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Editorial 10 MIN READ

Section 199A, two months in: operational questions the statute does not answer

The 20 percent pass-through deduction is live for tax years beginning after December 31, 2017, and the people who have to apply it are reading the statute like scripture

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 7 sections
  1. What the statute gives you, restated tightly
  2. What counts as a "trade or business" in the first place
  3. The specified service trade or business problem
  4. Aggregation, or the arithmetic of owning two things
  5. What Treasury has actually said
  6. What to do in the interim
  7. Sources

ection 199A took effect for tax years beginning after December 31, 2017, and two months later nobody has regulations, nobody has FAQs, and almost every CPA in the country is trying to plan a 2018 tax year off 52 pages of statutory text, a conference report, and a guess about what Treasury will publish this summer.

That is the state of the Section 199A pass-through deduction on February 20, 2018. We covered the statute at signing in our January 23 outline. This piece is the operational follow-up: what does a lawyer, a CPA, or a founder do with §199A between now and whenever regulations actually land.

What the statute gives you, restated tightly

Section 199A(a) grants an individual a deduction equal to 20 percent of "qualified business income" (QBI) from each qualified trade or business, plus 20 percent of qualified REIT dividends and qualified publicly traded partnership income. The total deduction cannot exceed 20 percent of the excess of taxable income over net capital gain. It is a below-the-line deduction that does not reduce adjusted gross income, which matters for every AGI-linked threshold on the return.

"Qualified business income" under §199A(c) is the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. It excludes investment income, reasonable compensation paid to the taxpayer for services rendered to the trade or business, and guaranteed payments to partners.

"Qualified trade or business" under §199A(d)(1) means any trade or business other than a specified service trade or business or the trade or business of performing services as an employee.

Above a threshold amount of taxable income, set at $157,500 for single filers and $315,000 for joint filers for 2018, two overlays kick in through a phase-in range of $50,000 for singles and $100,000 for joint filers. First, the W-2 and qualified property limitation in §199A(b)(2) caps the deduction at the greater of (i) 50 percent of the taxpayer's share of W-2 wages paid by the business, or (ii) 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis immediately after acquisition of qualified property. Second, the specified service trade or business exclusion in §199A(d)(2) phases the deduction out entirely.

At the top of the phase-in range, meaning $207,500 for singles and $415,000 for joint filers, both overlays are in full effect: a specified service business gets zero, and a non-service business is hard-capped by the W-2 / UBIA formula.

That is the entire mechanism. Everything else is interpretation.

What counts as a "trade or business" in the first place

Section 199A does not define the term. The drafters borrowed it. Treasury's only cross-reference point is §162(a), which allows a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." The phrase "trade or business" in §162 has been the subject of almost a century of litigation, and the leading Supreme Court case, Commissioner v. Groetzinger, 480 U.S. 23 (1987), says the activity must be engaged in with continuity and regularity and with the primary purpose of income or profit.

For an operating company with employees and a physical presence, this is not a close question. For the kinds of activities that make up a large fraction of pass-through income in 2018, it can be.

Rental real estate is the example on every practitioner's list. A taxpayer who owns one residential unit and collects a monthly rent check has an activity that produces income. Is that a §162 trade or business? The case law here is a mess. Hazard v. Commissioner, 7 T.C. 372 (1946), allowed §162 treatment for a single rental. Grier v. United States, 218 F.2d 603 (2d Cir. 1955), went the other way on similar facts. Treasury has never drawn a bright line because none has been needed; rental income has its own regime under §469 for passive loss purposes and the §162 question rarely came up.

It comes up now. If a rental property is a §162 trade or business, its net rental income is QBI and may qualify for the 20 percent deduction. If it is not, the income falls out entirely. For a taxpayer with one rental and modest income, the difference is real. For a taxpayer with a portfolio of twenty rentals and a property manager, the §162 story is easier to tell and the stakes are larger.

Nobody knows yet whether Treasury will draw a safe harbor, adopt a facts-and-circumstances standard, or punt and let the existing §162 case law carry the weight. Practitioners are planning for all three.

The specified service trade or business problem

Section 199A(d)(2)(A) defines a specified service trade or business by cross-reference to §1202(e)(3)(A), which lists the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services, along with "any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees."

The §199A cross-reference modifies this list in two unusual ways. First, it drops "engineering, architecture," from the enumerated fields. Second, it replaces "employees" with "employees or owners" in the reputation-or-skill clause. Subsection (d)(2)(B) then adds investing and investment management, trading, and dealing in securities, partnership interests, or commodities.

The engineering and architecture carve-out is, in the politest description available, unusual. Both fields fit every ordinary-language definition of a professional service business. They show up in every §1202 cross-reference that came before this one. Their exclusion from §199A's SSTB list appears in no committee report's narrative, shows up in no treasury green book, and traces to floor negotiation that neither side has explained on the record. It will, in effect, mean that a civil engineering partnership with $2 million of QBI and $400,000 of W-2 wages can take a $400,000 deduction (capped by the wage limit), while an almost identical actuarial partnership with the same numbers takes zero. Whether that carve-out survives a technical corrections bill is an open question, but as of today it is the law.

