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On January 18, 2019, the IRS issued Final Regulations under new Section 199A (“Final Regulations”), which generally provides a deduction equal to 20% of an owner’s allocable share of the “qualified business income” (QBI) from a pass-through entity (S corporation, partnership, LLC taxed as a partnership or S corporation), or from a sole proprietorship. The “Proposed Regulations” were previously discussed in an August 9, 2018, blog post, which can be found at: IRS Issues Proposed Regulations on Section 199A Deduction.
On October 16, 2018, a public hearing was held regarding the Proposed Regulations. In response to the Proposed Regulations, the IRS received 335 comment letters from tax professionals and taxpayers. The Final Regulations are comprised of 274 pages (both the Preamble to the Final Regulations as well as the Final Regulations themselves), and the IRS also concurrently issued Notice 2019-07, which details a proposed safe harbor under which a rental real estate enterprise may be treated as a trade or business solely for purposes of Section 199A. Additionally, the IRS concurrently issued Revenue Procedure 2019-11, which provides additional guidance on the definition of W-2 wages, including amounts treated as elective deferrals.
The Preamble to the Final Regulations states that the IRS considered all of the 335 comments submitted to them on the Proposed Regulations. Obviously, some comments were accepted and many comments were rejected by the IRS. For the most part, the changes are taxpayer-friendly, but there are certainly winners and losers in connection with the changes made (or not made) in the Final Regulations. This article highlights the key changes made by the Final Regulations from the Proposed Regulations, and it should be kept in mind that a number of other changes (not discussed in this article) were also made in the Final Regulations.
Section 199A Deduction In General
Effective January 1, 2018, the Tax Cuts and Jobs Act, formally entitled “An Act to Provide for Reconciliation Pursuant to Titles II and IV of the Concurrent Resolution on the Budget for Fiscal Year 2018” (the “Tax Cuts and Jobs Act”), enacts new Internal Revenue Code (“Code”) Section 199A. Under Section 199A, for taxable years beginning after December 31, 2017 and before January 1, 2026, taxpayers (which includes estate and trusts), but which excludes C corporations, generally may deduct twenty percent (20%) of the QBI of an S corporation, partnership, LLC (taxed as a partnership or S corporation), or a sole proprietorship allocable to such shareholder, partner, member or sole proprietor.
In order for a qualified trade or business to obtain the full benefit of the deduction without being subject to the wage and capital limitations discussed below, and in order for a specified trade or business to be treated as a qualified trade or business so as to be able to take advantage of the deduction under Section 199A, the taxable income of the shareholder, partner, member or sole proprietor must be less than $157,500 or less than $315,000 in the case of a married taxpayer filing jointly. Once a taxpayer has taxable income in excess of $207,500 ($157,500 plus $50,000), or $415,000 in the case of a married taxpayer filing jointly ($315,000 plus $100,000), the taxpayer: (1) may not take any Section 199A deduction with respect to a “specified service trade or business” (“SSTB”); and (2) will be subject to the wage and capital limitations with respect to a qualified trade or business.
Special rules provide for the phase-in of the wage and capital limitations in the case of a qualified trade or business and the phase-out of the Section 199A deduction for an SSTB. These rules apply when a taxpayer’s taxable income is between $157,500 and $207,500, or for married taxpayers filing jointly, where the taxpayer’s taxable income is between $315,000 and $415,000. For businesses other than an SSTB and for which the taxpayer’s income exceeds $207,500 or $415,000 if married filing jointly, the deductible amount of each trade or business carried on by the S corporation, partnership, LLC or sole proprietorship is equal to the lesser of: (1) 20% of the taxpayer’s allocable share of QBI with respect to the qualified trade or business; or (2) the greater of (a) the taxpayer’s allocable share of 50% of the W-2 wages with respect to the qualified trade or business, or (b) the taxpayer’s allocable share of the sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of all “qualified property” of the trade or business. These limitations on the 20% deduction under Section 199A are generally referred to as the “wage and capital limitations.” If a taxpayer of an SSTB has taxable income in excess of the $207,500 or $415,000 amounts, the taxpayer does not receive any deduction under Section 199A.
