The Tax Cuts and Jobs Act introduced many changes to the tax law, including new deductions, but few captured the attention of both tax preparers and taxpayers like the new deduction on pass-through business income under Section 199A.

Immediately following its passage into law, Section 199A elicited many strategies that were developed by tax planners to enable taxpayers to maximize their potential tax deduction under this new code section. For example, the use of multiple non-grantor trusts was initially proposed as a strategy to reduce the primary taxpayer’s taxable income and to ultimately allow all the business income to be eligible for the full 20% deduction. Another strategy, called “crack-and-pack,” was proposed to allow those working in a specified service trade or business to get at least a partial deduction for the non-specified trade or business income.

The crack-and-pack structure centers on the idea that non-specified service lines could be segregated from the specified service lines of business, and spun off into a separate business that would each be eligible for the 199A deduction. However, these planning methods were explicitly identified as abusive strategies designed to work around the law in the U.S. Treasury’s proposed regulations issued in August 2018.

Although most of the planning techniques initially developed are now explicitly disallowed by the proposed regulations, tax planning for Section 199A is not impossible. Forming new entities or restructuring existing entities as S corporations to generate wages, and restructuring or consolidating business structures to take advantage of the aggregation regime (defined in the proposed regulations), and creating non-grantor trusts that will not be consolidated under the proposed regulations are all tax planning techniques worthy of serious attention. Unfortunately, none of these techniques provides a “silver bullet” to maximize the deduction under Section 199A in either a quick or inexpensive manner. These techniques all require a comprehensive tax planning approach that focuses on the taxpayer’s current business and succession goals while being mindful of the potential costs and timeframe under which the deduction is available.

The Treasury’s proposed regulations for Section 199A state that guaranteed payments by a partnership to a partner are not includable in qualified business income and are not considered wages. S corporation wages paid to a shareholder are likewise not includable in qualified business income but are considered wages for high income taxpayers who are subject to the limitations on the Section 199A deduction. This makes the S corporation structure more appealing than a partnership structure. For taxpayers in non-specified service trades or businesses who currently are (or anticipate being) phased into the limitations on the deduction, the S corporation structure guarantees that the business will have at least some wages paid, meaning the taxpayer will be able to claim at least 50% of their wages as a deduction.

This strategy may be particularly valuable for taxpayers who are fully phased into the limitation based on their taxable income but who do not hire employees; or taxpayers who take guaranteed payments as a partner in a partnership. Where the wage limitation might otherwise prevent a 199A deduction, the requirement that S corporations pay a reasonable wage to shareholders will provide the taxpayer with wages to count against the wage limitation under Section 199A.

The aggregation regime defined in the proposed regulations is another area in which tax planning may provide value to taxpayers. Under the proposed regulations, a taxpayer with a business generating a loss for Section 199A purposes must allocate the loss across businesses with qualifying business income. However, the wages and unadjusted basis immediately after acquisition are not allocated to the other businesses. These factors, which are critical to maximizing the deduction, cannot be carried forward or back to another year. They are simply lost. Aggregating businesses together allows for the wages and unadjusted basis to be factored into the limitation calculations, thereby increasing the potential deduction.

Aggregation under the proposed regulations requires meeting several requirements. The aggregated businesses cannot be specified service trades or businesses. All businesses to be aggregated must have the same majority owner or owners for most the year. Most importantly, the proposed regulations state that the businesses must demonstrate that they meet two of three conditions that show that the businesses operate as one. The first condition is that the businesses are in either substantially the same or traditionally complementary trades or businesses. The proposed regulations give the example of a food truck and a restaurant as being in the same trade or business, while a car wash and gas station are in complementary businesses. The second condition is that the businesses have centralized business elements or shared facilities. An example of this includes common personnel working in administrative functions across the businesses. The final condition is that the businesses rely upon one another to operate. Interconnected supply chains are an example of how businesses might meet this condition.

