January 24, 2019
Final Section 199A regulations and other guidance provide welcome guidance, leave questions unanswered and raise new issues
Recently released guidance on Section 199A's 20% deduction generally contains welcome direction on issues raised by proposed Section 199A regulations issued in August 2018 (the 2018 Proposed Regulations), such as the aggregation of certain trades or businesses at entity-level, the safe harbor for certain rental real estate activities and the elimination of the so-called incidental rule. However, the guidance leaves some questions unanswered and raises new issues. Perhaps most significantly, many taxpayers will likely be unable to determine with certainty whether their activities constitute a trade or business and when their activities constitute multiple trades or businesses for Section 199A purposes.
The Section 199A guidance released January 18, 2019, consists of (1) final regulations (the Final Regulations), (2) proposed regulations (the 2019 Proposed Regulations), (3) Notice 2019-07, and (4) Revenue Procedure 2019-11.
The Final Regulations generally adopt, with changes, the 2018 Proposed Regulations. The Final Regulations include:
The 2019 Proposed Regulations address the treatment of previously disallowed losses (Prop. Reg. Section 1.199A-3 (2019)), and the treatment of qualified REIT dividends earned through a regulated investment company (RIC) (Prop. Reg. Section 1.199A-3 (2019)). They also provide special rules applicable to trusts, including charitable remainder trusts (CRTs) (Prop. Reg. Section 1.199A-3 (2019)).
Notice 2019-07 proposes a safe harbor revenue procedure that would treat a "rental real estate enterprise" as a trade or business under the Final Regulations for purposes of Section 199A.
Revenue Procedure 2019-11 outlines three methods for determining the amount of W-2 wages used in computing limitations applicable to the Section 199A deduction.
See Tax Alert 2018-1634 for a detailed description of the statutory provision and the 2018 Proposed Regulations.
I. Background: Section 199A
Section 199A, added to the Code by the Tax Cuts and Jobs Act (the TCJA), generally allows non-corporate taxpayers to deduct the combined qualified business income (CQBI) amount. Subject to certain limitations and netting rules, the CQBI amount is the sum of (i) 20% of QBI from each"qualified trade or business" (QTB) conducted by a partnership, S corporation, and/or sole proprietorship, (ii) 20% of qualified REIT dividends, and (iii) 20% of qualified PTP income. The taxpayer's deduction cannot be greater than 20% of the taxpayer's taxable income, less net capital gain. For higher-income individuals, Section 199A limits amount of deductible QBI from a trade or business based on the W-2 wages paid by the trade or business, and, in certain cases, the UBIA of qualified property used in the trade or business (the wage and property limitation). It also excludes "specified service trades or businesses" (SSTBs) from the definition of a QTB.
Section 199A is generally effective for tax years beginning after December 31, 2017 and before January 1, 2026.
II. Definitions and operational rules (Treas. Reg. Section 1.199A-1 and Notice 2019-07)
The Final Regulations generally conform to the guidance provided by the 2018 Proposed Regulations with respect to terms used in Section 199A and how to compute the Section 199A deduction. The Final Regulations provide additional guidance on several key definitional issues and computational rules and add special rules.
A. Definition of trade or business
Under Section 199A(b)(2), a taxpayer or an RPE1 must determine the amount of QBI for each of its trades or businesses. Thus, taxpayers and RPEs must determine whether they are engaged in a trade or business and, if so, how many trades or businesses in which they are engaged. The Final Regulations, like the 2018 Proposed Regulations, generally define the term trade or business by reference to Section 162. The Final Regulations do not provide clarification regarding the definition of trade or business for purposes of Section 199A or guidance on when a taxpayer or RPE will be treated as having multiple trades or businesses. The Preamble to the Final Regulations references case law establishing two requirements for an activity to be considered a trade or business under Section 162: a profit motive and considerable, regular and continuous activity. The Preamble also refers to the accounting method regulations under Section 446 as guidance for determining whether multiple trades or businesses exist within an entity, stating "no trade or business is considered separate or distinct unless a complete and separable set of books and records is kept for that trade or business." The text of the Final Regulations, however, neither states the judicial trade or business requirements nor incorporates the Section 446 separate trade or business standard. The Preamble further indicates that taxpayers should apply the Section 162 trade or business standard consistently (e.g., for purposes of Section 199A and the information filing requirements of Section 6041).2 The text of the Final Regulations does not, however, reflect a consistency requirement.
Implications: By merely retaining the reference to Section 162 as the standard for determining the existence of a trade or business, the Final Regulations will likely create uncertainty in many situations for a taxpayer in determining whether the taxpayer is engaged in a trade or business. Likewise, the guidance on the single-vs.-multiple trade or business issue is very limited. As such, the definition of a trade or business under Section 199A will likely continue to be an area of uncertainty for individuals and RPEs that could generate examination controversy.
