On January 18, 2019, the Treasury Department and the IRS issued final regulations that clarify the meaning of dealing and financial services under Section 199A of the tax code and provide relief to investors in certain loan originators.  Prior to this additional guidance, lending shops had been concerned that loan origination constituted “dealer” activity or a financial service, which are business lines not eligible for the new 20% deduction allowed to investors in certain pass-through businesses under Section 199A.

Section 199A, which was codified as part of the Tax Cuts and Jobs Act, allows individuals to deduct up to 20% of their “qualified business income” from a domestic sole proprietorship, partnership, S corporation, trust, or estate, resulting in a maximum effective tax rate of 29.6% with respect to that income (instead of 37%). The amount of qualified business income to which the deduction is available generally is capped at the greater of (1) 50% of the W-2 wages paid with respect to the business and (2) the sum of (x) 25% of those W-2 wages and (y) 2.5% of the unadjusted basis of certain depreciable property used in the business. Accordingly, the deduction generally is available only to investors in pass-through businesses that have significant employees and/or capital investments.

In addition, the deduction phases out for “specified service trade or business” (SSTB) income earned by taxpayers with aggregate income above a certain threshold, and is denied entirely for SSTB income earned by joint filers with aggregate income above $415,000 (or individual filers with aggregate income above $207,500).

“Dealing in securities” is a SSTB.  The Section 199A regulations define “dealing” similarly—but not identically—to Section 475, under which certain securities dealers are required to use annual “mark to market” tax accounting.  Under Section 475, a “dealer in securities” is a taxpayer who “regularly purchases from or sells securities to customers in the ordinary course of a trade or business” (emphasis added).  Loan originators have long assumed that they could be considered dealers under Section 475 since the origination of a loan (which likely is a security for this purpose) is effectively a “purchase” of the loan from a customer, i.e., the borrower.  Deviating from the language in Section 475, the Section 199A regulations define “dealing” as “regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business” (emphasis added).  As a result, dealing under Section 199A requires both purchasing and then selling securities to customers, while under Section 475 either activity is sufficient to trigger classification as a dealer. 

This distinction may help a loan originator who “purchases” (i.e., originates) loans but then retains those loans on its balance sheet avoid being a dealer under Section 199A.  It does not help the many loan originators who sell loans to government agencies, such as GNMA or Freddie Mac, to private-label sponsors of securitizations or to other third parties to the extent such purchasers constitute “customers.”  To address this concern, the Section 199A regulations provide that loan origination is not considered the “purchase” of a security when determining whether a lender is engaged in “dealing.”  Accordingly, even if a loan originator sells its loans to customers, it will not be a dealer for purposes of Section of 199A, which requires both the purchase from, and the sale to, a customer.

Additionally, under Section 199A financial and brokerage services are SSTBs.  It is unclear from the statute which activities are encompassed by these terms.  The final Section 199A regulations provide that making loans is not considered the “performance of services in the field of financial services” or brokerage services (although arranging lending transactions between a lender and a borrower is a financial service).