The long-awaited final guidance of the new 20 percent deduction for pass-through business owners can help significantly cut some of your wealthy clients’ tax bills. But the regs, tax advisors said, fall short in some areas when attempting to address one of the most complex changes of recent tax reform.
One tricky part of the new guidance for high net worth clients hinges on trade or business definitions. “The SSTB (specified service trades or businesses) area is almost impossible to define across such a broad spectrum of potential businesses,” said Bill Smith, Bethesda, Md.-based managing director for CBIZ MHM’s national tax office. “The more examples provided, the easier to interpret [but] there will always be gray areas. They clarify, for instance, that a well-known chef who owns multiple restaurants is not engaged in an SSTB for his restaurants but is engaged in an SSTB with respect to an endorsement fee for a line of cooking utensils and cookware.”
The rules also make it clear that there’s no material participation required (a rule important for deducting losses from relevant pass-through entities, or RPEs), “but that it is also immaterial whether a partner actively participates if the partnership/LLC itself is an SSTB,” Smith said.
Some professions also still render some definitions unclear. “There has to be a trade or business (or a TOB), which is sometimes difficult to determine in the rental real estate world,” Smith added. “The final regulations offer a safe harbor for this determination, but outside the safe harbor investors are thrown back into historical determinations of what constitutes a TOB.”
“Individuals who own large amounts of real estate will want to group their commercial rentals and treat them as a combined enterprise,” said David Desmarais, CPA/PFS and member of the American Institute of CPAs’ personal financial planning executive committee. “S corporations who pay shareholder salaries will want to adjust shareholder salaries to maximize the Section 199A deduction [but] shareholder salaries must be reasonable. Entities treated as partnerships who do not have a lot of wages to take advantage of the deduction may consider electing to be taxed as an S corporation and pay shareholder salaries when feasible,” he added.
“If [your client is] an investor, the RPE activity determines if the deduction is available,” Smith said. “The easiest way to insure the availability of the deduction is to invest in an RPE that’s clearly not an SSTB and won’t be limited by the W-2 wage or W-2 wage plus property limitation. If you don’t have that luxury, consult with tax advisors competent in determining whether your affairs can be restructured in a way that maximizes the QBI deduction – bearing in mind that the IRS has rules to thwart ‘cracking and packing’ strategies and de minimis rules that allow very little SSTB activity within a TOB without tainting the entire operation.”
Also tricky: Determining which businesses to aggregate among multiple owned businesses, according to Desmarais. “For rental business owners, it may still be difficult to determine whether their rental businesses rise to the level of a Section 162 trade or business,” he said.
In the aggregation area, the guidance provides some clarification for multi-tiered partnerships/LLCs, Smith said. The final regs permit a relevant pass-through entity to aggregate the trades or businesses (TOBs) it operates directly or through lower-tier RPEs. The resulting aggregation must be reported by the RPE and by all owners of the RPE. One entity may have several separate TOBs within it if certain rules are followed, Smith said.
“Specific guidance on what constitutes a TOB outside the safe harbors would be nice,” Smith said, adding that the Treasury Department and the IRS received a number of comments requesting additional guidance related to this area. “Also, the new lower-penalty threshold could benefit from guidance, which the IRS declined to provide,” Smith added. “With the importance of this deduction, the more guidance we get from the IRS the better.”