Proposed Regulations for 199A – The Good, The Bad, the Taxpayer-Unfriendly
Steve Leimberg’s Income Tax Planning Email Newsletter – Archive Message #152
|From:||Steve Leimberg’s Income Tax Planning Newsletter|
|Subject:||Alan S. Gassman, Martin M. Shenkman, Brandon L. Ketron, Christopher J. Denicolo & Kenneth J. Crotty: Proposed Regulations for 199A – The Good, The Bad, the Taxpayer-Unfriendly|
In the 2017 Tax Cuts and Jobs Act changed much of the Internal Revenue Code, including the addition of a new Section 199A, which provides for a 20% deduction for Qualified Business Income from flow-through entities, including S corporation, partnership, and Schedule C and E income as reported on Form 1040 tax returns (commonly known as sole proprietorships). This applies to income that is “effectively connected” to U.S. trades or businesses, and includes Puerto Rican trades or businesses but does not include any other territories or foreign activities.
The deduction for high wage earners is subject to limitations based on whether the entity engages in certain services (referred to as “Specified Service Trade or Businesses, or SSTBs” in the Proposed Regulations) or based on the amount of wages paid or Qualified Property held by the entity. Generally, once a taxpayer has significant taxable income ($157,500 for single filers and $315,000 for married filers), they must pass a wages or wages/Qualified Property hurdle to avoid a significant decrease, or elimination in their Section 199A deduction.
Proposed Regulations (the “Regulations”) for Section 199A were released on last Wednesday, April 8, 2018 with complex provisions that will take months of study and discussion to understand, and hopefully further clarification and corrections from Treasury. By and large, the Regulations have been viewed as anti-taxpayer and detrimental to many taxpayers and their advisors who, while waiting for further guidance from the IRS, have developed potential planning strategies to take advantage of the Section 199A deduction.
The Regulations do not eliminate all potential Section 199A planning opportunities, however. Despite the proposed limitations on having related entities provide management, billing, marketing, and other services and products to a Specified Service Trade or Business, “Crack and Pack” entities can still provide significant tax savings when held at arm’s-length, and owned by taxpayers who have income under the $157,500 (or $315,000 if married, filing jointly) threshold. For example, a partnership owned 51% by a dentist and 49% by the children of the dentist that receives rent or other arm’s-length payments can have profits that are considered to pass 49% to the children, who may qualify for the Section 199A deduction, based upon their lower tax brackets, as applicable.
Also, the proposed “disrespecting” of separately taxed non-grantor trusts that receive Qualified Business Income seems to be outside of the scope of the authority given to the Treasury under the statute. This “disrespecting” will not affect Section 678 trusts, which are funded by a grantor and considered as owned by a beneficiary or beneficiaries who had or have the opportunity to withdraw the assets placed into trust or the income therefrom. The lower tax brackets of children and other family member can therefore be safely used for Section 199A planning without any risk of aggregation of separate Section 678 trusts.
In addition, the new regulations under Section 643(f) with respect to multiple trusts will not apply if there are completely separate lifetime beneficiaries as demonstrated in 1.643(f)-1(c), Example 2, which is discussed below, so long as the principal reason in establishing the trusts is not tax avoidance.
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