THE MAGAZINE OF THE LOS ANGELES COUNTY BAR ASSOCIATION

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JULY/AUGUST 2019 / $5

EARN MCLE CREDIT

Los Angeles lawyer Ronald F. Brotis the 2019-20 president of theLos Angeles County Bar Associationpage 9

California’sNew Rules ofProfessionalConductpage 18

LACBA: A ContinuingForce for Good

Lawyer/ClientBusinessTransactionspage 32

Big Data andTax Enforcementpage 14

On Direct:Nora Phillipsof Al Otro Ladopage 10

New Tax Law’s20 PercentSolutionpage 24

2019GUIDE TO

INVESTIGATIVE SERVICES

Content is copyright protected and provided for personal use only - not for reproduction or retransmission.For reprints please contact the Publisher.

Los Angeles Lawyer July/August 2019 25

Tax Cuts and Jobs Act of 2017 (2017Tax Act)1 was enacted with the dualpromises of reducing taxes and sim-

plifying tax reporting. However, as many taxpayershave discovered, these promises have not always beenmet. The one area in which the 2017 Tax Act doesappear to live up to its selling points is in its promiseto reduce taxes on businesses. The initial focus of busi-ness tax reduction was on C corporations, with pro-ponents of tax reform emphasizing that the UnitedStates’ existing 35 percent federal corporate incometax rate (39.1 percent, taking into account averagestate and local tax rates) was the highest marginal cor-porate income tax rate of any nation in the Organizationfor Economic Cooperation and Development (OCED).2

Citing the need for corporate competitiveness, PresidentDonald Trump initially advocated reducing the federalcorporate tax rate to 15 percent. The 2017 Tax Actultimately provided for a 21 percent corporate rateapplicable to all levels of income.

Nevertheless, most businesses are not conducted inC corporation form. Businesses, particularly if privatelyheld, typically operate for income tax purposes as part-nerships (including LLCs and other legal entities treatedas partnerships for tax purposes), S corporations (col-lectively with partnerships, referred to as “pass-through

entities”), and sole proprietorships. Unlike C corpora-tions, pass-through entities generally are not subjectto entity-level income taxes.3 Instead, pass-throughentities allocate (or pass-through) items of income,gain, loss, and deduction among their owners, whoreport their respective allocable shares on their incometax returns, regardless of whether they receive cashdistributions from the entity.4

In order to reduce the federal income tax liabilityon most businesses, not just C corporations, the 2017Tax Act introduced an entirely new—and perhaps evenradical—concept: a federal income tax deduction ofup to 20 percent of income from a qualified business.While this concept appears simple, the new statutoryand regulatory provisions are complex to apply.

This 20 percent deduction is contained in newInternal Revenue Code (IRC) Section 199A. Introducingnew jargon and terminology, Section 199A essentiallyprovides a deduction of up to 20 percent of “qualifiedbusiness income” (referred to herein as “qualifiedincome”) from U.S. businesses operated as a sole pro-prietorship or through a pass-through entity, trust, orestate. It does not apply to businesses conducted by Ccorporations. Very generally, qualified income is thenet amount of items of income, gain, loss, and deductionwith respect to a “qualified trade or business.”5 Section

Gerald (Jerry) S. Janoff is a senior tax counsel in the Los Angeles office of Buchalter, specializing in mergers and acquisitions andcorporate, business, financing, and real estate transactions. Nick Hollinden is a tax partner with Crowe LLP in the firm’s Sacramentooffice who primarily practices partnership and other flow-through taxation. Stanislava Tochenova, a senior tax manager with CroweLLP, in Sherman Oaks, California, practices in the area of pass-through entities.

MCLE ARTICLE AND SELF-ASSESSMENT TEST

By reading this article and answering the accompanying test questions, you can earn one MCLE credit.

To apply for credit, please follow the instructions on the test answer sheet on page 27.

20 PercentTheTheSolution

Rules that qualify income for deduction under the new federal taxregime are carefully constructed to deter high-income taxpayers fromconverting nonqualifying compensation

by Gerald (Jerry) S. Janoff, Nick Hollinden, and Stanislava Tochenova

199A also provides for a 20 percent deduc-tion for qualified real estate investmenttrust (REIT) dividends and qualified pub-licly traded partnership income.

In January 2019, the U.S. Departmentof the Treasury issued final regulationsunder Section 199A accompanied by anexplanatory preamble, collectively consist-ing of 274 pages.6 Additional proposedregulations and two revenue procedureswere also released. The result is a complexregulatory framework, in which unan-swered questions and ambiguities remain.

Before delving into the multitude ofdefinitions, exceptions, and issues, it ishelpful to provide a general overview ofSection 199A. First, the 20 percent deduc-tion only applies to income from businessesnot held by a C corporation that otherwisequalify under Section 199A. Second, afteridentifying these businesses, the amountof qualified income for Section 199A pur-poses of each such business must be deter-mined. Third, taxpayers with qualifiedincome must determine whether their tax-able incomes exceed certain thresholds (for2019, $160,700 for single filers and$321,400 for those filing joint returns asmarried) (Threshold Amount).7 Those withtaxable incomes under the ThresholdAmount are entitled to the 20 percentdeduction without having to satisfy require-ments applicable to taxpayers with higherincomes.

Fourth, two additional requirementsapply to taxpayers with taxable incomesthat exceed the sum of the applicableThreshold Amount plus $50,000 (or, inthe case of joint returns, the applicableThreshold Amount plus $100,000) (Phase-In Amount). For these taxpayers, the busi-ness income must not be derived from oneof the categories of businesses that thestatute treats as effectively compensationfor services based on the provider’s skilland reputation. For businesses that meetthis requirement, the 20 percent deductionapplies only to qualified income thatexceeds the higher of two limits: one basedon the amount of employee wages paid bythe business and the other based on a com-bination of wages paid and the unadjustedtax basis of certain qualified depreciableproperty held by the business. Complicatedphase-in rules apply to taxpayers with tax-able income between the ThresholdAmount and the Phase-In Amount.

