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Final Regulations Under 20% Qualified Business Deduction Issued by Treasury In Time For Filing 2018 Tax Returns
Revenue Procedure to Set Forth Rental Real Estate as a Qualified Business to be Issued Shortly
By: Jerry August
On January 18, 2019, the Treasury and Internal Revenue Service issued final regulations under Section 199A, which was enacted into law by the Tax Cuts and Jobs Act (TCJA) P.L. 11-97, §11011 (12/22/2017). The guidance is needed for non-corporate taxpayers in reporting their taxable income for 2018, including to the extent available, the 20% deduction for qualified business income (QBI) under section 199A subject to applicable limitation. On August 8, 2018, proposed regulations were issued [REG-107872-18], It is estimated that between 17 and 40 million business owners who are US citizens or residents will be able to qualify under this deduction. Proposed regulations (REG-134652-18) were issued on the treatment of previously suspended losses that are characterized as QBI and on the determination of the section 199A deduction for REITS, split-interest trusts and charitable remainder trusts. The Service also issued guidance in Notice 2019-7 setting forth a proposed safe harbor under which a rental real estate enterprise will be treated as a trade or business solely for purposes of section 199A.
In general, the final regulations to section 1199A adopt many of the rules set forth in the proposed regulations. Still there were revisions made to the proposed regulations in response to the comments received and testimony provided at the public hearing, as in the Preamble to the final regulations. The Service acknowledged that it had received 335 comments to the notice of proposed regulations.
Additionally, clarifying language and additional examples have been added throughout the final regulations. The proposed regulations were intended to meet important guidance objectives, including identifying qualified business income (QBI), providing applicable rules for computing the amount allowable as a deduction in calculating taxable income, as well as providing rules concerning the important limitations under section 199A(d)(2)(B).
Section 199A provides a deduction of up to 20% of taxable income from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate (section 199A deduction). A section 199A deduction is not available for recipients of wage income or for business income earned through a C corporation. For taxpayers whose taxable income exceeds a statutorily defined amount (threshold amount), section 199A may limit the taxpayer's section 199A deduction based on (1) the type of trade or business engaged in by the taxpayer, (2) the amount of W-2 wages paid with respect to the trade or business (W-2 wages), and/or (3) the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the trade or business (UBIA of qualified property). Section 199A also allows individuals and some trusts and estates (but not corporations) a deduction of up to 20% of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, including qualified REIT dividends and qualified PTP income earned through pass-through entities. This component of the section 199A deduction is not limited by W-2 wages or UBIA of qualified property. In general, the section 199A deduction is the lesser of (1) the combined QBI amount, or (2) an amount equal to 20% of the excess (if any) of taxable income of the taxpayer for the tax year over the net capital gain of the taxpayer for the tax year.
As acknowledged by the statutory language and in the rule-makings issued by the Treasury, the law allows the issuance of regulations necessary to carry out the purposes of section 199A (section 199A(f)(4)), and grants authority with respect to: the treatment of acquisitions, dispositions, and short taxable years (section 199A(b)(5)); certain payments to partners for services rendered in a non-partner capacity (section 199A(c)(4)(C)); the allocation of W-2 wages and UBIA of qualified property (section 199A(f)(1)(A)(iii)); restricting the allocation of items and wages under section 199A and such reporting requirements as the Secretary determines appropriate (section 199A(f)(4)(A)); the application of section 199A in the case of tiered entities (section 199A(f)(4)(B); preventing the manipulation of the depreciable period of qualified property using transactions between related parties (section 199A(h)(1)); and determining the UBIA of qualified property acquired in like-kind exchanges or involuntary conversions (section 199A(h)(2)). The final regulations also make amendments to the proposed regulations issued last August with respect to the multiple trust doctrine contained in section 643(f) which sets forth instances where two or more trusts are to be treated as a single trust for federal income tax purposes. This rule, as applied to the 20% deduction under section 199A, is incorporated in the new provision to prevent otherwise identical trusts from leveraging the 20% deduction by separating the beneficiaries into separate trusts. This post sets forth some of the more important revisions made by the final regulations.
