IRS Issues Pass-Through Deduction Regulations

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The pass-through deduction added by the Tax Cuts and Jobs Act (TCJA), one of highest-profile portions of the act, was outlined in a Tax Alert we issued in April. Partners, S corp shareholders, and sole proprietors may deduct up to 20% of the ordinary income produced by their qualified business income. This week the IRS released long-awaited guidance on the new deduction, explaining many unclear issues. Although in proposed format, taxpayers may rely on the regulations until final rules are issued.

 

Ineligible Businesses

Our alert in April noted that some service industries are not eligible for the pass-through deduction, although this exclusion is eased for lower-income taxpayers. Besides businesses such as law, accounting, and medicine, TCJA says these specified service businesses (SSBs) include companies "where the reputation of an owner or employee is its principal asset." The regulations provide that this language will be treated very narrowly, only coming into play with businesses that endorse products or services, license the use of an individual's image, name or trademark, or receive appearance fees.

 

The regulations allow companies that engage in both ineligible and eligible activities to escape being treated as an SSB when less than 5% of their receipts are attributable to services (less than 10% when receipts don't exceed $25 million).

 

The regulations also limit the ability to use multiple companies to separate a business's eligible and ineligible activities. If at least 80% of a business's property or services is provided to a related (at least 50% common ownership) SSB, the business is treated as part of that SSB. For example, if a dentist owns a building that he rents to his dental practice, the rental business is treated as an SSB. If less than 80% is provided to the related SSB, the income stream is divided. In the example, if the dentist rents less than 80% of his building to his dental practice and the rest to an unrelated party, the rental income attributable to the other tenant gets the pass-through deduction.

 

Wage or Asset-plus-Wage Limitation

The April alert discussed how income eligible for the 20% deduction is reduced when the business doesn't have enough wages and assets (this limitation is eased for lower-income taxpayers). The new rules help define W-2 wages for this limitation. For example, businesses that utilize the services of a professional employer organization (PEO) can use their salary in the wage limitation, even though the W-2s are issued by the PEO.

 

The asset-plus-wage limitation, used by businesses with little or no salaries, was also addressed. The value of an asset for this purpose is the cost of the property on the date the business places it in service. Special basis adjustments such as section 754 elections are not treated as additional assets.

 

Reasonable Compensation and Guaranteed Payments

TCJA mandates that qualified income for the pass-through deduction be reduced by compensation received by owners, such as shareholder wages of S corps and guaranteed payments of partnerships. The regulations clarify that S corps must reduce the qualifying income by an amount equal to reasonable compensation whether or not a reasonable wage is actually paid, but partnership income is only reduced by actual guaranteed payments paid to partners. No rule analogous to S corp reasonable compensation is applied to partnerships.

 

These are just some of the many new rules included in the pass-through regulations issued this week. Contact your LMC professional for information about how specific provisions affect your situation.

 

All of LMC's prior Tax Cuts and Jobs Act Alerts are available for you to view in the Updates page on our website.

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