The 20 percent deduction is a below-the-line deduction that reduces adjustedgross income after the standard deductionor itemized deductions are taken.8 Gen -erally, taxpayers who take the standarddeduction may not reduce their adjustedgross income by itemized deductions.

However, the 20 percent deduction isunique in that it may be used by taxpayerswho take the standard deduction.9 In thecase of pass-through entities, the deductionis taken at the partner or shareholderlevel.10 Trusts and estates may also qualifyfor the 20 percent deduction.11

The 20 percent deduction applies onlyfor income tax purposes.12 It does notreduce net earnings for purposes of deter-mining self-employment tax or the 3.8 per-cent net investment income tax.13 Unlessextended by future legislation, the 20 per-cent deduction is available for taxable yearsbeginning after December 31, 2017 andbefore January 1, 2026.14 California doesnot presently provide a similar deductionfor state income tax purposes, althoughsome other states do.

Qualified Businesses

The first step in determining whether the20 percent deduction applies is to identifywhether the taxpayer holds, directly (suchas in a sole proprietorship) or indirectly(through a pass-through entity), one ormore “qualified trades or businesses” forSection 199A purposes (i.e., a “QualifiedBusiness”). In order to have a QualifiedBusiness, there must be activity that risesto the level of a “business” for income taxpurposes.

The Section 199A regulations define aQualified Business by reference to the mean-ing of “trade or business” under IRCSection 162 (162(a) Business), excludinga business consisting of the performanceof services as an employee.15 However,Section 162(a) and the related regulationsdo not clearly define this term. Instead,one must look to the large body of caselaw and regulatory guidance that interpretthis concept.

The U.S. Supreme Court, in Com -missioner v. Groetzinger,16 explained thatfor an activity to constitute a business 1)the taxpayer must be involved in the activ-ity with continuity and regularity and 2)the taxpayer’s primary purpose for engag-ing in the activity must be for income orprofit. Sporadic activities and hobbies donot qualify.17 Moreover, investment activ-ity generally does not rise to the level ofa business.18 A taxpayer need not activelyor materially participate in order for anactivity to qualify as a business. The pas-sive activity rules of IRC Section 469,which generally limit the ability to usedeductions from a passive activity againstincome from other sources, are inapplic-able for this purpose.

Many regularly conducted profit-seek-ing activities should have no problem qual-ifying as a business. The primary area of

uncertainty relates to rental real estate, asthere is limited case law on when suchactivity constitutes a business or an invest-ment. Due to this uncertainty, the IRSreleased Notice 2019-07,19 which setsforth a safe harbor that, if satisfied, treatsa “rental real estate enterprise” as a Qual -ified Business, but solely for Section 199Apurposes.

For purposes of the safe harbor, a“rental real estate enterprise” is an interestin one or more rental real properties con-sisting of commercial or residential prop-erties. The safe harbor generally does notapply to properties used as a residence formore than 14 days per year20 or rentedunder an arrangement whereby the tenantis responsible for taxes, insurance, andmaintenance (triple net lease).

The safe harbor generally applies to a“real estate rental enterprise” if 1) theenterprise maintains separate books andrecords, 2) at least 250 hours of “rentalservices” per year are performed by owners,employees, or agents,21 and 3) detailedcontemporaneous records and time logsare maintained. Rental services generallyinclude maintenance, lease negotiation,supervising employees, and certain otherdaily operations. Traveling to propertiesand activities relating to long-term capitalimprovements, finances, and investmentmanagement do not constitute rental ser-vices.

Rental real estate enterprises failing tosatisfy the safe harbor nevertheless maybe treated as a Qualified Business if theyqualify under an exception in the Section199A regulations applicable to the rentalof property to a “commonly controlled”Qualified Business or otherwise qualify asa 162(a) Business.22 Outside of the com-monly controlled context, rental activitiesinvolving triple net leases or a small numberof units may be insufficient activity to con-stitute a 162(a) Business, particularly whenthe owner and agents have little day-to-day involvement.

As employee-provided services are ex -plicitly excluded from the definition ofQualified Business, employee compensationis ineligible for the 20 percent deduction.In an attempt to qualify for the 20 percentdeduction, some taxpayers may restructureemployment relationships into that of anindependent contractor. The Section 199Aregulations contain a rebuttable presump-tion applicable to an employee who be -comes an independent contractor whileproviding substantially the same servicesto the former employer, including throughan entity. These persons are presumed toretain their “employee” status for threeyears after ceasing “employment,” absent

26 Los Angeles Lawyer July/August 2019

Los Angeles Lawyer July/August 2019 27

MCLE Answer Sheet #290

THE 20 PERCENT SOLUTION

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INSTRUCTIONS FOR OBTAINING MCLE CREDITS

1. Study the MCLE article in this issue.

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ANSWERS

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1. n True n False

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MCLE Test No. 290The Los Angeles County Bar Association certifies that this activity has been approved for Minimum ContinuingLegal Education credit by the State Bar of California in the amount of 1 hour. You may take tests from backissues online at http://www.lacba.org/mcleselftests.

1. The Tax Cuts and Jobs Act of 2017* reduced the corporatetax rate to 21 percent only on income above $200,000.

True.False.

