Many traders are filing 2018 tax returns, extensions, and Section 475 elections close to the deadline of April 15, 2019. Join Robert A. Green, CPA of GreenTraderTax.com to discuss several good reasons to file an extension, and his blog post “Tax Extensions: 12 Tips To Save You Money.” Mr. Green will set aside 15 to 30 minutes dedicated to answering questions, so come prepared.
Webinar hosted and recording produced by Interactive Brokers. Everyone is welcome; you don’t have to be a client of IB.
See our more recent blog post: A Rationale For Using QBI Tax Treatment For Traders.
Traders in securities and/or commodities, qualifying for trader tax status (TTS) as a sole proprietor, S-Corp, or partnership (including hedge funds), are wondering if they should use “qualified business income” (QBI) tax treatment on their 2018 tax returns. I see a rationale to include such treatment, but there are conflicts and unresolved questions, which renders it uncertain at this time. Section 199A QBI regs include “trading” as a “specified service trade or business” (SSTB), and QBI counts Section 475 ordinary income or loss. However, Section 199A’s interaction with 864(c) may override that and deny QBI tax treatment to U.S. resident traders.
QBI treatment might be an issue for all TTS traders, not just the ones who elected Section 475 ordinary income or loss. For example, a TTS sole proprietor trader filing a Schedule C would report business expenses as a QBI loss, which might reduce aggregate QBI from other activities, thereby reducing an overall QBI deduction. There are QBI loss carryovers, too.
Many TTS traders and hedge funds don’t want QBI tax treatment since they have not elected Section 475, and QBI excludes capital gains, Section 988 forex ordinary income, dividends, and interest income. Hedge fund accountants seem to prefer the Section 864 rationale to not use QBI treatment for TTS funds.
A partnership or S-Corp needs to report QBI items on Schedule K-1 lines for “Other Information,” in box 20 for partnerships and box 17 for S-Corps, including Section 199A income or loss, and related 199A factors like W-2 wages and qualified property.
With uncertainty over QBI tax treatment, traders should file 2018 tax extensions for partnerships and S-Corps by March 15, 2019, and extensions for individuals by April 15, 2019.
A 2019 Section 475 election is due by those extension deadlines. Section 475 gives tax loss insurance: Exemption on wash sale loss adjustments on securities and avoidance of the $3,000 capital loss limitation. There’s a chance traders might be entitled to a QBI deduction on 475 income, so factor that possibility into decision making. (See my recent blog on extensions and 475 elections.)
Section 864 might deny QBI treatment to TTS traders
I took a closer look at the confusing language in Section 199A’s interaction with Section 864(c), which might deny QBI treatment to TTS traders. Section 199A final regs imply that if a trade or business does not constitute “effectively connected income” (ECI) in the hands of a non-resident alien under Section 864(c), then it’s not QBI for a U.S. resident taxpayer operating a domestic trade or business.
Historically, Section 864 applied to nonresident aliens, and foreign entities for determining U.S. source income, including ECI in Section 864(c). Reading Section 864 makes sense with nonresident aliens in mind. However, it gets confusing when 199A overlays language on top of Section 864 for the benefit of determining QBI for U.S. residents.
The function of Section 864 is to show nonresident aliens how to distinguish between U.S.-source income (effectively connected income) vs. foreign-source income. An essential element of Section 199A is to limit a QBI deduction to “domestic trades or businesses,” not foreign ones. 199A also uses the term “qualified trades or business.” It appears the authors of 199A used a modified Section 864 for determining “domestic QBI.”
Section 864 a “trade or business within the U.S.” does not include:
“Section 864(b) — Trade or business within the United States.
Section 864(b)(2) — Trading in securities or commodities.
(A): Stocks and securities.
(i) In general. Trading in stocks or securities through a resident broker, commission agent, custodian, or other independent agent.
(ii) Trading for taxpayer’s own account. Trading in stocks or securities for the taxpayer’s own account, whether by the taxpayer or his employees or through a resident broker, commission agent, custodian, or other agent, and whether or not any such employee or agent has discretionary authority to make decisions in effecting the transactions. This clause shall not apply in the case of a dealer in stocks or securities.
