Tax Alert: Understanding the New Pass-Through Business Deduction Rules Under Code Section 199A

by Verrill Dana LLP

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Due to the significant changes to the Internal Revenue Code (“Code”) made by the Tax Cuts and Jobs Act (“Tax Act”) at the end of last year, the Department of the Treasury has been very busy issuing guidance and proposed regulations on various tax matters, including rules regarding the 20% deduction for pass-through entities under newly enacted Section 199A of the Code. Earlier this month, the Department of Treasury simultaneously issued proposed regulations and Notice 2018-64 to address some of the complexities inherent in the 199A statute. The preamble to the proposed regulations indicates that guidance is being provided for computational, definitional, and anti-avoidance purposes.


By way of background, for the 2018 tax year through the end of 2025, a non-corporate taxpayer may be eligible to deduct 20% of the taxpayer’s qualified business income (“QBI”) with respect to each qualified trade or business plus 20% of the aggregate amount of qualified cooperative dividends, qualified real estate investment trust dividends and qualified publicly traded partnership income of the taxpayer for the tax year pursuant to Code Section 199A. However, there are some limitations and adjustments to being able to claim the deduction. As discussed below, the deduction is not available for income from a list of disqualified activities and is also limited if the taxpayer (or the taxpayer’s pass-through business) does not pay sufficient wages or invest in sufficient tangible depreciable property used in the business. Neither of these limits apply to taxpayers with taxable income that is below the threshold level.

The deduction is applied to the taxpayer’s taxable income, not adjusted gross income and it cannot exceed the amount of the taxpayer’s taxable income for the tax year. This means that the deduction is taken “below the line,” so that it reduces taxable income rather than being taken “above the line” in determining adjusted gross income. The deduction applies at the partner or shareholder level and each partner or shareholder takes into account his or her allocable share of items of income, deduction and loss from the partnership or S corporation.


The amount of QBI eligible for deduction from each qualified trade or business is subject to certain limitations. QBI is defined as the net amount of items of income, gain, deduction, and loss with respect to the trade or business. Certain types of investment-related items are excluded from QBI, such as capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). Employee compensation and guaranteed payments to a partner are also excluded.

The deduction attributable to 20% of the taxpayer’s QBI cannot exceed the greater of (1) 50% of the taxpayer’s share of W-2 wages paid with respect to the QBI or (2) the sum of 25% of the taxpayer’s share of W-2 wages plus 2.5% of the unadjusted basis of qualified property determined immediately after the taxpayer’s acquisition of such qualified property. The term W-2 wages is defined to mean the sum of total wages subject to wage withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year ending during the taxable year of the taxpayer. W-2 wages do not include any such amount that is not properly allocable to QBI.

The above limitation does not apply to taxpayers with taxable income not exceeding $315,000 (joint filers) or $157,500 (other filers). The limitation is phased-in for taxpayers with taxable income exceeding these amounts over ranges of $100,000 and $50,000, respectively. Accordingly, the limitation fully applies when taxable income is over $415,000 for married individuals filing jointly, and $207,500 for other individuals.

Specified Service Trade or Business (“SSTB”)

A qualified trade or business includes any trade or business other than a SSTB or the trade or business of performing services as an employee. A SSTB means any trade or business in the fields of health, law, accounting, actuarial sciences, 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, or which involves the performance of services that consist of investing and investment management trading, or dealing in securities, partnership interests, or commodities.

The SSTB exclusion does not apply to the extent the taxpayer’s taxable income does not exceed the threshold amounts outlined in the Limitation section above.

Proposed Regulations

Due to the Proposed Regulations being over 180 pages long, this alert addresses only some of the major provisions that affect non-corporate taxpayers.

Definition of Trade or Business

The Proposed Regulations define the term “a trade or business” for purposes of Code Section 199A. This definition is pivotal because only income from “a trade or business” qualifies for the deduction. The Proposed Regulations define “a trade or business” to mean a section 162 trade or business other than the trade or business of performing services as an employee. According to the preamble the use of this standard because it is derived from a large body of existing case law and administrative guidance interpreting the meaning of trade or business in the context of a broad range of industries, thus, helping to reduce compliance costs, burden, and administrative complexity. The Proposed Regulations take the definition further by defining “a trade or business” to also include the rental or licensing of tangible or intangible property (rental activity) which activity would normally be excluded under Code Section 162 trade or business but is now included for purposes of section 199A, if the property is rented or licensed to a trade or business which is commonly controlled (same group of persons, directly or indirectly, owns 50% or more of each business).

Specific Categories of SSTBs

The Proposed Regulations provide some definitional context for certain types of SSTBs.


The Proposed Regulations define the term performance of services in the field of health to mean medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient, excluding services not directly related to a medical field such as gyms, spas, payment processing, or pharmaceutical and medical device testing, manufacturing, or sales.


The Proposed Regulations define the term performance of services in the field of law to mean legal services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals, but excluding services that do not require legal skills, such as printers, delivery or stenography.


The Proposed Regulations define the term performance of services in the field of accounting to mean services of accountants, enrolled agents, return preparers, auditors and similar professionals in tax return preparation, auditing, and bookkeeping services, regardless of state licensure, but excluding payment processing and billing analysis.


The Proposed Regulations define the term performance of services in the field of consulting to mean 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 Proposed Regulations state that the performance of services in the field of consulting does not include the performance of services other than advice and counsel, such as sales or economically similar services or the provision of training or educational courses. The Proposed Regulations also provide that the field of consulting does not include consulting that is embedded in, or ancillary to, the sale of such goods (or services), if there is no separate payment for the consulting services.

