The Department of Treasury issued in August proposed regulations (REG-107892-18) (the “Proposed Regulations”) under Section 199A of the Internal Revenue Code, providing individual taxpayers with interests in certain pass-through businesses, such as sole proprietorships, partnerships, LLCs, and S corporations, with a deduction of up to 20% of qualified business income (“QBI”).  This Nelson Mullins Tax Alert summarizes the guidance provided by certain key provisions of the Proposed Regulations, and identifies areas of concern requiring further clarification for taxpayers and their professional advisors.  

Trade or Business Standard

The Section 199A deduction is available only with respect to activities rising to the level of a “trade or business.” As expected, the Proposed Regulations provide that each activity must satisfy the Section 162 trade or business standard, which generally requires an activity to be conducted (i) with “continuity and regularity” and (ii) with the primary purpose of earning income or making a profit.  The Supreme Court articulated the standard in Commissioner v. Groetzinger, 480 U. S. 23 (1987), holding that a professional gambler was engaged in a trade or business.  

Note that while the rental of real estate may or may not meet the Section 162 trade or business standard depending on the facts of each case, the Proposed Regulations provide that  taxpayers who rent or lease tangible or intangible property to a commonly controlled trade or business (“self-rental activity”) are treated as engaged in a Section 162 trade or business.

Qualified Business Income

The definition of qualified business income (“QBI”) is the centerpiece of Section 199A and the Proposed Regulations. To be eligible for the 20% deduction (the “Section 199A deduction”), the income of an individual or relevant passthrough entity (“RPE”) must qualify as QBI.  An RPE is any partnership (other than a PTP, as defined below) or an S corporation that is owned, directly or indirectly, by at least one individual, estate or trust.  The Section 199A deduction reduces the effective tax rate applicable to QBI – a taxpayer in the maximum 37% federal tax bracket would receive an effective rate deduction of 7.4% (20% of 37%), bringing the effective tax rate to 29.6%.

Focus of the Proposed Regulation.  The Commentary to the Proposed Regulations (the “Commentary”) provides that the new regulations are intended to both (i) reduce uncertainty over what constitutes QBI and (ii) discourage the creation of tiered partnerships intended solely to take advantage of the Section 199A deduction (e.g., entity structures in which a lower-tier partnership makes a guaranteed payment to an upper-tier partnership that in turn pays income to the partners with no guarantee).  While more guidance will help, it appears that the Treasury Department and the IRS accomplished their mission on both points.

Level at which QBI is Determined.  Before determining what types of income are included in QBI, one must figure out the level of ownership at which QBI is determined (i.e., at the level of the ultimate beneficial owner, at the level where the business is generated, or some other level of business ownership).  The Proposed Regulation provides that QBI must be determined for each trade or business by the individual or RPE that directly conducts the trade or business.  For example, if two individuals are partners in a partnership and the partnership owns a business, the QBI must be determined for the business at the partnership level, without considering the individual’s other business interests.  The aggregation rules (discussed further below) will be applied after the QBI determination is made at the level of the business.

Allocation of QBI Items.  Prop. Reg. §1.199A-3(b)(5) provides that an individual or an RPE who directly conducts multiple trades or businesses, and has items of QBI which are properly attributable to more than one trade or business, must allocate those items among the several trades or businesses to which they are attributable using a reasonable method based on all the facts and circumstances.  The individual or RPE is permitted to use a different reasonable method for different items of income, gain, deduction, and loss; provided that the chosen reasonable method for each item is consistently applied from one taxable year to another and clearly reflects the income and expenses of each trade or business.  In addition, the overall combination of methods must be reasonable based on all facts and circumstances.

The Treasury Department and the IRS are considering whether “reasonable method” should be defined to include the direct tracing method, a method based on gross income, or other methods, within appropriate parameters.  The Treasury Department and the IRS have requested comments on methods of allocation for items that are not clearly attributable to a single trade or business and whether any safe harbors may be appropriate.

General Definition of QBI.  Prop. Reg. §1.199A-3 provides that QBI includes the net amount of items of income, gain, deduction, and loss with respect to any “trade or business” of the taxpayer to the extent such items are both:

• effectively connected with the conduct of a “trade or business” within the United States (determined by applying the definition of “trade or business” in Section 864(c) and substituting “qualified trade or business, as used in Section 199A, for “nonresident alien individual or a foreign corporation” or for “a foreign corporation” each place it appears), and
• included or allowed in determining taxable income for the taxable year.

The term “qualified trade or business” is defined in Section 199A as “any trade or business other than (i) a specified service trade or business, or (ii) the trade or business of performing services as an employee.” This definition is discussed in more detail below.

Items Taken Into Account.  Prop. Reg. §1.199A-3(b) lays out the specific items of income, gain, deduction and loss taken into account in computing QBI, including the following (some of which repeat the language of Section 199A and other Code Sections):

• Partnership Hot Assets.  Section 751(a) and (b), items of gain or loss attributable to assets of a partnership that give rise to ordinary income are taken into account.  The Commentary points out that this inclusion clarifies concerns raised in taxpayer comments about whether income described in Section 751(a) would not be included in QBI because of the reference in Section 199A to not including such income in QBI with respect to publicly traded partnerships (“PTPs”).  See the discussion of PTPs below.
• Accounting Method Adjustments.  Section 481 adjustments, whether positive or negative, are taken into account to the extent the other QBI requirements are satisfied. However, only adjustments that arise after December 31, 2017 are taken into account.
• Disallowed Losses.  Previously disallowed losses or deductions (including under Sections 465, 469, 704(d), and 1366(d)) allowed in the taxable year are taken into account for purposes of computing QBI; provided that losses or deductions that were disallowed, suspended, limited, or carried over from taxable years ending before January 1, 2018 (including under Sections 465, 469, 704(d), and 1366(d)), are not taken into account in a later taxable year.
• Excess Business Loss NOLs.  Excess Business Loss NOLs are taken into account to the extent they are disallowed under Section 461(l) (the new limitation on excess business losses of non-corporate taxpayers).  The Treasury Department and the IRS have requested comments regarding the interaction of Section 199A and Section 461(l).
• Wages.  Expenses for all wages paid (or incurred by an accrual method taxpayer) regardless of the application of the W-2 wage limitation in Prop. Reg. §1.199A-1(d)(2)(iv) are taken into account.