Net Capital Gain. Section 199A(a) provides, in relevant part, that the section 199A deduction is limited to the lesser of the taxpayer's combined QBI or 20% of the excess of a taxpayer's taxable income over the taxpayer's net capital gain (as defined in section 1(h)) for the taxable year. The proposed regulations do not contain a specific definition of net capital gain. The final regulations provide a definition of net capital gain for purposes of section 199A. Section 1(h) establishes the maximum capital gains rates imposed on individuals, trusts, and estates that have a net capital gain for the taxable year. Section 1222(11) defines net capital gain as the excess of net long-term capital gain for the taxable year over the net short-term capital loss for such year. Section 1(h)(11) provides that for purposes of section 1(h), net capital gain means net capital gain (determined without regard to section 1(h)(11)) increased by qualified dividend income. Final Treas. Reg. §1.199A-1(b)(3) defines net capital gain for purposes of section 199A as net capital gain within the meaning of section 1222(11) plus any qualified dividend income (as defined in section 1(h)(11)(B)) for the taxable year.
Relevant Pass Through Entity (RPE). The proposed regulations define an RPE as a partnership (other than a PTP) or an S corporation that is owned, directly or indirectly, by at least one individual, estate, or trust. A trust or estate is treated as an RPE to the extent it passes through QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, or qualified PTP income. In taking a comment it received into account, the final regulations provide that other passthrough entities, including common trust funds as described in Treas. Reg. §1.6032-T and religious or apostolic organizations described in section 501(d), are also treated as RPEs provided the entity files a Form 1065, U.S. Return of Partnership Income, and is owned, directly or indirectly, by at least one individual, estate, or trust. RICs may not be treated as RPEs as they are taxed as C corporations, not pass thru entities.
Trade or Business. The QBI concept applies to taxpayers that are engaged in and derive income from a trade or business. The proposed regulations defined trade or business for this purpose under section 162 which permits a deduction for all the ordinary and necessary expenses paid or incurred in carrying on a trade or business. While the standard is based on case law, including the leading case from the Supreme Court on the subject, Commissioner v. Groetzinger, 480 US 223 (1987)(regular, continuous and substantial activity for the production of income), the issue is resolved by reviewing all facts and circumstances. Comments were received that in order to provide greater certainty, a bright-line test or safe-harbor should be adopted in the final regulations in applying section 199A. Some commentators had suggested considering the trade or business activities rules set forth in sections 469 and 1411 in defining a trade or business under section 199A. It is recognized, however, that the definition of a trade or business is significantly broader than the definition under section 162 as section 469 is intended to include a much larger universe of activities, including passive activities. The Treasury and IRS therefore declined to follow this suggestion both with respect to section 469 and 1411 (medicare add-on tax). The material participation test in Treas. Reg. §1.469-5T was also rejected as that 7 tier test infrastructure “is not a proxy to establish regular, continuous, and considerable activity” that rises to the level of a trade or business under section 199A (based on section 162(a)’s definition of carrying on a trade or business). Instead the material participation test focuses simply on whether an individual is “active” or “materially participates” in one or more section 199A activities. On the other hand, the Treasury and IRS was more sympathetic to the comments concerning whether a rental real estate activity is (or is not) a section 162 trade or business. This determination is based on various factors as reflected in the case law. While a “bright line” rule or test was not adopted, the Service issued a safe harbor in Notice 2019-07 which provides notice of a proposed revenue procedure detailing a proposed safe harbor under which a rental real estate enterprise may be treated as a trade or business solely for purposes of section 199.
Under the proposed safe harbor, a rental real estate enterprise may be treated as a trade or business for purposes of section 199A if at least 250 hours of services are performed each taxable year with respect to the enterprise. This includes services performed by owners, employees, and independent contractors and time spent on maintenance, repairs, collection of rent, payment of expenses, provision of services to tenants, and efforts to rent the property. Hours spent by any person with respect to the owner's capacity as an investor, such as arranging financing, procuring property, reviewing financial statements or reports on operations, planning, managing, or constructing long-term capital improvements, and traveling to and from the real estate are not considered to be hours of service with respect to the enterprise. There are other requirements. Property leased under a triple net lease or used by the taxpayer including an owner/beneficiary of an RPE as a residence for any part of the year under section 280A is ineligible to qualify under the safe harbor. The failure to satisfy the requirements under the safe harbor does not preclude the rental real estate activities from constituting a trade or business for this purpose in accordance with case law.
Renting Property to a Related Person. Under Prop. Reg. §1.199A-4(b)(1)(i), solely for purposes of section 199A, the rental or licensing of tangible or intangible property to a related trade or business is treated as a trade or business if the rental or licensing activity and the other trade or business are commonly controlled. This rule also allows taxpayers to aggregate their trades or businesses with the leasing or licensing of the associated rental or intangible property if all of the requirements of Prop Reg. §1.199A-4 are met. The final regulations confirm that this relief rule will be limited to situations where the related party is an individual or RPE and that the term “related party” is to be defined in accordance with attribution rules set forth in sections 267(b) or 707(b). See Treas. Reg. §1.199A-4.
