While the Tax Cuts and Jobs Act (TCJA or the Act) became law approximately seven months ago, significantly transforming how we compute federal income taxes, the House Ways and Means Committee announced the next phase of tax reform: Tax Reform 2.0. In this edition of the Tax Reform Progress Report, we will look at what to expect with Tax Reform 2.0 in addition to focusing on the status of regulations under the TCJA, the new section 199A pass-through deduction, Form 1040 changes and the new Opportunity Zone provisions.
In this issue:
- Tax Reform 2.0
- Status of TCJA regulations and technical corrections
- Section 199A update
- IRS revises Form 1040
- New Opportunity Zone provisions
Tax reform 2.0
House Ways and Means Committee Chairman Kevin Brady outlined the next phase of tax reform, known as Tax Reform 2.0. While short on details, the proposal focuses on making permanent the individual tax cuts from the TCJA as well as changes to retirement and other savings vehicles. For example, a new universal savings account would be created as a savings tool for families. Use of section 529 education accounts would be expanded to include apprenticeship fees, home schooling and paying off student debt. In addition, the proposal plans to increase the ability for new businesses to write-off a greater portion of their startup costs.
This outline is supposed to be a basis for negotiating, similar to the one the White House released last spring that led to the TCJA. It is important to remember the individual provisions were enacted as temporary provisions in the TCJA because they would violate the 10-year budget rule and expand the deficit. Consequently, the Senate couldn’t use the budget reconciliation process to enact tax reform if those provisions were made permanent because budget reconciliation has to be revenue neutral. Budget reconciliation is not subject to filibuster, so 60 votes would be required for passage. Given this is an election year, it is unclear whether Tax Reform 2.0 will gain traction in the House and what details a final product would include. As a result, even if Tax Reform 2.0 gains traction in the House, Senate Republicans would need nine Democratic votes in order to pass any legislation that comes out of this outline. Consequently, we are skeptical whether this proposal will succeed. We will continue to monitor the status and bring to you any developments.
Status of TCJA regulations and technical corrections
Acting IRS Commissioner David Kautter has indicated a plethora of tax reform-related guidance will be released over the next several weeks. Speaking at the IRS Nationwide Tax Forum, Kautter said the IRS’ biggest challenges in terms of crafting guidance include the rules for the section 199A pass-through deduction, the section 59A base erosion and anti-abuse tax (BEAT) and the global intangible low-taxed income (GILTI) measures.
Kautter noted that while the IRS is treating all three guidance projects as integrated, they will not be released together; expect an announcement in late summer or early fall. He added that section 199A guidance, now under review by the Treasury Department, should be released within weeks. As new information is published, look for communications from us explaining how it relates to your tax situation.
In addition, do not expect technical corrections legislation before the November midterm elections. Typically a nonpartisan bill that tweaks drafting errors in major legislation, a technical corrections package cannot make new law or new policy and cannot affect revenue. Leading Republicans have indicated contents of such a package will be influenced by the Treasury guidance mentioned above. At the present time, Democrats appear unwilling to assist in fixing a law they had no part in creating. As passage requires 60 votes, Democratic support is needed to pass a technical corrections bill in the Senate. As a result, many outstanding issues, such as the treatment of qualified improvement property, which currently has a 39-year recovery period and is not eligible for bonus depreciation, will remain unresolved in the near term.
Section 199A status update
The section 199A pass-through deduction provides for a 20 percent deduction for domestic qualified business income (QBI) from a partnership, S corporation or sole proprietorship. The deduction does not apply to specified services businesses, except in the case of a taxpayer whose taxable income is below the threshold amount ($157,500, or $315,000 in the case of a joint return). While the IRS has not issued anything on section 199A as of the date of this report, we have identified several critical areas and uncertainties where – we hope – the IRS will issue guidance. Note that even when section 199A guidance is published, some issues may not be fully addressed and others may be “reserved” for future regulations. Unfortunately, this is likely to be an evolving process, and it may be months before all of our questions are answered. In the meantime, here are some critical issues to keep in mind as you are planning to implement the section 199A deduction:
Critical issue #1 – What is a trade or business?
