Proposed Section 199A Regulations are Issued
(The IRS attempts to explain the 20% Pass-Through Deduction)
One of the most wide-reaching features of December’s Tax Cuts and Jobs Act is the entirely new deduction under Internal Revenue Code Sec. 199A that provides a deduction equal to 20% of certain “pass-through” business income. However, as welcome as the new rule was, Congress rolled out ill-defined terminology and computational ambiguities that left even the most experienced practitioners with numerous questions. This was especially frustrating, because the concept itself of this new deduction is straightforward.
As it often does when writing new tax law, Congress directed the Treasury Department (the IRS) to write regulations that would further explain the Code. It did so last week, and the purpose of this article is to explain this new guidance, consisting of:
- New Proposed Treasury Regulations,
- Notice 2018-64 (a proposed method of calculating W-2 wages for purposes of the new pass-through deduction), and
- FAQs
Important Notes
This article assumes that its readers are familiar with the basics of 199A.
If that assumption is false, please first read our earlier article, written just after the Tax Cuts and Jobs Act was passed. Our previous article is a summary of the 20% deduction as written in the Code, while this article explains the new guidance, primarily derived from the proposed regulations.
Note that none of these new sources is truly authoritative.
Proposed regulations and notices do not carry the force of law that temporary or final regulations and revenue procedures do, but they are informative, and give us a sneak peek at what the authoritative versions of these documents will look like. The “before and after” versions are both written by the same party (the IRS), and it is likely that most of the language in these documents, with some significant and insignificant adjustments, will make it into the final versions.
Layout of this article (choose from two alternative levels of detail):
For a very narrow set of taxpayer situations, the 199A deduction is easy to compute, and the Code and the new regulations are relatively easy to follow. But for many fact patterns, the computations are very complex and the new regulations explaining them are highly technical. To be useful to as many readers as possible, this article will take the form of a somewhat deep dive. But it will be preceded with a “robustier”-than-usual executive summary that will allow the more casual reader to stay out of the deep end. The summary and the text will use identical headings, to allow readers of the summary to find more details on a topic-by-topic basis.
Executive Summary
Netting of Qualified Business Income (QBI) Losses and Carryforwards
Taxpayers who have multiple trades or businesses that qualify for the 199A deduction, with at least one such activity generating a loss, must allocate that loss proportionately to each of the profitable qualifying activities. If an overall net loss results, that loss must be carried forward to future years, for proportionate allocation in a similar manner. Other components of the calculation (like W-2 wages and property basis) generated by a loss activity are not allocated to profitable ones unless an aggregation election is made (discussed later), and those components never take part in the carryover to subsequent years.
Interaction with other IRS Code Sections
Tax rules describe many types of losses other than QBI losses noted above, including NOLs, passive activity losses, and others. These other types of losses are not taken into account for purposes of computing QBI. Those losses can indirectly impact the 199A deduction, though, by reducing taxable income itself.
Section 199A deduction for fiscal year pass-through businesses
Fiscal year entities may produce QBI beginning with the first tax year that ends after December 31, 2017. The income and other computational items (wages, property, etc.) are treated as having been incurred by the owner during the owner’s taxable year in which or with which such pass-through business taxable year ends.
Observation: A common example of this may include an individual who will first take advantage of the 199A deduction using a 2018 Form 1040, but whose 1040 may include income reported to that individual from a partnership whose year began 7/1/17 and ended 6/30/18. In this example, the partnership’s QBI components (income, wages, property) are derived from the partnership’s full 12 months of activity ended 6/30/18, even though half of that fiscal year fell outside of 2018.
Impact on self-employment taxes, net investment income tax, and alternative minimum tax (AMT)
Self-employment tax and the net investment income tax are not affected by Sec. 199A. No AMT adjustment is needed, because the deduction under Sec. 199A is identical for regular tax and AMT purposes.