Items Not Taken Into Account.  Prop. Reg. §1.199A-3(b) also provides specific items not taken into account in computing QBI, including the following (some of which repeat the existing language of Section 199A and others that clarify or add to that language):

• Reasonable Compensation from an S corporation.  Reasonable compensation received by a shareholder from an S corporation is not taken into account.  However, the S corporation's deduction for such reasonable compensation will reduce QBI if such deduction is properly allocable to the relevant trade or business and is otherwise deductible for Federal income tax purposes.  Note that the Treasury Department and the IRS decided not to apply a reasonable compensation standard to non-corporations.  But see the next two points for limitations on certain income of a partnership.
• Guaranteed Payments from a Partnership.  Any guaranteed payment described in Section 707(c) received by a partner for services rendered with respect to the trade or business, regardless of whether the partner is an individual or an RPE is not taken into account.  The Treasury Department and the IRS point out that because such income is determined without regard to the income of the partnership such income is not attributable to a trade or business and, therefore, does not constitute QBI.  As a result, regardless of the number of tiers of partnership and whether the payments are guaranteed payments to the ultimate recipient, the payments are excluded from QBI.  However, the partnership's deduction for such guaranteed payment will reduce QBI if such deduction is properly allocable to the relevant trade or business and is otherwise deductible for Federal income tax purposes.
• Partnership Payments to Partner Not Acting in Capacity as Partner.  Any payment described in Section 707(a) received by a partner for services rendered with respect to the trade or business, regardless of whether the partner is an individual or an RPE is not taken into account.  However, the partnership's deduction for such payment will reduce QBI if such deduction is properly allocable to the relevant trade or business and is otherwise deductible for Federal income tax purposes.  The Treasury Department and the IRS have requested comments on whether there are situations in which it is appropriate to include Section 707(a) payments in QBI.
• NOLs.  A deduction for net operating losses under Section 172 is not taken into account.
• Capital Gain Including Under Section 1231.  The Treasury Department and the IRS reviewed the legislative history of Section 199A and determined that QBI does not include any item taken into account in determining net long-term capital gain and net long-term capital loss.  Therefore, the regulation provides that QBI does not include any item of short-term capital gain, short-term capital loss, long-term capital gain, long-term capital loss, including any item treated as one of such items, such as gains or losses under Section 1231 which are treated as capital gains or losses.
• Dividends.  Income from a dividend, income equivalent to a dividend, or a payment in lieu of dividends, but not including patronage dividends from a cooperative described in Section 1385(a)(1), is not taken into account.
• Certain Interest Income.  Any interest income other than interest income which is properly allocable to a trade or business is not taken into account.  The Treasury Department and the IRS determined that interest income attributable to an investment of working capital, reserves, or similar accounts is not properly allocable to a trade or business and, therefore, is not taken into account in in determining QBI.
• Commodities and Foreign Currency.  Any item of gain or loss described in Section 954(c)(1)(C) (e.g. transactions in commodities) or Section 954(c)(1)(D) (e.g. excess foreign currency gains) (applied in each case by substituting “trade or business” for “controlled foreign corporation”) is not taken into account.
• Notional Principal Contracts.  Any item of income, gain, deduction, or loss taken into account under Section 954(c)(1)(F) (e.g. income from notional principal contracts) (determined without regard to Section 954(c)(1)(F)(ii) and excluding any item attributable to notional principal contracts entered into in transactions qualifying under Section 1221(a)(7)) is not taken into account.
• Certain Annuities.  Any amount received from an annuity which is not received in connection with the trade or business is not taken into account.
• Qualified REIT Dividends.  Any qualified REIT dividends are not taken into account in computing QBI, since qualified REIT dividends separately qualify for the Section 199A deduction.  A qualified REIT dividend means any dividend from a REIT received during a taxable year which (i) is not a capital gain dividend, as defined in Section 857(b)(3), and (ii) is not qualified dividend income, as defined in Section 1(h)(11).  A REIT dividend is not a qualified REIT dividend if the applicable REIT stock is held for fewer than 45 days, taking into account the principles of Section 246(c)(3) and (4).  Because qualified REIT dividends do not qualify for the deduction by virtue of being taken into account as QBI, the deduction is applicable to them without regard to the limitations applicable to QBI.  The same is also true of qualified PTP income (discussed below).
• Qualified PTP Income.  Any qualified PTP income is not taken into account.  Qualified PTP income means the sum of (i) the net amount of such taxpayer's allocable share of income, gain, deduction, and loss from a PTP (as defined in Section 7704(b)) that is not taxed as a corporation under Section 7704(a), plus (ii) any gain or loss attributable to assets of the PTP giving rise to ordinary income under Section 751(a) or (b) that is considered attributable to the trades or businesses conducted by the partnership.  Each PTP is required to determine its qualified PTP income for each trade or business and report that information to its owners.

Operating Rules

The Section 199A deduction for the taxable year is allowed to a taxpayer other than a C corporation to be applied against the lesser of (i) the “combined qualified business income amount” of the taxpayer; or (ii) an amount equal to 20% of the excess (if any) of (A) the taxable income of the taxpayer, over (B) the net capital gain (defined in Section 1(h)) of the taxpayer for the taxable year. Taxable income generally is computed without taking into account the deduction allowable by Section 199A. 

The term “combined qualified business income amount” means an amount equal to – (i) the sum of the “deductible amount for each trade or business” carried on by the taxpayer(discussed below), plus (ii) 20% of the aggregate amount of qualified REIT dividends and qualified publicly traded partnership (“PTP”) income of the taxpayer for the taxable year (“Qualified REIT and PTP income”). 

For taxpayers with income above the Threshold Amounts, defined below, the “deductible amount for each trade or business” for the taxable year is the lesser of (i) 20% of the QBI of such trade or business (“the 20% QBI Limitation”), or (ii) the greater of (A) 50% of the W-2 wages for the qualified trade or business (the “Wage Limitation”) or (B) the sum of 25% of the W-2 wages for the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of qualified property for the taxable year (the “UBIA Limitation” and collectively with the Wage Limitation, the “Wage and UBIA Limitations” and the 20% QBI Limitation and the Wage and UBIA Limitations, collectively, the “Limitations”).  Thus, the Section 199A deduction is generally limited by the amount of W-2 Wages or the UBIA of the qualified property of the qualified trade or business (whichever is greater).  However, these Limitations are phased in at certain levels of income. Accordingly, taxpayers whose taxable income for the taxable year does not exceed $157,500 for single return filers and $315,000 for joint return filers (the “Threshold Amounts”),  generally will not be subject to the Limitations when applying the Section 199A deduction.  The two figures included in the Threshold Amount are adjusted for inflation after 2018 based on cost of living adjustments pursuant to Section 1(f)(3). The following example illustrates the above computations:

• A is engaged in the construction business.  The business generated $750,000 of QBI in 2018.  The business paid wages of $250,000 and UBIA of the qualified property of the QBI was $2,000,000. A’s taxable income for 2018 was $500,000. A reported $50,000 of net capital gain in 2018 and $10,000 of qualified REIT dividends. 
• A ‘s taxable income is above the Threshold Amount, plus $50,000 for a single return filer. 
• The applicable Limitation is the $125,000 Wage and UBIA Limitation.
  