Generally, whether an activity rises to the level of a trade or business is based on all facts and circumstances. The section 199A analysis starts at the trade or business level; however, there is no legislative history or guidance on what constitutes a trade or business that is specific to section 199A. On the other hand, there is authority on the definition of a trade or business under other sections of the Code. For example, the Groetzinger case (Comm. v. Groetzinger, 59 AFTR 2d 87-532 (107 S.Ct. 980), Feb. 24, 1987) states that “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and the taxpayer's primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.” Under the section 1411 net investment income tax regulations, the rental of a single property may rise to the level of a trade or business in certain situations (but not as a matter of law). Finally, the passive activity rules under section 469 provide guidance on how activities may be grouped together — but the interaction between passive activity groupings under section 469 and the definition of a trade or business for section 199A purposes remains to be seen.
- Action steps. Identify your trades or businesses on a preliminary basis. Use a logical and reasonable approach, informed by current authority, to draw the lines around each trade or business for section 199A purposes … but be flexible and ready to adjust when guidance is issued.
Critical issue #2 – Wages paid by other entities
The W-2 wage limitation applies to wages paid “with respect to the qualified trade or business.” The meaning of the phrase “with respect to” is unclear. Does this mean wages paid only by the specific entity that operates the trade or business? Or can wages paid by an entity other than the common law employer, such as a professional employer organization (PEO), common paymaster or related party management company, also be included in the calculation?
- This question has real-world implications beyond taxes. Several PEOs have commented in the press that they are losing clients due to uncertainty about this question.
- Action steps. Obviously, it is important the IRS issues guidance in this area. For now, we recommend a cautious approach — only factor in wages paid by the entity that operates the trade or business for purposes of the W-2 limitation. Do not assume that wages paid by other entities or fees paid to reimburse a management company will qualify.
It is also important to keep in mind that this deduction expires in eight years. There are many good reasons to utilize a PEO, notwithstanding the uncertainty over the section 199A deduction. Consequently, any restructuring of a PEO arrangement, solely for the purpose of the temporary section 199A deduction, is premature.
Critical issue #3 – Definitions related to specified services
For taxpayers above certain taxable income thresholds, income from specified services trades or businesses is not eligible for the section 199A deduction. The statute defines a specified service trade or business as follows:
- “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, 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.”
- Any trade or business “which 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)).”
The lack of definitions related to specified services has caused perhaps the most confusion of any issue related to section 199A. While some of the terminology is relatively straightforward (e.g., law, accounting), the “reputation or skill” clause is so vague that it is essentially meaningless.
- Action steps. Guidance is greatly needed in this area. Identify all your trades or businesses, including those that may fall under the definition of specified services. We recommend a cautious approach, but only to a point – do not automatically assume that a trade or business will be excluded by the “reputation or skill” clause – in other words, do not negotiate against yourself. The IRS will likely not tightly restrict this deduction. By carving out engineering and architecture, Congress may have given an indication that specified services pertain only to intellectual services, while services resulting in tangible products will be eligible for the deduction.
Critical issue #4 – Impact of tiered structures
Is QBI “tainted” if it is allocated to an entity that provides a specified service? For example:
- A real estate fund earns fee income for managing a portfolio of rental real estate properties. The fund also receives allocations of rental income from the various properties.
- The fee income is specified service income and is not eligible for the section 199A deduction. The fund is providing investment management services related to its partnership interests in rental real estate entities.
- However, is the rental income earned “with respect to” the qualified trade or business at the lower-tier entity? Or is it tainted because the fund provides specified services to the lower-tier entities?
The statute authorizes Treasury and the IRS to issue regulations on the application of section 199A to tiered structures, but for now does not provide a clear answer on this question. It seems reasonable, however, that the rental income flowing through to the fund would still be QBI eligible for the deduction. The real estate fund example above seems analogous to a situation where a partner in a qualified trade or business receives a guaranteed payment for services plus eligible flow-through income on a K-1. Even if the partner receives the guaranteed payment for providing specified services to the trade or business (such as legal, accounting or consulting services), the underlying trade or business income would not be tainted and is still eligible for the section 199A deduction.
IRS revises Form 1040
You may have heard the IRS and Treasury recently unveiled a new Form 1040, the size of a postcard (front and back). The new Form 1040 consolidates the three versions of Form 1040 that were in effect for the 2018 filing season, rendering obsolete the Form 1040A and Form 1040EZ. The revised form uses a building block approach that reduces the tax return to a single form that can be “supplemented with additional schedules if needed,” the IRS release stated.
The form does very little to simplify the filing process. It actually adds up to six additional schedules for taxpayers to complete depending upon their circumstances. Numerous lines from the old Form 1040 have simply been moved to separate schedules in order to shrink the size of the new form.
