August 2018

New Tax Law Favors Hedge Funds Over Managed Accounts

August 28, 2018 | By: Robert A. Green, CPA | Read it on

Hedge fund investors benefited from tax advantages over separately managed accounts (SMA) for many years. The 2017 Tax Cuts and Jobs Act (TCJA) widened the difference by suspending all miscellaneous itemized deductions, including investment fees. SMA investors are out of luck, but hedge fund investors can limit the negative impact using carried-interest tax breaks. TCJA provided a new 20% deduction on qualified business income, which certain hedge fund investors might be eligible for if they are under income caps for a service business.

TCJA penalizes investors with separately managed accounts
SMA investors cannot claim trader tax status (TTS) since an outside manager conducts the trading, not the investor. Therefore, investment expense treatment applies for advisory fees paid.

Beginning in 2018, TCJA suspended all miscellaneous itemized deductions for individuals, which includes investment fees and expenses. If a manager charges a 2% management fee and a 20% incentive fee, an individual may no longer deduct those investment fees for income tax purposes. Before 2018, the IRS allowed miscellaneous itemized deductions greater than 2% of AGI, but no deduction was allowed for alternative minimum tax (AMT); plus, there was a Pease itemized deduction limitation. (Taxpayers are still entitled to deduct investment fees and expenses for calculating net investment income for the Net Investment Tax.)

For example: Assume an SMA investor has net capital gains of $110,000 in 2018. Advisory fees are $30,000, comprised of $10,000 in management fees and $20,000 in incentive fees. Net cash flow on the SMA for the investor is $80,000 ($110,000 income minus $30,000 fees). The SMA investor owes income tax on $110,000 since TCJA suspended the miscellaneous itemized deduction for investment fees and expenses. If the individual’s federal and state marginal tax rates are 40%, the tax hike might be as high as $12,000 ($30,000 x 40%). (See Investment Fees Are Not Deductible But Borrow Fees Are.)

Investment managers do okay with SMAs
In the previous example, the investment manager reports service business revenues of $30,000. Net income after deducting business expenses is subject to ordinary tax rates.

An investment manager for an SMA is not eligible for a carried-interest share in long-term capital gains, or 60/40 rates on Section 1256 contracts, which have lower tax rates vs. ordinary income. Only hedge fund managers as owners of the investment fund may receive carried interest, a profit allocation of capital gains and portfolio income.

Additionally, if the manager is an LLC filing a partnership tax return, net income is considered self-employment income subject to SE taxes (FICA and Medicare). If the LLC has S-Corp treatment, it should have a reasonable compensation, which is subject to payroll tax (FICA and Medicare).

Hedge funds provide tax advantages to investors
Carried interest helps investors and investment managers. Rather than charge an incentive fee, the investment manager, acting as a partner in the hedge fund, is paid a special allocation (“profit allocation”) of capital gains, Section 475 ordinary income, and other income.

Let’s turn the earlier example into a hedge fund scenario. The hedge fund initially allocates net capital gains of $110,000, and $10,000 of management fees to the investor on a preliminary Schedule K-1. Next, a profit allocation clause carves out 20% of capital gains ($20,000) from the investor’s K-1 and credits it to the investment manager’s K-1. The final investor K-1 has $90,000 of capital gains and an investment expense of $10,000, which is suspended as an itemized deduction on the investor’s individual tax return. Carried interest helps the investor by turning a non-deductible incentive fee of $20,000 into a reduced capital gain of $20,000. Carried interest is imperative for investors in a hedge fund that is not eligible for TTS business expense treatment. With a 40% federal and state tax rate, the tax savings on using the profit allocation instead of an incentive fee is $8,000 ($20,000 x 40%). To improve tax savings for investors, hedge fund managers might reduce management fees and increase incentive allocations.

TCJA modified carried interest rules for managers
Hedge fund managers must now hold an underlying position in the fund for three tax years to benefit from long-term capital gains allocated through profit allocation (carried interest). The regular holding period for long-term capital gains is one year. I’m glad Congress did not outright repeal carried interest, as that would have unduly penalized investors. The rule change trims the benefits for managers and safeguards the benefits for investors. The three-year holding period does not relate to Section 1256 contracts with lower 60/40 capital gains rates, where 60% is a long-term capital gain, and 40% is short-term.