1. Rental real estate activity
The Final Regulations, like the 2018 Proposed Regulations, define a trade or business as including the rental or licensing of tangible or intangible property that does not qualify as a Section 162 trade or business, provided the property is rented or licensed to a trade or business that is commonly controlled. Treas. Reg. Section 1.199A-1(b)(14) clarifies this rule to provide that the related lessee or licensee must be an individual or RPE. Section 267(b) and Section 707(b) apply to determine if trades or businesses are commonly controlled.
The Preamble lists factors that it states might be relevant in determining whether a rental real estate activity is a Section 162 trade or business. The factors listed are: (i) the type of rented property (commercial real property versus residential property), (ii) the number of properties rented, (iii) the owner's or the owner's agents' day-to-day involvement, (iv) the types and significance of any ancillary services provided under the lease, and (v) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease). The Preamble notes this list is non-exclusive. The Final Regulations, however, decline to adopt any bright line rules regarding the treatment of rental real estate activity or include the factors described in the Preamble in the regulatory text.
Notice 2019-07 provides a proposed revenue procedure safe harbor, available to both individuals and RPEs, under which a "rental real estate enterprise" will be treated as a trade or business for Section 199A purposes, provided enumerated requirements are met. A rental real estate enterprise is defined an "interest in real property held for the production of rent." A rental real estate enterprise may consist of an interest in multiple properties, but commercial and residential real estate may not be one rental real estate enterprise. The requirements of the safe harbor include record-keeping requirements and the annual performance of 250 hours of "rental services," as defined in the notice. This requirement will be met if owners or employees, agents, and/or independent contractors of the owners perform such services. Certain rental real estate arrangements, including those involving a triple net lease, are not eligible for the safe harbor. The failure to satisfy the safe harbor is not fatal to trade or business status: an enterprise may be still be treated as a trade or business for purposes of Section 199A if it meets the Section 162-based definition in the Final Regulations. Taxpayers may currently rely on the proposed revenue procedure's safe harbor.
Implications: The trade or business safe harbor for certain real estate activities may provide comfort to those satisfying its requirements. The Section 199A safe harbor, however, is distinct from existing safe harbors, including the safe harbor in Treas. Reg. Section 1.1411-4(g) (which allows real estate professionals to treat rental income as derived in the ordinary course of a trade or business for purposes of determining applicability of the 3.8% NIIT to such income). The Section 199A safe harbor thus creates additional compliance and contemporaneous record-keeping burdens. Moreover, it is unclear why commercial and residential real estate may not be combined as one real estate enterprise under the safe harbor, particularly regarding mixed-use real estate. Furthermore, the treatment of many types of real estate activities that do not fall within the safe harbor, including those involving triple net leased property, remains unclear. The example in Treas. Reg. Section 1.199A-4 under which residential and commercial rentals are not the same type of property is consistent with the proposed revenue procedure. Neither the proposed revenue procedure nor the examples under Treas. Reg. Section 1.199A-4 addresses mixed-use real estate.
B. Definition of net capital gain
A taxpayer's deduction under Section 199A cannot be greater than 20% of the taxpayer's taxable income less net capital gain. The statute and the 2018 Proposed Regulations, however, did not define net capital gain, creating uncertainty around the computation of this limit. Treas. Reg. Section 1.199A-1(b)(3) defines net capital gain, for Section 199A purposes, as net capital gain within the meaning of Section 1222(11) (the excess of net long-term capital gain over net short-term capital loss) plus any qualified dividend income (as defined in Section 1(h)(11)(B)).
Implications: A definition of net capital gain provides taxpayers with welcomed clarity. Taxpayers, however, should note that the amount they treat as net capital gain for Section 1 purposes may not be the same as the amount they treat as net capital gain for Section 199A purposes.
C. Other Treas. Reg. Section 1.199A-1 guidance
Treas. Reg. Section 1.199A-1(b)(10) expands the definition of RPE to provide that other pass-through entities, including certain common trust funds and religious or apostolic organizations, are also treated as RPEs if 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.
Treas. Reg. Section 1.199A-1(d)(3) describes the "qualified REIT dividends/qualified PTP income component" and clarifies that, for individuals with taxable income above the threshold amount, the SSTB limitations (including the phase-in rules) apply to qualified income received by an individual from a PTP.
Treas. Reg. Section 1.199A-1(e) provides special rules, including a special rule for disregarded entities. Under that rule, an entity with a single owner that is treated as disregarded entity separate from its owner is disregarded for purposes of Section 199A. The Preamble states: "Accordingly trades or businesses conducted by a disregarded entity will be treated as conducted directly by the owner of the entity for purposes of [Section] 199A."
