Redpath Insights


Guidance on 20% Pass Through Deduction for Income Under Section 199A

by John Kammerer, CPA

August 10, 2018 โ€”On Wednesday, August 8th, the IRS released proposed regulations providing guidance on the new 20% pass-through deduction for qualified trade or business income in Section 199A.  The 20% pass-through deduction is a key provision in the Tax Cuts and Jobs Act (TCJA) providing a deduction that has the effect of lowering the top federal income tax rate on eligible business income from 37% down to 29.6%.  The proposed rules address a variety of subjects and, while generally positive, leave some uncertainty.

Background on the Section 199A Deduction

Beginning in 2018, non-corporate owners of pass-through entities and sole proprietorships will be allowed a deduction equal to 20% of qualified business income.  Qualified business income is income from a domestic trade or business that is not a โ€œspecified service businessโ€ and is not an item that is typically investment income such as capital gains, interest, and dividends.  Also, qualified business income does not include reasonable compensation paid to the taxpayer by a qualified trade or business.

For married taxpayers with income above $315,000 ($157,500 for other taxpayers), the deduction is generally limited to the greater of 50% of the taxpayers share of W2 wages of the trade or business or the sum of 25% of the taxpayers share of W2 wages plus 2.5% of the taxpayers share of the unadjusted basis of โ€œqualified propertyโ€.  Taxpayers below the income threshold are not limited by those two tests and are also allowed to count specified service business income as eligible for the 20% pass-through deduction.

Key Takeaways


A significant concern for many taxpayers was the ability to aggregate appropriate businesses (to avoid limitations related to the wage or qualified property restrictions noted above) that may have been separated into different entities for legal, regulatory or other non-tax reasons.   The proposed regulations address this concern by permitting aggregation in the calculation of the 20% pass-through deduction if taxpayers can demonstrate that:

  • The same person or persons directly or indirectly own 50% or more of each trade or business to be aggregated for a majority of the taxable year in which the items are included in income;
  • The items are reported on returns with the same taxable year (not including short years);
  • None of the aggregated businesses are specified service businesses; and
  • The trades or businesses to be aggregated must satisfy at least two of the following:
    • All trades or businesses provide products or services that are the same or are customarily provided together;
    • The businesses share facilities or share significant centralized business elements such as personnel, accounting, legal, human resources, manufacturing, etc.; or
    • The trades or businesses are operated in coordination with one or more of the businesses the aggregated group (supply chain or other integrations).

The decision to aggregate is at the election of the taxpayer; however, it is required to be used and reported consistently once established.


Another important clarification in the proposed regulations was the determination of wages for entities that utilize third party payors (including professional employer organizations, certified professional employer organizations, and agents).  There was concern that they would not be considered to have wages in their respective trade or businesses and would thus be limited in the calculation of the 20% pass-through deduction.  The proposed regulations eliminate this concern and provide that the wages of common law employees of the taxpayer can be included for each trade or business in the same proportion to which the deduction associated with the trade or business is allocated.  These rules are similar to the rules allowed under the domestic production deduction which was repealed as part of the TCJA.

Specified Service Businesses

One of the key questions related to specified service businesses was the definition itself and how broadly it would be interpreted.  Section 199A (in part through modifications of Section 1202) defines a specified service business as

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 have a fairly substantial listing of definitions that help clarify how this will be interpreted for a variety of businesses and industries.

Another concern related to specified services businesses was related to activities performed in conjunction with another trade or business that would otherwise qualify such as consulting in relation to the sale of or installation of a product.  The regulations address this concern by providing a de minimis rule where a trade or business will not be considered a specified service business if less than 10% of their total gross receipts (5% if the gross receipts are greater than $25 million in a taxable year) are related to a specified service business.

The IRS was concerned that taxpayers would separate components of a business that would otherwise be a specified service business into other trade or businesses that would be eligible for the 20% pass-through deduction.  In an attempt to curtail this type of planning, the proposed regulations contain an anti-abuse rule that provides that a business will be considered a specified service business if it has more than 50% common ownership with a specified service business and provides 80% or more of its property or services to the specified service business.  Furthermore, if a business has more than 50% common ownership with a specified service business, the income will be considered specified service income to the extent of the property or services provided.

While this approach addresses the concerns of potentially abusive transactions, it is also written broadly and will encompass transactions that are not typically considered abusive.  For example, the regulations listed an example of a taxpayer that owns a dental practice and a building that has half of the space rented to the dental practice and the other half to unrelated parties.  The regulations would treat the portion of the building rented to the dental practice as a specified service business.

In addition to the key takeaways noted previously, the proposed regulations provide many examples and definitions that help eliminate some of the uncertainty regarding the deduction and the impact on taxpayers operating as a pass-through business.

The proposed regulations requested comments on a number of points and could certainly change before being issued in final form.  However, taxpayers are permitted to rely on the regulations as proposed until final regulations are issued which should provide some certainty as taxpayers plan and determine their tax situation in 2018.

John Kammerer, CPA

John Kammerer, CPA

John Kammerer is a partner at Redpath and Company and holds a seat on the firmโ€™s board of directors. He leads the firmโ€™s business tax and M&A service areas, assisting clients with tax planning and preparation, research, entity structuring, and M&A transactions. John works with a variety of clients in industries such as manufacturing, construction, real estate, and professional services. He is a frequent presenter on topics of business taxation and entity structuring. John is also a member of the S Corp Association advisory board and is actively involved with the group to promote and support tax policies that positively impact S Corporations and privately-held businesses. John graduated from Winona State University with a Bachelor of Science degree in Accounting. He is a member of the American Institute of Certified Public Accountants (AICPA) and the Minnesota Society of Certified Public Accountants (MNCPA). He has provided public accounting services at Redpath and Company since 2004.