2. Who may take the 20 percent deduction with respectto qualified income earned by a partnership?

A. The partnership.B. The partners of the partnership in all cases.C. The partnership and the partners who aretreated as individuals.D. The partners who are treated as individuals.

3. The 20 percent deduction applies to which of thefollowing:

A. The net investment income tax.B. Self-employment tax, for the purposes ofreducing earnings.C. California income taxes.D. None of the above.

4. The 20 percent deduction is available for taxableyears beginning after December 31, 2017, and beforeJanuary 1, 2022.

True.False.

5. To what income does the 20 percent deduction apply?A. Income from a regularly conducted activityprimarily engaged in to make a profit.B. Income from a regularly conducted business orinvestment activity.C. Income satisfying A and B.D. None of the above.

6. Rental real estate operations automatically constitutea qualified business under I.R.C. Section 199A.

True.False.

7. At least 250 hours of “rental services” per year mustbe performed by owners, employees, or agents to satisfythe “real estate rental enterprise” safe harbor.

True.False.

8. Maintenance of complete and separate books andrecords is required to have a trade or business if anentity or individual conducts more than one business.

True.False.

9. Which of the following is included in determiningqualified business income?

A. Dividends.B. Interest earned on accounts receivable forservices provided by a business.C. Interest earned on the business’ workingcapital.D. None of the above.

10.Which of the following potentially may be includedin determining qualified business income?

A. Guaranteed payments for the use of capital.B. Guaranteed payments for the use of services.C. Income attributable to a preferred distributionsto a partner.D. None of the above.

11.Apartner of a partnership generally cannot be treatedas the partnership’s employee.

True.False.

12. A partnership may never deduct a guaranteed pay-ment to a partner from qualified business income.

True.False.

13. Which of the following is true for taxpayers withincome exceeding the Phase-In Amount?

A. The 20 percent deduction is unavailable.B. The 20 percent deduction is generally fullyavailable provided the income does not derivefrom a specified service trade or business (SSTB)and the business has employees.C. The 20 percent deduction is generally availablefor income from an SSTB provided the amount ofqualified business income exceeds 50 percent ofthe wages paid by the business.D. None of the above.

14. Which of the following is true for taxpayers withincome between the Threshold Amount and the Phase-In Amount?

A. Income from an SSTB may be included inqualified business income if less than 25 percentof the business’s gross receipts relate to specifiedservices.B. Income from an SSTB may be included in aqualified business income to the extent allowableunder certain phase-in rules.C. Income from an SSTB may never be included inqualified business income.D. Both A and B.

15. The field of architecture is an SSTB.True.False.

16. The income of a pharmacist who sells prescriptiondrugs is considered to be compensation for servicesin the field of health.

True.False.

17. Providing landscaping design advice is an SSTB. True.False.

18. The 20 percent deduction applies to endorsementincome to those earning above the Phase-in Amount.

True.False.

19.Which of the following industries generally benefitsfrom the alternative test limiting the 20 percent deduc-tion to 25 percent of W-2 wages plus 2.5 percent of theunadjusted basis of qualified property.

A. Service businesses.B. Retail.C. Real estate rental property businesses.D. All of the above.

20. In order to aggregate two businesses, there mustbe identical direct or indirect ownership of each busi-ness.

True.False.

* General note: The answer to each question assumesthat all other requirements of I.R.C. §199A are satisfied.

a showing that the services are performedin a nonemployee capacity.23 This pre-sumption does not apply to former employ-ees who enter into an independent con-tractor relationship with a new servicerecipient. Moreover, federal employmenttax law and state law might not recognizea purported “independent contractor” clas-sification.24 Failing to properly classify aworker as an employee could result inback taxes, penalties, and fines for employ-ers.

An individual or a pass-through entitymay be engaged in more than one Qual -i fi ed Business. Whether a single entityconducts multiple businesses is a factualdetermination to which court decisionsdefining a 162(a) Business provide guid-ance. The U.S. Treasury’s view is that mul - tiple businesses cannot exist within a sin-gle entity unless each business maintainscomplete and separate books and re -cords.25 In addition, a business generallycannot be conducted across multiple enti-ties for tax purposes.26

As a general matter, each Qualified Bus -iness is considered separately for purposesof determining the 20 percent deduction.However, as discussed later, under certaincircumstances individuals and pass-throughentities may elect to aggregate multiplebusinesses into a single business for thepurpose of applying Section 199A.

Qualified Business Income

After the taxpayer’s Qualified Businessesare identified, the amount of qualifiedincome from each business must be sepa-rately determined on an annual basis. Qual -ified income generally is the net amountof qualified items of gross income, gain,loss, and deduction that are 1) “effectivelyconnected” with a business conducted inthe U.S. and 2) allowed in determiningtaxable income for the taxable year.27 Per -sons who are not U.S. citizens are eligiblefor the 20 percent deduction, provided thatthe income is effectively connected with aU.S. business.

Certain investment-related items areexcluded from qualified income, including1) capital gains and losses, 2) dividends,3) interest income that is not allocable toa business, and 4) items of deduction orloss allocable to any of the foregoingitems.28 For this purpose, capital gains andlosses include any items treated as suchunder the IRC, even if they do not involvethe disposition of a capital asset.29 In addi-tion, interest attributable to a business’sworking capital and reserves is not includedin qualified income, as it is consideredincome derived from investment assets.30

By contrast, interest on accounts receivable

for goods or services provided by a businessis considered income received on assetsacquired in the business’s ordinary courseand, as such, is included in qualifiedincome.31

With respect to S corporation share-holders, amounts received that are treatedas “reasonable compensation” are excludedfrom qualified income.32 If a shareholderperforms services for an S corporationwithout drawing a reasonable salary fromthe corporation prior to the distributionof dividends, all or part of dividends maybe recharacterized as “reasonable com-pensation” and, as such, excluded fromqualified income.33 This exclusion is inaddition to the actual payment of wagesto employee-shareholders.