III. Determination of W-2 wages and unadjusted basis immediately after acquisition of qualified property (Treas. Reg. Section 1.199A-2 and Notice 2019-11)
Section 199A(b)(2) limits the deductible amount of QBI from a trade or business based on the W-2 wages paid by the trade or business and, in some cases, the UBIA of the qualified property used in the trade or business. The Final Regulations adopt many aspects of the 2018 Proposed Regulations' rules on W-2 wages and UBIA of qualified property. The Final Regulations also make several significant additions and changes to the rules regarding the UBIA of qualified property.
A. W-2 wages
The W-2 wage rules in the Final Regulations generally follow the 2018 Proposed Regulations, and retain guidance on wages paid by a person other than a common law employer, acquisition and disposition guidance, short tax year guidance and W-2 wage allocation guidance.
In coordination with the Final Regulations, the Service contemporaneously released Revenue Procedure 2019-11, which provides three methods for calculating W-2 wages. Revenue Procedure 2019-11 is substantively the same as the proposed revenue procedure provided in Notice 2018-64, which was contemporaneously released with 2018 Proposed Regulations.
B. UBIA of qualified property
Under Section 199A(b)(6), qualified property must be tangible, depreciable property used in a QTB and the "depreciable period"3 of the property cannot have ended before the close of the tax year. The 2018 Proposed Regulations reiterated the statutory definition and provided guidance on whether certain items would be treated as qualified property (or separate qualified property) and how to compute UBIA. The Final Regulations retain many of the rules from the 2018 Proposed Regulations, but significantly change rules on non-recognition transfers of property and acquisitions of partnership interests.
The 2018 Proposed Regulations stated that basis adjustments under Sections 734(b) and 743(b) would not be treated as qualified property. The Final Regulations retain the rule for Section 734(b) adjustments. In response to numerous comments, however, the Preamble states that a Section 743(b) basis adjustment should be treated as qualified property if the fair market value of the underlying property has increased. As a result, the Final Regulations provide that "excess Section 743(b) basis adjustments" are treated as a separate item of qualified property placed in service when the transfer of the partnership interest occurs.4 The Final Regulations also contain a rule under which a partner's excess Section 743 basis adjustments, if negative in the aggregate, can decrease a partner's share of partnership UBIA.
Implications:The treatment of Section 743(b) basis adjustments under the Final Regulations will often be taxpayer-favorable. This may not be the case, however, when the fair market value of the partnership's property has decreased because it may cause a transferee partner to have a negative adjustment to the partner's share of UBIA of qualified property. Thus, taxpayers should carefully consider the effect of the Final Regulations' rules on excess Section 743 basis adjustments.
The 2018 Proposed Regulations generally took the position that UBIA is based on the placed-in-service date of the qualified property, as determined under Section 1012 or other applicable Code Section. The Final Regulations retain this framework.
The Final Regulations, like the 2018 Proposed Regulations, provide special rules to determine the UBIA and placed-in-service date if an individual or RPE acquires qualified property in certain nonrecognition transactions (i.e., a transaction described in Section 168(i)(7)(B), such as a Section 721 contribution to a partnership or a Section 351 contribution to an S corporation). Under the 2018 Proposed Regulations, the UBIA of qualified property contributed to a partnership in a Section 721 transaction generally would equal the partnership's tax basis under Section 723 rather than the contributing partner's original UBIA of the property (and similar constructs would apply in other Section 168(i)(7)(B) transactions).
In response to concerns about a possible step-down in UBIA following a change in entity structure, the Final Regulations deem the transferee's UBIA in the qualified property to be the same as the transferor's, decreased by the amount of money received by the transferee in the transaction or increased by the amount of money paid by the transferee to acquire the property in the transaction. For this deemed treatment to apply, however, the qualified property must be acquired in a Section 168(i)(7)(B) transaction.
Consistent with the 2018 Proposed Regulations, the Final Regulations provide that the date the transferee is deemed to place the qualified property in service is the same as the date the property was placed in service by the transferee to the extent the transferee's UBIA does not exceed the transferor's UBIA in the property. To the extent the transferee's UBIA exceeds the transferor's UBIA in the property, the excess UBIA is treated as separate qualified property placed in service on the date of the transfer.
The Final Regulations also include an anti-abuse provision to discourage transactions with a principal purpose of increasing UBIA. Specifically, if qualified property is acquired in a transaction that is described in Sections 1031, 1033 or 168(i)(7) and has a principal purpose of increasing the property's UBIA, the UBIA of the acquired qualified property will be its basis as determined under the relevant Code Section, rather than under the rule previously described.
Implications:The Final Regulations are a welcome change in that a non-recognition transfer of property under Section 721 and Section 351 will not reduce the UBIA of qualified property.