For taxpayers with multiple related trades or businesses, the aggregation rules provide an opportunity to simultaneously streamline business operations and maximize tax deductions. For example, a taxpayer with multiple businesses providing similar products may want to consider creating one central office that would house administrative staff (such as human resources and information technology). The benefit of centralizing would be twofold. First, the taxpayer could realize business savings by consolidating multiple offices into one that would handle multiple businesses. The same could be said for staffing. Second, the taxpayer would now be eligible to aggregate the businesses under Section 199A. If one of the businesses generates a loss for Section 199A, the wages and unadjusted basis of property of that business can be used towards the wage and basis limitations for the other businesses. Were the businesses not aggregated, these factors would be of no use to the taxpayer.

Alternatively, the taxpayer could look for ways to further interconnect their businesses to meet the reliance condition. Businesses may be able to sell products to one another or allow for orders in one location to be fulfilled by another. By further enmeshing the businesses, the taxpayer may be able to aggregate the businesses.

The aggregation strategy would be beneficial to taxpayers with multiple separate but related trades or businesses. For example, an individual with significant real estate holdings, directly or indirectly through partnerships, would be one potential beneficiary of this strategy. Another would be an individual who has a separate company for each location of their business or franchise.

The Treasury’s proposed regulations identify the use of multiple non-grantor trusts which have substantially the same grantor and beneficiaries and are created with the intent to maximize the 199A deduction as abusive and will not be respected for the purposes of the 199A deduction. However, this is not to say that all uses of trusts under Section 199A are abusive. In fact, the proposed regulations expressly state that trusts with significant non-tax differences, trusts with substantially different beneficiaries, and trusts that are not created with Section 199A maximization as a primary purpose will not be considered abusive.

Therefore, a planning opportunity exists for individuals who own businesses and are planning to pass their business along to their children. Such an individual could gift a portion of their business into separate trusts for each child. To ensure that the trusts are not consolidated by the IRS, the trust agreements should be written separately and should be tailored to meet the needs of each child rather than to merely maximize the 199A deduction.

Because each trust in this scenario is only for one child, the beneficiaries are, by definition, substantially different. The trust agreements are also different, which suggests that there are significant non-tax differences between the trusts. Furthermore, because the purpose of the trusts is not to maximize the 199A deduction but rather to allow each child to gain ownership of the business at an appropriate time, the trusts are unlikely to be consolidated by the IRS. Note that this structure also happens to have the favorable side effect of moving income out of the individual’s tax return and onto the trusts’ returns, which might allow for an increased deduction on the pass-through business income.

It’s often said that taxes should not drive business decisions. Despite the excitement in the tax community over the new deduction on pass-through income (or perhaps because of it), preparers must have the taxpayer’s priorities in mind when planning for Section 199A. Suggesting changes to a business entity, organization, or succession plan should not be made lightly. None of these changes are small or quick changes because the proposed regulations under Section 199A are intentionally designed to prevent simple techniques from successfully increasing the deduction. Therefore, the planning options that do remain require taxpayers and their tax preparers to work together to assess both the taxpayer’s short- and long-term goals for their business to determine the strategies, if any, that will maximize the likelihood of successfully meeting these goals while minimizing taxes. While simple tax planning will not suffice, comprehensive business and personal planning may allow taxpayers to maximize their deductions.

Additionally, tax preparers should consider all the additional costs these planning strategies may involve before encouraging clients to make changes to their business. Consolidating administrative functions may cause the individuals in these functions to have greater workloads which in turn could cause delays or turnover. Gifting business interests to trusts may make future changes to business succession plans significantly more challenging. Additionally, such gifts would generally require a gift-tax filing and a valuation of the business, both of which are additional costs that taxpayers may not expect.

Tax preparers also must be keenly aware of the timeframe under which the deduction is allowable. Under the Tax Cuts and Jobs Act, all individual and trust provisions, including Section 199A, are due to sunset in 2025. Given the current political climate, it’s nearly impossible to say if these provisions will be repealed early, extended beyond the original sunset date, or allowed to sunset per the original law. Taxpayers and tax preparers need to carefully weigh the costs of any plan suggested against the benefits, especially given the limited window the deduction will be allowed under the law as written.