W-2 Wages
For higher-income taxpayers, the Sec. 199A deduction may be limited unless sufficient wages are paid to the trade or business’s employees. The Tax Cuts and Jobs Act limited “wages” for this purpose to those that were reported directly by the taxpayer on a form filed with the Social Security Administration – a limitation that severely punishes taxpayers who utilize leased employees or a common paymaster. The proposed regulations remedy this limitation by allowing wages paid to leased employees or through a common paymaster to qualify. Some complex rules are provided that primarily are designed to provide ways of allocating wages between trades or businesses, prevent employee leasing companies and taxpayers who use their services from both using the same wages in their QBI calculations, or otherwise create a higher deduction than intended.
Unadjusted Basis Immediately After (UBIA) of Qualified Property
As described above, higher-income taxpayers may see their Sec. 199A deduction reduced unless the entity producing QBI also pays sufficient wages to its employees. To accommodate endeavors that use remuneration other than wages (primarily for the real estate industry), taxpayers may alternatively qualify using the basis of “qualified property” used in the trade or business.
The Code, however, is not clear regarding how basis is computed when Sec. 179 expensing, like-kind exchanges or involuntary conversions, and partnership basis adjustments enter the picture. The proposed regulations address these scenarios.
Treatment of Section 1231 gains and losses in determining QBI
The Tax Cuts and Jobs Act made it clear that gains generally cannot qualify as QBI, but until now, it was unclear how Sec. 1231 gains and losses would be treated, because they can take different forms depending on a number of factors.
The proposed regulations clarify that if ultimately treated as capital gain or loss, Sec. 1231 gains or losses are ignored for purposes of computing QBI. Otherwise, they are included.
Aggregation Rules
Many portions of the proposed regulations address allocation of various QBI components from one entity amongst others, but the need for many such allocations (and accompanying computational burdens) can be eliminated if an election to “aggregate” multiple trades or businesses is made. We knew aggregation rules were forthcoming, because Congress punted that responsibility to Treasury when the Tax Cuts and Jobs Act was passed.
The proposed regulations provide lengthy new aggregation rules, which allow aggregation if certain criteria are met. “Specified trades or businesses,” including many professional service endeavors, are excluded.
Specified Service Trade or Business (SSTB)
A Specified Service Trade or Business is a term that describes a list of activities involving performance of certain personal services. It is significant because for owners of such businesses, the Sec. 199A deduction is phased out if taxable income (from all sources – including a spouse’s income on a joint return) reaches certain thresholds. It is partially phased out at income of $315,000 and $157,500 for married couples and others, respectively, and fully phased out at $415,000 and $207,500.
The Code left open a lot of questions regarding what constitutes an SSTB, but the proposed regulations do a reasonably good job of answering some of them.
Electing Small Business Trusts
Electing Small Business Trusts are a unique type of taxpayer applicable only to a small subset of S corporations. Their qualification under the Sec. 199A rules was unclear, but the proposed regulations explain that they do qualify, and provide computational guidance.
A Swing and a Miss (some unanswered questions)
Some of the most asked questions following the release of the Tax Cuts and Jobs Act involved what types of activities constitute a qualified “trade or business” under new Sec. 199A – and more specifically, whether or not rental activity is eligible. This should have been easy for the IRS to answer, because for purposes of self-employment tax, passive loss rules, and the net investment income tax, mountains of ink have been spilled to help distinguish rental income that is a trade or business vs. rental income that is instead viewed as a different type of revenue-producing animal. With the release of the proposed regulations, we have higher mountains of ink but very little useful guidance, other than assurance that for certain self-rental activities, the deduction is available. It is implied that rental activity that “rises to the level” of a trade or business qualifies, but that assertion is not stated clearly and a description of exactly what constitutes that rising is glaringly absent. Whether for real estate professionals or the casual renter, we frustratingly (and inexcusably) are forced to continue to speculate.
Similar ambiguity exists for other components of income, such as interest that is disallowed (deferred) pursuant to other portions of the Tax Cuts and Jobs Act, and depreciation or amortization related to partnership adjustments.