  
  • The QBI Limitation is $150,000 ($750,000 X .2).
  • The Wage and UBIA Limitation is $125,000 (e.g. the greater of 50% of W-2 wages ($125,000 or $250,000 X .5) or the sum of 25% of W-2 wages ($62,500 or $250,000 X .25) and 2.5% of UBIA of qualified property ($50,000 or 2.5% of $2,000,000) ($62,500 + $50,000 = $112,500). 
  • Thus, the applicable Limitation is the Wage and UBIA Limitation of $125,000 (e.g. the lesser of $150,000 or the greater of $125,000 or $112,500). 
• 20% of the construction business’s qualified REIT dividends is $2,000.  The qualified business income amount therefore is $127,000 ($125,000 + $2,000).
• The QBI deduction for A is the lesser of the qualified business income amount of $127,000 or 20% of the excess of taxable income of $500,000 over the net capital gain of $50,000 or $90,000 (($500,000 - $450,000) X .2).  Therefore the QBI deduction for 2018 for A is $90,000.

In contrast, if the taxable income of a taxpayer for any taxable year exceeds the relevant Threshold Amount, but does not exceed the sum of such Threshold Amount plus $50,000 for a single return filer or $100,000 for a joint return filer, and the Wage and UBIA Limitations for any qualified trade or business carried on by the taxpayer is less than the 20% QBI Limitation for such trade or business, then the determination of the deductible amount for each trade or business is calculated with respect to such trade or business without regard to the Wage and UBIA Limitations and by reducing the  20% QBI Limitation by the amount determined by phase-in calculations (the “Phase-In”) below.

In determining the Phase-In, the amount of the reduction is the amount which bears the same ratio to the “excess amount” as (i) the amount by which the taxpayer’s taxable income for the taxable year exceeds the Threshold Amount, bears to (ii) $50,000 for a single return filer and $100,000 for a joint return filer.  The “excess amount” is the excess of the 20% QBI Limitation over the Wage and UBIA Limitations.  The following example illustrates the Phase-In computation:

• B is engaged in grocery business and her husband earned a salary from an unrelated business in the amount of $250,000 in 2018. The business generated $225,000 of QBI in 2018.  The W-2 wages were $75,000. The couple had no capital gains, dividends nor PTP income and their taxable income was $375,000 in 2018. The couple’s taxable income exceeds the Threshold Amount for a joint return filer but not by more than $100,000 (specifically, the couple’s taxable income exceeds the Threshold Amount by $60,000).
• 50% of W-2 Wages of $75,000  (e.g. the Wage and UBIA Limitation, or $37,500) is less than 20% of the QBI of the trade or business (e.g. the 20% QBI Limitation, or $45,000).
• The excess amount of the 20% QBI Limitation over the Wage and UBIA Limitation is $7,500 (e.g. $45,000 minus $37,500). 
• $7,500 multiplied by $60,000 (e.g. the amount by which the taxpayer’s taxable income exceeds the relevant Threshold Amount) /$100,000 is $4,500.  The married couples QBI deduction for 2018 is $45,000 less $4,5000 or $40,500.

For taxpayer whose taxable income for the taxable year exceeds $207,500 for single return filers and $415,000 for joint return filers, the deductible amount for each trade or business is calculated with no adjustment, resulting in both the 20% QBI Limitation and the Wage and UBIA Limitations being used to determine such deductible amount, if any, for the taxpayer.  These two amounts are subject to adjustments for inflation beginning in years after 2018.

If an individual has more than one trade or business, the individual must calculate the QBI from each trade or business and net the amounts before applying the Limitations.  Prop. Reg. §1.199A-1(d)(iii) provides that if an individual has QBI of less than zero from one trade or business, but has overall QBI greater than zero when all of individual’s trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the Limitations. The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses.  Then for purposes of applying the Limitations, the net gain or income with respect to each trade or business (as offset by the apportioned losses) is the taxpayer’s QBI with respect to that trade or business.  The W-2 wages and UBIA of qualified property from the trades or businesses which produced negative QBI are not taken into account for purposes of Prop.  Reg. §1.199A-1(d) and are not carried over into the subsequent year.

In the event the net overall QBI amount is less than zero, Section 199(c)(2) provides that such amount shall be treated as a loss from a qualified trade or business in the succeeding taxable year.  Prop. Reg. §1.199A-1(c)(2)(i) adds that the Section 199A carryover rules do not affect the deductibility of the losses for purposes of other Sections.

Qualified REIT dividends and PTP income are computed and taken into account separately from QBI.  If upon combining the amounts a net loss results, a separate loss carryover rule applies for a net loss with respect to qualified REIT dividends and PTP income.  The overall loss of qualified REIT dividends and PTP income amounts does not affect the amount of a taxpayer’s QBI. Instead, such overall loss is carried forward and must be used to offset combined qualified REIT dividends and PTP income in the succeeding taxable year or years for purposes of Section 199A.

With respect to special rules, Prop. Reg. §1.199A-1(e) provides that, in the case of partnership or an S corporation, Section 199A applies at the partner and shareholder level. The Section 199A deduction has no effect on the adjusted basis of the partner’s interest in the partnership or the adjusted basis of a shareholder’s stock in an S corporation or an S corporation’s accumulated adjustment account. Prop. Reg. §1.199A provides that the Section 199A deduction does not reduce net earnings from self-employment under Section 1402 or net investment income under Section 1411. Section 199A(f)(2) provides that for purposes of determining alternative minimum taxable income under Section 55, QBI shall be determined without regard to adjustments under Sections 55 through 59. Prop. Reg. §1.199A-1(e)(4) provides that, for purposes of determining alternative minimum taxable income, the deduction allowed under Section 199A for a taxable year shall be equal in amount to the deduction allowed under Section 199A(a) in determining taxable income for that taxable year. Therefore, the Section 199A deduction does not result in individuals being subject to alternative minimum tax.

W-2 Wages.  Prop. Reg. §1.199A-2(b)(1) provides that each individual or RPE must determine its total W-2 wages paid for the taxable year, must allocate its W-2 wages between or among one or more trades or businesses and must determine the amount of wages with respect to each trade or business that are allocable to the qualified business income of the trade or business.

For this purpose, Prop. Reg. §1.199A-2(b)(2)(i) provides that employees of the individual or RPE are limited to “employees” (or former employees) of the individual or RPE as defined in Sections 3121(d)(1) and (2). The term “W-2 wages” is defined for each person for each taxable year as the total amount of wages as defined in Section 3401(a) plus the total amount of elective deferrals (within the meaning of Section 402(g)(3)), the compensation deferred under Section 457 and the amount of designated Roth contributions (as defined in Section 402A) 

In determining W-2 wages, Prop. Reg. §1.199A-2(b)(2)(ii) provides that an individual or RPE may take into account any W-2 wages paid by another person on Forms W-2 with the other person listed as the employer on Box c, provided that the W-2 wages were paid to common law employees or officers of such individual or RPA for employment by the individual or RPE. In such cases, the person paying the W-2 wages and reporting the W-2 wages on Form W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person.  Persons that pay and report W-2 wages on behalf of or with respect to others can include certified professional employer organizations under Section 7705, statutory employers under Section 3401(d)(1), and agents under Section 3504.  Accordingly, persons who otherwise qualify for the deduction under Section 199A are not limited in applying the deduction merely because they use a third party payer to pay and report wages for their employees.

