CODE § 199A QUALIFIED BUSINESS INCOME DEDUCTION

By ©2018 Scott P. Greiner, J.D., LL.M. (Taxation), Moye White LLP.

Earlier this year the CBA Business Law Section published an article by this author in its January 2018 newsletter. The article included a brief summary of the new Code¹ § 199A qualified business income (QBI) deduction enacted as part of the 2017 Tax Cuts and Jobs Act. Since then, the statute has been amended and proposed reliance regulations have been promulgated.

This author presented on this subject matter at the 2018 Business Law Institute held last September. The materials submitted included an updated version of the article published in the January newsletter. For those interested members who were unable to attend the 2018 Business Law Institute, the updated article can be downloaded here.

Shortly before the September presentation, the U.S. Treasury promulgated proposed regulations interpreting Code § 199A. These regulations are generally helpful in applying this new Code section. More importantly, these proposed regulations expressly state that taxpayers may rely upon them until Treasury adopts final regulations. Normally, proposed regulations have no force of law.

The proposed regulations are broken down into six sections. A copy can be downloaded here. A detailed analysis of these regulations is beyond the scope of this article. What you will find below is a high-level overview of each section. If you first read this author’s updated article to familiarize yourself with Code § 199A, the overview that follows will make more sense. This Code section is complicated. You are strongly urged to read the proposed regulations in full, along with the preamble, or consult with competent tax counsel prior to advising a client on the new QBI deduction.

QBI Deduction Computational Rules

Prop. Reg. § 1.199A-1 sets forth operational rules regarding the mathematics of Code § 199A. It first defines key terms, then provides rules for computing the QBI deduction for individuals with taxable income that does not exceed a threshold amount and then for those whose taxable income is above the threshold amount. There are helpful examples that illustrate the arithmetic. The threshold amount is $157,500 (or twice that amount in the case of married individuals filing a joint return) indexed for inflation starting in 2019.

Determination of W-2 Wages and UBIA of Qualified Property

Prop. Reg. § 1.199A-2 contains rules for determining what is meant by “W-2 wages” and “the unadjusted basis immediately after acquisition of qualified property” (UBIA of qualified property). The proposed regulations define W-2 wages, set forth requirements for reporting such wages to the Social Security Administration, plus provide methods for calculating W-2 wages, allocating them to trades or businesses, and allocating them to QBI. No easy task.

Next, Prop. Reg. § 1.199A-2 defines the term “qualified property” then explains what is meant by unadjusted basis immediately after acquisition. Beware of the anti-abuse rule at Prop. Reg. § 1.199A-2(c)(1)(iv).

QBI; Qualified REIT Dividends; Qualified PTP Income

Prop. Reg. § 1.199A-3 defines the terms “qualified business income”, “qualified REIT dividends” and “qualified publicly traded partnership income.” Each term is critical to the calculation of the QBI deduction. Pay particular attention to the long list of items that are included and excluded in the calculation of QBI. While S corporation shareholder-employees are prevented from including an amount of “reasonable compensation” in QBI, the concept of reasonable compensation is not extended to guaranteed payments to partners for services under Code § 707(c). This is out of concern that a partnership could then be required to apply this concept to its partners in violation of the principle set forth in Rev. Rul. 69-184, 1969-1 CB 256, that a partner cannot be an employee of his or her partnership.

Aggregating Trades or Businesses

Generally, each trade or business is a separate trade or business for purposes of calculating the QBI deduction. Prop. Reg. § 1.199A-4 provides a helpful rule that allows individuals and relevant pass-through entities (RPEs) to aggregate trades or businesses. This is a permissive rule. Aggregation is not mandated. But if an individual or RPE desires to aggregate more than one trade or business, trades or businesses can be combined only if a five part test is satisfied. The examples are helpful in flushing out the circumstances under which trades or businesses may or may not be aggregated. Once two or more trades or businesses have been aggregated though, there are consistency and annual reporting requirements that must be satisfied. Failure to comply risks disaggregation by the IRS.