Trader tax status and Section 475 tax advantages
If a hedge fund qualifies for TTS, then it allocates deductible business expenses to investors, not suspended investment expenses. I expect many hedge funds will still use a profit allocation clause since it might bring tax advantages to the investment manager — a share of long-term capital gains, and a reduction of payroll taxes on earned income vs. not owing payroll taxes on short-term capital gains.

TCJA 20% QBI deduction on pass-through entities
The TCJA included a lucrative new tax cut for pass-through entities. An individual taxpayer may deduct whichever is lower: either 20% of qualified business income (QBI) from pass-through entities or 20% of their taxable income minus net capital gains, subject to other limitations, too. (Other QBI includes qualified real estate investment trust REIT dividends and qualified publicly traded partnership PTP income.)

The proposed QBI regulations confirm that traders eligible for TTS are considered a service business (SSTB). Upper-income SSTB owners won’t get a deduction on QBI if their taxable income (TI) exceeds the income cap of $415,000/$207,500 (married/other taxpayers). The phase-out range is $100,000/$50,000 (married/other taxpayers) below the income cap, in which the QBI deduction phases out for SSTBs. The W-2 wage and property basis limitations apply within the phase-out range, too.

Hedge funds with TTS are an SSTB if the fund is trading for its account through an investment manager partner. A hedge fund with TTS is entitled to elect Section 475 ordinary income or loss. Hedge fund QBI likely includes Section 475 ordinary income. QBI excludes all capital gains, commodities and forex transactions, dividends, and interest. The SSTB taxable income thresholds and cap apply to each investor in the hedge fund; some may get a QBI deduction, whereas, others may not, depending on their TI, QBI aggregation, and more. (See How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations.)

The proposed QBI regulations also describe investing and investment management as an SSTB. QBI includes advisory fee revenues for investment managers earned from U.S. clients, but not foreign clients. QBI must be from domestic sources. I presume QBI should exclude a carried-interest share (profit allocation) of capital gains but will include a carried-interest percentage of Section 475 ordinary income.

TCJA might impact the investment management industry
Many investors are upset about losing a tax deduction for investment fees and expenses. Some just realized it. I recently received an email from an investor complaining to me about TCJA’s suspension of investment fees and expenses. He was about to sign an agreement with an investment manager for an SMA but scrapped the deal after learning he could not deduct investment fees. Most hedge funds only work with larger accounts and adhere to rules for accredited investors and qualified clients who can pay performance fees or profit allocations.

Larger family offices may have a workaround for using business expense treatment without TTS, as I address on my blog post How To Avoid IRS Challenge On Your Family Office.

Managed accounts vs. hedge fund
Investment managers handle two types of investors: separately managed accounts (SMAs) and hedge funds (or commodity or forex pools). In an SMA, the client maintains a retail customer account, granting trading power to the investment manager. In a hedge fund, the investor pools his money for an equity interest in the fund, receiving an annual Schedule K-1 for his allocation of income and expense. It’s different with offshore hedge funds.

In an SMA, the investor deals with accounting (including complex trade accounting on securities), not the investment manager. In a hedge fund, the investment manager is responsible for complicated investor-level accounting, and the fund sends investors a Schedule K-1 that is easy to input to tax returns.

There are several other issues to consider with SMAs vs. hedge funds; tax treatment is just one critical element. “SMAs provide transparency, and this is important to many clients, particularly tax-exempts or fiduciary accounts,” says NYC tax attorney Roger D. Lorence.

Roger D. Lorence contributed to this blog post.

 


How To Save U.S. Taxes For Nonresident Aliens

August 21, 2018 | By: Robert A. Green, CPA | Read it on

The U.S. stock markets have been stellar, and many non-U.S. persons have been accessing them from their home country. Other foreign individuals and entities prefer to open U.S.-based brokerage accounts for lower commissions, and better trading platforms.

In either case, the foreign individual or foreign company is subject to U.S. tax withholding on U.S. dividends and certain other U.S. passive income. The default withholding tax rate is 30%, and income tax treaties provide for lower rates, usually around 15% or less. U.S. brokers handle this tax withholding and pay those taxes to the Internal Revenue Service (IRS). The foreign investor does not have an obligation for U.S. tax compliance if withholding is done correctly.

