Final Section 199A Regulations
While most of the government was shut down, parts of the Treasury Department, including IRS personnel responsible for implementing late December 2017’s Tax Cuts and Jobs Act (TCJA), remained open. One of the most significant features and largest potential benefits in the TCJA for business owners is its introduction of Internal Revenue Code Section 199A, commonly referred to as the 20% qualified business deduction or QBI deduction. This deduction is temporary and applicable to years after December 31, 2017 and before January 1, 2026. A few days ago (and just in time for tax return filing season), the IRS provided final regulations and some related material explaining how to implement this deduction. The purpose of this article is to highlight specific features in the final regulations, relative to proposed regulations that were issued in August.
How we got here
To supplement and better explain Sec. 199A, the IRS provided proposed regulations in August of 2018, but significant questions remained regarding how to implement its rules. The proposed regulations resulted in more than 330 comments from taxpayers, advisors, and industry groups. A few days ago, the IRS modified the proposed regulations and issued finalized regulations. At the same time, it released a notice of a proposed revenue procedure providing a safe-harbor for certain real estate enterprises (addressed in a concurrent BNN article), a new set of proposed regulations providing guidance related to the QBI deduction for RIC’s and trusts (among other things), and a revenue procedure providing guidance on determining W-2 wages for QBI deduction purposes.
As noted above, this article will focus on the finalized regulations under Sec. 199A. Its discussion assumes the reader is somewhat familiar with the rules, and if not, please consider first reading our previous articles: A New 20% Deduction for Qualified Business Income of Flow-thru Entities., and Proposed Section 199A Regulations are Issued.
Note that the final regulations are mandatory for the tax year 2019 and are optional for 2018 tax years. Taxpayers who choose to do so can rely on the proposed regulations, but only for the 2018 tax year.
Trade or Business
After release of the proposed regulations, one of the most talked about aspects was the definition of qualified “trade or business,” and specifically whether rental activity is eligible. The proposed regulations defined trade or business by reference to Internal Revenue Code Section 162. In other (non-Sec. 199A) contexts, whether a rental activity rises to the level of trade or business under this code section, as opposed to being governed by IRC Sec. 212 (which contains somewhat less favorable provisions governing many rental activities), has been the subject of many court cases. Many respondents to the 199A proposed regulations requested a bright-line or factor test to apply to rental property for purposes of the 199A deduction, fearing the same ambiguity that has haunted the rental industry for years. In the final regulations, the IRS concluded that whether a business activity is a section 162 business is factual, but declined to give any specific test or additional guidance. In other words, the IRS let this ambiguity remain – but with one very significant exception: Released concurrently with the finalized regulations, the IRS issued Notice 2019-07. This notice announces the IRS intention to issue an authoritative revenue procedure containing the provisions explained in the notice. It provides a safe harbor method that will remove all ambiguity for many (but not all) rental activities, allowing them to qualify for the 199A deduction. As noted above, this notice is described in another BNN article.
Special Rule for Self Rental
The proposed regulations provide a special rule for property rented or licensed to a related trade or business. Even if the rental property would otherwise not rise to the level of a business under Section 162, it allows such treatment for Section 199A purposes if the rental business and the operating business are commonly controlled. This accommodates a very common scenario by allowing many business owners operating the business in one legal entity and renting the building from a separate legal entity to treat the rental entity as a trade or business for 199A purposes. The final regulations clarify that this exception does not apply to operating entities that are C Corporations. A C Corporation business renting from an individual or pass-through entity, even if commonly controlled, will prevent the rental activity from qualifying under this special rule. It does not necessarily preclude 199A’s benefits, but instead forces the regular standards of Section 162 to be applied in determining if the rental business is a qualified business.
The final regulations clarify ‘net capital gain’ for 199A purposes. The QBI deduction’s final limitation caps the deduction at the lesser of 20% of QBI from the business or 20% of taxable income in excess of the taxpayer’s net capital gain. The final regulations explain that net capital gain is increased for (and includes) qualified dividend income, which is taxed at the same preferential rates as long-term capital gains.