The Deeper Dive
Netting of Qualified Business Income (QBI) Losses and Carryforwards
If an individual, trust or estate has multiple qualified trades or businesses and one of them has QBI that is less than zero (a loss), the individual must offset the QBI of each trade or business that produced net positive QBI (income) with that loss. The loss is proportionately allocated to the positive QBI businesses. The adjusted overall QBI is then used in computing the potential pass-through deduction. Without the new grouping election (discussed later in the article), the W-2 wages and unadjusted property basis of the loss-generating activity are not taken into account by the income-producing activities.
If an individual’s combined QBI from all qualified trades or businesses is less than zero, the pass-through deduction is zero and the net loss is carried forward to the succeeding taxable year for purposes of determining (and reducing) QBI for that year. The W-2 wages and UBIA of qualified property from the trades or businesses are not carried over to the subsequent year.
For purposes of the pass-through deduction, an individual must treat qualified REIT dividends and income or loss from publicly-traded partnerships (PTP) as a separate “bucket” from other qualified trades or businesses. If the net REIT dividends and qualified PTP loss are a combined loss, the loss is carried forward and offsets only net income from REIT dividends and PTPs for purposes of the pass-through deduction.
Observation: In addition to the other existing and revised carryovers, such as net operating losses, passive activity loss, general business credits, and the newly created excess business losses, individuals potentially will need to track two additional loss carryovers for purposes of calculating the pass-through deduction.
Interaction with other IRS Code Sections
Losses or deductions that were disallowed, suspended, limited, or carried over from one taxable year are not taken into account in a later taxable year for purposes of computing QBI. Examples include suspended at-risk losses described in Internal Revenue Code (IRC) Sec. 465, passive loss carryovers under Sec. 469, loss limitations based on a partner’s interest or shareholder’s basis under Secs. 704(d) or 1366(d), and net operating loss carryforwards described in Sec. 172.
Observation: While these will not directly impact QBI, these items will reduce a taxpayer’s taxable income which could indirectly reduce the pass-through deduction.
Section 199A deduction for fiscal year pass-through businesses
The proposed regulations do not provide any special definitions or specific examples for fiscal year pass-through entities but reference them several times in various sections. If an owner (which includes individuals, trusts, and estates) receives any of these items from a pass-through business with a taxable year that begins before January 1, 2018 and ends after December 31, 2017, such items are treated as having been incurred by the owner during the owner’s taxable year in which or with which such pass-through business taxable year ends.
This means that a pass-through entity does not need to allocate QBI, W-2 wages, and UBIA of qualified property based on pre and post-tax reform periods, but instead can use readily-available fiscal year amounts for QBI, W-2 wages, and UBIA of qualified property, and pass those through to the owner.
Observation: Many view the Sec. 199A 20% deduction as a replacement to the now-defunct Sec. 199 “DPAD” (domestic productive activities deduction). However, because DPAD existed through 2017 and 199A can include a fiscal year that straddles 2017/2018, it appears that a fiscal year taxpayer who qualifies for both benefits can actually generate deductions under Sections 199 and 199A for the same activity, at the same time.
Impact on self-employment taxes, net investment income tax, and alternative minimum tax (AMT)
The deduction under section 199A does not reduce net earnings from self-employment under section 1402 or net investment income under section 1411. The deduction under section 199A is the same for both regular tax and AMT; no adjustments are made for AMT purposes.
W-2 Wages
For taxpayers with income over certain levels ($315,000 for married couples and $157,500 for others), the Sec. 199A deduction can be diminished or even lost unless the trade or business that qualifies also pays sufficient wages to its employees. For this reason, the concept of wages in this context is very important.
Code Section 199A defines eligible W-2 wages as the total wages subject to wage withholding, plus any elective deferrals, plus any deferred compensation paid by the qualified trade or business with respect to employment of its employees during the calendar year and reported on a return filed with the Social Security Administration. This was a major cause for concern for many taxpayers that used a common paymaster or leased employees.