The deduction set forth above is sometimes referred to as the “20% pass-through deduction” or the “QBI deduction.” In addition to the 20% pass-through deduction (or QBI deduction), there is a separate and distinct deduction under Section 199A equal to 20% of a taxpayer’s qualified REIT dividends and publicly-traded partnership income for the year. After these two separate deductions are computed, they are added together and subjected to the so-called “overall limitation,” which is equal to 20% of the excess of the taxpayer’s taxable income for the year over the sum of the taxpayer’s net capital gain for the year. For a more detailed discussion of Section 199A, see the blog post from December 29, 2017, which can be found at: New Deduction For Qualified Business Income.
Trade or Business Requirement and Rental Real Estate
The Final Regulations retain and slightly re-word the definition of a trade or business as set forth in the Proposed Regulations. Specifically, for purposes of Section 199A and the Regulations thereunder, a trade or business is defined as a trade or business under Section 162 (a “Section 162 Trade or Business”) other than the trade or business of performing services as an employee. Unfortunately, after nearly a century of case law on this issue, there is no “bright line” test of when an activity constitutes a Section 162 Trade or Business. As such, the Section 162 Trade or Business standard remains problematic, especially with respect to rental real estate activities. However, in Rev. Proc. 2019-7, the IRS sets forth a safe harbor for when a rental activity will rise to the level of a Section 162 Trade or Business. The requirements for the safe harbor are as follows:
- Separate books and records must be maintained for the rental real estate activity;
- At least 250 hours or more of “rental services” must be performed per year for the rental real estate activity; and
- The taxpayer must maintain contemporaneous records, including time reports or similar documents, regarding hours of all services performed, a description of all services performed, the dates on which such services are performed and who performed such services.
Very generously, in determining whether the 250 hours of service requirement is met, the taxpayer/owner is allowed to include services provided 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. However, 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 rental real estate. It should be kept in mind that failing to meet the safe harbor does not necessarily preclude a rental real estate activity from being treated as a Section 162 Trade or Business for purposes of Section 199A.
This safe harbor cannot be used by a taxpayer for the rental of any residence that the taxpayer uses as a personal residence for more than 14 days during the year. Even more significantly, the Final Regulations provide that a taxpayer cannot use the safe harbor for any property rented on a “triple net lease” basis. Consequently, many taxpayers may seek to restructure existing leases so that they are not characterized as triple net leases, where feasible.
The definition of a trade or business also includes the rental or licensing of tangible or intangible property to a related trade or business if the rental or licensing activity and the other trade or business are commonly controlled. The Final Regulations provide that the related party rules under Sections 267(b) and 707(b) will be used to determine related parties for purposes of this special rule. The Final Regulations also clarify that the special rule only applies to situations in which the related party is an individual or relevant pass-through entity (“RPE”), and as such, will not include a rental to a C corporation. An RPE is defined as a partnership, other than a publicly traded partnership (“PTP”), or an S corporation that is owned, directly or indirectly, by at least one individual, estate, or trust. Additionally, 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.
The Final Regulations decline to address how 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. However, the Preamble to the Final Regulations does indicate that no trade or business will be considered separate or distinct unless a complete separate set of books and records is kept for such trade or business. The Preamble to the Final Regulations also provides that the IRS believes 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 the Section 446 Regulations.
Determination of Qualified Business Income
Provided a taxpayer is engaged in a Section 162 Trade or Business, the taxpayer must determine the QBI for each separate qualified trade or business. One of the items excluded from QBI is capital gain. The Proposed Regulations provided a specific reference to Section 1231 which treats certain gains of a trade or business as capital gain (and losses as ordinary losses). In order to avoid any unintended inferences, the Final Regulations remove the specific reference to Section 1231, and provide that any item of short-term capital gain, short-term capital loss, long-term capital gain or long-term capital loss, including any item treated as one of such items under any other provision of the Code, is not taken into account as a qualified item of income, gain, deduction, or loss. As a result, qualified dividends received by a taxpayer are excluded from the definition of QBI.