The Final Regulations also change the computation of UBIA following a Section 1031 exchange. Assuming no excess boot, no money paid and no other property transferred, the UBIA of qualified like-kind property received in a Section 1031 like-kind exchange generally equals the UBIA of the relinquished property. The Final Regulations similarly changed the computation of UBIA following a Section 1033 involuntary conversion. The placed-in-service-date rules for replacement property under Section 1031 for like-kind exchanges and under Section 1033 for involuntary conversions reflect the 2018 Proposed Regulations.
Furthermore, the Final Regulations require a partner's share of the qualified property's UBIA to be determined in accordance with how depreciation would be allocated for Section 704(b) book purposes under Treas. Reg. Section 1.704-1(b)(2)(iv)(g) on the last day of the tax year. In contrast, the 2018 Proposed Regulations required a partner's allocable share of the qualified property's UBIA to be determined in the same manner as the partner's allocable share of tax depreciation (i.e., Section 704(c) items would have been taken into account).
For an S corporation, the Final Regulations base a shareholder's share of UBIA on the ratio of shares in the S corporation held by the shareholder on the last day of the tax year over the S corporation's total issued and outstanding shares.
Implications:The Preamble notes the change was to avoid "unintended shifts in the allocation of UBIA"; the change will generally align better with how partners share in the economics of the qualified property. Taxpayers should note that the determination is based on a hypothetical allocation at year-end (not on how Section 704(b) book depreciation is actually allocated).
For qualified property held by an S corporation, the Final Regulations regard a shareholder's share of qualified property UBIA as proportional to the ratio of the shareholder's shares in the S corporation held on the last day of the tax year over the total issued and outstanding shares of the S corporation.
Implications:When shareholders change during the S corporation's tax year, taxpayers should be aware that the UBIA will not be allocated to shareholders in the same proportion as other items under Section 199A.
The Final Regulations address the UBIA of qualified property acquired from a decedent. The UBIA of qualified property acquired from a decedent and immediately placed in service is the fair market value at the date of the decedent's death under Section 1014; a new depreciable period begins as of the date of the decedent's death. The Final Regulations do not address other types of basis increases, such as additions to basis under Section 1015(d) for gift taxes paid and additions to basis under Sections 465 and 469 that arise as the result of gifts.
IV. QBI, qualified REIT dividends and qualified PTP income (Treas. Reg. Section 1.199A-3 and Prop. Reg. Section 1.199A-3 (2019))
The Final Regulations addressing QBI, qualified REIT dividends and qualified PTP income adopt the 2018 Proposed Regulations, with changes and clarifications. Prop. Reg. Section 1.199A-3 (2019), released concurrently with the Final Regulations, provides rules regarding the treatment of previously disallowed losses and qualified REIT dividends earned through RICs.
The Final Regulations make several notable changes regarding items included or excluded from QBI. For items treated as capital gain or loss, the Final Regulations remove the reference to Section 1231. Under the 2018 Proposed Regulations, the treatment of a Section 1231 gain or loss as excluded from QBI depended on whether the Section 1231 gain or loss was a capital gain or loss. The Preamble explains that the reference to Section 1231 was removed to avoid any unintended inferences about the treatment of other gains, such as gains under Sections 475, 1245 and 1250. Moreover, the Preamble clearly states that Section 1231 items may affect QBI and notes that, under Section 1231, a taxpayer nets all of its Section 1231 gains and losses from all trades or businesses before determining an excess gain (which characterizes all of the gain or loss as capital such that the net capital gain is excluded from QBI) or an excess loss (which characterizes all of the gain or loss as ordinary such that the net ordinary loss is included in QBI). The Preamble further indicates that this does not change in the Section 199A context (i.e., the determination of whether Section 1231 gains and losses is made at the individual level, rather than at the QTB level). Additionally, the Preamble indicates that taxpayers must apply the Section 1231(c) recapture rules and directs taxpayers to Notice 97-59 for guidance.
Implications: The removal of the reference to Section 1231 merely indicates that a variety of other gain and loss items exist whose QBI status depends on whether the item is treated as a capital gain or loss. The Final Regulations make clear that the determination of whether a Section 1231 gain or loss is a capital gain or loss is determined at the taxpayer level. As such, RPEs likely need not factor in Section 1231 gains or losses in computing QBI. RPEs already must disclose their Section 1231 gains or losses separately.
The 2018 Proposed Regulations required previously disallowed losses or deductions (including those under Sections 465, 469, 704(d), and 1366(d)) allowed in a given tax year to be taken into account for purposes of computing QBI. Under the 2018 Proposed Regulations, however, losses or deductions that were disallowed, suspended, limited or carried over from tax years ending before January 1, 2018, would not be taken into account in computing QBI. The 2018 Proposed Regulations did not provide an ordering rule with respect to the use of such losses. In response to comments, the Final Regulations provide for a first-in, first-out (FIFO) ordering rule.