The critical point is that capital gains are not taxable in the U.S. if the nonresident alien does not spend more than 183 days per year in the U.S. Most active traders don’t generate significant dividend income paid by U.S. companies, so tax withholding is not a problem. Many of them get a foreign tax credit for U.S. tax withholding in their resident country.

Some nonresident aliens establish a spousal-member LLC in the U.S. and file a U.S. partnership tax return. The LLC/partnership opens a U.S.-based brokerage account as a domestic entity. The LLC files a W-9 with a U.S. tax identification number. The broker treats the U.S. LLC/partnership as a U.S. account, which means the broker does not handle the tax withholding on dividends and other passive income for the foreign owners of the LLC.

Therefore, the nonresident alien owners must file a W-8BEN with the U.S. partnership. The U.S. partnership assumes responsibility for tax withholding on dividends and other portfolio income, and payment of those taxes to the IRS on a timely basis. It’s extra tax compliance work, but it’s not too complicated.

U.S. estate tax might come into play. Estate tax treaties may exempt brokerage accounts for nonresident aliens or provide higher exemptions from the tax. U.S. partnership interests are likely not includible in an estate for a nonresident alien. Brokers are not responsible for estate tax compliance, so it’s a tax matter for nonresident aliens and their tax advisors. Brokers require a conclusion of IRS estate proceedings before releasing assets from the account of the deceased.

Nonresident alien U.S. income tax treatment
In this scenario, nonresident aliens are subject to U.S. tax withholding on dividends paid by U.S. companies and on other “fixed or determinable, annual, or periodic” (FDAP) income. Per IRS Taxation of Nonresident Aliens: “FDAP income is passive income such as interest, dividends, rents or royalties. This income is taxed at a flat 30% rate unless a tax treaty specifies a lower rate.” Many countries have a tax treaty with the U.S. providing for 15% or lower withholding tax rate on FDAP income. Interest income on bonds and commercial paper issued by U.S. companies, by the U.S. Treasury, and by U.S. government agencies is generally exempt from U.S. tax withholding, although it’s reportable on Form 1042-S.

Nonresident alien individuals fill out W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding and Reporting – Individuals) and furnish it to the broker. Don’t overlook Part II to claim tax treaty benefits. The broker then withholds taxes on U.S.-source dividends and other FDAP income at the appropriate tax treaty rates, or 30% if there is no tax treaty, and pays those taxes to the IRS directly. As a withholding agent, the broker is required to report all U.S.-source FDAP to the IRS and the client on Form 1042-S. There are other types of W-8 forms including W–8BEN–E (entities), W–8ECI (ECI from U.S. business), W–8EXP (foreign government or organization), and W–8IMY (foreign intermediary or branch).

Capital gains 183-day rule
If the nonresident alien spends more than 183 days in the U.S., he owes taxes on net U.S. source capital gains, even though he may not trigger U.S. residency under the substantial presence test. (U.S. residency is triggered with legal residence status or by meeting the substantial presence test. The IRS taxes U.S. residents on worldwide income.)

See IRS The Taxation of Capital Gains of Nonresident Alien Students, Scholars and Employees of Foreign Governments:

“Nonresident alien students and scholars and alien employees of foreign governments and international organizations who, at the time of their arrival in the United States, intend to reside in the United States for longer than 1 year are subject to the 30 percent taxation on their capital gains during any tax year (usually calendar year) in which they are present in the United States for 183 days or more, unless a tax treaty provides for a lesser rate of taxation. These capital gains would be reported on page 4 (not page 1) of Form 1040NR and would not be reported on a Schedule D because they are being taxed at a flat rate of 30 percent or at a reduced flat rate under a tax treaty.”

Income tax treaties
Per IRS Taxation of Nonresident Aliens:

“The United States has income tax treaties with a number of foreign countries. For nonresident aliens, these treaties can often reduce or eliminate U.S. tax on various types of personal services and other income, such as pensions, interest, dividends, royalties, and capital gains. Each individual treaty must be reviewed to determine whether specific types of income are exempt from U.S. tax or taxed at a reduced rate. More details can be found in IRS Publication 901, U.S. Tax Treaties.”

“Form 8833 does not apply to a reduced rate of withholding tax on noneffectively connected income, such as dividends, interest, rents or royalties.”