- Schedule 1, Additional Income and Adjustments to Income, summarizes sources of income including tax refunds, business income, capital gains and losses, rental real estate, farm income and income from other sources. Familiar schedules C, D, E and F will be used to support amounts included on Schedule 1. Totals from this schedule will be included on line 6 of Form 1040.
- Schedule 2, Tax, calculates federal taxes on income. Alternative minimum tax, among other taxes, is recorded here. Forms 6251, 8962, 8814 and 4972 will still be used to determine additional taxes owed. Totals from Schedule 2 are included on line 11 of Form 1040.
- Schedule 3, Nonrefundable Credits, condenses multiple types of credits on one form. Credits for foreign taxes, childcare, education, retirement among others are reported here and total to line 12 of Form 1040. Forms 1116, 2441, 8863, 3800 and others are used to determine the appropriate amounts to be included on Schedule 3.
- Schedule 4, Other Taxes, includes taxes such as self-employment tax, additional retirement plan taxes, net investment and additional Medicare taxes. Forms 8959, 8960, 5329, Schedules H, and SE are still used to calculate the correlative taxes. The total flows to line 14 of Form 1040.
- Schedule 5, Other Payments and Refundable Credits, reports estimated tax payments, overpayments from prior-year returns, excess Social Security withholding, extension payments, certain credits and other tax payments. Total Schedule 5 amounts are included in line 17d of Form 1040.
- Schedule 6, Foreign Address and Third Party Designee, provides foreign country of residence information. Taxpayers allowing a third-party person, such as a tax preparer, to discuss their tax return with IRS personnel, will provide this permission on Schedule 6.
While the actual Form 1040 size has been reduced, the forms and schedules taxpayers have historically used remain in place. The IRS is in the process of amending more than 450 existing forms and schedules for tax reform changes.
Opportunity Zone provisions
Similar to the deferral and exclusion incentives afforded by the New Markets Tax Credit and other enterprise and empowerment zone programs, the Opportunity Zone provisions of the TCJA allow for the temporary deferral of the inclusion of gains on sales or exchanges in a taxpayer’s gross income to the extent the proceeds are reinvested in a qualified opportunity fund (QOF). If held for at least 10 years, there is a permanent exclusion of gains from any appreciation on the QOF investment. A QOF is defined as “any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property (other than another QOF) that holds at least 90 percent of its assets in qualified opportunity zone property.” In April, the IRS clarified that a QOF “self-certifies” (no IRS approval needed) its status as such by attaching to its tax return a form expected to be released later this summer.
Qualified Opportunity Zone (QOZ) property includes QOZ stock, QOZ partnership interests and QOZ business property; very generally, stock or a partnership interest in a business operating within a QOZ; and property utilized within a QOZ.
Opportunity Zones defined
A QOZ is defined as a population census tract that is a low-income community and has been designated as a QOZ by the state government. A low-income community is defined using the same criteria for determining New Markets Tax Credit eligibility, any population census tract:
- With a poverty rate of at least 20 percent,
- Not located within a metropolitan area, with a median family income that does not exceed 80 percent of the statewide median family income (85 percent if located within a “high migration rural county”), or
- Located within a metropolitan area, with a median family income that does not exceed 80 percent of the greater of statewide median family income or the metropolitan area median family income (85 percent if located within a “high migration rural county”)
A QOZ designation remains in effect for the period beginning on the date of designation and ending at the close of the tenth calendar year beginning on or after such date of designation.
The CDFI Fund published a list on its website of the QOZs designated as of June 14, 2018. In addition, the IRS published this information in a notice in June. For example, the following jurisdictions have been designated multiple QOZs: the District of Columbia (25), Maryland (149), Michigan (288), Minnesota (128), New Jersey (169), New York (514), Pennsylvania (300), Texas (628), Virginia (212) and Wisconsin (120).
In keeping with the common theme, this is an area of the new law where guidance is needed to clarify the QOZ rules. For example, it is unclear what types of property qualify for gain deferral or exclusion, how the timing of the QOZ designation expiration and 10-year holding period required for gain exclusions interact, and whether LLCs are eligible for consideration as QOFs.
Broadly, the new Opportunity Zone provisions represent significant opportunities for tax savings and fostering economic growth in distressed communities. The tax savings/deferral will of course, need to be weighed against the economic risk of investing in these communities. To help you navigate this new program, Baker Tilly has launched a new resource center for Opportunity Zones that further explores how the program works and offers an interactive map of the designated zones.
Please visit our Tax Reform Resource Center for additional information.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.