The 2019 Proposed Regulations provide additional rules on the treatment of previously disallowed losses or deductions. Prop. Reg. Section 1.199A-3(b)(1)(iv) (2019) would treat such losses as losses from a separate trade or business. Furthermore, to the extent losses relate to a PTP, the losses would have to be treated as losses from a separate PTP. The Preamble to the 2019 Proposed Regulations explains that it is appropriate to treat the losses as from a separate trade or business because the losses may relate to a business that no longer exists and the Section 469 groupings may differ from the Section 199A aggregations. In addition, Prop. Reg. Section 1.199A-3(b)(1)(iv) (2019) would require the attributes of the loss, including whether the loss or deduction is attributable to a trade or business or an SSTB, to be determined in the year the loss is incurred.
Implications: The ordering rule in the Final Regulations provides guidance on how to track and account for losses arising from and carried over throughout multiple years. Treating losses as arising from a separate trade or business means that, if such losses are treated as QBI losses, they must be allocated against all other trades or businesses with positive QBI. This may provide a more unfavorable result for some taxpayers than if the losses were traced to the trade or business in which they originally arose. As the Preamble indicates, however, tracing losses from prior years to trades or businesses in the current year may not be feasible.
The Final Regulations clarify that an excess business loss arising under Section 461(l) carried over to the following tax year is taken into account in computing QBI in the year it is deducted. The Final Regulations do not address, however, the interaction between Sections 199A and 461(l). The Preamble notes that Treasury and IRS plan to address additional issues in future guidance under Section 461(l).
Implication: Despite taxpayers' requests, the Final Regulations do not specifically address what happens when a taxpayer has an excess business loss under Section 461(l) that is partially a QBI loss and partially a non-QBI loss.
The Final Regulations clarify that all deductions attributable to a trade or business are taken into account for purposes of computing QBI. This may include the deductible portion of the tax on self-employment income under Section 164(f), the self-employed health insurance deduction under Section 162(l), and the deduction for contributions to qualified retirement plans under Section 404. Such deductions are considered attributable to a trade or business to the extent that the individual's gross income from the trade or business is taken into account in calculating the allowable deduction on a proportionate basis to the gross income received from the trade or business. The Preamble indicates that Treasury and the IRS would not specifically address whether unreimbursed partnership expenses, interest expense incurred to acquire partnership and S corporation interests, and state and local taxes are attributable to a trade or business.
Implication: Despite the fact that some trade or business expenses may be viewed as inherently personal in nature, such expenses are deductible for purposes of computing QBI. The use of the reference to "gross income" is problematic. The deductions cited in the Final Regulation are calculated based on net income, not gross income. As a result, the allocation of deductions based on gross income may cause unnecessary complexities and may lead to distortions between the amounts deducted for income tax purposes and for purposes of QBI. Sometimes this distortion will favor the taxpayer, while other times it will favor the government.
The Final Regulations and the Preamble provide guidance on whether certain other items, including Section 1245 amounts, Section 1250 amounts and income from notional principal contracts, are included in QBI.
B. Qualified REIT dividends and qualified PTP income
The Final Regulations modified the definition of a qualified REIT dividend to specify that a qualified REIT dividend excludes: (A) a dividend received with respect to a share of REIT stock held by the shareholder for 45 days or less during the 91-day period beginning on the date that is 45 days before the ex-dividend date with respect to the dividend, and (B) a dividend, to the extent that the shareholder is under an obligation (whether under a short sale or otherwise) to make certain related-party payments. The Preamble indicates that Treasury and the IRS intend to provide additional guidance to REITs and brokers on how to report qualified REIT dividends when it is impractical to determine the shareholder's holding period. Such guidance is expected to require taxpayers to report those dividends as qualified REIT dividends; it may also advise taxpayers that they may receive Forms 1099-DIV reporting qualified REIT dividends that are not actually qualified REIT dividends.
Implications: The Final Regulations clarify that a REIT share does not need to be held for the 45 days preceding the ex-dividend date for the dividend to be a qualified REIT dividend. Ultimately, it will be the shareholder's responsibility to determine if the required holding period has been satisfied.
Treasury and the IRS received multiple comments on the 2018 Proposed Regulations requesting that shareholders of a RIC be allowed to take a Section 199A deduction for certain RIC earnings. Because a RIC is a C corporation, RIC shareholders generally are not treated as directly earning the RIC's items of income, deduction, gain, or loss.