Financial Services

The Proposed Regulations define the term performance of services in the field of financial services to mean services typically performed by financial advisors and investment bankers, which includes managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, providing advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings, and raising financial capital by underwriting, or acting as the client’s agent in the issuance of securities, and similar services.


The Proposed Regulations define the term performance of services in the field of trading to mean a trade or business of trading in securities, commodities, or partnership interests. Whether a person is a trader is determined taking into account the relevant facts and circumstances, and relevant factors 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.

Reputation or Skill

Surprisingly, the Proposed Regulations define this term narrowly to cover only a trade or business in which a person (1) receives income for endorsing products or services; (2) licenses or receives income for the use of the taxpayer’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the taxpayer’s identity or (3) receives income from appearance fees for radio, television or other media events or formats.

Determination of SSTB

The Proposed Regulations require each partnership or S corporation to determine whether it conducts a SSTB and then provide that information to its owners. To alleviate taxpayers’ concerns that their business might not qualify if they had a small amount of SSTB activity, the Proposed Regulations contain de minimis rules. A trade or business is not an SSTB if it has gross receipts of $25M or less in a taxable year and less than 10% of the gross receipts of the business is attributable to the performance of services in an SSTB. A trade or business is also not a SSTB if it has gross receipts of over $25M in a taxable year and less than 5% of the gross receipts of the business is attributable to the performance of services in a SSTB.

Determination of Wages

For taxpayers whose income exceeds the threshold amount, in order to qualify for the Code Section 199A deduction there must be sufficient wages paid to employees of the trade or business. The Proposed Regulations include rules for determining which taxpayer is allowed to report wages and is largely based on the rules under former Code Section 199. In general, the common law employer is the one entitled to include the wages, allowing for wages paid to leased employees or through a common paymaster to be eligible as wages for 199A purposes.

The W-2 wage limitation applies separately for each trade or business in the same manner the wages are allocated to those trades or businesses for purpose of producing the income from those activities. W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.

Notice 2018-64 provides three methods for calculating W-2 wages which are very similar to the methods provided in former section 199 (the unmodified box method, the modified box 1 method and the tracking wages method.).

Determination of UBIA of Qualified Property

Taxpayers are also eligible for the deduction if they can use the basis of qualified property that is used in the trade or business. The Proposed Regulations identify the term “UBIA” to mean the unadjusted basis immediately after the acquisition of qualified property. The Proposed Regulations contain detailed rules for calculating UBIA. UBIA is determined without regard to any adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense. Special rules are provided for like-kind exchanges, involuntary conversions, and other nonrecognition transactions.

Aggregation Rules

The Proposed Regulations contain aggregation rules allowing separate trades or businesses to be grouped when applying the Code Section 199A rules. The Proposed Regulations allow, but do not mandate, taxpayers to aggregate their businesses if they meet certain requirements focused on the relatedness of the owners of the businesses and of the activities conducted or services or products provided by the businesses. The Proposed Regulations contain the following four requirements in order for taxpayers to be eligible to aggregate:

  • Each trade or business must be a section 162 trade or business for purposes of Code Section 199A;
  • Same group of persons must directly or indirectly own a majority interest (50% or more) in each of the businesses for the majority of the relevant taxable year;
  • No trade or business is an SSTB; and
  • Taxpayer can establish that the businesses are part of a larger, integrated trade or business, they share common facilities or significant business elements, or they operate in coordination with each other.

The Proposed Regulations provide that aggregation is permitted only at the taxpayer level and not allowed at the entity-level (thus no aggregation by partnerships or S corporations). The Proposed Regulations provide that individuals must consistently report the aggregated trades or businesses in all subsequent tax years once multiple trades or businesses are aggregated into a single aggregated trade or business. The Proposed Regulations provide rules for situations in which the aggregation rules are no longer satisfied as well as rules for when a newly created or acquired trade or business can be added to an existing aggregated group.

Anti-Abuse Rules

The Proposed Regulations establish anti-abuse rules to prevent taxpayers from developing creative structures in order to fall within the purview of Code Section 199A rules. The preamble states that the Treasury Department and the IRS are aware 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 (the so called “crack and pack” strategy). According to the preamble, this strategy is inconsistent with the purpose of section 199A. The Proposed Regulations provide that a 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 a SSTB. The Proposed Regulations also provide that, if a trade or business has 50% or more common ownership with a 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 a SSTB (causing the related income to be treated as income from a SSTB).

The Proposed Regulations also provide 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 an SSTB if the trade or business represents no more than 5% of gross receipts of the combined business.

The Proposed Regulations further provide that, 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. The preamble states that 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. The Proposed Regulations combat this treatment by providing that 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.

The Proposed Regulations further provide that if an individual who was treated as an employee for Federal employment tax purposes by the person to whom he or she provided services, and who is subsequently treated as other than an employee by that person with regard to the provision of substantially the same services directly or indirectly to the person (or a related person), is presumed to be in the trade or business of performing services as an employee with regard to such services. 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 also include an anti-abuse rule that disregards property as qualified property for purposes of the UBIA of qualified property limit if the property is acquired within 60 days of the end of a taxable year and disposed of within 120 days without having been used in a business for at least 45 days, unless the taxpayer can demonstrate that the principal purpose of acquisition and disposition was a purpose other than increasing the Code Section 199A deduction.

Next Steps

The Proposed Regulations are generally to apply to tax years ending after the date that the regulations become final. It is unclear if the Proposed Regulations will be finalized prior to the end of 2018. The final regulations could significantly modify the Proposed Regulations as comments are due 45 days from when the regulations are posted in the Federal Register. However taxpayers may rely on the Proposed Regulations, in their entirety, until final regulations are published in the Federal Register. NOTE however that many of the anti-abuse rules are proposed to apply to tax years ending after 12/22/2017 – the enactment of the Tax Act.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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