Specified Service Trades or Businesses (Including Law Firms); Trade or Business of Performing Services as an Employee

The fifth section, Prop. Reg. § 1.199A-5, directly impacts Business Law Section members. This section addresses the limitations imposed on the QBI deduction because of the involvement of “specified service trades or businesses” (SSTBs) or because it involves the trade or business of performing services as an employee. This is particularly relevant to individuals performing services in the field of law in their capacities as lawyers, paralegals, legal arbitrators, mediators and similar professionals.
If a trade or business is an SSTB, no QBI, W-2 wages or UBIA of qualified property from the SSTB may be taken into account by any individual whose taxable income exceeds the threshold amount plus $50,000 (or twice that amount in the case of married individuals filing a joint return) (phase-in range). If a trade or business conducted by a RPE is an SSTB, this limitation applies to any direct or indirect individual owners of the business, regardless of whether the owner is passive or participates in any specified service activity. Importantly, the SSTB limitation does not apply to individuals with taxable income below the threshold amount. And there is a phase-in rule applicable to individuals with taxable income within the phase-in range. This rule allows them to take an applicable percentage of QBI, W-2 wages and UBIA of qualified property from the SSTB into account in computing their QBI deduction.

The crux of the SSTB limitation lies in the definition of an SSTB. Prop. Reg. § 1.199A-5 first reiterates the trades and businesses targeted by the statute, e.g., services performed in the fields of health, law, accounting, etc. It then launches into a rather useful explanation of what each of those terms means for purposes of the SSTB limitation.

Next, the proposed regulations set forth three special rules for applying Prop. Reg. § 1.199A-5. First, for a trade or business with gross receipts of $25,000,000 or less in a taxable year, the trade or business will not constitute an SSTB if less than 10% of its gross receipts are attributable to the performance of services in one of the targeted fields. If gross receipts are in excess of $25,000,000, 5% is substituted for 10%.

Second, an SSTB includes any trade or business that provides 80% or more of its property or services to an SSTB if there is 50% or more common ownership, including indirect ownership by related parties. If the trade or business provides less than 80% of its property or services to an SSTB, only that lesser portion is treated as a part of the SSTB.

Third, if a trade or business that would not otherwise be an SSTB has 50% or more common ownership with an SSTB, including ownership by related parties, and has shared expenses with the SSTB, including shared wage or overhead expenses, then it is treated as incidental to, and therefore, part of the SSTB if gross receipts of the trade or business represent no more than 5% of the combined gross receipts of the trade or business and the SSTB.

Prop. Reg. § 1.199A-5 further provides that the trade or business of performing services as an employee does not constitute a trade or business for purposes of Code § 199A, and thus, no items of income, gain, loss or deduction from the trade or business of being an employee constitute QBI. How a worker is classified by an employer is immaterial for these purposes. If a worker should be properly classified as an employee, it is of no consequence that the employee is treated as a non-employee by the employer. Moreover, there is a rebuttable presumption that once an employee always an employee if the former employee continues to provide services to his or her former employer (or a related person) that are substantially the same services as he or she previously provided.

As true in other sections of the proposed regulations, there are useful examples illustrating the rules of Prop. Reg. § 1.199A-5.

Rules for RPEs, Publicly Traded Partnerships and Trusts and Estates

Finally, Prop. Reg. § 1.199A-6 provides computational and reporting rules for RPEs, publicly traded partnerships (PTPs), trusts and estates necessary for the determination of the QBI deduction of their owners and beneficiaries. While as a general rule a client’s CPA will be tasked with complying with these computational and reporting rules, attorneys should nevertheless be familiar with them if ever asked to assist with their compliance.

For those attorneys working with trusts and estates, pay particular attention to the computational and reporting rules for non-grantor trusts and estates. Notably, each trust and estate is entitled to a separate threshold amount of $157,500. One way to avoid exceeding a single trust’s threshold amount is to establish multiple trusts to own equity interests in RPEs and PTPs. ;Before proceeding down this path, however, beware of the following anti-abuse rule: trusts formed or funded with a significant purpose of receiving a QBI deduction will not be respected. Immediately following this rule is a cross reference to Prop. Reg. § 1.643(f)-1.