Fortunately, the IRS modeled the W-2 wages after former Section 199’s Domestic Production Activities Deduction, so taxpayers and their advisors should have a baseline understanding of this calculation. Taxpayers who aggregate their businesses under 1.199A-4 (discussed later in this article) must first determine W-2 wages for each trade or business before applying the new aggregation rules.
The proposed regulations provide that, in determining W-2 wages, a person may take into account any W-2 wages paid by another person (common paymaster or leased employee company) and reported by that other person on Forms W-2, provided that the W-2 wages were paid to common law employees or officers of the business. In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 (the common paymaster or employee leasing company) is precluded from taking into account such wages for purposes of determining their own W-2 wages (no double-dipping!). Under this rule, persons who otherwise qualify for the deduction under section 199A are not limited in applying the deduction merely because they use a third party payer to report and pay the wages to their employees.
Unlike former Section 199, the W-2 wage limitation in Section 199A applies separately for each trade or business. Proposed §1.199A-2 provides that, in the case of W-2 wages that are allocable to more than one trade or business, the W-2 wages must be allocated to each trade or business for purposes of the W-2 limitation in the same manner as the wages were allocated to those trades or businesses for purpose of producing the income from those activities. Section 199A(b)(4) also requires that to be taken into account, W-2 wages must be properly allocable to QBI. W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.
Most of this article is based on guidance provided in the proposed regulations, but here is where the IRS notice mentioned at the beginning of this article comes into play: Notice 2018-64, which provides three methods for calculating W-2 wages, was issued concurrently with the Proposed Regulations. The three methods described in the notice are substantially similar to the methods provided in former section 199. The first method (the unmodified Box method) allows for a simplified calculation, while the second and third methods (the modified Box 1 method and the tracking wages method) provide for greater accuracy.
Observation: Although the wage allocation must be done prior to applying the aggregation rules, if an individual aggregates a group of businesses the W-2 wages will ultimately be combined for purposes of determining the pass-through deduction.
In determining W-2 wages for purposes of the pass-through deduction, no wages are included if they were not properly reported on a return filed with the SSA on or before the 60th day after the due date, including extension.
Unadjusted Basis Immediately After (UBIA) of Qualified Property
As described above, higher-income taxpayers may see their Sec. 199A deduction reduced unless the entity producing QBI also pays sufficient wages to its employees. To accommodate endeavors that use remuneration other than wages (primarily the real estate industry), taxpayers may alternatively qualify using the basis of “qualified property” used in the trade or business.
While the original definition of qualified property UBIA was fairly clear, there were some specific items that needed to be addressed, including property deducted under Section 179, partnership basis adjustments, and basis of property received in a like-kind exchange or involuntary conversion.
UBIA is determined without regard to any depreciation, amortization, depletion, adjustments for tax credits claimed by the taxpayer, or adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense (i.e. under sections 179, 179B, or 179C). Therefore, for purchased or produced qualified property, UBIA generally will be its cost as of the date the property is placed in service.
The proposed regulations state that special basis adjustments common to partnerships are not treated as separate qualified property. Any step-up in assets from a section 754 election will not qualify as UBIA.
Observation: While it is clear that a step-up of partnership assets made using a Sec. 754 election (for those described in both Secs. 743 and 734) does not qualify as UBIA for purposes of determining the pass-through deduction, the recently released proposed regulations for 100% bonus regulations have indicated a step-up of assets under a partnership interest acquisition (a Sec. 743 basis step-up) can qualify for the 100% bonus depreciation deduction, while adjustments related to a redemption of a partnership interest (a Sec. 734 step-up) cannot qualify for the 100% bonus.