Multiple Trades or Businesses within an Entity
Many commenters to the proposed regulations asked for factors to determine how to identify separate trades or businesses and instances in which multiple activities would be considered one single entity for Sec. 199A purposes. The IRS declined to adopt any of the recommendations from commenters but indicated that multiple businesses can exist in one legal entity, and for reporting purposes, taxpayers need to be able to report QBI, W-2 wages, SSTB status and qualified property separately for each business. The determination of whether multiple or single trade or businesses exist under one legal entity is factual.
Unadjusted Basis of Qualified Property
The final regulations provide multiple changes to the determination and allocation of the unadjusted basis of qualified property (UBIA). These changes are primarily taxpayer-friendly. In the proposed regulations, for any property in a tax free transaction such as a like-kind exchange or contribution to a partnership or S Corporation, a taxpayer would assume a net (usually lower) basis at the time of contribution while using the original placed in service date. The final regulations retain the same date but change the qualified basis to equal the original cost. This will be less detrimental and less burdensome to taxpayers when calculating the UBIA.
In the proposed regulations, the UBIA is allocated based on the allocation of depreciation, and in the case of partnerships, the UBIA that does not produce depreciation would use an allocation based on the partnership provisions of 704(b) and 704(c) as if the property were sold in a hypothetical transaction. In the final regulations, the UBIA is allocated based on the depreciation as of the last day of the year for partnerships, and based on the share ownership on the last day of the taxable year for S corporations.
In the proposed regulations, any special basis adjustments for partners and partnerships under 743(b) and 734(b) are not considered UBIA. Many people questioned this, because it omits amounts in excess of the original basis of property. In the final regulations, the IRS agrees and concedes that the step-up for the “excess section 743(b) basis adjustment” is UBIA. The final regulations do not change the treatment of 734(b) partnership step-up in assets, therefore such amounts do not represent UBIA. In the case of property acquired from a decedent and immediately placed in service, the UBIA will be equal to the property’s fair market value at the time of the decedent’s death. The IRS continues to study this issue and requests additional comments on the treatment of special basis adjustments for purposes of section 199A.
Previously Disallowed Losses
The final regulations clarify that losses are taken into account in computing QBI in a first in, first out basis (oldest first, then most recent). They also reiterate that losses created prior to 2018 do not reduce QBI.
Qualified Business Income
Many comments requested additional guidance and clarity regarding exactly which items of income and expense are included in the calculation of qualified trade or business income. The final regulations explain that if a deduction is related to a trade or business it should be taken into account for purpose of computing QBI, unless there is an exception in these regulations. The final regulations add that QBI is reduced by the deductible portion of self-employment taxes, self-employed health insurance, and retirement contributions to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction. Treasury declined to address the QBI impact of deductions for unreimbursed partnership expenses, interest expense incurred to acquire an interest in a pass-through entity, or state or local taxes attributable to the business generating the QBI.
In the proposed regulations, the IRS and Treasury noted that items treated as capital, including gains and losses treated as capital for Section 1231 purposes, would be excluded from QBI. In the final regulations, the IRS recognizes the potential complexity of netting Section 1231 gains and losses from multiple businesses to determine its exclusion or inclusion with QBI, but did not change the rule when finalizing the regulations.
- Observation: Deductible self-employment taxes, self-employed health insurance, and retirement contributions are items computed and deducted at the partner’s individual level. This may lead to hypothetical computations of QBI based on factors outside the partner’s interest in the partnership. A taxpayer should consider relying on the proposed regulations for the 2018 tax year until further guidance is issued.
In the proposed regulations, the IRS allows certain taxpayers to aggregate trades or businesses as long as they meet specified requirements. One requirement was a common ownership test of 50% for an owner or group of owners among aggregated entities. The final regulations explain that this common ownership must exist for a majority of the year, including the last day of the year. For purposes of attribution, the final regulations adopt existing Code Sections 267 and 707.
In the final regulations, the IRS indicates that a taxpayer not aggregating in year 1 is not precluded from aggregating in year 2. However, once an election to aggregate is made, it is irrevocable. An election to aggregate cannot be made on an amended return except for the initial tax year - 2018. The proposed regulations provided that only individuals and trusts could aggregate, but in the final regulations they allow a pass-through entity in a tiered structure to aggregate, as long as all requirements are met. Once aggregated at the pass-through level, an owner must continue to aggregate those trades or businesses but can add additional trades or businesses to the group by making an aggregation election. Both of these changes were welcomed by taxpayers and their advisors.
