On August 8, 2018 the IRS issued long-awaited proposed regulations related to the new 20 percent deduction for qualified business income flowing from pass-through businesses and sole proprietors. The proposed regulations provide answers to many questions that have existed since enactment of the Tax Cuts and Jobs Act, but in doing so, have made it clear that the calculation of the deduction will, in many cases, add significant additional complexity to tax returns.

Over the next few months, the IRS will be seeking comment on these regulations, which may eventually lead to a final version. While the current version of the proposed regulations could be changed or modified based on the comments received during this period, taxpayers should rely on the proposed regulations as guidance in the interim.

The 20 percent deduction generally applies to taxable years beginning after 2017 and before 2026. Qualifying taxpayers who find themselves subject to the highest individual tax bracket of 37 percent will now have the ability to lower their effective tax rate to 29.6 percent for income qualifying for the deduction.

In this alert, we have provided some background on the events that have led to these proposed regulations, as well as a summary of the key provisions. We encourage you to contact your Kreischer Miller tax advisor if you have any questions or would like to discuss how these regulations apply to your personal circumstances.


The Tax Cuts and Jobs Act added Internal Revenue Code section 199A, which allows individuals, trusts, and estates to take a deduction of up to 20 percent of domestic income from a qualified trade or business (“business”) operated as a sole proprietorship, partnership, or S corporation. The resulting deduction is limited to 50 percent of the qualifying W-2 wages allocable to the shareholder or partner from the business, or 25 percent of the qualifying W-2 wages from that business plus 2.5 percent of the unadjusted basis of qualifying fixed assets from the business. If the individual taxpayer’s taxable income is below “threshold amounts” ($315,000 if married filing jointly or $157,500 for all other filers,) the W-2 wage- and asset-based limitations discussed above do not apply.

This new deduction is reported as a deduction on the shareholder’s/partner’s individual tax returns or estate/trust income returns, where a potential further limitation applies equal to 20 percent of their overall taxable income less capital gains.

A qualified business does not include a specified service trade or business (“service business”) that operates in the fields of health, law, accounting, actuarial services, performing arts, consulting, athletics, financial services, brokerage services, investment management, trading, or dealing in securities. A business where the principal asset is the reputation of skill of one or more of its employees or owners is also not eligible. Therefore, such service businesses would not qualify for the 20 percent deduction. However, an exception to this rule will apply where the taxable income of the shareholder/partners on their individual tax return is below the threshold amounts defined above.

Below are some of the questions that have been addressed in the proposed regulations as well as some observations relating to potential issues that remain.

Does my service business qualify for the new 20 percent deduction?

Since enactment, there has been concern about what types of service business activities would be ineligible for the deduction. The proposed regulations set out somewhat narrow parameters in defining ineligible service businesses. In particular, the exclusion for business activities involving skills and reputation of owners or employees will not be applied except where financial gain is received from the use of a name of the service provider (e.g., actors, celebrities, etc.). The proposed regulations also provide a detailed discussion of the various specified ineligible service categories.

Although helpful with certain industries – for example, brokerage services where the definition is narrowed to someone dealing in financial securities – the proposed regulations still only vaguely define what constitute ineligible consulting services.

Business owners and their advisors will need to carefully review the definitions of service businesses and apply them to their business to determine whether they will qualify for the new 20 percent deduction. This could pose some risk for penalties should the IRS disagree, with a new lower threshold applicable to penalty assessments that may be asserted during an examination dispute.

Will my real estate activity qualify for the 20 percent deduction?

The 20 percent deduction only applies to a qualified trade or business. The statutory language does not provide a definition of what constitutes a qualified trade or business, leaving many wondering whether real estate activities would qualify for the deduction. Prior regulatory and other IRS pronouncements as well as court decisions rendered over time have not done a good job of providing a clear definition of a trade or business, especially as the term relates to real estate activities which involve triple net lease terms.

The proposed regulations define a qualified trade or business by referencing precedent under preexisting law. Real estate leasing arrangements may be subject to a higher level of IRS examination scrutiny. Activities involving a triple net lease may be in jeopardy of not being considered a qualified trade or business.

A positive provision in the proposed regulations provides clarity that real estate activities will qualify for the deduction where activities involve a related party (so called “self-rental” arrangements). Under these circumstances, the real estate activity will be deemed to qualify as a trade or business. This is a significant win for many privately-held companies that typically arrange for ownership of real estate used in business operations to be held in a separate legal entity.

Can all of my trades or businesses qualify for the 20 percent deduction?

The 20 percent deduction may pose challenges for commonly controlled companies that operate as Q-Subs, Brother/Sister Companies, or Tiered Partnerships. This is because the deduction may need to be determined for each separate business and the W-2 wage and property limitations may need to be applied separately to each business.

The challenge for many of these organizational structures is that a material amount of otherwise qualifying W-2 wages are paid out of one of the legal entities in the group, even though the employees are providing services to the other entities. This could lead to the loss of the 20 percent deduction for a profitable business within such a structure which has little or no W-2 wages.

The proposed regulations provide two solutions to address this issue. The first involves an “Aggregation Election” which will permit a group of certain qualified businesses to be combined in order to maximize the 20 percent deduction. The second option involves an allocation method wherein each business component is assigned its share of W-2 wages in connection with determination of the 20 percent deduction.

The aggregation election is a significant development under the proposed regulations which should be considered by business owners potentially impacted in connection with the filing of  2018 individual tax returns. Once an aggregation election is made, it can’t be revoked.

Other Developments:

The proposed regulations have provided additional clarity in the following areas:

  • Taxpayers who are owners of fiscal year business pass-through entities will qualify for the 20 percent deduction for their personal 2018 tax year to the extent that the pass-through entity taxable year ends within 2018. This applies to the full amount of income for the pass-through entity even in cases where the entity’s fiscal year would have begun prior the December 22, 2017 enactment of the new tax law.
  • W-2 wages that are paid by a professional employment organization on behalf of a qualifying business will count as W-2 wages for that business.
  • Qualified Business Income for purposes of including in the calculation of the 20 percent deduction includes gains and losses from the sale of business property to the extent characterized as ordinary in nature. Capital gains and losses, however, will not be included in the calculation of qualified business income.
  • Anti-abuse rules are established for businesses that are considered service companies and are intended to prevent splitting up business operations to create the appearance of an integrated component of the business that could qualify for the 20 percent deduction (e.g., a law firm that splits out the administration and billing in a separate legal entity).


The proposed regulations have provided clarity on many of the questions advisors and business owners have been trying to answer over the past eight months. However, the proposed regulations have also layered in additional complexity to the planning and compliance that goes into the 20 percent deduction.

For business owners who clearly have a qualified business (e.g., manufacturing, distribution) and no other business, the analysis may be less complicated. But for many businesses that fall into the service category, owners will need to determine how the proposed regulations impact whether they will qualify for the deduction and, if so, what limitations may apply and how planning may change outcomes for the better. Taxpayers with multiple businesses may need to decide whether they should aggregate their qualifying business to maximize the deduction. Finally, taxpayers with material investments in real estate activities may need to analyze prior regulatory and court authorities to determine whether their activities will qualify and whether an aggregation election may help maximize the deduction that may be otherwise available.

These rules are complex, and determining whether and how to qualify for the 20 percent deduction involves careful analysis and planning. As always, we are here to help. Please do not hesitate to contact your Kreischer Miller tax advisor with any questions or to learn more about the proposed guidance.

If you have any questions about this information or would like to discuss this subject further, please do not hesitate to contact a member of Kreischer Miller's Tax Strategies group at 215.441.4600.

Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect, or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.