The Tax Cuts and Jobs Act (“TCJA”) enacted laws that had a significant impact on how pass-through income is taxed. For the past eight months, tax practitioners have been reviewing and interpreting the Internal Revenue Code (“IRC”) associated with the pass-through deduction (Sec. 199A) and awaiting additional guidance. On August 9, 2018, the Internal Revenue Services (“IRS”) issued proposed reliance regulations intended to provide the long-awaited guidance.
In general, Individuals owning a pass-through entity (sole proprietorship, partnerships or S Corporations) may be entitled to a 20% deduction on their individual tax return for income generated from a qualified business (excluding services business). The deduction is limited to the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property (alternative method).
The recent proposed reliance regulations provided the necessary guidance as well as numerous examples related to some of the more ambiguous areas of the code.
For example, the regulations provided clarification on the treatment of wages paid through a third-party payor. Based on the analysis of the IRC issued in December it was not clear whether these types of wages would qualify in computing the threshold amounts stated above. The proposed regulations not only confirm that third-party wages can be used in determining the above threshold, it provides three methods in which a taxpayer can compute W-2 wages.
- Unmodified box method – the lesser of Box 1 of all form W-2’s or Box 5 of all form W-2’s.
- Modified box 1 method – total of Box 1 of all form W-2’s, less amounts in Box 1 that are not subject to federal withholding (e.g. unemployment compensation), plus amounts in Box 12 with a code of D, E, F, G or S.
- Tracking wages method – total amount of income subject to withholding tax, plus amounts in Box 12 with a code of D, E, F, G or S.
Additionally, the regulations clarified the definition of qualified property and confirms that accelerated bonus depreciation does not impact the threshold computation under the alternative method mentioned above.
Lastly, the regulations provide a lengthy description of each of the excluded services that do not qualify for the 20% deduction. The regulation provides examples of some of the services that could mistakenly be included. For example, “health” services is listed as an excluded service (e.g. physician, pharmacists, nurses, etc.), however, the regulation clarifies that health clubs and health spas that provide physical exercise or conditioning to its customers would not fall within the exclusion and therefore qualify for the 20% deduction.
The above is just an example of the additional information that can be found in the proposed regulations. As each business and each situation is unique, additional information would be necessary to determine if you qualify for the 20% deduction on your pass-through income. Clearly, the new regulations are clear that splitting the business off in two in order to qualify is not going to be allowed.