The bigger interpretive problem is the reputation-or-skill clause. On a plain reading, this phrase could capture any service business whose value is tied to the skill of its owners, which is to say almost every professional services firm not already captured by the enumerated fields. Consulting firms. Boutique advisory shops. Authors. Software developers who sell their own code. Solo physicians already covered under "health," but also solo translators, graphic designers, freelance engineers (carved out of SSTB on one clause, potentially pulled back in by this one).

The question Treasury is going to have to answer is whether the reputation-or-skill clause is a narrow backstop aimed at endorsement income, licensing of likeness, and appearance fees (the "celebrity clause" reading), or a broad capture of any service business whose principal asset is human capital (the "professional services" reading). The first reading leaves most consulting firms alone below the income threshold. The second cleans out the whole field.

Every major tax commentator expects the first reading. The Tax Foundation's early write-ups of §199A assume the narrower interpretation is where Treasury will land. The Tax Policy Center has noted that the broader reading is difficult to square with the statute's decision to enumerate specific fields at all. The enumeration, they argue, is evidence that the drafters meant the catch-all to be narrow. Whether Treasury is persuaded by that structural argument is the single largest open question in §199A planning right now.

For a founder trying to decide whether to form a management-consulting LLC in 2018, that uncertainty is directly load-bearing.

Aggregation, or the arithmetic of owning two things

Section 199A applies its W-2 and UBIA test on a per-trade-or-business basis. For a taxpayer who owns several related businesses, that creates a planning question with no statutory answer.

Consider a common structure: an operating LLC that generates $500,000 of QBI and pays $50,000 of W-2 wages, plus a real estate LLC that owns the building and generates $100,000 of QBI with no wages. Taken separately at the threshold, the operating LLC's wage limit caps the deduction at $25,000 (50 percent of $50,000) rather than the $100,000 that 20 percent of QBI would allow, while the real estate LLC's deduction is hard-zeroed because it has no wages.

Aggregation could produce a very different answer. If the two businesses can be treated as one for §199A purposes, their combined QBI is $600,000, their combined W-2 wages are $50,000, and the UBIA of the building comes into the formula. Whether aggregation is available, and on what common-ownership test, is unaddressed by the statute. The §469 grouping rules are one obvious template. The §414 controlled-group tests are another. Treasury could borrow from either, combine them, or write its own.

The operating-versus-real-estate fact pattern is the easiest case to explain. The real planning opportunities involve taxpayers with three or four related entities of different kinds, where the aggregation question changes the number by six figures.

What Treasury has actually said

Nothing in writing. The Secretary's office has told practitioner groups to expect proposed regulations this summer. Treasury officials have confirmed at ABA Tax Section meetings that the regulations will address the meaning of "trade or business," the aggregation rules, and the reputation-or-skill clause as priorities. No draft has been circulated. No informal guidance has been issued. The only document on the IRS website that addresses §199A is the statute itself.

The Tax Policy Center has published early commentary arguing that §199A's complexity will produce more tax-minimization gamesmanship than the provision was worth, that the SSTB cliff is an invitation to restructure, and that the W-2 wage test biases the deduction toward capital-heavy firms that do not need it. The Tax Foundation's analysis of the statute runs roughly parallel on complexity while being more sympathetic to the underlying pass-through parity argument. Both organizations have noted that the 2025 sunset combined with the absence of guidance is the worst of both worlds for tax planners: too short a horizon to restructure around, too long to ignore.

The one piece of policy movement worth flagging is the so-called "grain glitch." As enacted, §199A permits farmers who sell to cooperatives to take a 20 percent deduction on gross sales rather than net income, which gives cooperatives a decisive competitive advantage over independent grain buyers like Archer Daniels Midland and Cargill. A legislative correction is being negotiated in the appropriations package moving through Congress in March. The fact that a correction was already needed, two months into the statute, is the clearest signal available that the drafting of §199A outran its review.

What to do in the interim

For a founder forming in early 2018, the honest advice is: do not restructure around §199A yet. If your income is below the threshold you get the full 20 percent regardless of SSTB status, and below-the- threshold planning is mostly a question of making sure your activity qualifies as a trade or business, which the typical operating LLC with revenue and expenses already does.

Above the threshold, any structural decision made now has to be unwindable. Splitting a consulting firm into a consulting arm and a non-SSTB arm (the "crack-and-pack" idea already making the rounds in tax blogs) relies on guesses about what counts as a separate trade or business and whether Treasury will impose an anti-abuse rule. Every tax blog running crack-and-pack examples this month has a standard disclaimer at the bottom. Read the disclaimer.

For rental real estate, document the hours, keep the books, hire a property manager if the portfolio is large enough to warrant one. The facts you build in 2018 are the facts Treasury or a court will read later when deciding whether the activity was a §162 trade or business.

For everyone, file extensions liberally. The first 1040 that has to calculate a §199A deduction is the 2018 return, due April 15, 2019. Proposed regulations this summer plus a comment period plus final regulations could easily push substantive guidance into the fall, which does not leave long to plan around.

The deduction itself is real money and worth the effort. The statute that created it is thirty pages of compressed drafting whose seams are going to be visible for years. The operating lesson for February 2018 is that anyone quoting a specific §199A number to a client right now is quoting it conditional on rules that have not been written.

Sources

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