A number of commentators argued that guaranteed payments for the use of capital under Section 707(c) should not be excluded from the definition of QBI. Additionally, a number of commentators suggested that Section 707(a) payments received by a partner for services rendered with respect to a trade or business should be included in QBI. The IRS declined to adopt these recommendations so that guaranteed payments for capital and payments under Section 707(a) for services rendered by a partner to a partnership are excluded from QBI, just as amounts received by an S corporation shareholder as reasonable compensation (W-2 wages) or by a partner as a guaranteed payment for services are not taken into account as qualified items of income, gain, deduction, or loss, and therefore are excluded from QBI.
Wage and Capital Limitation: W-2 Wages and UBIA of Qualified Property
As mentioned above, Revenue Procedure 2019-11, issued concurrently with the Final Regulations, provides additional guidance on the definition of W-2 wages, including amounts treated as elective deferrals.
The Final Regulations also make a number of taxpayer-friendly changes in connection with the determination of the UBIA of qualified property. The first change is that in determining a partner’s share of the UBIA of qualified property, rather than using the partner’s share of tax depreciation, the Final Regulations provide that each partner’s share of UBIA of qualified property is determined in accordance with how depreciation would be allocated for Section 704(b) book purposes on the last day of the taxable year.
Another controversial aspect of the Proposed Regulations concerned the determination of UBIA of qualified property received in a non-taxable transaction. The Proposed Regulations provided that the UBIA of qualified property contributed to a partnership in a Section 721 transaction generally equals the partnership’s tax basis under Section 723 rather than the contributing partner’s original UBIA of the qualified property. Similarly, the Proposed Regulations provided that the UBIA of qualified property contributed to an S corporation in a Section 351 transaction is determined by reference to Section 362 (a carryover basis). Many commentators expressed that this rule could result in a step-down in the UBIA of qualified property due merely to a change in entity structure and suggested that the UBIA of qualified property contributed to a partnership under Section 721 or to an S corporation under Section 351 be determined as of the date it was first placed in service by the contributing partner or shareholder. In response to these comments, the Final Regulations provide that qualified property contributed to a partnership or S corporation in a non-recognition transaction should generally retain its UBIA on the date it was first placed in service by the contributing partner or shareholder.
The Proposed Regulations also provided that that the UBIA of qualified property received in a Section 1031 like-kind exchange (or in a Section 1033 involuntary conversion) would be equal to the adjusted basis of the relinquished property transferred in the exchange, which would also result in a downward adjustment as a result of depreciation deductions previously taken under Section 168. Accordingly, the Final Regulations provide that the UBIA of qualified property that a taxpayer receives in a Section 1031 like-kind exchange (or in a transaction qualifying under the involuntary conversion rules of Section 1033) will be equal to the UBIA of the relinquished property. The Final Regulations also provide that the UBIA in the replacement property is adjusted downward by reason of receiving money or property not of a like-kind to the relinquished property, and that there should be an upward adjustment to the UBIA of the replacement property for money paid or the fair market value of other property transferred to reflect the additional investment made by the taxpayer.
Another departure from the Proposed Regulations is that the Final Regulations provide that Section 743(b) basis adjustments should be treated as qualified property to the extent the Section 743(b) basis adjustment reflects an increase in the fair market value of the underlying qualified property. However, the IRS refused to adopt a rule that Section 734(b) basis adjustments on a distribution of property should be taken into account in determining a partner’s share of the UBIA of qualified property.
The Final Regulations made several changes from the Proposed Regulations with respect to the rules that allow taxpayers to aggregate different trades or business together in determining their QBI deduction under Section 199A. In most cases, it will be beneficial for a taxpayer to aggregate trades or business where the aggregation requirements are met.