But, for individuals who taxpayers assert are their common law employees for purposes of Section 199A, such taxpayers are required to file employment returns and apply the tax law consistently for such common law employees.  Prop. Reg. §1.199A(b)(2)(iii) provides that the term W-2 wages does not include any amount that is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for such return. 

In computing the Section 199A deduction, the W-2 wage limitation apples separately for each trade or business.  Under Prop. Reg. §1.199A-2, in  the case of W-2 Wages that are allocable to more than one business, the portion of the W-2 wages allocable to each business is determined in the same manner as the expenses associated with those wages are allocated among the trades or businesses under Prop. Reg. §1.199A-3(b)(5).  Once W-2 wages for each trade or business have been determined, each individual and RPE must identify the amount of W-2 wages properly allocable to qualified business income for each trade or business. W-2 wages are properly allocable to qualified business income if the associated wage expense is taken into account in computing qualified business income under Prop. Reg. §1.199A-3.  In case of an RPE, the wage expense must be allocated and reported to the partners or shareholders of the RPE as required by the Code, and the RPE must also identify and report the associated W-2 wages to its partners and shareholders pursuant to the rules set forth in Prop. Reg. §1.199A-6.

Prop. Reg. §1.199A-2(b)(iv)(B)(1) provides that, in the case of an acquisition or disposition of a trade or business (or the major portion of a trade or business, or the major portion of a separate unit of a trade or business) that results in more than one individual or entity being an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated based on the period during which the employees of the acquired or disposed of trade or business were employed by the relevant individual or entity, regardless of which permissible method is used for reporting predecessor and successor wages on Form W-2.

UBIA of Qualified Property.  Prop. Reg. §1.199A-2(c)(1)(i) provides that the term “qualified property” means with respect to any trade or business of an individual or RPE for a taxable year, tangible property of a character subject to the allowance of depreciation under Section 167(a) which (i) is held by and available for use in, the trade or business at the close of the taxable year, (ii) is used at any point during the taxable year in the trade or business’s production of QBI, and (iii) the depreciable period for which has not ended before the close of the individual’s or RPE’s taxable year.

Prop. Reg. §1.199A-2(c)(1)(ii) provides, in the case of any addition to, or improvement of, qualified property that has already been placed into service by the individual or RPE, such addition or improvement is treated as separate qualified property first placed into service on the date such addition or improvement is placed in service.  In addition, Prop. Reg. §1.199A-2(c)(1)(iii) provides that basis adjustments under Sections 734(b) and 743(b) are not treated as qualified property.  Several commentators have  questioned whether Section 734(b) and 743(b) should be taken into account as qualified property. On the other hand, however, it could be argued that such adjustments are not relevant except for those partners actually receiving the adjustment and such computations may add a degree of administrative complexity for partnerships.

Prop. Reg. §1.199-2(c)(1)(iv) contains an “anti-abuse rule” which provides that property is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days of acquisition without having been used in a trade or business for at least 45 days prior to disposition.  However, such property may be treated as qualified property if the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the Section 199A deduction.

Prop. Reg. §1.199A-2(c)(2)(i) provides that “depreciable period” means, with respect to qualified property of a trade or business, the period beginning on the date the property was first placed into service by the individual or RPE and ending on the later of: (i) the date that is 10 years after such placement into service, or (ii) the last day of the last full year in the applicable recovery period that would apply to the property under Section 168(c), regardless of any application of Section 168(g).  Prop. Reg. §1.199A-2(c)(2)(ii) provides that any additional first-year depreciation deduction allowable under Section 168 (for example, Section 168(k) bonus depreciation) does not affect the applicable recovery period for the qualified property. 

Prop. Reg. §1.199A-2(c)(2)(iii) provides that qualified property that is acquired in a like kind exchange under Section 1031 or an involuntary conversion under Section 1033 is treated as replacement MACRS property as defined in Reg. §1.168(i)-6(b)(1). For purposes of the depreciable period under Prop. Reg. §1.199A-2(c)(2)(i), the date on which the replacement MACRS property was first placed into service by the individual or RPE is determined as follows:

(1)     the date on which the exchanged basis, as defined in Reg. §1.168(i)-6(b)(7), in the replacement MACRS property was first placed into service by the trade or business is the date on which the relinquished property was first placed into service by the individual or RPE; and

 (2)    the date on which the excess basis, as defined in Reg. §1.168(i)-6(b)(8), in the replacement MACRS property was first placed into service by the trade or business is the date on which the replacement MACRS property was first placed into service by the individual or RPE; and

(3)     if the individual or RPE makes an election under Reg. §1.168(i)-6(i)(1), neither 1 or 2 above would apply and the date the exchanged basis and excess basis in the MACRS replacement property was first placed into service by the trade or business is the date on which the replacement MACRS property was first placed into service by the individual or RPE.

Prop. Reg. §1.199A-2(c)(iv) provides that if an individual or RPE acquires qualified property in a transaction described under Section 168(i)(7)(B) (pertaining to treatment of transferees in certain non-recognition transactions such as provided in Sections 332, 351, 361, 721, and 731), the individual or RPE must determine the date on which the qualified property was first placed into service for purposes of Prop. Reg. §1.199A-2(c)(2)(i) as follows:

(1)     for the portion of the transferee’s unadjusted basis in the qualified property that does not exceed the transferor’s unadjusted basis in such property, the date that such portion was first placed into service by the transferee is the date on which the transferor first placed the qualified property into service; and

(2)     for the portion of the transferee’s unadjusted basis in qualified property that exceeds the transferor’s unadjusted basis in such property, such portion is treated as separate qualified property that the transferee first placed into service on the date of the transfer.

Prop. Reg. §1.199A-2(c)(3) provides that the term “unadjusted basis immediately after acquisition” (UBIA) means the basis on date such property is placed into service as determined under Section 1012 or other applicable sections of Chapter 1, including subchapters O (relating to gain or loss on dispositions of property), C (relating to corporate distributions and adjustments), K (relating to partners and partnerships), and P (relating to capital gains and losses). UBIA is determined without regarding to adjustments described in Sections 1016(a)(2) or (3), to any adjustments for tax credits claimed by the individual or RPE (for example Section 50(c)), or any adjustments for any portion of the basis for which the individual or RPE has elected to treat as an expense (for example, Sections 179, 179B or 179C).  However, UBIA does reflect the reduction in basis for the percentages of the individual’s or RPE’s use of property for the taxable year other than in the trade or business. 

The Treasury Department and IRS believe that Reg. §1.263(a)-3(h)(5) provides a reasonable basis for an administrable rule that is appropriate for purposes of defining “unadjusted basis” for Section 199A. Likewise, they believe that “immediately after acquisition” means as of the date the property was placed in service because Section 199A provides that “qualified property” must be used in the production of QBI.  In order to be used in the production of QBI, the qualified property necessarily must be placed into service. For purchased or produced qualified property, UBIA generally is its cost under Section 1012 as of the date the property is placed into service.  For qualified property contributed to a partnership in a Section 721 transaction and immediately placed into service, UBIA generally will be its basis under Section 723.  For qualified property contributed to an S corporation in a Section 351 transaction and immediately placed in service, UBIA generally will be its basis under Section 362.