The proposed regulations provided that the commissioner could disaggregate trades or businesses if the taxpayer failed to attach certain required disclosures or if the aggregation was inappropriate. The final regulations clarify that if disaggregation by the commissioner occurs, the affected trade or business may not be re-aggregated for three subsequent taxable years.
Specified Service Trade or Business (SSTB)
Owners of specified service trades or businesses are less likely to receive the full benefits of the Sec. 199A deduction, and in many cases will receive no benefit at all. In the final regulations, the IRS declined to provide much guidance defining what types of businesses constitute a “specified service trade or business” (SSTB) and vaguely referred to a facts and circumstances test and provided limited examples. The final regulations provide additional examples to help apply the SSTB rules.
The proposed regulations provided a de minimis rule that allows businesses with only modest levels of SSTB receipts to be excluded from the SSTB restrictions. The final regulations confirm that if the de minimis test is failed, then all gross receipts will be considered gross receipts from an SSTB. They also eliminate a 5% incidental rule that would have re-characterized non-SSTB income as SSTB income, if the non-SSTB income is under the 5% threshold of the entire “pot” of income of commonly controlled businesses and shared expenses are present.
Under the proposed regulations, if a trade or business provided more than 80% of its property or services to an SSTB and there was 50% or more common ownership, then the entire trade or business would be considered an SSTB itself. The final regulations remove the 80% feature and clarify that if the 50% common ownership exists, the unfavorable treatment applies only to those who make up the 50%. In other words, owners of the otherwise qualifying trade or business who also own part of the SSTB will find their allocation of income from the trade or business completely tainted as if it, too, is an SSTB. Meanwhile, their colleagues who own the otherwise qualifying trade or business who do NOT own part of the SSTB will find their allocation of income from the trade or business to be completely untainted as an SSTB.
Lastly, the final regulations confirm the proposed regulations’ stance that an individual initially treated as an employee who is subsequently treated as a subcontractor, but is performing substantially the same services, will be presumed to be an employee for three years. This discourages individuals from trying to convert their own wages, which do not qualify for QBI treatment, to subcontractor revenue, which can qualify for QBI treatment.
- Observation: The final regulations do a decent job explaining which business activities are SSTBs and which ones are not, as well as the de minimis “cliff.” However, taxpayers with consulting receipts should be prepared to demonstrate that their services are embedded in, or ancillary to, the sale of goods or performance of services on behalf of a qualifying trade or business, or agree to the harsh SSTB limitations.
Under the proposed regulations, if a pass-through entity failed to report separately its QBI, W-2 wages and UBIA, then all items would be assumed to be zero. In the final regulations, the IRS revised its stance to indicate if a taxpayer failed to report one of the items, only that item is assumed to be zero. Additionally, this information can be reported on an amended tax return. A pass-through entity must report multiple trades or businesses and indicate whether each business is an SSTB.
- Observation: The 20% deduction can be a substantial tax deduction for some taxpayers. Filers should be carefully reviewing the 2018 tax returns and Schedule K-1 to ensure that all required information is reported.
Trusts and Estates
The final regulations clarify that the S portion and non-S portion of an electing small business trust are treated as a single taxpayer for purposes of applying the potentially limitation-imposing “threshold amount.” The final regulations also clarify that taxable income of the trust or estate does take into account any distribution deduction.
It is frustrating that final regulations under Section 199A were provided as late as January of 2019, at the beginning of the 2018 tax filing season. However, overall they are welcome provisions, generally taxpayer-friendly, and provide much-needed clarification and guidance. Taxpayers and their advisors should consider the final regulations’ impact on their businesses and consider whether certain elections should be made, or even whether any changes should be made to their business structures in order to comply with the final regulations of Section 199A and optimize their benefits.
As noted above, the final regulations are effective for the tax year 2019 but may be relied upon for 2018 tax years. For one year – 2018 – taxpayers may choose whether to utilize the proposed regulations or the final regulations.
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.