A nonresident alien may owe U.S. estate tax
U.S. estate tax considerations also may come into play in this situation. Nonresident aliens should learn how repatriation of funds work on death; they might have delays due to probate of the estate and getting IRS estate tax clearance. By opening a U.S.-based brokerage account, it lands the account in the U.S., which could potentially trigger U.S. estate taxes if over the estate exemption. While many types of funds like U.S. bonds are exempt from estate tax, U.S. equities are includible in an estate. (Nonresidents holding U.S. securities in a foreign brokerage account must count those U.S. securities in a U.S. estate.) The default estate exemption for nonresident aliens is $60,000; however, many estate tax treaties provide a significantly higher threshold. The estate tax rate starts at 18% and rises to 40%. An estate tax treaty beneficiary may be exempt from U.S. estate tax entirely on U.S. financial assets.  (Learn more about nonresident alien accounts income and estate taxation on Schwab’s Website and Schwab’s U.S. Tax, and Estate Disclosure to Non-U.S. Persons.)

Here is an IRS list of Estate & Gift Tax Treaties (International). The U.S.–Canada Income Tax Treaty includes estate tax issues. Canadians have a $2,000,000 estate exemption instead of the default $60,000 threshold.

Some nonresident aliens open a U.S. partnership account
Some U.S. brokers are not set up to accommodate nonresident aliens or other foreign persons including foreign corporations, partnerships, and trusts. They might recommend forming a U.S. LLC entity to open a U.S. entity account instead of a nonresident alien or foreign entity account. This U.S. entity account should be treated like other U.S. persons or entities, not subject to tax withholding on dividends by the broker. The U.S. LLC entity account should receive a Form 1099-B reporting dividends, interest, sale proceeds and cost basis, and other items of income or loss. The LLC files a W-9 with U.S. tax id number, not a W-8BEN-E for foreign entity status.

There are problems using a single-member LLC (SMLLC). Without classification as a partnership or C-Corp, an SMLLC is a disregarded entity. That would mean the SMLLC disregards to the nonresident alien individual, who should then file a W-8BEN-E. Nonresident aliens may not own an S-Corp. If the broker did treat the SMLLC disregarded entity as a domestic entity, the owner would have to file a complicated Form 1040NR in the event there is a U.S. tax liability (i.e., on U.S. dividends).

As stated above, it’s better to have a spousal-member LLC to file a partnership return. The U.S. partnership takes over the role as tax withholding agent from the broker, and the U.S. partnership must issue the Form 1042-S to the nonresident alien owners. Using a company does not avoid withholding taxes on U.S.-source FDAP income for nonresident owners.

“The Chapter 3 withholding regulations on U.S. source payments to foreign persons make clear that there is no U.S. withholding on payments to U.S. persons, which includes a partnership formed under U.S. law,” says tax attorney Roger D. Lorence. “The partnership is the withholding agent, and it is required to withhold on U.S. source dividends allocable to non-U.S. partners (nonresident aliens).” (See IRS Publication 515, Withholding of Tax on Nonresident Aliens and Foreign Entities.)

The Form 1065 U.S. partnership tax return can be reasonably straightforward because all owners are non-resident aliens. The partnership can report zero capital gains and losses but reconcile to the 1099-B for IRS matching purposes. The partnership can omit expenses as they do not affect U.S. income taxes. In the tax return footnotes, the partnership should explain that the nonresident owners do not owe capital gains taxes, because they are in the U.S. under 183 days per year.

Usually, the partnership can allocate dividends and portfolio income to partners on the last day of the year, so tax deposits for withholding can wait until early January of the subsequent year. It’s one accounting period, which reduces the stress of making tax payments on a timely basis to avoid penalties.

There might be challenges to establishing an LLC bank account, and repatriating funds to a foreign country.

“The U.S. partnership is not engaged in a trade or business in the U.S. with effectively connected income (ECI). It’s an investor partnership with FDAP and a Section 864 exemption,” Lorence says. “Although not free from doubt, the better view is that it is not included in a U.S. estate of a nonresident alien owner. Intangible assets like partnership interests are situated where the owner resides and dies. Legal situs is where the owner is located on death.”