These rules effectively prevent a taxpayer from looking back to the original cost of property before it is contributed to and placed into service by an S corporation or partnership, limiting the UBIA to the adjusted basis on the date of the contribution. This prevents “stuffing” property with a historically high basis in an S corporation or partnership for the purpose of increasing the UBIA of the S corporation or partnership.

Further, for property inherited from a decedent and immediately placed into service by the heir, the UBIA generally will be its fair market value at the time of the decedent’s death under Section 1014. However, Prop. Reg. §1.199A-2(c)(3) provides that UBIA does reflect the reduction in basis for the percentage of the taxpayer’s use of property for the taxable year other than in the taxpayer’s trade or business. 

Prop. Reg. §1.199A-2(a)(3) provides that the determination of the unadjusted basis immediately after acquisition of qualified property must be made for each trade or business by the individual or RPE that directly conducts the trade or business before applying the aggregation rules of Prop. Reg. §1.199A-4. In the case of qualified property held by a RPE, each partner’s or shareholder’s share of UBIA of qualified property is an amount that bears the same proportion to the total UBIA of qualified property as the partner’s or shareholder’s share of tax depreciation bears to the RPE’s total tax depreciation with respect to the property for the year. Comments have been made that computations of tax depreciation on a property by property basis may prove difficult. However, because Reg. §1.704-1(b) provides support for such special allocations, it could be argued that this would not be difficult. In the case of qualified property held by a partnership that does not produce tax depreciation during the year, each partner’s share of the UBIA of qualified property is based on how gain would be allocated to the partners pursuant to Sections 704(b) and 704(c) if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property in accordance with Prop. Reg. §1.199A-2(a)(3).  Such procedure may be burdensome as the partnership would have to value each item of fully depreciated property annually and provide test allocations both with and without the hypothetical gain.

Prop. Reg. §1.199A-2(a)(3) provides that in the case of qualified property held by an S corporation that does not produce tax depreciation during the year, each shareholder’s share of UBIA of qualified property is a share of the unadjusted basis proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.  Prop. Reg. §1.199A-2(a)(3) provides that the UBIA of qualified property is presumed to be zero if not determined and reported by each trade or business. 

Aggregation Rules

The Proposed Regulations allow taxpayers to aggregate businesses for purposes of calculating the deduction under Section 199A if certain requirements are met.  The Treasury Department and the IRS received comments proposing that the regulations permit taxpayers to aggregate trades or businesses using the grouping rules found in the passive loss regulations under Section 469.  The Proposed Regulations reject these comments for several reasons but primarily because the grouping rules under Section 469 apply to activities, whereas, Section 199A applies to trades or businesses.  The Treasury Department and the IRS expressed some concern that such distinction may result in under-inclusion or over-inclusion in determining what activities constitute a trade or business for purposes of Section 199A.  In light of concerns raised in some of the comments to the Proposed Regulations, the Treasury Department and the IRS have requested additional comments on the aggregation rules provided in the Proposed Regulations, including whether the approach taken therein would be an appropriate approach for grouping or aggregating under Sections 469 and 1411.

Prop Reg. §1.199A-4(a) provides that if certain requirements are met, taxpayers may elect to combine their trades or businesses solely for the purpose of applying the Wage and UBIA Limitation when calculating their Section 199A deduction.  Thus, the aggregation rules will be of no significance to a taxpayer whose taxable income does not exceed the Threshold Amount because such individual will not be subject to the Wage and UBIA Limitation.  For those taxpayers who are subject to the Wage and UBIA Limitation, the aggregation rules provide such taxpayers with an opportunity to maximize their Section 199A deduction.  For example, suppose a taxpayer operates two separate trades or businesses that are eligible to be combined under the aggregation rules under Section 199A.  One business has significant QBI but pays very little in W-2 wages and has very little depreciable property.  Whereas, the other business does not have significant QBI but pays significant amounts of W-2 wages and has significant amounts of depreciable property.  Without the ability to aggregate, each business would generate a very small, if any, Section 199A deduction for the taxpayer.  The aggregation rules under the Proposed Regulations would allow the taxpayer to combine the two businesses and take advantage of the positive elements provided by both for purposes of calculating the Section 199A deduction.

Aggregation is permitted but not required and is done at the level of the taxpayer taking the Section 199A deduction.  Under Prop. Reg. §1.199A-4(b)(1), a taxpayer must satisfy six requirements in order to be eligible to elect to aggregate trades or businesses for purposes of Section 199A.  First, each trade or business to be aggregated must independently qualify as a trade or business for purposes of Section 199A.  Second, the same person, or group of persons, must directly or indirectly, own a majority interest (50% or more) in each of the trades or businesses to be aggregated.  Because the Proposed Regulations look to a group of persons, non-majority owners may benefit from the common ownership and aggregate.  For purposes of applying this ownership rule, Prop. Reg. §1.199A-4(b)(3) provides that family attribution rules apply and each taxpayer is deemed to own the interest in a trade or business owned, directly or indirectly, by or for the taxpayer’s spouse (other than a spouse who is legally separated from the taxpayer under a decree of divorce or separate maintenance) and the taxpayer’s children, grandchildren and parents.  The reference to “indirect” ownership also implies that double attribution may be applicable under these rules, although, again, the Proposed Regulations are not clear.  Third, such ownership must exist for the majority of the taxable year in which the items attributable to each trade or business are included in income.  Fourth, all of the items attributable to the trades or businesses to be aggregated must be reported on income tax returns with the same taxable year except to the extent one or more of the trades or businesses is subject to a short tax year.  Fifth, none of the trades or businesses to be aggregated can be an SSTB.  Sixth, the trades or businesses to be aggregated must meet at least two of the following three factors:  (i) the trades or businesses provide products and services that are the same or they provide products and services that are customarily provided together, (ii) the trades or businesses share facilities or significant centralized business elements or (iii) the trades or businesses are operated in coordination with, or reliance on, other businesses in the group to be aggregated.

Taxpayers may aggregate trades or businesses operated directly and trades or businesses operated through RPEs to the extent of the taxpayer’s share of the QBI, W-2 wages and UBIA of qualified property from such RPE.  The owners of a RPE are not required to aggregate in the same manner.  A taxpayer directly engaged in a trade or business must compute QBI, W-2 wages and UBIA of qualified property for each trade or business separately before applying the aggregation rules.  RPEs are required to compute QBI, W-2 wages and UBIA of qualified property for each trade or business, to identify if any of its trades or businesses are SSTBs and to provide such information to its owners.  RPEs must identify and report this information not only for trades or businesses operated directly by the RPE but also for any QBI, W-2 wages, UBIA of qualified property or SSTB determinations reported to it by any RPE in which the reporting RPE owns a direct or indirect interest.  The Treasury Department and the IRS have requested comments on the proposed approach to tiered structures and the reporting necessary to allow taxpayers to calculate the Section 199A deduction.