The Joint Committee on Taxation's general explanation of the TCJA (Bluebook) indicates that individual RIC shareholders were intended to be treated as receiving any qualified REIT dividends or qualified PTP income received by the RIC. Prop. Reg. Section 1.199A-3(d) (2019) provides for conduit treatment of qualified REIT dividends earned by RICs. That is, the 2019 Proposed Regulations would allow a RIC shareholder to be treated as if the shareholder directly earned its share of any qualified REIT dividends earned by the RIC. A distribution of qualified REIT dividends from a RIC to a shareholder is called a "Section 199A dividend." A non-corporate shareholder receiving a Section 199A dividend from a RIC treats that amount as a qualified REIT dividend, provided the shareholder satisfies the 45-day holding period requirement applicable to qualified REIT dividends. The 2019 Proposed Regulations include an example demonstrating the calculation of the Section 199A dividend by the RIC and application to the RIC shareholder.
Treasury and the IRS continue to consider whether it is appropriate to provide conduit treatment for qualified PTP income earned through a RIC. Treasury and the IRS seek comments to assist in resolving these issues with a goal of allowing qualified PTP income to pass to RIC shareholders, similar to qualified REIT dividends.
Implications: The provision of a conduit regime for qualified REIT dividends earned by a RIC is welcomed by many practitioners, RICs and RIC shareholders. Treasury and the IRS are considering allowing similar treatment for PTP income earned by a RIC, as the Bluebook indicates is intended, but acknowledge difficulty in creating a similarly administrable regime. Finally, because Forms 1099 are due shortly, taxpayers may see an unusual amount of corrected Forms 1099 issued as RICs compute the Section 199A dividends and update investors.
The Final Regulations also modify the rules applicable to PTPs to clarify that the SSTB limitations described in Treas. Reg. Section 1.199A-1(d)(3) and 1.199A-5 apply to income earned from a PTP.
Implication: Despite the fact that qualified PTP income is not subject to the W-2 or UBIA of qualified property limitations, the fact that the SSTB limitation applies means that taxpayers earning PTP income that is attributable to an SSTB may not be able to deduct the full 20% of such PTP income.
V. Aggregation rules (Treas. Reg. Section 1.199A-4)
Under the statute, the computation of CQBI requires combining the separately-computed QBI (in certain cases, as limited by W-2 wages and/or UBIA of qualified property) from each QTB. The 2018 Proposed Regulations allowed an individual to elect to aggregate multiple QTBs in limited instances.5 The 2018 Proposed Regulations did not allow an RPE to aggregate QTBs. The Final Regulations allow individuals and RPEs to aggregate QTBs, in limited circumstances. Treas. Reg. Section 1.199A-4(b)(2)(ii) allows an RPE to aggregate trades or businesses operated directly or through a lower-tier RPE. An upper-tier RPE, however, may not disaggregate trades or businesses aggregated by a lower-tier RPE. Furthermore, an individual may aggregate trades or businesses operated directly or through a RPE. An individual may not disaggregate trades or businesses aggregated by a RPE.
Implications:This change will allow RPEs engaged in multiple trades or businesses to reduce their compliance burden resulting from Section 199A by electing to aggregate trades or businesses, and therefore reducing the amount of information required to be reported to their owners.
For aggregation to apply under the Final Regulations, an individual or RPE must satisfy several requirements that are described in Treas. Reg. Section 1.199A-4(b)(1) and reflect common ownership and indicia of a relatedness between the aggregated trades or businesses. These requirements are generally the same as those set forth in the 2018 Proposed Regulations. One notable change under the Final Regulations, however, is that the attribution rules under Sections 267(b) and 707(b) now apply in determining if the 50% common ownership standard is satisfied; the 2018 Proposed Regulations applied the Section 318 attribution rules. The Preamble notes that a C corporation may constitute part of the common ownership group. The common ownership standard must exist both (1) for the majority of the tax year and (2) on the last day of the tax year. For such purposes, the applicable tax year is the tax year used by the entity conducting the trade or business. Like the 2018 Proposed Regulations, the Final Regulations require the QTBs to be part of a larger, integrated business enterprise by demonstrating, based on all of the facts and circumstances, the presence of two of three factors. The first factor has been modified to make clear that a real estate trade or business may be included.
Implications:Changing the applicable attribution rules in determining common control from Section 318 to Sections 267(b) and 707(b) should generally allow more trades or businesses to satisfy the control requirement necessary to aggregate, as the attribution rules under Sections 267(b) and 707(b) are generally broader than those under Section 318. While the Final Regulations make some clarifications about the requirements that a taxpayer must satisfy to aggregate QTBs, the aggregation standard remains specific to Section 199A and requires a fact-and-circumstances analysis. Taxpayers and RPEs seeking to aggregate will have to apply the Treas. Reg. Section 1.199A-4(b)(1) standards to determine whether they can aggregate. In many instances, this analysis will be time-intensive.