The proposed regulations generally follow the existing rules regarding like-kind exchanges and involuntary conversion (Reg. §1.168(i)-6), and provide that the carryover basis of qualified property that is acquired in a like-kind exchange or involuntary conversion keeps the original in-service date and any excess paid that is capitalized on the date of the exchange or conversion uses that in-service date. As a result, the depreciable period under section 199A for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.
The exception is that proposed §1.199A-2(c)(2)(iii)(C) provides that, for purposes of determining the depreciable period, if the individual or pass-through entity makes an election not to apply §1.168(i)-6, the date the exchanged basis and excess basis in the replacement qualified property are first placed in service by the trade or business is the date on which the replacement qualified property is first placed in service by the individual or pass-through entity, with UBIA determined as of that date. In this case, the depreciable periods under section 199A for the exchanged basis and the excess basis of the replacement qualified property will end on the same date.
To prevent taxpayers from beefing up their UBIA of qualified property, the proposed regulations contain an anti-abuse provision. Property is not qualified if it is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the section 199A deduction.
Treatment of Section 1231 gains and losses in determining QBI
Sec. 1231 represents a rare “best of both worlds” scenario for taxpayers, by generally allowing favorable long-term capital gain treatment for Sec. 1231 gains, while allowing deductions against ordinary income for Sec. 1231 losses. The treatment is determined at the individual level. Sec. 199A of the Code made it clear that gains generally cannot qualify as QBI, but until now, it was unclear how this hybrid category of Sec. 1231 gains and losses would be treated.
The proposed regulations clarify that if ultimately treated as capital gain or loss, Sec. 1231 gains or losses are ignored for purposes of computing QBI. Otherwise, they are included.
Observation: Further guidance is needed on how to present this on the Schedule K-1 and make the proper adjustment at the individual, trust, or estate level.
Aggregation Rules
Tax reform was supposed to include the simplification of the tax code, but the IRS missed an opportunity to make their lives simpler (and yours and ours) when they addressed aggregation rules for common ownership of multiple pass-through entities. As part of the Tax Cuts and Jobs Act, Congress directed Treasury to provide Sec. 199A aggregation rules, and many practitioners assumed that the IRS would model the rules on existing portions of tax law that allows for aggregation in other contexts (like Sec. 469). Instead, Section 1.199A-4 of the proposed regulations rolls out an entirely new set of rules for purposes of the pass-through deduction.
Generally, an individual, trust, or estate can aggregate a group of pass-through entities if they can demonstrate the following:
- The same person or group of persons, directly or indirectly, owns 50 percent or more of each trade or business to be aggregated, meaning in the case of such trades or businesses owned by an S corporation, 50 percent or more of the issued and outstanding shares of the corporation, or, in the case of such trades or businesses owned by a partnership, 50 percent or more of the capital or profits in the partnership;
- The ownership exists for a majority of the taxable year in which the items attributable to each trade or business to be aggregated are included in income;
- All of the items attributable to each trade or business to be aggregated are reported on returns with the same taxable year, not taking into account short taxable years;
- None of the trades or businesses to be aggregated is a specified service trade or business (SSTB); and
- The trades or businesses to be aggregated satisfy at least two of the following factors (based on all of the facts and circumstances):
- The trades or businesses provide products and services that are the same or customarily offered together.
- The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources.
- The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies).
An individual may only aggregate trades or businesses operated directly and the individual’s share of QBI, W-2 wages, and UBIA of qualified property from trades or businesses operated through a relevant pass-through entity (RPE). An RPE is a pass-through entity that directly operates the trade or business or passes-through the trade or business’s items from lower-tier RPEs to the individual. The aggregation is done at the individual level and thus each owner in a pass-through entity must make his or her own determination and election. For those trades or businesses directly operated by the individual, the individual computes QBI, W-2 wages, and UBIA of qualified property for each trade or business before applying these aggregation rules.
