WARNING: This post is more cathartic than instructive. It’s my rant on this lousy Bill before Congress that will likely become law. It’s not intended to be political. It addresses wrongs committed by both Republicans and Democrats. It so happens that the latest wrongs are all attributable to Republicans. The latest wrongs, though, are particularly offensive. They are packaged and sold as tax reform. They are not tax reform. Real tax reform requires an intensive policy-driven process. The Tax Cuts and Jos Act (it may well  become known as the Jobs Cuts and Tax Act) stinks of politics. It has no soul. It will hopefully soon be replaced with a new tax code based on real tax reform.

Section 199A (the 20% pass-through business income deduction) exemplifies the wrong that bothers me. So, my rant about the Tax Cuts and Jobs Act picks on that provision.

Section 199A

If any member of Congress or the Executive Branch attempts to claim that the Tax Cuts and Jobs Act simplifies the Internal Revenue Code, ask that member to explain in 30 seconds or less the details of new Section 199A.

Section 199A epitomizes so many politically-driven provisions of the Code. It excludes certain income from gross income. The exclusion is not based on any broadly-shared policy goal. It’s directed to certain taxpayers. Those taxpayers tend to be higher-income. They also tend to be very well-represented by lobbyists. It costs a lot of money. Without complicated exclusions, it would cost too much money. So, Congress must narrow the exclusion to reduce its cost. Section 199A limits the exclusion in several ways:

• The income does not include investment income: interest, dividends, commodities trading, notional principal contract income, foreign currency gains, any annuity payments;
  • Without going into details, Section 199A provides exceptions to these qualified business income exceptions. Creating exceptions to exceptions is another feature of provisions like Section 199A.
• The income must be effectively connected with a US trade or business;
• The deduction is capped at 20% of qualified business income.
• Despite the popular name for the provision (a 20% pass-through deduction), the deduction is really the sum of
  • The greater of 2 amounts (subject to the 20% cap):
    • 50% of “adjusted wages” paid by the trade or business, or
    • 25% of the “adjusted wages” paid by the trade or business, plus 2.5% of the “unadjusted basis” of the business capital assets, plus
  • 20% of the sum of:
    • qualified REIT dividends, plus
    • qualified publicly-traded partnership income.

As you might expect for a provision like Section 199A, the terms like “adjusted wages” and “unadjusted basis” are determined with reference to existing Code concepts. Those concepts, though, are tweaked just for Section 199A. Isn’t that grand?

But wait, there’s more! While the House version of the Act excluded professional service income from Section 199A benefits, the Conference version includes it, subject to more limits. Those limits are based on the income of the taxpayer. The Section 199A benefit phases out for taxpayers who are married and file jointly at $315,000 taxable income. The benefit phases out for other taxpayers at $157,500 of taxable income. The benefit is completely phased out for married-filing-jointly taxpayers at $415,000 taxable income and for other taxpayers at $207,500.

As noted above, the Section 199A deduction is not a simple 20% of easily-calculated income. It’s based on a formula that takes adjusted wages paid and unadjusted bases of capital items. The phase-out just complicates that formula. No biggie! Could it get more complicated? Why yes!!

Only certain professional service income is subject to the phase out. Apparently, the engineers and architects had better lobbyists than the ABA. Or maybe Congress decided to penalize the ABA for determining that 2 of the Administration’s nominees for Appeals Courts were not competent. In any case, the engineers and architects are not subject to this professional service rule.

So, what will professional service partnerships do? Well, they might divide their businesses between the pure consulting/counseling element and other elements that are more based on capital and product sales.

The Act provides the Treasury Department (Internal Revenue Service) with authority to issue regulations to implement this provision and to provide anti-abuse provisions. Whenever you see an Act that grants IRS regulatory authority to draft anti-abuse provisions, it usually means that Congress knows it just created a provision that is vulnerable to (maybe even invites) abuse.

Based on the IRS budget allocation and the regulatory comment period, we should expect final regulations about the time that another Congress repeals this provision in a real tax reform act.

 

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