The Final Regulations retain, but modify, the 2018 Proposed Regulations' consistency and reporting/disclosure requirements. The changes make clear that the failure to aggregate in an earlier tax year does not preclude an individual or RPE from aggregating in a later tax year; once aggregation is adopted, though, the individual or RPE is generally precluded from thereafter disaggregating. The Final Regulations preclude an initial aggregation of trades or businesses on an amended return, other than amended returns for the 2018 tax year.
Treas. Reg. Section 1.199A-4(d) illustrates the aggregation rules with 18 examples. In one example, Treasury and the IRS conclude that a taxpayer may not aggregate a residential condominium building and commercial rental office building, as they are not the same type of property.
Implications:These examples provide helpful insights into applying the aggregation rules set forth in the Final Regulations. These examples may also be viewed as providing insights into Treasury and the IRS's view regarding the definition of a trade or business and the single-vs.-multiple trade or business issue. The conclusion in the example relating to residential and commercial rental properties may reflect an unexplained concern of Treasury and the IRS with respect to these activities. As noted earlier in Section II.A.1, Notice 2019-7 does not treat residential and commercial rentals as the same type of property.
VI. Specified service trades or businesses and the trade or business of performing services as an employee (Treas. Reg. Section 1.199A-5)
For higher-income taxpayers, the definition of a QTB excludes an SSTB. The Final Regulations confirm that an SSTB is any trade or business involving the performance of services in one of the listed fields. In defining what consists an SSTB, Treasury and the IRS place particular emphasis on the word "involving," observing, in the Preamble, that Section 199A "looks to the trade or business of performing services involving one or more of the listed fields, and not the performance of services themselves in determining whether a trade or business is an SSBT."
Furthermore, under the de minimis rule, a trade or business will not be considered an SSTB merely because it performs a small amount (based on gross receipts) of SSTB activity. The language of the de minimis rule suggests that, if a trade or business performs SSTB activity above a threshold amount, the entire trade or business is treated as an SSTB. Following the publication of the 2018 Proposed Regulations, however, it was unclear if this result was intended. In the Preamble, Treasury and the IRS confirmed the cliff effect of the de minimis rule and reference the statutory language, "involving the performance of services." Per Treasury and the IRS, the use of the word "involving" suggests that any amount of specified service activity causes a trade or business to be an SSTB.
Implications: In light of the interpretation of the phrase "involving the performance of services," taxpayers must carefully examine each activity of a trade or business to determine whether they derive receipts, in any amount, from an SSTB activity, and apply the de minimis rule accordingly. Taxpayers may also want to consider whether or not it would be possible to separate the SSTB activities and the QTB activities into separate trades or businesses to avoid losing the QBI deduction relating to the QTB activities as a result of the SSTB activities.
The definitions of the listed fields, along with the meaning ascribed to the skills and reputation clause, remain substantially unchanged from the 2018 Proposed Regulations. However, the definitions of some of the listed fields, including health, consulting, financial services, and dealing in commodities, are clarified. The Final Regulations include the following changes:
In addition to changes reflected in the operative provisions of Final Regulations, many new and updated examples are provided demonstrating clarifications in response to comments received by the Treasury and IRS. The Preamble also includes substantial commentary regarding Treasury and the IRS's interpretation of the SSTB definitions, which is not reflected in the text of the Final Regulations.
Implications:Taxpayers and their advisors should carefully review the examples in the Final Regulations in determining whether they are in a specified service field, as many of the examples add clarity to the regulatory definitions. Because Treasury and the IRS declined to address numerous specific fact patterns, however, many trades or businesses may struggle with determining whether their trade or business involves the performance of services in one of the listed specified service fields.
Treas. Reg. Section 1.199A-5 made noteworthy changes to the SSTB anti-abuse rules. The Final Regulations modified the anti-abuse rules in the 2018 Proposed Regulations aimed at preventing disaggregation of trade or business activities to avoid SSTB characterization (i.e., crack-and-pack strategies). The rule in the 2018 Proposed Regulations treated a non-SSTB as an SSTB if it provided 80% or more of its property or services to an SSTB with 50% or more common ownership, and treated a proportional amount of a non-SSTB as an SSTB if it provided less than 80% of its property or services to an SSTB with 50% or more common ownership. Treas. Reg. Section 1.199A-5(c)(2) removed the 80% threshold in the 2018 Proposed Regulations and, instead, provides that, if a non-SSTB provides property or services to an SSTB and there is 50% or more common ownership of the 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 related parties.
Implications:The modification provides some relief for taxpayers. The removal of the 80% threshold means that a non-SSTB can provide property or services to a commonly-owned SSTB without causing 100% of the non-SSTB to be treated as an SSTB. The limitation of this rule to related parties is advantageous for non-related-party owners, as it prevents tainting QBI from the non-SSTB for unrelated parties, regardless of the amount of property or services the non-SSTB provides to the SSTB. The Final Regulations do not, however, address whether this rule applies if the SSTB is a C corporation.