For income tax purposes, a partner ofa partnership cannot be treated as the part-nership’s employee. 34 Thus, two categoriesof employment-like payments to partnersare excluded in determining qualified in -come. These categories are: 1) “guaranteedpayments” (i.e., amounts payable withoutregard to the partnership’s income) paidby a partnership to a partner for servicesrendered by the partner with respect to aQualified Business and 2) payments froma partnership to a partner for services whenthe partner does not act in the capacity aspartner of the partnership (Section 707(a)payments).35 As a general matter, partnerswho receive these payments report ordinaryincome, subject to self-employment taxes,and the partnership deducts these amounts.These deductions generally will reduce theamount of the partnership’s income thatwould otherwise be eligible for the 20 per-cent deduction.36 In the case of a tieredpartnership structure (i.e., when an upper-tier partnership owns an interest in a lower-tier partnership), any Section 707(a) pay-ment or guaranteed payment for servicesfrom a lower-tier partnership to an upper-tier partnership is excluded from qualifiedincome, even if it is not accompanied bya similar payment made to a partner ofthe upper-tier partnership.37

Guaranteed payments to a partner forthe use of capital (in contrast to guaranteedpayments for the use of services), payablewithout regard to the partnership’s income,also are excluded from qualified income.A limited exception applies to the extentthe guaranteed payment is allocable to abusiness of the partner, although the pre-amble to the Section 199A regulationsexplains that this fact pattern is unlikelyto occur.38 Partners of partnerships payingguaranteed payments may consider restruc-turing these arrangements as preferred cashflow distributions matched with priorityallocations of net profit. In order to have

preferred cash distributions and matchingallocations that are respected as such, part-ners should not have an absolute right toreceive preferred distributions regardlessof whether the business generates sufficientcash flow or produces a profit. Instead,these distributions should be limited tothe partnership’s available cash flow afterexpenses are paid and amounts are setaside for reasonable reserves.

Similar to guaranteed payments, netprofit allocations generally constitute ordi-nary income (assuming that the income isordinary in the hands of the partnership),subject to self-employment taxes for servicepartners, and reduce the amount of netincome allocated to the other partners.Unlike guaranteed payments, allocationsof net profit may constitute qualifiedincome. This alternative may not preciselymirror the guaranteed payment approach,as priority distributions are not uncondi-tionally payable. In many cases, however,they should achieve a similar economicresult.

High-Income Taxpayers

Taxpayers with taxable income (beforetaking into account the 20 percent deduc-tion) not exceeding the Threshold Amount(for 2019, $160,700 for single filers and$321,400 for those filing joint returns)need not satisfy any additional require-ments for the 20 percent deduction. Thesetaxpayers generally are entitled to a deduc-tion in an amount equal to 20 percent ofthe lesser of 1) the “total qualified incomeamount”39 and 2) the amount by whichthe individual’s taxable income (beforethe 20 percent deduction) exceeds the sumof the individual’s net capital gain andqualified dividends taxed at the capitalgains rates.40 The “total qualified incomeamount” is determined by netting theamount of qualified income from eachQualified Business in which the taxpayerhas an interest, including the taxpayer’sshare of qualified income from QualifiedBusinesses held by a pass-through entity.41

If the taxpayer’s “total qualified incomeamount” is negative, then the taxpayerwill not have qualified income for the tax-able year. Instead, this negative amountwill carry forward to the succeeding tax-able year and will be treated as negativequalified income from a separate businessin that year.42 Taxpayers with ordinaryincome in a taxable year that is less thanthe “total qualified income amount” mayconsider accelerating income to that yearin order to take advantage of the 20 per-cent deduction.

Taxpayers whose taxable income (be -fore the 20 percent deduction) exceeds

28 Los Angeles Lawyer July/August 2019

the Phase-In Amount (for 2019, $210,700for single filers and $421,400 for jointreturns) are subject to two additional lim-itations on the 20 percent deduction. Theselimitations aim to deter high-income tax-payers from converting compensation in -come into qualified income, including byusing a pass-through business to provideservices that the taxpayer otherwise wouldperform as an employee.43 First, these tax-payers generally may not treat incomefrom a “specified service trade or business”(SSTB) as qualified income. Second, withrespect to each Qualified Business, theamount of qualified income is limitedbased on the amount of W-2 wages paidby the business and the unadjusted costbasis of “qualified property” held by thebusiness. Complicated phased-in provi-sions apply to taxpayers with taxable in -come between the Threshold Amount andthe Phase-In Amount.44

Generally, an SSTB is a business thatprovides certain categories of services(specified services). Section 199A defines“SSTB” as any business either:• Involving the performance of servicesin the fields of health, law, accounting,actuarial science, performing arts, con-sulting, athletics, financial services, bro-kerage services;• When the principal asset is “the repu-tation or skill of 1 or more of its employeesor owners”; or• Involving the performance of servicesconsisting of investing and investment man-agement, trading, or dealing in securities,partnership interests, or commodities.45

The fields of architecture and engineer-ing are explicitly excluded from the defi-nition of SSTB.46

The Section 199A regulations elaborateon the various specified services enumerat -ed in the definition of “SSTB” and do notfollow state licensing laws.47 For example,the term “services performed in the fieldof law” is not limited to services perform -ed by attorneys. It also includes servicesby mediators, legal arbitrators, and para-legals. However, services not requiringskills unique to the field of law (such asstenography services) are not included inthis field.48