Taxpayers are not required to aggregate all of the their trades or businesses that are eligible to be aggregated.  Also, a taxpayer may have more than one group of aggregated trades or businesses even where all such trades or businesses could be aggregated together into a single group.  For example, if individual A has five trades or businesses that can potentially be aggregated together, individual A may elect to aggregate trades or businesses 1 through 3 together as one group and may elect to aggregate trades or businesses 4 and 5 together as another group.  This flexibility may prove helpful as there may be circumstances where it will be more taxpayer advantageous to aggregate certain trades or businesses together in a manner described in the foregoing example.  The election to aggregate is not revocable.  Once a taxpayer elects to aggregate multiple trades or businesses into a single aggregated trade or business, the taxpayer must consistently report the aggregated group in subsequent tax years.  Once an election to aggregate has been made, a taxpayer may add a newly started or newly acquired trade or business (including an acquisition in the form of a non-recognition transaction) to the existing group of aggregated trades or businesses assuming such new trade or business qualifies to be aggregated.  If there are changes in years subsequent to the election that causes one or more of the aggregated trades or businesses to cease to qualify for aggregation, then such trades or businesses will cease to be part of the aggregated group and the taxpayer must reapply the aggregation rules to determine a new permissible aggregation, if any. 

Prop. Reg. §1.199A-4(c)(2) provides that for each taxable year, taxpayers that have elected to aggregate trades or businesses under Section 199A must attach a statement to their income tax returns identifying each trade or business that is part of the aggregated trade or business and certain information with regard to such trade or business.  If a taxpayer fails to attach the required aggregation statement disclosure, the IRS may disaggregate the aggregated trades or businesses.

Definition of Specified Service Trade or Business

QBI does not include income earned from a specified service trade or business (“SSTB”).  Thus, income earned by an individual or RPE from an SSTB will not be eligible for the Section 199A deduction.

In General.  The Commentary notes that the definition of a SSTB set forth in Section 199A incorporates, with modifications, the text of certain other sections of the Code.  Consistent with ordinary rules of statutory construction, the guidance in the Proposed Regulations is consistent with  existing interpretations and guidance under Sections 1202 and 448 of the Code when relevant.  However, existing guidance under those sections is sparse and the scope and purpose of those sections and Section 199A are different.  The Commentary notes that, unlike Sections 1202(e)(3)(A) and 448, the purpose of Section 199A is to provide a deduction based on the character of the taxpayer’s trade or business. 

Guidance on the Meaning of the Listed SSTB Activities.  Section 199A(d)(2)(A) provides that an SSTB is any trade or business described in Section 1202(e)(3)(A) (applied without regard to the words “engineering [and] architecture”) or any trade or business that would be so described in Section 1202(e)(3)(A) if the term “employees or owners” were substituted for “employees.”  In addition, Section 199A(d)(2)(B) provides that an SSTB is any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in Section 475(c)(2)), partnership interests, or commodities (as defined in Section 475(e)(2)).

After application of the modifications described in Section 199A(d)(2)(A), the definition of an SSTB for purposes of Section 199A is as follows:

(1)     any 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 (the “Listed SSTBs”), or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners, and

(2)     any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in Section 475(c)(2)), partnership interests, or commodities (as defined in Section 475(e)(2)).

Prop. Reg. §1.199A-5(c) provides a de minimis rule, under which a trade or business is not an SSTB if less than 10% of the gross receipts (5% if the gross receipts are greater than $25 million) of the trade or business are attributable to the performance of services in a specified service activity. 

The Commentary notes that Section 199A is a new Code provision intended to benefit a wide range of businesses, and taxpayers need certainty in determining whether their trade or business generates income that is eligible for the Section 199A deduction. The Proposed Regulations provide guidance on the definition of an SSTB based on the “plain meaning of the statute, past interpretations of substantially similar language in other Code provisions, and other indicia of legislative intent.”

Listed SSTBs.  Notably, the Proposed Regulations, contrary to many comments, do not adopt a bright-line “licensing” rule for purposes of determining whether a trade or business is a Listed SSTB for purposes of Section 199A.  The following is a summary of the guidance provided in the Proposed Regulations with respect to the primary Listed SSTB activities.