(C) Limitation. Subparagraphs (A)(i) and (B)(i) (for commodities) shall apply only if, at no time during the taxable year, the taxpayer has an office or other fixed place of business in the United States through which or by the direction of which the transactions in stocks or securities, or in commodities, as the case may be, are effected.”
Example of (ii) above: A nonresident alien “trades his own account” at a U.S. brokerage firm. The nonresident does not have an office in the U.S., but it doesn’t matter since the 864(b)(2)(C) limitation does not apply to (ii), a trader for his account, it only applies to (i). Although this trader might qualify for TTS, he does not have a “trade or business within the U.S.” and therefore does not have QBI as a nonresident alien.
Notice how Section 199A regs reference Section 864:
“Section 199A(c)(3)(A)(i) provides that for purposes of determining QBI, the term qualified items of income, gain, deduction, and loss means items of income, gain, deduction and loss to the extent such items are effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c), determined by substituting ‘qualified trade or business (within the meaning of section 199A’ for ‘nonresident alien individual or a foreign corporation’ or for ‘a foreign corporation’ each place it appears).”
According to tax publisher Checkpoint, “Effectively connected income-qualified business income defined for purposes of the 2018-2025 pass-through deduction.”
“Income derived from excluded services under Code Sec. 864(b)(1) (performance of personal services for foreign employer, or Code Sec. 864(b)(2) (trading in securities or commodities) can never be effectively connected income in the hands of a nonresident alien.
Code Sec. 864(b)(2) generally treats foreign persons, including partnerships, who are trading in stocks, securities, and in commodities for their own account or through a broker or other independent agent as not engaged in a U.S. trade or business. So, if a trade or business isn’t engaged in a U.S. trade or business by reason of Code Sec. 864(b), items of income, gain, deduction, or loss from that trade or business won’t be included in QBI because those items wouldn’t be effectively connected with the conduct of a U.S. trade or business.”
In 199A, the first reference to Section 864 is under the heading “Interaction of Sections 875(1) and 199A.”
“Section 875(1) Partnerships; beneficiaries of estates and trusts: (i) a nonresident alien individual or foreign corporation shall be considered as being engaged in a trade or business within the United States if the partnership of which such individual or corporation is a member is so engaged, and (ii) a nonresident alien individual or foreign corporation which is a beneficiary of an estate or trust which is engaged in any trade or business within the United States shall be treated as being engaged in such trade or business within the United States.”
An example of Section 875(1): Consider a U.S. partnership in the consulting business. U.S. residents and nonresident alien investors own it. The Schedule K-1 for partners reports ordinary income on line 1, which according to Section 875(1) is ECI for the nonresident partners. The nonresident alien must file a Form 1040NR to report this ECI, and she might be eligible for a QBI deduction since it’s from a “domestic trade or business,” determined on the entity level.
Conflicts and unresolved questions
Tax writers in 199A regs left conflicts and unresolved questions when it comes to traders in securities and or commodities. Are traders in no man’s land? I’ve asked several of the tax attorneys in IRS Office of Chief Counsel listed in the 199A regs to answer the following question: Are U.S. resident traders in securities and or commodities with trader tax status subject to QBI tax treatment? I am awaiting an answer.
The 199A regs state:
“The trade or business of the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2))…
(xii) Meaning of the provision of services in trading. For purposes of section 199A(d)(2) and paragraph (b)(1)(xi) of this section only, the performance of services that consist of trading means a trade or business of trading in securities (as defined in section 475(c)(2)), commodities (as defined in section 475(e)(2)), or partnership interests. Whether a person is a trader in securities, commodities, or partnership interests is determined by taking into account all relevant facts and circumstances, including the source and type of profit that is associated with engaging in the activity regardless of whether that person trades for the person’s own account, for the account of others, or any combination thereof.”
Section 199A regs define “trading” as a “specified service trade or business” (SSTB). The regs focus on “performance of services,” which relates to a proprietary trader performing trading services to a prop trading firm and issued a 1099-Misc as an independent contractor. Some tax advisors had suggested that hedge funds don’t perform trading services; their management companies do. That may be why tax writers added “trading for your own account.”