“Performing services in the field ofhealth” means the direct provision of med-ical services to a patient by physicians,pharmacists, nurses, dentists, veterinarians,physical therapists, psychologists, andother health care professionals. This cat-egory does not include providing health-related services not directly related to amedical services field, such as operatinghealth clubs or the research, manufacture,and sales of pharmaceuticals.49

The determination of whether a pro-fessional performs services in the field ofhealth is not always cut and dry. For exam-ple, the sale of prescription drugs by aretail pharmacy does not by itself consti-tute the performance of services in the“field of health.”50 However, a pharmacistwho is engaged by physicians to makerecommendations on dosing, performinginoculations, and checking for drug inter-actions is engaged in the performance ofservices in the field of health.51

“Services performed in the field of con-sulting” means providing professionaladvice and counsel to assist clients inachieving goals and solving problems,including landscaping design advice52 andregarding advocacy with the intent toinfluence government. “Consulting” doesnot include services other than advice andcounsel. Sales and providing training andeducational courses does not constitute“consulting.” This field also does notinclude performing consulting servicesancillary to the sale of goods if there isno separate payment for the consultingservices.53 For example, a computer sellermay provide customers with services relat-ing to the setup, operation, and repair ofcomputers without being an SSTB.54

Before the release of the proposed reg-ulations under Section 199A, there wasuncertainty as to what constitutes a busi-ness when the principal asset is “the rep-utation or skill of 1 or more of its employ-ees or owners.” Many tax practitionerswere concerned that this category couldcause most businesses with skilled employ-ees to be deemed an SSTB. The Section199A regulations take a more narrowview.55

The Section 199A regulations limit the“reputation or skill” category to situationsin which one is engaged in the businessof receiving income from 1) endorsements;2) the use of an individual’s image, likeness,name, or symbol associated with the indi-vidual’s identity; or 3) appearing at anevent or on radio, television, or anothermedia format.56 To illustrate the scope ofthis category, assume that H, a famouschef, owns multiple restaurants. H receivesa $500,000 endorsement fee for the useof H’s name on a cookware line. H’s busi-ness of being a chef and owning restau-rants does not constitute an SSTB. How -ever, H’s business of receiving income forthe use of H’s name is an SSTB.57

The Section 199A regulations providea de minimis exception to the rule thatthe performance of any specified serviceswill cause a business to constitute an SSTB.Businesses with gross receipts of $25 mil-lion or less in the taxable year will not

constitute an SSTB if less than 10 percentof the gross receipts are attributable tothe performance of specified services. Ifgross receipts exceed $25 million in thetaxable year, the business will not consti-tute an SSTB if less than 5 percent of grossreceipts are attributable to performingspecified services.58

The Section 199A regulations containan anti-abuse rule aimed at structuresattempting to separate parts of what oth-erwise would be an integrated SSTB intoseparate SSTB and non-SSTB businesses.If a business provides property or servicesto an SSTB with at least 50 percent director indirect common ownership, then theincome attributable to providing propertyor services to the SSTB will be treated asincome from an SSTB.59

To illustrate this rule, assume that Aand B each owns 50 percent of Partnership1, a law firm; Partnership 2, which man-ages an office building; and Partnership3. Partnership 2 leases 70 percent of itsbuilding to Partnership 1 and the remain-ing 30 percent to unrelated tenants. Part -nership 3 employs administrative staff, allof whom provide administrative servicesto Partnership 1 in exchange for fees paidby Partnership 1 to Partnership 3. Part -nership 3 would be an SSTB because itprovides all of its services to a commonlycontrolled SSTB. Partnership 2’s lease withPartnership 1 would be treated as an SSTB.Partnership 2’s remaining leasing activitywould not be considered an SSTB.60

The second set of limitations applicableto high-income taxpayers is based on theamount of W-2 wages paid by the businessand the unadjusted cost basis of qualifiedproperty held by the business. These lim-itations are applied annually and separatelywith respect to each Qualified Business.

More specifically, with respect to eachQualified Business, the deductible amountfor a taxpayer with taxable income overthe Phase-In Amount is limited to thegreater of 1) 50 percent of the “W-2wages” paid with respect to the businessthat is allocable to qualified income or 2)the sum of (x) 25 percent of the W-2 wagespaid with respect to the business that isallocable to qualified income plus (y) 2.5percent of the “unadjusted basis” deter-mined immediately after acquisition(UBIA) of all “qualified property” of thebusiness. Neither W-2 wages nor UBIAof an SSTB may be taken into account byany individual earning above the Phase-In Amount, even if derived from a non-specified service activity.61 Phase-in rulesapply to taxpayers with income betweenthe Threshold Amount and the Phase-InAmount.

29Los Angeles Lawyer July/August 2019

When the Qualified Business is held bya pass-through entity, the taxpayer onlytakes into account the taxpayer’s allocableshare of the entity’s W-2 wages and UBIA.62

The Section 199A regulations provide rulesas to how to allocate an entity’s W-2 wagesand UBIA among its owners.63

For purposes of the wage limitation,the term “W-2 wages” generally meanswages for income tax withholding purposesand certain elective deferrals, such asSection 401(k) contributions.64 Paymentsto independent contractors do not consti-tute W-2 wages. The Section 199A regu-lations contain extensive rules for identi-fying which W-2 wages are paid withrespect to a Qualified Business and areallocable to qualified income.65 Specialrules apply in the case of short taxableyears, acquisitions and dispositions, andwages paid by persons other than a com-mon law employer (e.g., a professionalemployer organization).66

Wages paid to S corporation share-holder-employees qualify as W-2 wages.By contrast, guaranteed payments to part-ners for services performed for the payor-partnership do not. Accordingly, a part-nership with high income partners and few nonpartner employees may considerconverting to an S corporation. After aconversion, the owners would receive W-2 wages from the S corporation, insteadof excluded guaranteed payments from apartnership.