Once two or more businesses have been aggregated, the individual must consistently report the aggregated businesses in all subsequent tax years, unless there is a change in facts that makes the aggregation disqualified. To aggregate, a disclosure must be attached to the individual return and must be included in the return each subsequent year. If the disclosure is not included with the tax return the IRS may disaggregate the individual’s trades or businesses.
Specified Service Trade or Business (SSTB)
A Specified Service Trade or Business is any trade or business involving the performance of services in the fields of health, law, accounting, consulting, financial services, brokerage services, or any trade or business where the principal asset of the business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management, or trading or dealing in securities. However, a trade or business that involves the performance of engineering or architectural services is excluded from this definition.
Observation: The above definition was provided by the law when enacted at the end of 2017. This section of the new pass-through deduction was one that produced many questions. Many business industries and commenters asked for clarification of such a broad statement like “…where the principal asset of the business is the reputation or skill of one or more of its employees or owners… .” The proposed regulations provide clarity to the definition of an SSTB (discussed below), although there certainly will be some remaining questions as all potential scenarios or facts could not have been addressed.
Many commentators’ ideas have been shut down by the IRS in these proposed regulations. The proposed regulations define in more detail and give specific lines of work regarding each of the service fields listed above. For instance, the proposed regulations heard commentators request guidance surrounding financial services and the treasury responded that for SSTB purposes financial services do not include taking deposits or making loans. Brokerage services for purposes of SSTB include stock brokers and similar professionals but does not include services provided by real estate agents and brokers or insurance agents and brokers.
The phrase “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners” was a blanket statement that left many people asking, what does that mean? The IRS received many comments in regards to the “reputation or skill” section of this statement. The IRS noted that this phrase was intended to describe a narrow set of trades or businesses and not a wide range that it could have. The proposed regulation (1.199A-5(b)2(xiv)) provides standards in which an individual or PTE can make that determination.
- A trade or business in which a person receives fees, compensation, or other income for endorsing products or services,
- A trade or business in which a person licenses or receives fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity,
- Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.
- The term fees, compensation, or other income includes the receipt of a partnership interest and the corresponding distributive share of income, deduction, gain or loss from the partnership, or the receipt of stock of an S corporation and the corresponding income, deduction, gain or loss from the S corporation stock.
Businesses are complicated and many have different trades or businesses (i.e. an auto dealer sells cars but also provides repair and maintenance services). While the definition of a qualifying trade or business for the pass-through deduction still leaves areas of questions, there are some de minimis exceptions for businesses that have both an SSTB and non-SSTB activity. For a trade or business with gross receipts of $25 million dollars or less for the taxable year, a trade or business is not an SSTB if less than 10 percent of the gross receipts of the trade or business are attributable to the performance of services. For a trade or business with gross receipts of greater than $25 million for the taxable year, a trade or business is not an SSTB if less than 5 percent of the gross receipts of the trade or business are attributable to the performance of services. While they help somewhat, curiously, it appears that the de minimis SSTB rules can unfavorably taint other activities.
Prior to the proposed regulations there was a lot of creative ideas of how an SSTB could ‘game’ the system. An SSTB includes any trade or business that provides 80 percent or more of its property or services to an SSTB if there is 50 percent or more common ownership of the trades or businesses.
Observation: This claw back rule is designed to taint income in which entities try to carve out qualified components of the SSTB business to gain the Section 199A deduction. For example, an accounting firm splits into three LLCs. LLC 1 performs tax preparation services to clients. LLC 2 owns the office building and rents the entire building to LLC 1. LLC 3 employs the administrative staff and through a contract with LLC 1 provides administrative services to LLC 1 in exchange for fees. All three of the LLCs are owned by the same people. Because there is 50% or more common ownership of each of the three LLCs, LLC 2 provides substantially all of its property to LLC 1, and LLC 3 provides substantially all of its services to LLC 1, LLC 1, 2, and 3 will be treated as SSTBs and none will qualify for the pass-through deduction.
