IRC 199A Proposed Regulations: An Overview – Part I

Take-Away: On August 8, Treasury published its proposed Regulations to implement the new 20% income tax deduction with respect to qualified business income for flow-through entities like S corporations, partnerships and sole proprietors. Unfortunately the Treasury’s proposed Regulations seem to derail two planning strategies to enable professionals to take advantage of the 20% income tax deductions: (i) spinning off separate lines-of-businesses from an existing business and (ii) using multiple trusts to ‘spread’ income among several separate taxpaying entities.

Background: The 2017 Tax Cut Act (the Act) gave us new Tax Code 199A. The presumed purpose of IRC 199A is Congress’s attempt to put small businesses on a similar, but not equal, ‘tax footing’ with large C corporations which had their maximum income tax rate permanently reduced to 21%. The IRC 199A income tax deduction is taken against income that is ‘effectively connected’ to a U.S. trade or business. The IRC 199A income tax deduction for high wage earners is subject to limitations based upon whether the business entity engages in certain services (e.g. highly paid physicians, lawyers, CPAs, vets, professional athletes, performers are generally excluded from claiming the deduction- for ease they are collectively referred to  simply as an excluded profession) or the deduction is based on the amount of wages paid by the business or the qualified property placed in service by the business entity that seeks the income tax deduction. As a general rule, once a taxpayer has significant taxable income ($157,500 for single filers and $315,000 for married filers) the taxpayer must pass a wages or a wages/qualified property ‘hurdle’ to avoid a significant decrease in, or elimination of, the IRC 199A income tax deduction.

Initial Planning Strategies: When IRC 199A first became law, two separate planning strategies were initially identified to assist small business and the excluded professions that earned too much income,  to position themselves to qualify for the IRC 199A 20% income tax deduction.

• ‘Crack and Pack:’ Due to the proposed limitations on the excluded professions, one strategy was to ‘spin off’ parts of on on-going business,  and have related entities provide management, billing, marketing or other related services and products to the excluded profession. This method was informally called the “Crack and Pack” response, by creating a separate line-of-business from an existing business (‘crack’)  and then  ‘pack’ that separate line of business with taxable income that could then attract the IRC 199A deduction. Example: A medical practice, which owns its own building, is generally precluded from claiming an IRC 199A income tax deduction since it is an excluded profession. But an S corporation might be formed to provide management services to the medical practice, as well as own the building that is leased to the medical practice at fair rental value. Thus, the S corporation could be separated out from the medical practice as an independent management company and claim the IRC 199A income tax deduction with regard to the income and rent that the medical practice paid to the S corporation. That ‘spin-off’ might also reduce the professional’s income to a level where he/she might be eligible to claim some of the IRC 199A deduction.  That planning strategy may not fly under the proposed IRC 199A Regulations for excluded professionals.
• Use  of Non-Grantor Trusts: Along the same lines as the ‘Crack and Pack’ strategy, if separate management functions were owned by a non-grantor trust and provided to a business, or part of the business was owned lower income tax bracket family members, that approach would spread taxable income away from the high earning taxpayer and possibly attract the IRC 199A income tax deduction to offset that income among multiple taxpayers. The concept was to use multiple non-grantor trusts to own part of the business, or to provide services to the business for a fee. This strategy would be exploited by reducing the income of the excluded professional to a level where the excluded professional could avail themselves of the IRC 199A income tax deduction (since their income was below the identified thresholds) or by shifting some of that income to a separate trust created for the professional’s family members. That strategy, too, may not be viable in light of the proposed Regulations’ ‘aggregation of multiple trusts’ approach.

Proposed Regulation Response- Aggregation: In anticipation of exploitation of the above two planning strategies, Treasury’s proposed IRC 199A Regulations have come up with broad and sweeping aggregation rules to stem the use of non-grantor trusts and ‘crack and pack’ separate lines-of-business.