The Secction 199A regulations containextensive rules defining “qualified prop-erty.” As a general matter, “qualified prop-erty” is tangible property subject to depre-ciation that 1) is held by the business atthe end of the taxable year, 2) is used inthe production of qualified income duringthe year, and 3) has a “depreciable period”not ending during the taxable year.67 Forthis purpose, the depreciable period gen-erally begins when the property is firstplaced in service and ends on the later often years thereafter or the last day of thelast full year of the recovery period thatwould apply if the property were depreci-ated under the modified accelerated costrecovery system.68 Inventory and unim-proved land are not qualified propertybecause they are not depreciable. Realestate improvements (which have a depre-ciable life in excess of 10 years) that arefully depreciated for income tax purposesalso are not qualified property.

The nominal purpose of the qualifiedproperty-based limitation is to allow cap-ital-intensive Qualified Businesses that donot pay substantial W-2 wages to qualifyfor the 20 percent deduction. The legislativehistory, however, suggests more limited

policy considerations. The Senate bill orig-inally limited the 20 percent deduction ofhigh-income taxpayers with respect to non-SSTBs solely based on W-2 wages.69 Realestate rental property businesses often donot pay significant salaries. Instead, theytypically pay compensation to independentcontractors or “management fees” torelated entities. Thus, had the Senate billbecome law, owners of non-wage payingreal estate companies would not qualifyfor the 20 percent deduction. During thereconciliation process, the alternative UBIAlimitation was introduced for the first time,thereby creating a new tax break for high-income real estate business owners.70 Asa result, large landlords can take intoaccount the fully nondepreciated cost ofbuildings over their 39-year depreciationperiod in computing the 20 percent deduc-tion, regardless of whether they haveemployees.

Aggregation of Businesses

While Section 199A generally is appliedon a business-by-business basis, the Section199A regulations contain an aggregationregime that allows individual taxpayersand pass-through entities to combine busi-nesses so long as certain requirements aremet. The aggregate is treated as a singlebusiness for purposes of applying the Sec -tion 199A rules.71 Aggregation provides apowerful tax planning tool when a taxpayerhas interests in multiple businesses andcombining the businesses would producea more favorable mix of qualified income,W-2 wages, or UBIA. In order to aggregatebusinesses, the following requirements mustbe satisfied:• Each business rises to level of a QualifiedBusiness,72 has the same taxable year, andis not an SSTB.• The same person or group of persons,directly or indirectly through attributionrules, own at least 50 percent of each busi-ness to be aggregated for the majority ofthe taxable year and at the end of the tax-able year.• Two of the following three factors aresatisfied: 1) the businesses provide prod-ucts, property, or services that are thesame (such as a restaurant and a foodtruck) or customarily offered together(such as a gas station and a car wash);2) the businesses share facilities or signif-icant centralized business elements, suchas personnel, accounting, legal, manufac-turing, purchasing, human resources, orinformation technology resources; or 3) thebusinesses are operated in coordinationwith, or reliance upon, one or more ofthe businesses in the aggregated group(e.g., supply chain interdependencies).73

Both individuals and pass-through enti-ties may elect to aggregate. Taxpayers maydecide to aggregate some activities whilekeeping others separate. A pass-throughentity may aggregate businesses operateddirectly or through a lower-tier pass-through entity. It may aggregate additionalbusinesses with the businesses aggregatedby a lower-tier entity. However, the entitymay not exclude a business that is aggre-gated by the lower-tier entity. If a pass-through entity does not aggregate, its own-ers may elect to aggregate and need notaggregate in the same manner.74

Individuals may elect to aggregate busi-nesses operated directly or through a pass-through entity to the extent it is not in -consistent with the pass-through entity’sag gregation of its businesses. An individualmay elect to aggregate additional businesseswith the pass-through entity’s aggregatedbusiness but may not disaggregate any ofthe businesses aggregated by the pass-through entity.75

Reporting Requirements

Taxpayers who hold interests in a QualifiedBusiness through a pass-through entitygenerally should receive the informationrequired to calculate their 20 percent deduc-tion on a Schedule K-1 issued by the entity.The Section 199A regulations obligate pass-through entities to compute each owner’sallocable share of qualified income, W-2wages, and UBIA of qualified property andprovide relevant disclosures for each Quali -fied Business.76 If the amounts of qualifiedincome, W-2 wages, and UBIA are not sodisclosed, they are presumed to be zero,77

and amended tax returns may be requiredto subsequently provide complete and accu-rate information.

A pass-through entity is also obligatedto determine and disclose whether any ofits businesses constitute an SSTB.78 Whilea pass-through entity may not have theinformation to determine whether the tax-able income of any of its owners is abovethe Threshold Amount, the entity is bestpositioned to determine whether its businessconstitutes an SSTB.

Careful consideration should be givento businesses potentially subject to theaggregation rules since aggregated busi-nesses must be consistently reported insubsequent taxable years unless circum-stances materially change. These rulesincrease compliance costs of those electingto aggregate because they must calculatetheir deduction for both disaggregated andaggregated businesses to make the aggre-gation decision.

With respect to individuals and pass-through entities electing to aggregate, the

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Section 199A regulations provide annualdis closure requirements, which containiden tifying information about each busi-ness constituting a part of the aggregatedbusiness.79 Aggregation need not be re -port ed on the initial tax return; the tax -payer can elect to aggregate the busines sesin subsequent years.80 However, a failureto aggregate may not be corrected on anamend ed tax return, subject to an excep -tion for the 2018 tax year.81

Those operating rental real estate enter-prises who are relying on the safe harborof Notice 2019-07 must attach a statementto their tax return certifying that the safeharbor has been satisfied.