This latter regulation authorizes the IRS to aggregate two or more trusts if they have substantially the same grantor(s) (with spouses treated as one person) and substantially the same primary beneficiary(ies) where the principal purpose for establishing such trusts or for contributing additional cash or property is the avoidance of Federal income tax. If a significant income tax benefit results from the establishment or funding of a trust, the trust is presumed to have the tainted principal purpose. This presumption can only be overcome if there is a significant non-tax (or non-income tax) purpose that could not have been achieved without the creation of separate trusts. These rules are illustrated by two examples: one specifically in the context of Code § 199A where the trusts were aggregated, one where they were not.

With winter approaching, these proposed regulations make for good fireside reading.

UNSOLICITED AND UNEXPECTED COMMUNICATIONS AND THE TROUBLE THEY CAN CREATE

2018 ETHICS UPDATE¹

Presentation to the Tax, Business Law, Real Estate and
Trust and Estate Sections
December 12, 2018

By Herrick K. Lidstone, Jr.
Burns, Figa & Will, P.C.
Greenwood Village, CO

How many times have we received emails from unknown parties starting off: “Can your firm handle IP Litigation agreement matter matter [sic], a referral will be appreciated. Thanks, Michael.”² Sometimes they talk about existing agreements, an attorney needed to perform due diligence to validate the assets, or running funds through an attorney trust account because we are so reputable. Another scam is to fund your law firm with working capital: “Get an offer and capital in your account within 24 hours.”  DON’T.

Remember the old adage: “If it sounds too good to be true, it probably is.” ;The following emails reflect the risks that lawyers run in those situations.

1. SCAMS TO AVOID:

This is from the [email protected] email listserv on November 6, 2018, where they used the actual lawyers’ names, which I have redacted to save the embarrassment for the ethical and financial problems that developed.

Email No. 1 – The Inquiry

Subject:  Help with Due Diligence

I have a client who has received a term sheet for a $1.5 Million convertible note investment from:
Al ****** Investment LLC
Bahrain Financial Harbour
Manama, Bahrain

Our checking supports that this a very well-respected organization. The Term Sheet does not require any upfront payment by the client, other than a trip to the Middle East to attend the closing.

Having heard, and personally seen, quite a number of scams, I am perhaps overly suspicious. I wonder if anyone on the listserv has had any experience with the organization?
I would appreciate anybody with direct experience with Al ******** Investment LLC letting me know if there is a reason not to proceed.

Thanks,
AAAA BBBBBB, Attorney

Email No. 2 – The Rule of Law Is a Suggestion – Not a Law

I have done business in that area for years and you must be very careful. The Rule of Law is a suggestion so once you’re burned it, it is very difficult to seek justice from the Court. I would do a very through Due Diligence including asking for money up front.
CCCC DDDDDD, Attorney

Email No. 3 – Don’t Get Taken

I disagree with the suggestion that an attorney or client request money “up front” before the identity and legitimacy of the counterparty and funder is determined definitively. Accepting money from an unverified foreign source can bite the lawyer in the tuchas.³
EEEE FFFFFF, Attorney

Email No. 4 – I Was Burned; There Were Criminal and Ethical Consequences

Hello AAAA and all:

Let me recommend that you be more than cautious. I was burned earlier this year in a matter by a foreign business that did everything to verify that they were legitimate and that all the facts of the story lined up without a problem. It was supposed to be a straightforward matter that they wanted to do on contingency, they agreed to pay the going rate on the matter. I had a retainer agreement from them, the existing contracts that were in dispute, email communications between the parties, term sheets, verification of everything, etc. I had contacts that verified their existence, their addresses were verified via passport, LinkedIn, corporate records, and register of deeds searches on the property they claimed to be located be at. I thought I had been extra careful and verified everything possible. Little did I know.

Once we started the litigation on the contract, the other side settled really fast to protect their “business reputation” and signed a settlement offer and cut the first payment on a large settlement, just as they said they would. We never got the formal papers filed with the courts or the government agencies involved in the dispute, because it was “settled”. I received the first payment, deducted my fees, and got ready to transfer the monies back overseas to the Plaintiff corporation. I did everything I could to verify their existence and then some.

In the end, the settlement check ended up being a fraudulent check, drawn on a major Canadian Bank (my client was a Canadian Co.). The check cleared my bank, the Federal Reserve Bank, the international clearing house, but when it was presented back to Canada Bank and Trust for payment, they stated the check was fraudulent. Contemporaneous to this realization, my bank clawed back as much of the funds they dispersed, as they could, from my operating account and people I paid with that money from my fees. Because the check washed thru my IOLTA, they made a formal complaint to the Bar, and the police, claiming I passed a bad check.