The million-dollar question is “Why define TTS trading as an SSTB unless the tax writers intended QBI treatment for that SSTB?
Only a Section 475 election can generate QBI income for a trading SSTB (or QBI losses, if incurred). The 199A final regs added Section 475 to QBI. This combination of SSTB and 475 income would make a trader eligible for a QBI deduction. Others could argue 475 was added only for dealers in securities and or commodities.
The 199A regs indicate if a trade or business does not constitute “effectively connected income” (ECI) in the hands of a nonresident alien under Section 864(c), then it’s not QBI for a U.S. resident taxpayer, even if operating a domestic trade or business. Is there a loophole in that “trader in securities or commodities” are covered under Section 864(b)(2), not 864(c)?
My partner Darren Neuschwander CPA, and I communicated with leading CPAs, including two big-four tax partners. Those tax partners acknowledged conflicts and uncertainties in QBI treatment for hedge funds and solo TTS traders. The vast majority of larger hedge funds don’t elect Section 475, so those hedge funds would only experience the downside to QBI treatment — QBI losses for investors.
The tax attorneys who drafted TCJA and199A regs may have intended to exclude TTS trading companies including hedge funds from QBI tax treatment because they figured these companies would most likely have QBI losses caused by TTS business expenses. They knew QBI excluded most portfolio income like capital gains, dividends, and interest income so that traders might consider the law unfair. I advocated for TTS trades to have QBI treatment because many solo TTS traders have elected Section 475 and they would get a QBI deduction.
TTS and 475 elections help traders
No matter which way the pendulum swings on QBI treatment for traders, I still recommend trader tax status for deducting business expenses, and a TTS S-Corp for health insurance and retirement plan deductions. There are always the tax loss insurance benefits in Section 475. (See Traders Elect Section 475 For Massive Tax Savings.)
Darren L. Neuschwander CPA, and Roger Lorence JD contributed to this blog post.
The Tax Cuts And Jobs Act (TCJA) regulations, tax forms, and instructions have some surprises and unintended consequences. In this Webinar, GreenTraderTax CPA Robert A. Green will discuss how to maximize tax deductions for traders.
– There are lingering questions about whether a trader is eligible for a “qualified business income” (QBI) deduction.
– Learn how to claim trader tax status (business expense treatment).
– Consider a 2019 Section 475 election for tax loss insurance.
Webinar hosted and recording produced by Interactive Brokers. Everyone is welcome; you don’t have to be a client of IB.
Good news for traders: Section 199A final regs confirm QBI includes Section 475 ordinary income and loss.
On Jan. 18, 2019, the IRS issued final 199A regs for the 2017 Tax Cuts and Jobs Act (TCJA) 20% qualified business income (QBI) deduction. The final regs update the August 2018 proposed/reliance 199A regs and confirm that QBI includes Section 475 ordinary income/loss.
Based on our interpretation of TCJA and the proposed/reliance regs, we figured QBI included Section 475 ordinary income/loss, but it was uncertain. Our previous content stated that QBI “likely” included Section 475 ordinary income/loss. The final and proposed/reliance regs each state that QBI expressly excludes capital gains and losses, and also excludes Section 954 items of ordinary income, including forex Section 988 and notional principal contracts.
Making our case to the IRS
After noticing that the proposed/reliance regs were silent about Section 475 income/loss, I contacted one of the lawyers at the Office of Chief Counsel listed on the 199A proposed regs.
The attorney called me back after he saw my interview in Tax Notes, “Groups Urge IRS to Rethink 199A Business Income Rules.” I presented our firm’s rationale for including Section 475 ordinary income/loss in QBI for TTS traders and suggested he read and watch our content. The IRS attorney said my rationale sounded “plausible” in his opinion.
Excerpts from final regs
Final 199A regs, p. 55-56:
“Given the specific reference to section 1231 gain in the proposed regulations, other commenters requested guidance with respect to whether gain or loss under other provisions of the Code would be included in QBI. One commenter asked for clarification about whether real estate gain, which is taxed at a preferential rate, is included in QBI. Additionally, other commenters requested clarification regarding whether items treated as ordinary income, such as gain under sections 475, 1245, and 1250, are included in QBI.