Four ways nonresidents trade U.S. financial markets

1. Some foreign-based brokers offer limited access to U.S. financial markets. Even on foreign-based brokerage accounts, there is U.S. tax withholding on dividends paid by U.S. companies and other FDAP income. Foreign brokerage accounts do not issue a Form 1042-S as a U.S.-based broker does for nonresident aliens. There are U.S. estate tax considerations for U.S. securities.

2. Leading U.S. brokers open affiliate brokerage firms in some countries. There may be affiliates in Canada and some European and Asian countries. It’s the same tax treatment as the previous: tax withholding on U.S.-source FDAP income, no 1042-S issuance, and potential U.S. estate tax on U.S. securities.

3. Some U.S. brokers open accounts for nonresident aliens. The nonresident alien files a W-8BEN claiming tax treaty benefits, if applicable. The U.S. broker is an income tax withholding agent on U.S.-source FDAP with a default tax rate of 30% unless overridden by a treaty rate of usually 15% or less. The U.S. broker issues Form 1042-S reporting U.S. source income and withholding tax. There are some U.S. estate tax considerations for the nonresident so check if there is an estate tax treaty with your country, perhaps providing a higher exemption amount or exclusion. Some nonresident aliens form a foreign corporation, partnership or trust to open the brokerage account with a U.S. broker, which helps avoid potential U.S. estate taxation.

4. Some U.S.-based brokers suggest the nonresident alien open a U.S. LLC to create an account and file as a partnership. The broker treats the account like a U.S. person or entity issuing an annual tax report Form 1099-B. The broker does not withhold taxes on dividends paid by U.S. companies or on other U.S.-source FDAP income. The U.S. partnership takes over that role as tax withholding agent and issues the 1042-S to the IRS and nonresident owner of the partnership. There is probably no U.S. estate tax on a U.S. partnership interest in an investment company. There are challenges to establishing an LLC bank account, and repatriating funds to a foreign country. Consult a tax advisor.

Roger D. Lorence, JD contributed to this blog post.


How Traders Can Get 20% QBI Deduction Under IRS Proposed Regulations

August 15, 2018 | By: Robert A. Green, CPA | Read it on

The IRS recently released proposed reliance regulations (Proposed §1.199A) for the 2017 Tax Cuts and Jobs Act’s new 20% deduction on qualified business income (QBI) in pass-through entities.

The proposed regulations confirm that traders eligible for trader tax status (TTS) are a service business (SSTB). Upper-income SSTB owners won’t get a deduction on QBI if their taxable income (TI) exceeds the income cap of $415,000 married, and $207,500 for other taxpayers. The phase-out range is $100,000/$50,000 (married/other taxpayers) below the income cap, in which the QBI deduction phases out for SSTBs. The W-2 wage and property basis limitations apply within the phase-out range, too. Hedge funds eligible for TTS and investment managers are also SSTBs.

The new law favors non-service business (non-SSTB), which don’t have an income cap, but do have the W-2 wage and property basis limitations above the TI threshold of $315,000/$157,500 (married/other taxpayers). The 2018 TI income cap, phase-out range, and threshold will be adjusted for inflation in each subsequent year.

A critical question for traders
The proposed regulations do not answer this essential question: What types of trading income are included in QBI? The proposed regulations define a trading business, so I presume tax writers contemplated some types of ordinary income might be included in QBI. They probably wanted to limit tax benefits for traders by classifying trading as an SSTB subject to the income cap.

In my Jan. 12, 2018 blog post, How Traders Can Get The 20% QBI Deduction Under New Law, I explained how the statute excluded certain “investment-related” items from QBI, including capital gains, dividends, interest, annuities and foreign currency transactions. That left the door open for including Section 475 ordinary income for trading businesses. After reading the proposed regulations, I feel that door is still open.

Trading is a service business
See the proposed regulations, REG-107892-18, page 67. The Act just listed the word “trading,” whereas, the proposed regulations describe trading in detail and cite TTS court cases.

“b. Trading: Proposed §1.199A-5(b)(2)(xii) provides that any trade or business involving the “performance of services that consist of trading” means 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. Factors that have been considered relevant to determining whether a person is a trader 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. See Endicott v. Commissioner, T.C. Memo 2013-199; Nelson v. Commissioner, T.C. Memo 2013-259, King v. Commissioner, 89 T.C. 445 (1987). A person that is a trader under these principles will be treated as performing the services of trading for purposes of section 199A(d)(2)(B).”