It is now being investigated by the bar, and the bank and I, who are both the victims here, are suing each other. They are suing me for passing a bad check; I am suing them on my banking agreement and reliance on the fact that the funds cleared my bank and all the clearing houses, and we all believed the system would work normally and the funds being paid out from Canada, to my bank, upon presentment of the check. That never happened.

The only saving grace here was that I insisted upon some legal fees up front, so they would have some “skin in the game”. They were happy to do that because I reduced the contingency I was going to collect to insure I got something. That check was fraudulent also. I would have transferred the initial settlement payout to them, and they would have made out like bandits (which they were) had the system run just a couple of days slower. In the end, we are fighting over $152,250.00 and I am probably going to get stuck with it. Who knows what the MI Bar is going to do. The police have dismissed the matter against me and my firm.

The moral of this is, be very, very careful. Don’t use any phone number they give you. Check the websites, physical addresses, names of people, and everything else you possibly can. Even then, unless you actually meet face-to-face, you still might get burned.  I have no idea what the ABA’s opinion is on this, what they would say about this, or what anybody else’s experience is with this type of fraud, but I got burned.  Good luck.

Respectfully yours,
GGGG HHHHHH, Attorney

Email No. 5 – Scammers Prey on Smaller Firms; a Less Costly Mistake

Thank you GGGG for sharing this story. This is heartbreaking!

These scammers prey on us smaller firms, as they think we don’t conduct our due diligence.  But even if we do, they are very slick with how much effort they go to in order to make it look real.

1. I too spent five hours into an Asset Purchase Agreement, making deal suggestions and higher level of comment and edit, with a totally fake company. Looking back, it was probably going to be a money laundering scheme to get money into the US. They offered to send me a $10,000 retainer and the next question they had was, “oh BTW, can I hold the entire $1.5 million sale proceeds in my own lawyer’s escrow account.” NO WAY!

Luckily, I had spent only five hours of my time making comments and suggestions on the POS (piece of junk) Asset Purchase Agreement, on their promise of sending a retainer “shortly”. Luckily I didn’t receive any money from them, so I was not tied into it like you were but sadly I was out 5 hours of time, which PALES compared to what you are out. As soon as I asked the guys I dealt with for the name of their US Accountant and their general corporate counsel, they disappeared.

2. In two other situations, these scammers emailed me seeking to buy a company here in Illinois, in one case they were very clever, they picked an address in Downers Grove (Chicago suburb where my office is located) thinking I’d take the bite, to do a local deal. I did… for a just a short while… until I physically drove over to the location address they provided (five minutes from my office) and it was a completely different company, not the one they said.


3. In another case I called the purported target company the scammers were buying, but instead of using their fake phone numbers, I used the website phone number. The people at the REAL company, including the CFO, had no idea what I was talking about and said they were not selling the company.


4. I’ve also had clients ripped off in similar situations with scammers who say they want to buy their company, or invest into it.

IIII JJJJJJ, Attorney

Email No. 6 – Catch Me If You Can

This entire thread is crazy to me, especially since I work in the blockchain space and it’s supposed to solve stuff like this. It’s like “Catch Me If You Can” except 50 years later, the problem still persists.

MMMM NNNNNN, Attorney

2. AVOID CHECKS – DOES A FED WIRE WORK?

A. Contact the Issuing Bank Before Counting the Money

In case this was not already mentioned in this thread, for those who ask for a retainer up front in these types of situations, another option is to contact the relevant bank prior to depositing the check. My former firm dealt with a very similar situation to what GGGG described, circa 2010-11, up through receipt of the initial retainer fee. We also insisted on some legal fees up front, so they would have skin in the game. When a certified bank check from Chase arrived via UPS, I asked an associate at our firm to walk it into a Chase branch across the street from our offices. No surprise for this thread – upon entering the check number into their system, the bank advised that the check was not real.
KKKK LLLLLL, Attorney