The Section 199A regulations still leavea lot of unanswered questions, and addi-tional reporting disclosures might berequired in certain specific situations. n

1 Tax Cuts and Jobs Act, Pub. L. 115–97, 131 Stat.2054 (2017). The actual name of the act is “An Actto provide for reconciliation pursuant to titles II andV of the concurrent resolution on the budget for fiscalyear 2018.”2 The emphasis on marginal statutory tax rates is mis-placed, as they do not reflect the actual tax burdenon U.S. corporations. Due to deductions, credits, andthe deferral of certain categories of non-U.S. sourceincome, the pre-2018 average U.S. tax rate on pre-tax corporate profits was not significantly differentfrom the average effective foreign tax rate.3 I.R.C. §701 (partnerships); §1363 (S corporations).Under certain circumstances, S corporations are subjectto federal corporate income tax. Moreover, Californiasubjects an S corporation’s California-source incometo corporate tax at a 1.5 percent rate. REV. & TAX.CODE §23802(b)(1).4 I.R.C. §702(a) (partnerships); §1366 (S corporations).5 I.R.C. §199A(c)(1).6 The Section 199A regulations were reissued in cor-rected form in February 2019.7 I.R.C. §199A(e)(2); Rev. Proc. 2018-57, 2018-49I.R.B. 827, §3.27. The Threshold Amount is increasedfor cost-of-living adjustments in subsequent taxableyears.8 “Above-the-line” deductions (e.g., certain businessdeductions, employer deductions, and losses) reduce“gross income” (defined in I.R.C. §61), resulting in“adjusted gross income.” See I.R.C. §62. By contrast,“below-the-line” deductions reduce “adjusted grossincome,” resulting in “taxable income.” See I.R.C. §63.9 I.R.C. §63(b)(3).10 I.R.C. §199A(f)(1)(A)(i).11 Trusts and estates generally are treated as pass-through entities to the extent qualified income is allo-cated to beneficiaries. To the extent qualified incomeis treated as retained, trusts and estates generally aretreated as individuals. See Treas. Reg. §1.199A-6(d)(1).12 I.R.C. §199A(f)(3).13 Treas. Reg. §1.199A-1(e)(3). See I.R.C. §§1402,1411.14 I.R.C. §199A(i).15 Treas. Reg. §1.199A-1(b)(14).16 Commissioner v. Groetzinger, 480 U.S. 23 (1987).17 Id. at 35.18 SeeHiggins v. Commissioner, 312. U.S. 212 (1941).19 2019-9 I.R.B. 740.20 The safe harbor excludes real estate used as a resi-dence for any part of the year under I.R.C. §280A.21 For taxable years ending after December 31, 2022,

at least 250 hours of rental services must be performedin any three of the five consecutive years.22 Treas. Reg. §1.199A-1(b)(14) provides that therental or licensing of property to “commonly con-trolled” Qualified Business will be treated as a QualifiedBusiness. Treas. Reg. §1.199A-1(b)(14).23 Treas. Reg. §1.199A-5(d)(3)(i). This rule only treatsthe purported “independent contractor” as an employeefor Section 199A purposes. It does not necessary applyfor other tax purposes.24 See, e.g., Dynamex Operations W., Inc. v. SuperiorCt., 4 Cal. 5th 903 (2018).25 Section II(A)(3)(d) of the Preamble to the Section199A regulations [hereinafter Preamble] states thatmultiple businesses generally will not exist within anentity unless different methods of accounting can beused for each business under Treas. Reg. §1.446-1(d),one requirement of which is that complete and separatebooks and records be maintained for each business.26 See Preamble, §V(A). 27 I.R.C. §199A(c)(3)(A); Treas. Reg. §1.199A-3(b)(2)(i)“Effectively connected” with a U.S. business is deter-mined under I.R.C. §864(c), applied by substituting“qualified trade or business” for “nonresident alienindividual or a foreign corporation” or for “foreigncorporation.”28 I.R.C. §199A(c)(3)(B)(i)-(vii); Treas. Reg. §1.199A-3(b)(2)(ii). Other excluded investment items includeamounts from certain annuities, foreign currency gainsand losses, and items from notional principal contracts.Id. 29 Treas. Reg. §1.199A-3(b)(2)(ii)(A). An example ofitems treated as capital gain under the I.R.C. whenthere may not be a sale of a capital asset is I.R.C.§1231 gains. I.R.C. §1231(a) provides that certaingains and losses from business property and involuntaryconversions are treated as either long-term capital gainor loss or as items with ordinary character. Section 1231gains and losses are excluded from qualified income.By contrast, if I.R.C. §1231 treats gains and losses asordinary, these items must be included in the calculationof qualified income, even they derive from the dispo-sition of a capital asset. See Preamble, supra note 25,at Summary §IV(A)(10). 30 Treas. Reg. §1.199A-3(b)(2)(ii)(C).31 See Preamble to the Proposed Regulations, Explana -tion of Provisions, §III(A)(vii)(b) [hereinafter Preambleto Proposed Regs.].32 Treas. Reg. §1.199A-3(b)(2)(ii)(H). The S corpora-tion’s deduction for reasonable compensation willreduce qualified income if the deduction is allocableto the Qualified Business. Id.33 See Rev. Rul. 74-44, 1974-1 C.B. 287. An S corpo-ration shareholder generally would prefer dividendsrather than wages because wages are subject to employ-ment taxes.34 See Treas. Reg. §1.707-1(c); Rev. Rul. 69-184,1969-1 C.B. 256. Instead, the partner is generallytreated as an independent contractor who receives a“guaranteed payment” from the partnership, whichis reported on Schedule K-1.35 I.R.C. §199A(c)(4)(B), (C); Treas. Reg. §1.199A-3(b)(2)(ii)(I), (J).36 Treas. Reg. §1.199A-3(b)(2)(ii)(I), (J).37 See Preamble to Proposed Regs., supra note 31, at§III(A)(vii)(d), (e).38 Treas. Reg. §1.199A-3(b)(1)(ii). See Preamble, supranote 25, at §IV(A)(6).39 Treas. Reg. §1.199A-1(c)(1) actually uses the term“total QBI amount.”40 Treas. Reg. §1.199A-1(c)(1). Treas. Reg. §1.199A-1(b)(3) defines “net capital gain” as the sum of netcapital gain and qualified dividend income (as definedin I.R.C. §1(h)(11)(B)).41 Treas. Reg. §1.199A-1(b)(13).42 I.R.C. §199A(c)(2); Treas. Reg. §1.199A-1(c)(2)(i).