QBI excludes certain items
See REG-107892-18, page 30: “Section 199A(c)(3)(B) provides a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, amounts received from an annuity other than in connection with a trade or business, certain items described in section 954, and items of deduction or loss properly allocable to these items.”

See REG-107892-18, page 144: “Items not taken into account” in calculating QBI. Here’s an excerpt of the list.

 “(A) Any item of short-term capital gain, short-term capital loss, long-term capital gain, long-term capital loss, including any item treated as one of such items, such as gains or losses under section 1231 which are treated as capital gains or losses.

(B) Any dividend, income equivalent to a dividend, or payment in lieu of dividends.

(C) Any interest income other than interest income which is properly allocable to a trade or business. For purposes of section 199A and this section, interest income attributable to an investment of working capital, reserves, or similar accounts is not properly allocable to a trade or business.

(D) Any item of gain or loss described in section 954(c)(1)(C) (transactions in commodities) or section 954(c)(1)(D) (excess foreign currency gains) applied in each case by substituting “trade or business” for “controlled foreign corporation.”

(E) Any item of income, gain, deduction, or loss taken into account under section 954(c)(1)(F) (income from notional principal contracts) determined without regard to section 954(c)(1)(F)(ii) and other than items attributable to notional principal contracts entered into in transactions qualifying under section 1221(a)(7).

(F) Any amount received from an annuity which is not received in connection with the trade or business.”

Section 954 is for “foreign base company income,” and tax writers used it for convenience sake to define excluded items including transactions in commodities, foreign currencies (forex) and notional principal contracts (swaps). The latter two have ordinary income, but they are excluded from QBI.

Section 475 ordinary income
The new tax law excluded specific “investment-related” items from QBI. In earlier blog posts, I wondered if QBI might include “business-related” capital gains. The proposed regulations dropped the term “investment-related,” which seems to close that door of possibility.

I searched the QBI proposed regulations for “475,” and there were 20 results, and each instance defined securities or commodities using terminology in Section 475. None of the search results discussed 475 ordinary income and its impact on QBI. The proposed regulations seem to allow the inclusion of Section 475 ordinary income in QBI.

TTS traders are entitled to elect Section 475 on securities and/or commodities (including Section 1256 contracts). For existing taxpayers, a 2018 Section 475 election filing with the IRS was due by March 15, 2018, for partnerships and S-Corps, and by April 17, 2018, for individuals. New taxpayers (i.e., a new entity) may elect Section 475 internally within 75 days of inception. Section 475 is tax loss insurance: Exempting 475 trades from wash sale losses on securities and the $3,000 capital loss limitation. With the new tax law, there’s now likely a tax benefit on 475 income with the QBI deduction.

Section 1231 ordinary income
See REG-107892-18, page 37: “Exclusion from QBI for certain items.”

“a. Treatment of section 1231 gains and losses. (Excerpt)
Specifically, if gain or loss is treated as capital gain or loss under section 1231, it is not QBI. Conversely, if section 1231 provides that gains or losses are not treated as gains and losses from sales or exchanges of capital assets, section 199A(c)(3)(B)(i) does not apply and thus, the gains or losses must be included in QBI (provided all other requirements are met).”

If you overlay Section 475 on top of the above wording for Section 1231, there is a similar result: Section 475 ordinary income is not from the sale of a capital asset, and it should be included in QBI since it’s not expressly excluded.

Section 1231 is depreciable business or real property used for at least a year. A net Section 1231 loss is reported on Form 4797 Part II ordinary income or loss. Section 475 ordinary income or loss for TTS traders is reported on Form 4797 Part II, too. A net Section 1231 gain is a long-term capital gain.

Section 64 defines ordinary income
“The term ordinary income includes any gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b). Any gain from the sale or exchange of property which is treated or considered, under other provisions of this subtitle, as ordinary income shall be treated as gain from the sale or exchange of property which is neither a capital asset nor property described in section 1231(b).”

The tax code does not define business income.

TTS traders with 475 ordinary income
A TTS trader, filing single, has QBI of $100,000 from Section 475 ordinary income, and his taxable income minus net capital gains is $80,000. He is under the TI threshold of $157,500 for single, so there is no phase-out of the deduction, and W-2 wage or property basis limitations do not apply. His deduction on QBI is $16,000 (20% x $80,000) since TI minus net capital gains is $80,000, which is lower than QBI of $100,000.