Multiple Trades or Businesses Within an Entity. Whether a single entity has multiple trade or businesses is based on all facts and circumstances based on existing case law. Comments were received that safe harbors or factors be adopted and set forth in the final regulations to delineate separate section 162 trades or businesses within an entity and when an entity’s combined activities should be considered as a single section 162 trade or business. Some of the factors suggested include whether the activities: (i) have separate books and records, facilities, locations, employees, and bank accounts; (ii) operate separate types of businesses or activities; (iii) are held out as separate to the public; and (iv) are housed in separate legal entities. The Treasury Department and the IRS declined to adopt recommendation it received for providing additional rules and safe harbors in this area. The Preamble to the final regulations explains that the Treasury and IRS also believe that multiple trades or businesses will generally not exist within an entity unless different methods of accounting could be used for each trade or business under Treas. Reg. §1.446-1(d). Further, trades or businesses will not be considered separate and distinct if, by reason of maintaining different methods of accounting, there is a creation or shifting of profits and losses between the businesses of the taxpayer so that income of the taxpayer is not clearly reflected.
Aggregation of Positive and Negative QBI. Prop. Reg. §1.199A-1(d)(2)(iii)(A) provides that if an individual’s QBI from one or more trades or businesses is less than zero, the individual must offset the QBIT attributable to each trade or business that produced net QBI with the QBI from each trade or business that produced net negative QBIT in proportion to the relative amounts of net QBI in the trades or businesses with positive QBI. This rule applies prior to the application of the limitations based on W-2 wage base or unadjusted cost basis in property. Various comments were received criticizing this approach. The calls for modifications were rejected in the final regulations. The Preamble provides that the aggregation rules provided in Treas. Reg. §1.199A-4 are optional and intended to assist taxpayers in applying the W-2 wage and qualified property limitations in situations in which a unified business is conducted across multiple entities. In contrast, the netting rule for positive and negative QBAIs is sourced from section 199A(b), which provides, in relevant part, that the term “combined qualified business income amount” includes the sum of 20% of the taxpayer's QBI for each qualified trade or business of the taxpayer. An example from the legislative history was cited: “For example, an individual has two business activities that give rise to a net business loss of 3 and 4, respectively, in year one, giving rise to a carryover business loss of 7 in year two. If in year two the two business activities each give rise to net business income of 2, a carryover business loss of 3 is carried to year three (that is, <7> - (2 + 2) = <3>).”
Reduction of QBI from a Specified Service Trade or Business (SSTB). On the other hand, the Treasury and IRS agreed that clarification regarding the reduction of QBI from an SSTB when a taxpayer has multiple trades or businesses was needed in the final rule-making. Section 199A(d)(3)(A)(ii) provides that “only the applicable percentage of qualified items of income, gain, deduction, or loss, and the W-2 wages and the unadjusted basis immediately after acquisition of qualified property, of the taxpayer allocable to such specified service trade or business shall be taken into account in computing the qualified business income, W-2 wages, and the unadjusted basis immediately after acquisition of qualified property of the taxpayer for the taxable year for purposes of applying this section.” The final regulations provide that for taxpayers with taxable income within the phase-in range, QBI from a SSTB must be reduced by the applicable percentage before the application of the netting and carryover rules described in Treas. Reg. §1.199A-1(d)(2)(iii)(A). The final regulations clarify that the SSTB limitations also apply to qualified income received by an individual from a PTP.
Other important areas of section 199A are set forth in the final regulations reflecting certain modifications from the proposed regulations. Such areas include: (i) determination of W-2 wages; (ii) qualified property and the treatment of qualified property by members of an RBE; (iii) concession with respect to the UBIA of qualified property (less the amount of money received in the transaction and increase by the amount of money paid by the transferee to acquire the property) contributed in a non-recognition transaction to a partnership or corporation instead of adjusted basis on the date contributed; (iv) application of non-recognition rules in sections 1031 and 1033; (v) application of special basis adjustment rules in sections 734(b) and 743(b) with respect to partnerships; (vi) qualified property acquired a decedent; and (vii) modifications and clarifications concerning the definition of QBI, qualified REIT dividends and qualified PTP income.
This post may not be relied upon by the reader as constituting legal advice by either Chamberlain Hrdlicka or this author. The post is intended solely for educational purposes. Any reader having questions concerning the subject addressed and/or content of this post should consult with the reader’s tax counsel or tax adviser.