• Aggregated ‘Trade or Businesses:’ The proposed Regulations allow owners of non-excluded professions to aggregate some of their businesses to maximize a claimed IRC 199A income tax deduction. At the same time they force certain excluded professions and their ancillary services to be aggregated for all to  be considered to be part of the same excluded profession, even if the applicable services (as labeled) would clearly not be an excluded profession if they were owned and operated by owners not related to the involved excluded profession. In other words, a separate trade or business, e.g. billing services, will be considered to be an extension of the excluded profession if it is 50% or more commonly controlled with the excluded profession and it provides 80% or more of its property or services to that excluded profession. Even if that separate trade or business provides less than 80% of its property or services to the excluded profession, but is 50% or more commonly controlled by the owners of the excluded profession, the income attributable to that separate line-of-business that services or sells products to the excluded profession will still be considered to be part of the excluded profession’s reported income.
• Response: With these proposed Regulations, it is important to avoid the ‘common control’ requirement used in the proposed Regulations that triggers the aggregation of the separate line-of-business with the excluded profession. Example: Three separate orthopedic medical practices might set up a management and billing company to provide services to the three separate orthopedic medical practices, with the separate owners of each orthopedic practice each owning less than 50% of the management company and the profits of the management company being divided based upon their percentage ownership. Example: A dentist owns his office building. The dentist forms a partnership with his children to own the office building used in the dental practice. The dentist owns 51% of the partnership, his children own 49% of the partnership. The dentist’s dental practice pays rent a fair market value to the partnership. 49% of the profit of the partnership passes to the dentist’s children who may, in turn,  qualify for the IRC 199A income tax deduction based upon their lower income tax brackets based on their income from the partnership.
• ‘Disrespecting’ Separately Taxed Non-Grantor Trusts: In something of a surprise, Treasury’s proposed Regulations will ignore separately taxed non-grantor trusts that receive qualified business income. The surprise is that Treasury finally got around to publishing Regulations under IRC 643(f) with respect to multiple non-grantor trusts. The key provision in the proposed Regulation follows: “Trusts formed or funded with a significant purpose or receiving a deduction under Section 199A will not be respected for purposes of Section 199A. See also Section 1.643(f)-1.” Example: An S corporation business owner decides to set up trusts for his family members intending to avoid the wage/qualified property limitations of IRC 199A, and the owner is not engaged in an excluded profession. The owner establishes three trusts for the following beneficiaries: Trust #1 for the owner’s sister, Susan, and the owner’s brothers Bob and Bill; Trust #2 for the owner’s other sister, Sally, and for Bob and Bill; and Trust #3 for the owner’s mother Maud. The result is that all three trusts would be aggregated and treated as a single trust, the key fact being that the owner would not have created or funded the three separate trusts but for his desire to qualify for the IRC 199A deduction.
• Restated, this position ties into IRC 643(f) which has been in the Tax Code for a long time, but with no implementing regulations to guide taxpayers. IRC 643(f) provides that the IRS may treat two or more trusts as a single trust if they (i) were formed by substantially the same grantor; (ii) had substantially the same primary beneficiaries; and (iii) were formed for the principal purpose of avoiding income taxes. These  proposed IRC 643 Regulations state that its principal purpose will be presumed to reduce income taxes if it results in a significant income tax benefit, unless there are significant non-tax purposes that could not have been achieved without the creation of the separate trusts. If the IRS intends to disregard trusts that are formed in order to claim the IRC 199A income tax deduction, it would seem that the IRS would want to completely invalidate the trusts altogether, since even when aggregated,  the ‘aggregated’ trust(s) helps the owner avoid the wage/qualifying property limitation because the trusts still lower the owner’s reported taxable income. If a non-grantor trust is established it will be presumed to not a ‘significant non-tax purpose’ under IRC 643. [More on trusts in a later email.]
• Response: It is possible that a no-grantor trust that has a reasonable family planning purpose will be respected by the IRS, but multiple trusts will be aggregated for income tax purposes if they have common beneficiaries and their use would save tax dollars. The example used in Reg. 1.643(f)-1(c) Example 2 seems to suggest that having different siblings as beneficiaries suffices to break the ‘substantially same primary beneficiary’ test of IRC 643(f). The Regulations appear to make the tax avoidance motive the sole condition to trigger the multiple trust rule, even if the grantors or the primary beneficiaries differ.
• Exception: Excluded from this disrespecting or aggregating of separate trusts are irrevocable trusts that are established under IRC 678, which are funded by a grantor yet are considered to be owned by a beneficiary who had or has the opportunity to withdraw assets placed into the trust or the income from the trust. Thus, lower income tax brackets of children and other family members can safely be used for IRC 199A planning without any risk of aggregation of separate IRC 678 trusts.

Trade or Business: What is meant by a separate trade or business will be addressed in greater detail in another email.  Many clients will consider as part of their IRC 199A planning the spin-off of real estate and other assets from their existing businesses to treat that separately owned activity as a separate  line-of-business, then leased back to the business. But renting real estate to a separate business is not always treated as a separate trade or business.

Conclusion: Treasury’s proposed Regulations are not taxpayer-friendly. If Congress’ intent in adopting IRC 199A was to try to treat small businesses fairly in comparison with large C corporations that had their corporate income tax rate permanently reduced, it is hard to see where there is a fair or reasonably equivalent tax treatment for closely held pass-through business entities if these proposed Regulations become final. To put these proposed Regulations in some perspective, the Regulations themselves mention that an estimated 10 million taxpayers well be impacted by IRC 199A, and that over 25 million (yep, that million) hours will be spent each you to comply just with this one Tax Code Section. That is a lot of expense taxpayers will incur trying to fit their square-peg businesses into Treasury’s round-hole Regulations. Ah, the dark side of income tax relief!