If his TI is greater than $157,500 but less than the income cap of $207,500 for a service business, then the deduction on QBI phases-out and the W-2 wage and property basis limitations apply inside the phase-out range.

If his TI is higher than the income cap of $207,500, there is no deduction on QBI in a trading service business.

Anti-abuse measures
The proposed regulations prevent “cracking and packing” schemes where an SSTB might contemplate spinning-off non-SSTBs to achieve a QBI deduction on them. “Proposed §1.199A-5(c)(2) provides that an SSTB includes any trade or business with 50 percent or more common ownership (directly or indirectly) that provides 80 percent or more of its property or services to an SSTB. Additionally, if a trade or business has 50 percent or more common ownership with an 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 an SSTB (meaning the income will be treated as income from an SSTB).”

Other anti-abuse measures prevent employees from recasting themselves as independent contractors and then working for their ex-employer, which becomes their client.

Aggregation, allocation and QBI losses
There are QBI aggregation and allocation rules which come in handy for leveling out W-2 wage and property basis limitations among commonly owned non-SSTBs. If you own related businesses and one has too much payroll and property, and the other not enough, you don’t need to restructure to improve wage and property basis limitations. Aggregation rules allow you to combine QBI, wage and property basis limitations to maximize the deduction on aggregate QBI. Allocation rules are a different way to accomplish a similar result.

There are also rules for how to apply and allocate QBI losses to other businesses with QBI income and carrying over these losses to subsequent tax year(s).

Section 199A is a complicated code section requiring significant tax planning and compliance. The proposed regulations close loopholes, favor some types of businesses and prevent gaming of the system, which otherwise would invite excessive entity restructuring.

Hedge funds and investment managers
If a hedge fund qualifies for TTS, the fund is trading for its account through an investment manager partner. As a TTS trading business, the hedge fund is an SSTB.

A hedge fund with TTS is entitled to elect Section 475 ordinary income or loss. A hedge fund with TTS and Section 475 has ordinary income, which is likely includible in QBI. The SSTB taxable income thresholds and cap apply to each investor in the hedge fund; some may get a QBI deduction, whereas, others may not, depending on their TI, QBI aggregation and more.

The proposed regulations also describe investing and investment management as an SSTB (p. 66-67). I presume a carried-interest share (profit allocation) of capital gains should be excluded from QBI, but a carried-interest percentage of Section 475 ordinary income is likely included in QBI. Incentive fees and management fees are also included for management companies, which are SSTBs. QBI must be from domestic sources.

Service businesses
The proposed regulations state: “The definition of an SSTB for purposes of section 199A is (1) 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, and (2) any trade or business that 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 proposed regulations exempted some types of service businesses from SSTBs, including real estate agents and brokers, insurance agents and brokers, property managers, and bankers taking deposits or making loans. It also narrowed SSTBs — for example, sales of medical equipment are not an SSTB, even though physician health care services are. Performing artists are service businesses, but not the maintenance and operation of equipment or facilities for use in the performing arts.

The proposed regulations significantly narrowed the catch-all category of SSTBs based on the “reputation and skill” of the owner. The updated definition is “(1) receiving income for endorsing products or services; (2) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players).”

Proposed vs. final regulations
The IRS stated that taxpayers are entitled to rely on these “proposed reliance regulations” pending finalization. The IRS is seeking comments, and they scheduled a public hearing for Oct. 16, 2018.

The 2017 Tax Cuts and Jobs Act was a significant piece of legislation for this Congress and President. I presume the IRS will attempt to issue final regulations in time for the 2018 tax-filing season, which starts in January 2019. The IRS needs to produce tax forms for the 2018 QBI deduction, and that is best accomplished after finalization of the regulations. Tax software makers need time to program these rules, too.

The new tax law reduced tax compliance for employees by suspending many itemized deductions. They may have a “postcard return.” However, the new law and proposed regulations significantly increase tax compliance for business owners, many of whom would like to get a 20% deduction on QBI in a pass-through entity.

See IRS FAQs and several examples on Basic questions and answers on new 20% deduction for pass-through businesses. 

Darren Neuschwander CPA contributed to my blog post.

 


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