• Health.  Prop. Reg. §1.199A-5(b)(2)(ii) is informed by the definition of “health” under Section 448 and provides that the term “performance of services in the field of health” means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.  The performance of services in the field of health does not include the provision of services that are not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient.  For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.  The Proposed Regulations leave open the question of whether an ambulatory surgical center, dialysis center, or lithotripsy center operated in a separate entity where the entity is compensated for the patient’s use of the center through so-called “facility or technical” fees, and professional services provided by physicians and other health care professionals are billed separately.
• Law.  Prop. Reg. §1.199A-5(b)(2)(iii) is based on the ordinary meaning of “services in the field of law” and provides that the term “performance of services in the field of law” means the provision of services by lawyers, paralegals, legal arbitrators, mediators, and  similar professionals in their capacity as such.  The performance of services in the field of law does not include the provision of services that do not require skills unique to the field of law.  For example, the provision of services in the field of law does not include the provision of services by printers, delivery services, or stenography services.
• Accounting.  Prop. Reg. §1.199A-5(b)(2)(iv) is based on the ordinary meaning of “accounting” and provides that the term “performance of services in the field of accounting” means the provision of services by accountants, enrolled agents, return preparers, financial auditors, and similar professionals in their capacity as such.  Provision of services in the field of accounting is not limited to services requiring state licensure as a certified public accountant (CPA).  The aim of Prop. Reg. §1.199A-5(b)(2)(iv) is to capture the common understanding of accounting, which includes tax return and bookkeeping services, even though the provision of such services may not require the same education, training, or mastery of accounting principles as a CPA. The field of accounting does not include payment processing and billing analysis.
• Actuarial Science.  Prop. Reg. §1.199A-5(b)(2)(v) is based on the ordinary meaning “actuarial science” and provides that the term “performance of services in the field of actuarial science” means the provision of services by actuaries and similar professionals in their capacity as such.  Accordingly, the field of actuarial science does not include the provision of services by analysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events.
• Performing Arts.  Prop. Reg. §1.199A-5(b)(2)(vi) is informed by the definition of “performing arts” under Section 448 and provides that the term “performance of services in the field of the performing arts” means the performance of services by individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors, and similar professionals performing services in their capacity as such.  The performance of services in the field of performing arts does not include the provision of services that do not require skills unique to the creation of performing arts, such as the maintenance and operation of equipment or facilities for use in the performing arts.  Similarly, the performance of services in the field of the performing arts does not include the provision of services by persons who broadcast or otherwise disseminate video or audio of performing arts to the public.
• Consulting.  Prop. Reg. §1.199A-5(b)(2)(vii) is informed by the definition of “consulting” under Section 448 and provides that the term “performance of services in the field of consulting” means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.  Consulting includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such.  The performance of services in the field of consulting does not include the performance of services other than advice and counsel.  This determination is made based on all the facts and circumstances of a person's business.  Additionally, the Treasury Department and the IRS are aware of the concern noted by commenters that in certain kinds of sales transactions it is common for businesses to provide consulting services in connection with the purchase of goods by customers.  For example, a company that sells computers may provide customers with consulting services relating to the setup, operation, and repair of the computers, or a contractor who remodels homes may provide consulting prior to remodeling a kitchen. While the SSTB de minimis rule (where the SSTB does not exceed 5% or 10% of the gross receipts of the business depending on whether the gross receipts of the business are more or less than $25 million) may provide relief for many businesses, it may not provide sufficient relief for certain trades or business that provide ancillary consulting services. The Treasury Department and the IRS believe that if a trade or business involves the selling or manufacturing of goods, and such trade or business provides ancillary consulting services that are not separately purchased or billed, then such trades or businesses are not in a trade or business in the field of consulting.  Accordingly, Prop. Reg. §1.199A-5(b)(2)(vii) provides that the field of consulting does not include consulting that is embedded in, or ancillary to, the sale of goods if there is no separate payment for the consulting services.
• Athletics.  The field of athletics is not listed in Section 448(d)(2), and there is little guidance on its meaning as used in Section 1202(e)(3)(A).  However, commenters noted, and the Treasury Department and the IRS agree, that among the services specified in Section 199A(d)(2)(A) the field of athletics is most similar to the field of performing arts. Accordingly, Prop. Reg. §1.199A-5(b)(2)(viii) provides that the term “performance of services in the field of athletics” means the performances of services by individuals who participate in athletic competition such as athletes, coaches, and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing.  The performance of services in the field of athletics does not include the provision of services that do not require skills unique to athletic competition, such as the maintenance and operation of equipment or facilities for use in athletic events.  Similarly, the performance of services in the field of athletics does not include the provision of services by persons who broadcast or otherwise disseminate video or audio of athletic events to the public.  The Proposed Regulations leave open the issue of whether a professional sports team which employs professional athletes and competes in a professional sports league, but is not otherwise involved in the “performance of services in the field of athletics,” is an SSTB and is ineligible for the 20% QBI deduction.
• Financial Services.  The Proposed Regulations limit the definition of financial services to services typically performed by financial advisors and investment bankers and provides that the field of financial services includes the provision of financial services to clients including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings (including in title 11 or similar cases), and raising financial capital by underwriting, or acting as the client’s agent in the issuance of securities, and similar services.  This includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals, but does not include taking deposits or making loans.
• Brokerage Services.  Prop. Reg. §1.199A-5(b)(2)(x) uses the ordinary meaning of “brokerage services” and provides that the field of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities (as defined in Section 475(c)(2)) for a commission or fee.  This includes services provided by stock brokers and other similar professionals, but does not include services provided by real estate agents and brokers, or insurance agents and brokers.  The Proposed Regulations do not address the question of whether brokerage businesses not involving securities, in addition to real estate and insurance brokerage businesses, qualify as QBI under Section 199A (for example, a mortgage brokerage business assisting taxpayers in securing mortgages secured by real property, including  mortgages for the purchase and refinancing of personal residences).

Where the Principal Asset of a Trade or Business is the Reputation or Skill of 1 or More of its Employees or Owners.  The Commentary notes that guidance on the meaning of the “reputation or skill” clause in Section 1202(e)(3)(A) is limited to dicta in one case, John P. Owen v. Commissioner, T.C. Memo 2012-21, where the Tax Court examined whether Mr. Owen, whose business was insurance, was entitled to benefits under Section 1202 with respect to the sale of his interest in a corporation conducting such business.  Under the facts described in the case, the corporation had extensive training programs and sales structures, but primarily relied on the services of independent contractors (including Mr. Owen) in conducting its business.  Although the Tax Court acknowledged that the business’ success was due to Mr. Owen’s efforts, it found that the principal asset of the company in question was the training program and sales structure of the business rather than Mr. Owen’s services.

The Treasury Department and the IRS received several comments regarding the meaning of the “reputation or skill” clause.  Commenters described potential methods to give maximum effect to the literal language of the reputation or skill clause by describing ways to (i) determine the extent to which the reputation or skill of employees or owners constitutes an asset of the business under Federal tax accounting principles, and (ii) measure whether such an asset is in fact the principal asset of the business.

The Commentary indicates that the “reputation or skill” clause as used in Section 199A was intended to describe a narrow set of trades or businesses, not otherwise covered by the enumerated specified services, in which income is received based directly on the skill and/or reputation of employees or owners.  Additionally, “reputation or skill” must be interpreted in a manner that is both objective and administrable.  Thus, the Proposed Regulations limit the meaning of the “reputation or skill” clause to fact patterns in which the individual or RPE is engaged in the trade or business of: (i) receiving income for endorsing products or services, including an individual’s distributive share of income or distributions from an RPE for which the individual provides endorsement services; (ii) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, including an individual’s distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual’s image; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players).  Further comments are requested on this rule, the clarity of definitions for the statutorily enumerated trades or businesses that are SSTBs under Section 199A(d)(2)(A), and the accompanying examples.

SSTBs described in Section 199A(d)(2)(B).  Section 199A(d)(2)(B) provides that an SSTB includes any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in Section 475(c)(2)), partnership interests, or commodities (as defined in Section 475(e)(2)).

Section 475(c)(2) provides a detailed list of interests treated as securities, including stock in a corporation; ownership interests in widely held or publicly traded partnerships or trusts; notes, bonds, debentures, or other evidences of indebtedness; interest rate, currency, or equity notional principal contracts; evidences of an interest in, or derivative financial instruments in any of the foregoing securities or any currency, including any option, forward contract, short position, or any similar financial instruments; and certain hedges with respect to any such securities. Section 475(e)(2) provides a similarly detailed list of property treated as a commodity, including any commodity which is actively traded (within the meaning of Section 1092(d)(1)) or any notional principal contract with respect to any such commodity, evidences of an interest in, or derivative financial instruments in any of the foregoing commodities, and certain hedges with respect to any such commodities.

Investing and Investment Management.  The Proposed Regulations use the ordinary meaning of “investing and investment management” and provides that any trade or business that involves the “performance of services that consist of investing and investment management” means a trade or business that earns fees for investment, asset management services, or investment management services including providing advice with respect to buying and selling investments.  The performance of services that consist of investing and investment management would include a trade or business that receives either a commission, a flat fee, or an investment management fee calculated as a percentage of assets under management.  The performance of services of investing and investment management does not include directly managing real property.

Trading.  The Proposed Regulations provide that any trade or business involving the “performance of services that consist of trading” means a trade or business of trading in securities, commodities, or partnership interests.  Whether a person is a trader is determined by taking into account the relevant facts and circumstances.  Factors that have been considered relevant to determining whether a person is a trader include the source and type of profit generally sought from engaging in the activity regardless of whether the activity is being provided on behalf of customers or for a taxpayer’s own account.  A person that is a trader under these principles will be treated as performing the services of trading for purposes of Section 199A(d)(2)(B).