To avoid any unintended inferences, the final regulations remove the specific reference to section 1231 and provide that any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss, including any item treated as one of such items under any other provision of the Code, is not taken into account as a qualified item of income, gain, deduction, or loss. To the extent an item is not treated as an item of capital gain or capital loss under any other provision of the Code, it is taken into account as a qualified item of income, gain, deduction, or loss unless otherwise excluded by section 199A or these regulations.
Similarly, another commenter requested clarification regarding whether income from foreign currencies and notional principal contracts are excluded from QBI if they are ordinary income. Section 199A(c)(3)(B)(iv) and §1.199A-3(b)(3)(D) provide that 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) is not included as a qualified item of income, gain, deduction, or loss. Section 199A(c)(3)(B)(v) and §1.199A-3(b)(3)(E) provide any item of income, gain, deduction, or loss described in 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) is not included as a qualified item of income, gain, deduction, or loss. The statutory language does not provide for the ability to permit an exception to these rules based on the character of the income. Accordingly, income from foreign currencies and notional principal contracts described in the listed sections is excluded from QBI, regardless of whether it is ordinary income.”
Parsing the language in the final 199A regs
In the proposed 199A regs, QBI excluded all capital gains and losses, and ordinary income/loss items expressly listed in Section 954. Section 954 does not include Section 475 ordinary income/loss. In the proposed regs, QBI expressly included Section 1231 losses from the sale of business property, whereas, QBI excluded Section 1231 capital gains. Section 475 ordinary income/loss is similar to Section 1231 ordinary losses, and it’s not in Section 954, so we determined that QBI likely included Section 475 ordinary income/loss.
The final 199A regs acknowledge the uncertainty and tax writers fixed it in the above language. They opened the door for Section 1231 losses to include more items like Section 475 ordinary income/loss, reiterating that it must not be on the Section 954 list, which Section 475 is not.
There’s an important caveat
Section 199A interacts with a modified Section 864(c), and Section 864 might deny QBI treatment to TTS traders and hedge funds. On the one hand, there is a rationale for QBI treatment for TTS traders, as expressed in this blog post, and Section 864 conflicts with that case. There are unresolved questions which I expect to write a blog post about it soon. Considering conflicts with Section 864, I think QBI treatment for traders is uncertain at this time.
How QBI might work for a TTS trading business
The proposed and final 199A regs state that traders eligible for trader tax status are a “specified service trade or business” (SSTB), so the SSTB taxable income (TI) cap applies. Taxpayers who make one dollar over the TI cap will not be allowed a QBI deduction on SSTB QBI. On the other hand, non-SSTB activity is not restricted to the TI cap, although the W-2 wage and property limitations apply over the TI threshold.
For 2018, the SSTB TI cap is $415,000/$207,500 (married/other taxpayers). The phase-out range below the cap is $100,000/$50,000 (married/other taxpayers), in which the QBI deduction phases out for an SSTB. The 50% W-2 wage and property basis limitations also apply within the phase-out range. For 2018, the TI threshold is $315,000/$157,500 (married/other taxpayers): If a taxpayer is below the TI threshold, there are no phase-out, wage or property limitations for SSTB and non-SSTB.
For 2019, the SSTB TI cap increases to $421,400/$210,700 (married/other taxpayers) based on the inflation adjustment. The phase-out range remains the same, so for 2019, the TI threshold is $321,400/$160,700 (married/other taxpayers).
Hedge funds with TTS and Section 475 ordinary income/loss should report QBI, too. Investors in these hedge funds are eligible for a QBI deduction if they are under the TI cap. Even without a 475 election, trading SSTB has QBI losses from trading expenses.
Investment managers are also SSTB, and they have QBI from advisory fees. Carried interest as a profit allocation of Section 475 ordinary income/loss is QBI, too. Carried interest in capital gains is not.