43 See 1 H.R. Conf. Rep. 115-466, at 222 (2017). 44 See I.R.C. §199A(d)(3); Treas. Reg. §1.199A-1(d)(2).45 I.R.C. §199A(d)(2) (incorporating I.R.C.§1202(e)(3)(A)).46 I.R.C. §199A(d)(2)(A).47 See Preamble to Proposed Regs., supra note 31, at§V(A)(2)(a)(i). 48 Treas. Reg. §1.199A-5(b)(2)(iii).49 Treas. Reg. §1.199A-5(b)(2)(ii).50 Preamble, supra note 25, at §VI(A)(2). 51 Treas. Reg. §1.199A-5(b)(3)(i).52 See Treas. Reg. §199A-5(c)(1)(iii)(A).53 Treas. Reg. §1.199A-5(b)(2)(vii).54 Preamble to Proposed Regs., supra note 31, at§V(A)(2)(a)(i)(f). 55 The Treasury Department expressed concern thata broad definition of “reputation or skill” would resultin substantial uncertainty for taxpayers and potentiallyexcluding all service business income of high-incometaxpayers from the 20 percent deduction would beinconsistent with Congressional intent. Preamble, supranote 25, at §VI(A)(13).56 Treas. Reg. §1.199A-5(b)(2)(xiv)(A)-(C). The reg-ulations clarify that income includes the receipt “ofequity in a pass-through entity and any income at -tributable to that equity. Treas. Reg. §1.199A-5(b)(2)(xiv)(D).57 See Treas. Reg. §1.199A-5(b)(3)(xv).58 Treas. Reg. §1.199A-5(c)(1)(i), (ii).59 Treas. Reg. §1.199A-5(c)(2)(i), (ii).60 See Treas. Reg. §1.199A-5(c)(2)(iii)(A)-(B).61 Treas. Reg. §1.199A-5(a)(2).62 I.R.C. §199A(f)(1)(A).63 See Treas. Reg. §1.199A-2(a)(3)(ii), (iii). When qual-ified property is held by a partnership, the partners’shares of UBIA are determined based on how the part-nership would allocate depreciation for book purposeson the last day of the taxable year under the capitalaccount maintenance rules in the Treasury Regulations.Treas. Reg. §1.199A-2(a)(3)(ii). See Treas. Reg. §1.704-1(b)(2)(iv)(g).64 I.R.C. §§199A(b)(4)(A), 6051(a)(3), (8). Treas. Reg.§1.199A-2(b)(2)(i). Amounts are excluded as W-2wages if they are not properly included in a returnfiled with the Social Security Administration on orbefore the 60th day after the due date (including exten-sions) for such return. I.R.C. §199A(b)(4)(C).65 See Treas. Reg. §1.199A-2(b).66 See Treas. Reg. §§1.199A-2(b)(2)(ii), (iv)(B), (iv)(C).67 I.R.C. §199A(b)(6)(A). Treas. Reg. §1.199A-2(c)(1)(i).68 I.R.C. §199A(b)(6)(B). See I.R.C. §168. If qualifiedproperty that has been placed in service is subsequentlyadded to or improved, then the addition or improvementis treated as “separate” qualified property first placedin service on the date the addition or improvement isplaced in service. Treas. Reg. §1.199A-2(c)(1)(ii).69 See 1 H.R. Conf. Rep. 115-466, at 217 (2017).70 See Josh Keefe, Last-Minute Real Estate Tax BreakIn GOP Bill Will Benefit Trump, INT’L BUS. TIMES

(Dec. 16, 2017), http://www.ibtimes.com/political-capital/last-minute-real-estate-tax-break-gop-bill-will-benefit-trump-2629381.71 Treas. Reg. §1.199A-4(a).72 See Treas. Reg. §1.199A-4(d)(13) (explaining thata business cannot be aggregated with a nonbusinessactivity).73 Treas. Reg. §1.199A-4(b)(1).74 Treas. Reg. §1.199A-4(b)(2)(ii).75 Treas. Reg. §1.199A-4(b)(2)(i).76 Treas. Reg. §1.199A-6(b)(3)(i), (ii).77 Treas. Reg. §1.199A-6(b)(3)(iii).78 Treas. Reg. §1.199A-6(b)(3)(i)(B).79 See Treas. Reg. §§§1.199A-4(c)(2)(i), -4(c)(4)(i).80 Preamble, supra note 26, at §V(D).81 Treas. Reg. §§1.199A-4(c)(1), (3).

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