Dealing in securities, partnership interests, and commodities.  The Proposed Regulations provide that the “performance of services that consist of dealing in securities (as defined in Section 475(c)(2))” means regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business.  For purposes of the preceding sentence, a taxpayer that regularly originates loans in the ordinary course of a trade or business of making loans but engages in no more than negligible sales of the loans is not dealing in securities for purposes of Section 199A(d)(2).

Similarly, “the performance of services that consist of dealing in partnership interests” means regularly purchasing partnership interests from and selling partnership interests to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in partnership interests with customers in the ordinary course of a trade or business.

The “performance of services that consist of dealing in commodities (as defined in Section 475(e)(2))” means regularly purchasing commodities from and selling commodities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in commodities with customers in the ordinary course of a trade or business.

Otherwise Qualifying Trades or Businesses may be Treated as an SSTB.  The Commentary notes that some taxpayers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the Section 199A deduction, and states that such a strategy is inconsistent with the purpose of Section 199A.  The Proposed Regulations provide that an SSTB includes any trade or business with 50% or more common ownership (directly or indirectly) that provides 80% or more of its property or services to an SSTB.  Additionally, if a trade or business has 50 % or more common ownership with an SSTB, to the extent that the trade or business provides property or services to the commonly-owned SSTB, the portion of the property or services provided to the SSTB will be treated as an SSTB (meaning the income will be treated as income from an SSTB).  For example, a dentist, owns a dental practice and also owns an office building, renting half the building to the dental practice and half to unrelated persons, the renting of half of the building to the dental practice will be treated as an SSTB.

Additionally, the Proposed Regulations provide a rule that if a trade or business (that would not otherwise be treated as an SSTB) has 50% or more common ownership with an SSTB and shared expenses, including wages or overhead expenses with the SSTB, it is treated as incidental to an SSTB and, therefore, as an SSTB, if the trade or business represents no more than five% of gross receipts of the combined business.

Trade or Business of Performing Services as an Employee.  Under Section 199(d)(1)(B), the trade or business of performing services as an employee is not a qualified trade or business.  Unlike an SSTB, there is no threshold amount that applies to the trade or business of performing services as an employee.  Thus, wage or compensation income earned by any employee is not eligible for the Section 199A deduction no matter the amount.

Employee Definition.  An individual is an employee for Federal employment tax purposes if he or she has the status of an employee under the usual common law and statutory rules applicable in determining the employer-employee relationship.  Under the applicable employment tax regulations, generally, the common law relationship of employer and employee exists when the person for whom the services are performed has the right to direct and control the individual who performs the services, not only as to the result to be accomplished by the work but also as to the details and means by which that result is accomplished.  That is, an employee is subject to the direction and control of the employer not only as to what shall be done but how it shall be done.  It is not necessary that the employer actually direct or control the manner in which the services are performed. It is sufficient if he or she has the right to do so.

In addition, the employment tax regulations state, generally, that an officer of a corporation (including an S Corporation) is an employee of the corporation.  However, an officer of a corporation who does not perform any services or performs only minor services in his or her capacity as officer and who neither receives nor is entitled to receive, directly or indirectly, any remuneration is not considered to be an employee of the corporation.  Whether an officer’s services are minor is a question of fact that depends on the nature of the services, the frequency and duration of their performance, and the actual and potential importance or necessity of the services in relation to the conduct of the corporation’s business.

To provide clarity, the Proposed Regulations provide a general rule that income from the trade or business of performing services as an employee refers to all wages (within the meaning of Section 3401(a)) and other income earned in a capacity as an employee, with certain exceptions. If an individual derives income in the course of a trade or business that is not described as statutory wages, the individual is not considered to be in the trade or business of performing services as an employee with regard to such income.

Presumption for Former Employees.  Section 199A provides that the trade or business of providing services as an employee is not eligible for the Section 199A deduction.  The Commentary notes that the longstanding prohibition against regulations and rulings on employment status for purposes of employment taxes of Section 530 of the Revenue Act of 1978 limits the ability of the IRS to impose employment tax liability on employers for misclassifying employees as independent contractors but do not preclude challenging a worker’s status for purposes of Section 199A, an income tax provision under subtitle A of the Code.  Therefore, the Proposed Regulations provide that for purposes of Section 199A, if an employer improperly treats an employee as an independent contractor or other non-employee, the improperly classified employee is in the trade or business of performing services as an employee notwithstanding the employer’s improper classification.  This issue is particularly important in the case of individuals who cease being treated as employees of an employer, but subsequently provide substantially the same services to the employer (or a related entity) but claim to do so in a capacity other than as an employee.  This presumption may be rebutted only upon a showing by the individual that, under Federal tax rules, regulations, and principles (including common-law employee classification rules), the individual is performing services in a capacity other than as an employee. This presumption applies regardless of whether the individual provides services directly or indirectly through an entity or entities.  The Proposed Regulations contain three examples illustrating this rule:

• Example 1.  A is employed as a fulltime employee by a partnership and is treated as such for Federal employment tax purposes.  A quits his job for the partnership and enters into a new contract under which he performs substantially the same services for the partnership as he did in his capacity as an employee.  According to the example, A is presumed to be in the trade or business of performing services as an employee and any amounts paid by the partnership to A with respect to such services will not be QBI for purposes of Section 199A.  To rebut the presumption, A would have to show that, under Federal tax law, regulations, and principles, A is not an employee.  The example notes that the presumption would apply even if A entered into a contract with the partnership through a disregarded entity or an S corporation.
• Example 2.  C is an associate in a Law Firm 1 and is treated as an employee for Federal employment tax purposes.  Law Firm 1 terminates the employment of C and several other associates.  C and the other terminated associates form Law Firm 2 as partners.  Law Firm 2 contracts to perform legal services for Law Firm 1.  As a partner in Law Firm 2 earning income from providing legal services to Law Firm 1, C continues to provide substantially the same legal services to Law Firm 1 and its clients as she did when she was an employee of Law Firm 1.  According to the example, because C was previously treated as an employee for the services that C provided to Law Firm 1, she is presumed (for purposes of Section 199A) to be in the trade or business of performing services as an employee.  C’s distributive share of Law Firm 2’s income will not be QBI for purposes of Section 199A.  The example notes that the results would not change if, instead of Law Firm 2 contracting with Law Firm 1, Law Firm 2 was instead admitted as a partner in Law Firm 1.
• Example 3.  E is an engineer in an engineering firm.  The engineering firm is a partnership structured in such a way so that after 10 years senior engineers, such as E, are considered for partnership.  After 10 years E is admitted as a partner of the engineering firm and shares in the net profits of the firm (and satisfies the requirements under Federal tax law, regulations, and principles to be respected as a partner).  According to the example, E is presumed to be in the trade or business of performing services as an employee with respect to the services E provides to the engineering firm.  However, E may rebut that presumption by showing that he satisfies the requirements under Federal tax law, regulations, and principles to be respected as a partner.