It’s more crucial to qualify for TTS than ever before
TTS allows business expense treatment, whereas, TCJA suspended “certain miscellaneous itemized deductions subject to the 2% floor,” which includes investment fees and investment expenses. TCJA still allows investors itemized deductions for investment-interest expenses limited to investment income, and stock borrow fees as other itemized deductions. TTS business expenses allow a long list of deductions from gross income, including home office, and that’s far better!
TTS traders may elect Section 475 mark-to-market (MTM) accounting on securities and or commodities (Section 1256 contracts). Securities traders appreciate that Section 475 trades are exempt from dreaded wash-sale loss adjustments and the $3,000 capital loss limitation. I call it “tax loss insurance,” because 475 ordinary losses lead to much faster tax refunds. (TCJA did repeal NOL carrybacks, forcing NOL carryforwards, instead.) TTS traders are entitled to segregate investment positions to achieve lower tax rates on long-term capital gains. TTS traders prefer to skip Section 475 on commodities to retain lower 60/40 capital gains rates on Section 1256 contracts.
Now with final 199A regs, there’s still uncertainty for QBI treatment for TTS traders. Profitable TTS traders might want to consider a Section 475 election to be perhaps eligible for a potential QBI deduction. In some years, the trader might be under the TI cap, allowing a QBI deduction, and in other years, he might have a (good) problem of exceeding the cap for no QBI deduction.
Married taxpayers should consider filing separately, as that might unlock a QBI deduction for one spouse since the other spouse might have income exceeding the SSA income cap. TCJA equalized the tax rates for filing jointly vs. separately.
TTS traders with Section 475 ordinary losses might be unhappy. For example, assume a trader has $100,000 of QBI from a consulting business. She also has TTS/Section 475 ordinary losses of $40,000, so her aggregate QBI is $60,000, which reduces the QBI deduction.
Section 199A regs are complicated
There are complex issues over what constitutes an SSTB vs. non-SSTB, how to calculate the W-2 wage and property limitations, definitions of QBI, and more.
Taxpayers have to calculate the QBI deduction on whichever is lower: aggregate QBI or taxable income minus net capital gains/losses.
If you expect to receive a 2018 Schedule K-1 containing QBI tax information, then consider filing an automatic extension by April 15. I assume that many pass-through entities won’t issue final 2018 Schedule K-1s until after that date. It’s great that the IRS issued the final 199A regs now, but there are still conflicts and unresolved questions. Look for QBI items on partnership Schedule K-1 line 20 “Other Information” marked with various codes for 199A items of income, wages, property and more. See the K-1 instructions for line 20.
Elect Section 475 on time
Individual TTS traders need to file a 2019 Section 475 election statement with the IRS by April 15, 2019. Existing partnerships and S-Corps need to file a 2019 Section 475 election statement with the IRS by March 15, 2019. New taxpayers (i.e., new entities) may elect Section 475 within 75 days of inception by internal election. Existing taxpayers have a second step to file a Form 3115 with their 2019 tax return.
Learn more about TTS, Section 475, QBI and entity solutions in Green’s 2019 Trader Tax Guide.
Darren L. Neuschwander, CPA contributed to this blog post.
I revised this blog post on March 5, 2019, in conjunction with my new blog post Uncertainty About Using QBI Tax Treatment For Traders.
Tax season is underway, and TV commercials from tax software companies are stressing the need for CPAs on-demand. This is probably because 2018 is the first year of changes from the 2017 Tax Cuts and Jobs Act (TCJA). Join Robert A. Green, CPA of GreenTraderTax to review highlights from Green’s 2019 Trader Tax Guide.
– Business traders fare better.
– Can traders deduct trading losses?
– Tax treatment on financial products.
– Entities for traders.
– Retirement plans for traders.
– Tax Cuts and Jobs Act impact on traders.
– 20% deduction on qualified business income.
– Investment management carried interest.
Webinar hosted and recording produced by Interactive Brokers. Everyone is welcome; you don’t have to be a client of IB.
See my March 5, 2019 blog post Uncertainty About Using QBI Tax Treatment For Traders.
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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The Act impacts investors in many ways, some negative and others positive. Investors with significant investment expenses will decry the suspension of that miscellaneous itemized deduction.
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