This proposed regulation has provided a lot of information when it comes to specified service trades or businesses but this will continue to be an area discussed and debated based on a business owner’s specific facts and circumstances. Many people will be happy with the information and examples provided while others will continue to make their case to qualify for the pass-through deduction.
Electing Small Business Trusts
The proposed regulations clarify that an electing small business trust (ESBT) is entitled to the deduction under section 199A. The S portion of the ESBT must take into account the QBI and other items from any S corporation owned by the ESBT, the grantor portion of the ESBT must take into account the QBI and other items from any assets treated as owned by a grantor or another person (owned portion) of a trust under sections 671 through 679, and the non-S portion of the ESBT must take into account any QBI and other items from any other entities or assets owned by the ESBT.
A Swing and a Miss (some unanswered questions)
What is a qualified trade or business under Section 199A?
In order to produce qualified business income, which can generate up to a 20% pass-through deduction, the business must be a qualified “trade or business.” There was much speculation around what that term means, and the proposed regulations give more detail but do not answer all questions. In fact, they go out of their way to avoid clearing up the most glaring omission. In the proposed regulations they primarily just define a trade or business as a section 162 trade or business, not including performance of services as an employee. In an especially poorly-worded section, the proposed regulations allow the deduction to apply to self-rental activity (explained below). The regulations insinuate that such special treatment may be needed because the rental activity might not qualify on its own by “ris(ing) to the level” of a Section 162 trade or business. Obviously the IRS believes, then, that some rental activity does qualify as a result of some sort of mysterious levitation, but heaven forbid that it actually tells us anything whatsoever about what that level looks like or how to attain it.
Observation: For non-tax reasons, such as liability, many operating businesses will hold the real estate they operate within in a separate entity and charge rent to the business (often referred to as a self-rental arrangement). Such rental activity will be treated as a qualified trade or business for purposes of the pass-through deduction calculation as long as the two entities are commonly controlled (the same direct or indirect ownership of 50% or more).
Unfortunately, whether rental real estate rises to the level of a Section 162 “trade or business” must be looked at on a case by case basis using facts and circumstances, because we don’t have a definitive set of characteristics explaining how to get there. (But unfortunately, we also don’t even know how to identify whether we have arrived, either.) This is a frustratingly absurd situation to be in, and inexcusable given how much this very issue has monopolized the 199A discussion starting with the day the Tax Cuts and Jobs Act was released. We can only hope that additional clarification on this matter is included in the final regulations.
Observation: In the meantime any owner of rental real estate should review their ownership and consider (as well as possible) whether the current facts and circumstances support the activity is a qualified trade or business under section 162.
What other income and deductions are considered QBI?
It would have been logical and easy to state in the proposed regulations that QBI (excluding a Sec. 1231 loss) consists of a partner’s or shareholder’s Schedule K-1 Box 1 (ordinary) or 2 (rental) income or loss plus net Schedule C, E, and F income or loss, but that didn’t happen. The proposed regulations state that interest income, dividends, capital gains, reasonable compensation, and guaranteed payments to a partner are excluded, but Section 751 gain and Section 481 adjustments arising in years after December 31, 2017 are QBI. Without specifically including or excluding other separately stated items such as depreciation or amortization under Section 743 or 734, disallowed business interest, interest on debt financed distributions, and other “indirect” business deductions, tax advisors must speculate how they impact QBI.
Conclusion
While these regulations can be relied on currently, they are merely proposed regulations and the Treasury Department, as is customary, is soliciting written or electronic comments and public hearing requests, and asking that such responses be received by 45 days after the date of publication in the federal register. These proposed regulations will continue to evolve based on that feedback and will ultimately produce final regulations that could look very different in some areas (and unchanged in others). For now there is a road map of sorts provided by these proposed regulations and many taxpayers should begin to consider the impact of them and consider any tax planning and action items they should take or be prepared to take before year-end.
For more information or a discussion on how this may impact you, please contact Josh Lapierre or your BNN tax advisor at 800.244.7444.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.