The Final Regulations clarify the meaning of a “majority of the taxable year” in connection with the 50% or more common ownership test. Specifically, the Final Regulations provide that the “majority of the taxable year” must include the last day of the taxable year.
The Final Regulations also expand the attribution rules determining whether a taxpayer or taxpayers own 50% or more of an entity by replacing the very limited family attribution rules contained in the Proposed Regulations (which did not include siblings), with the more expansive attribution rules of Sections 267(b) and 707(b).
Another significant change made by the Final Regulations allows aggregation to be made at the entity level rather than at the induvial level. Accordingly, the Final Regulations permit an RPE to aggregate trades or businesses it operates directly or through lower-tier RPEs. The resulting aggregation must be reported by the RPE and by all owners of the RPE. In order words, the owners of an RPE are bound by the aggregation election made by the RPE. However, an individual or upper-tier RPE may aggregate additional trades or businesses with the lower-tier RPE’s aggregation if such additional trades or businesses meet the requirements for aggregation.
The Final Regulations provide that a taxpayer’s failure to aggregate trades or businesses will not be considered to be an aggregation under the aggregation rules, so that the taxpayer is not precluded from making an aggregation election later. Although the Final Regulations generally do not allow an initial aggregation election to be made on an amended return, because many individuals and RPEs were unaware of the aggregation rules when filing returns for the 2018 taxable year, the IRS will allow initial aggregations to be made on amended returns for the 2018 taxable year.
Specified Service Trade or Business
The Final Regulations provide some clarity beyond that contained in the Proposed Regulations regarding when a business is classified as an SSTB. The first area upon which additional clarification was provided in the Final Regulation deals with the meaning of the performance of services in the field of health. The IRS noted in the Preamble to the Final Regulations that skilled nursing, assisted living and similar facilities provide multi-faceted services to their residents, and that whether such facility and its owners are in the trade or business of performing services in the field of health requires a facts and circumstances inquiry that is beyond the scope of the Final Regulations. However, the Final Regulations do provide a specific example of one such facility offering services that the IRS does not believe rises to the level of performance of services in the field of health. This example clearly provides that the facility’s income is derived solely from the provision of living facilities to its residents, and that the facility contracted with outside healthcare organizations to provide any medical services to the residents.
Likewise, the Final Regulations contain an example of an outpatient surgery center where the IRS finds the surgery center is not a trade or business providing services in the field of health. However, in the example, the entity is a private organization that owns a number of facilities throughout the country and it is expressly provided that the entity does not employ physicians, nurses or medical assistants, but enters into agreements with other professional medical organizations or directly with medical professionals to perform the procedures and provide all medical care. The example also expressly provides that the patients are only billed by the surgery center for facility costs related to the procedure, and that any fees for the provision of the procedure itself were billed by the medical provider to the patients. The example concludes that the surgery center did not perform services in the field of health within the meaning of Section 199A so that it is treated as a qualified trade or business for purposes of the Section 199A deduction. Hopefully, physician-owned surgery centers will be treated in a similar manner by the IRS.
Following the issuance of the Proposed Regulations, a number of commentators suggested that the definition of a trade or business involving the performance of services in the field of athletics should not include the trade or business of owning a professional sports team, since such owners are not directly performing athletic activities. The Final Regulations rejected the arguments of the commentators, stating that while sports club and team owners are not performing athletic services directly, that is not a requirement of Section 199A, which looks to whether there is income attributable to a trade or business involving the performance of services in a specified activity, and not to who performed the services.
With respect to the SSTB of brokerage services, the Final Regulations expressly state that although the performance of services in the field of financial services does not include taking deposits or making loans (i.e., banking), it does include arranging lending transactions between a lender and borrower.
There were a number of comments that traditional banking activities, such as the performance of services that consist of dealing in securities, should be excluded from the definition of an SSTB. The Final Regulations continue to exclude taking deposits or making loans from the definition of an SSTB involving the performance of financial services and also exclude the origination of loans from the definition of dealing in securities for purposes of Section 199A. However, the IRS expressly stated that it did not believe that there is a broad exemption from the listed SSTBs with respect to all services that may be performed by banks. This suggests that a subchapter S bank should segregate specified service activities from the trade or business of banking and operate such specified service activities as an SSTB separate from its banking trade or business, either within the same legal entity or in a separate entity.