B. Payment Terms.

I always insist that any large sum be paid by wire transfer. That makes the money go through the entire system up front. Even so I wait several days before taking any money out or disbursing any funds. I also check with my banker before disbursing. Wire transfers seem to work. However, I have gotten large checks, presumably in payment, which I did not deposit. Oddly, the senders did not make much of a fuss – because they were frauds. However, I never had a situation which went so far as you describe.
OOOO PPPPPPP, Attorney

C. Unexpected $199,800 Cashier’s Check Issued by a Major Canadian Bank

We recently received a large cashier’s check purportedly issued by a major Canadian bank for the account of a person who was not a client and had communicated with us several months before. Our staff was suspicious and brought it to my attention. I contacted our bank who referred me to the bank’s fraud department. The fraud investigator declared the check fraudulent in less than a minute because of the routing and account numbers not being consistent with the balance of the check.

Trying to learn, I asked her how she was going to proceed. She was going to do more investigation (I had sent her all of our communications and information) and write a fraud report which she would send to the U.S. Secret Service. The Secret Service tracks these fraudulent checks and takes action where they can identify the participants and obtain jurisdiction. The fraud examiner said that she receives approximately 20 of these checks for examination each month from clients – and they are all fraudulent.

I asked her how innocent law firms and others can protect themselves from this situation – thus avoiding the problems that Email #4 pointed out. Her comment was client awareness – each bank client must be aware of the risk of fraudulent checks. Awareness goes to staff opening the mail; attorneys receiving the mail; bookkeeping persons depositing the checks.

We did not deposit the check.  We did respond to the person who had contacted us earlier that we did not and have not represented that person in any matter – to ensure that there could be no allegation of the existence of an attorney-client relationship.

D. Money Laundering and Other Issues

Even when the funds are real, there are issues under AML Laws, FIRPTA, FIRRMA (Foreign Investment Risk Review Modernization Act of 2018), FinCEN regulation requiring disclosure of beneficial owners of foreign investments (including through geographic targeting orders), and other regulations.⁴

3. ETHICAL RULES AT ISSUE

There is always a question of “who is your client” – implicating the establishment of the attorney-client relationship. If you cannot obtain and verify sufficient information to identify your client, you will be taking risks on the authority of the persons giving you information, the ability to provide the client competent representation and meet your communication obligations, manage conflicts and protect confidentiality, and comply with the anti-money laundering rules. Consider Rules 1.1, 1.2, 1.3, 1.4, 1.6, 1.7, 1.8, 1.9, 1.13, and 8.4.

Many of these opportunities as described above use checks, even cashiers’ checks, which the banking system can take a long while to clear (even though we as customers think differently). Similarly, for credit cards – most issuers allow holders to challenge charges 90 days or more after made – after, of course, we have spent the funds we thought we received. This, of course implicates Rules 1.5, 1015A through 1.15E, and again Rule 8.4. CAUTION should be the word of the day.

Colorado Secretary of State End-of-Year Hours

The Secretary of State’s office will be closed on Tuesday, January 1.

In addition, online services will be unavailable from 11:30 p.m. on Monday, December 31 until noon on Tuesday, January 1. The Secretary of State is conducting yearly maintenance during this time and services like filing and searching are affected. Filing deadlines will not be extended, so be sure to finish your filings before 11:30 p.m. on December 31.

The filing of paper forms, such as mergers, will be unavailable from 4:30 p.m. on December 31, 2018 until January 2, 2019 at 8:00 a.m. If a filing needs an effective date of December 31, 2018 or January 1, 2019, it should be submitted as soon as possible and include a delayed effective date.

CBA-CLE Upcoming Programs

Tax Cuts and Jobs Act: Critical Provisions Non-Tax Attorneys Need to Know – December 5

Real Estate Legal Considerations in M&A Transactions – December 11

1031 Like-Kind Exchanges on December 14: Fundamentals, Advanced or Both Programs

36th Annual National CLE Conference© in Vail, January 2–6, 2019: Business and Tax Law – Strategic Planning

CBA-CLE Business Law Homestudies

2018 Legislative Update

2018 Business Law Institute

Colorado’s NEW Data Privacy Law: What It is and Its Impact on You and Your Clients

Featured CLE Publication

Guide for Colorado Nonprofit Organizations, Second Edition

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Contact Ed Naylor at [email protected], 303-292-2900.
This newsletter is for information only and does not provide legal advice.