified as W-2 wages.
While “reasonable compensation” received by the shareholder/employee of a subchapter S corporation is also excluded from QBI, such payments in the S corporation context do at least qualify as W-2 compensation that count for purposes of the limit. In the partnership context, in contrast, guaranteed payments for services help neither the partner/payee (as the payments do not constitute QBI) nor the partnership/payer (as the payments do not count towards the limit) qualify for the QBI deduction.
Convert to Priority Distribution/Allocation
In order to avoid the harsh treatment accorded to guaranteed payments for services, in many situations it should be possible to replace such payments with priority cash flow distributions and priority income allocations. While such an approach may not precisely and absolutely mirror the economic result of a guaranteed payment, it should in many if not most cases achieve a very similar economic result. And even in those cases where the partner is harmed economically by the conversion of the guaranteed payment to a priority cash flow distribution/income allocation, the ability to qualify for the QBI deduction may outweigh any such harm.
Tiered Structure Approach
If, for whatever reason, a priority distribution/allocation approach is not feasible, a tiered ownership structure, which allows for W-2 payments to indirect partners and is described in greater detail below, should be considered. Although the payments will not qualify as QBI to the recipient under this approach, they will at least count as W-2 wages for purposes of the limit with respect to the payer. The tiered ownership structure is best illustrated with an example.
Example: Assume that A, B, and C are equal 1/3 owners of the ABC partnership. Assume further that (1) A and B provide services to ABC, while C does not, and (2) ABC desires to compensate A and B for their services with guaranteed payments. Assume further that the parties do not want to replace the guaranteed payments with priority cash flow distributions and income allocations.
As described above, not only will the guaranteed payments received by A and B not qualify as QBI with respect to A and B, they will also not count towards the limit for ABC, resulting in significant tax inefficiencies.
To avoid this result, A and B could form an upper-tier, 50/50 partnership, AB partnership, and transfer their ABC interests to AB. They would then not be direct partners of ABC, but would rather own their ABC interests through AB. Under this structure, any compensation payments received by A and B from ABC should qualify as W-2 wages and could at least count towards the limit, thus potentially permitting A, B, and C to qualify for the QBI deduction with respect to any QBI passing through to them from ABC.
GUARANTEED PAYMENTS FOR THE USE OF CAPITAL
Guaranteed Payments for Capital May Not Qualify as QBI
Unlike guaranteed payments for services, which are explicitly excluded from QBI, there is no explicit exclusion for guaranteed payments for the use of capital. Section 199A(c)(3)(B)(iii), however, excludes “interest income,” which is not allocable to a trade or business from the QBI definition, and in many cases, guaranteed payments for the use of capital will be disqualified from QBI pursuant to this exception.
Convert to Preferred Return
Fortunately, however, there is a relatively simple way to restructure guaranteed payments for the use of capital in order to qualify them as QBI. To be considered a guaranteed payment for the use of capital (and thus be tainted as non-QBI “interest income” to the recipient), a payment must be determined “without regard to the income of the partnership” (i.e., it must be payable even if the partnership doesn’t have sufficient income). If, however, a guaranteed payment for the use of capital is replaced with a preferred return on such capital, which is dependent on the income/cash flow of the partnership, the income allocation associated with such preferred return would generally not be classified as non-QBI “interest income,” but would be treated as “normal” QBI passing through from the partnership.
While there could in some cases be an economic detriment to the partner receiving a preferred return instead of a guaranteed payment, in many if not most cases, the partner should be able to achieve very similar economic results. In addition, as in the case of guaranteed payments for services, even where the switch from a guaranteed payment to a preferred return causes some detriment to the partner, the ability to qualify for the QBI deduction may outweigh any such detriment.
MULTIPLYING $157,500 PER PERSON THRESHOLD THROUGH TRANSFERS
As discussed above, Section 199A generally prohibits use of the QBI deduction with respect to SSB income, and imposes certain limits based upon a business’s W-2 wages and qualified property basis. Neither of these rules, however, applies to taxpayers with taxable income below the lower thresholds ($157,500 for a single filer, and $315,000 for a married couple filing jointly).
Thus, below the lower thresholds, income from SSBs can qualify as QBI, and businesses need not pay any W-2 wages nor have any qualified property basis in order for their owners to qualify for the QBI deduction.
Threshold Applies to Each Individual
Significantly, the $157,500 per person threshold applies to each and every individual taxpayer. In addition, like the $200,000 threshold for the imposition of the 3.8% net investment income tax under Section 1411, which allows each child to use his or her $200,000 threshold, regardless of his or her age or parents’ income (i.e., there is no “kiddie tax” concept applicable in this context), the $157,500 per person threshold of Section 199A also is available to each child, regardless of age or his or her parents’ income. Thus, gifting of pass-through business interests to children, children-in-law, and grandchildren in situations where the business owner would not otherwise fully qualify for the QBI deduction (because such owner’s income exceeds the applicable thresholds and is either SSB income or subject to the limit) should be considered as a way of increasing the availability of the QBI deduction.
Threshold Applies to Each Trust
Moreover, in contrast to the 3.8 percent net investment income tax, which has a very low threshold in the case of non-grantor trusts, for purposes of the QBI deduction, each and every non-grantor trust that pays federal income tax qualifies for its own $157,500 exemption. Furthermore, in order to take advantage of the $157,500 per trust exemption, it should not be necessary for a business owner to make a taxable gift of pass-through business interests to trusts for the benefit of children and grandchildren, although that certainly can be done. Rather, if business owners prefer not to give away their pass-through business interests, they can still avail themselves of the $157,500 per trust exemption by transferring such interests to one or more “incomplete gift non-grantor trusts” (ING Trusts). While a full discussion of ING Trusts is beyond the scope of this article, suffice it to say that use of such trusts would allow a business owner to take advantage of multiple $157,500 per trust exemptions, but still retain the right to receive all the economic benefits of the property transferred to the ING Trusts.
Section 199A is certainly one of the more complicated provisions added to the Internal Revenue Code by the 2017 tax act, and this article touches on only a very limited number of its complexities. Moreover, until we receive further guidance from the Treasury Department, it is difficult to determine with certainty precisely how and when the new provision will apply.
Nevertheless, Section 199A offers significant tax savings for taxpayers that can qualify to use it in that it has the potential to effectively reduce the highest marginal tax rate from 37% to 29.6%. Tax practitioners must therefore familiarize themselves with the opportunities offered by Section 199A, and hopefully this article has provided readers with at least some helpful planning ideas.