The Final Regulations also retain the so-called de minimus rule, which provides that for a trade or business with gross receipts of $25,000,000 or less for the taxable year, the trade or business is not an SSTB if less than 10% of the gross receipts of such trade or business is attributable to a specified service field. This percentage is reduced to 5% in the case of trades or business with gross receipts in excess of $25,000,000. The Final Regulations retain the de minimis rule, and the Preamble to the Final Regulations makes it clear that trades or businesses with gross income from a specified service activity in excess of the de minimus threshold are considered to be SSTBs (a “cliff” approach). However, the Final Regulations add an example demonstrating a situation in which a trade or business has income from a specified service activity in excess of the de minimus threshold but is able to demonstrate that the entity separately conducts another trade or business, so that the separate trade or business is not tainted by the SSTB conducted by the entity.
In addition to these changes, the anti-abuse rule in the Final Regulations removes the 80% rule, and simply provides that if a trade or business provides property or services to an SSTB and there is 50% or more common ownership of such trades or businesses, the portion of the trade or business providing property or services to the 50% or more commonly-owned SSTB will be treated as a separate SSTB with respect to the related parties. Additionally, the so-called “incidental to” rule contained in the Proposed Regulations was eliminated in the Final Regulations.
The Proposed Regulations provided that an individual who was previously treated as an employee and is subsequently treated as other than an employee while performing substantially the same services to the same person, or a related person, will be presumed to be in the trade or business of performing services as an employee for purposes of Section 199A, and therefore cannot receive the benefit of the Section 199A deduction. The Final Regulations soften this rule somewhat by providing that the presumption will apply to the individual only if such individual was an employee of the entity during the three-year period prior to the date such individual is treated as other than an employee with respect to such entity.
The Proposed Regulations generally retain the rules relating to reporting of QBI, W-2 wages and UBIA of qualified property to the owners of an RPE, but modify the rule which provided that all of an RPE’s items related to Section 199A are presumed to be zero because of a failure to report one item. Accordingly, the Final Regulations revise the presumption to provide that if an RPE fails to separately identify and report an item of QBI, W-2 wages or UBIA of qualified property, the owner’s share of each unreported item of positive QBI, W-2 wages or UBIA of qualified property attributable to trades or businesses engaged in by that RPE will be presumed to be zero.
Trusts and Estates
The Final Regulations generally retain the rules set forth in the Proposed Regulations with respect to the application of Section 199A to estates and trusts. However, several clarifications and changes were made. The first clarification is that the Final Regulations provide that the S portion and non-S portion of an ESBT are treated as a single trust for determining the applicable threshold amounts.
Additionally, the Final Regulations specifically provide that for purposes of determining whether a trust or estate has taxable income that exceeds the threshold amount, the taxable income of the trust or estate is determined after taking into account any distribution deduction under Sections 651 or 661.
The Final Regulations clarify that the anti-abuse rule is designed to thwart the creation of even one single trust with a principal purpose of avoiding, or using more than one, threshold amount.
With respect to the anti-abuse rule contained in the Proposed Section 643(f) Regulations, the IRS removed the definition of “principal purpose” and the examples illustrating this rule that had been included in the Proposed Regulations.
The Preamble also provides that the anti-abuse rules contained in Section 643(f) apply to any arrangement involving multiple trusts entered into or modified prior to the effective date of the Final Regulations.
The Final Regulations are very helpful and mostly favorable to taxpayers. However, because of the complexity of the regulations, considerable analysis of the Final Regulations will need to be done in connection with determining a taxpayer’s Section 199A deduction.
If you have any questions regarding Section 199A and its application to your business, please contact one of the tax attorneys at Dean Mead.