The Final Regulations eliminate the incidental rule in Prop. Reg. Section 1.199A-5(c)(3) (2018), which required a non-SSTB with common ownership and shared expenses with an SSTB to be treated as an SSTB if the non-SSTB's gross receipts were no more than 5% of the combined businesses' gross receipts.
Implications: The elimination of the incidental rule is taxpayer-favorable, which will prevent start-up companies from being treated as SSTBs because it will not cause such non-SSTBs to be tainted by their relationship to an SSTB due to lack of sufficient gross receipts.
Finally, the Final Regulations modified the presumption in the 2018 Proposed Regulations that a former employee is still treated as an employee by limiting the presumption to a three-year look back. That is, a former employee who provides substantially the same services to the former employer is presumed to be in the trade or business of performing services as an employee for three years after ceasing to be treated as an employee for Federal employment tax purposes. Such presumption is rebuttable with corroborating evidence of non-employee status.
VII. RPEs, PTPs, and trusts and estates (Treas. Reg. Section 1.199A-6 and Prop. Reg. Section 1.199A-6 (2019))
The Final Regulations require RPEs to compute and report Section 199A items, including QBI, W-2 wages and UBIA of qualified property, in a substantially similar manner as set forth in the 2018 Proposed Regulations. If RPEs choose to aggregate trades or businesses under Treas. Reg. Section 1.199A-4, the Final Regulations clarify that the RPE must compute and report QBI, W-2 wages, and UBIA of qualified property for the aggregated trade or business. The Final Regulations confirm that such information can be reported on an amended or late-filed return, provided the statute of limitations for that tax year remains open. Despite commentator requests, Treasury and the IRS declined to provide an exception from reporting or special reporting requirements for RPEs with only corporate owners and/or owners with taxable income below the threshold amounts.
The Final Regulations modified the implications of an RPE's failure to report an item of QBI, W-2, or UBIA. Under the Final Regulations, if an RPE fails to separately identify or report such an item, the owner's share of the unreported item of positive QBI, W-2 wages, or UBIA of qualified property are presumed to be zero (as opposed to all items attributable to the trades or businesses operated by the RPE presumed to be zero, as was indicated in the 2018 Proposed Regulations).
Implications: The modifications included in the Final Regulations may provide reporting simplification for many RPEs and taxpayers. Failure to report required information on an original return will not prevent a taxpayer from obtaining a Section 199A deduction with respect to income from the RPE. Although not exempt from reporting requirements, owners with taxable income below the threshold will still be able to claim a Section 199A deduction if they choose to provide limited information to their owners, such as QBI and SSTB information only.
The Final Regulations implement the 2018 Proposed Regulations with respect to trusts and estates with notable modifications. First, Treas. Reg. Section 1.199A-6(d)(3)(iv) requires, for purposes of determining whether a trust or estate has taxable income over the threshold amount, the taxable income of the trust or estate to be determined after taking into account the trust's or estate's income distribution deduction. Second, Treas. Reg. Section 1.199A-6(d)(3)(vi) treats the "S portion" of an electing small business trusts (ESBT) and "non-S portion" of an ESBT as a single trust for purposes of determining whether an ESBT's taxable income exceeds the threshold amount. Finally, the anti-abuse rule applicable to trusts under Treas. Reg. Section 1.199A-6(d)(3)(vii) clarifies that the creation of even one trust with the principal purpose of avoiding, or using more than one, threshold amount will not be respected. The Preamble explains that, for purposes of determining the threshold amount, such trusts will be aggregated with the grantor or other trusts from which it was funded.
Implications: The modification of how trusts and estates determine their taxable income for purposes of the threshold amount relieves concerns that income would be double-counted by the trust/estate and beneficiaries. While both the S and non-S portion of an ESBT are each entitled to the Section 199A deduction, the provision requiring a single threshold amount for both the S and non-S portion of an ESBT is perhaps the correct result for preventing abuses. Unlike the NIIT rules, these Final Regulations do not actually instruct ESBTs as to how to calculate combined taxable income for this purpose. Presumably, the taxable incomes of the S and non-S portions are simply added together. Finally, the modification to the anti-abuse rule clarifies that the rule applies to a single trust, rather than multiple trusts.
1. Treatment of charitable remainder trusts and split-interest trusts
The 2019 Proposed Regulations address the application of the Section 199A deduction to charitable remainder trusts (CRTs). A CRT generally allows a non-charitable beneficiary to retain a current annuity or unitrust payment stream, while providing a remainder interest to a charitable beneficiary.
The Preamble to the 2019 Proposed Regulations states that the Treasury and the IRS determined that it is inappropriate to calculate the Section 199A deduction at the CRT-level because a CRT is not subject to income tax. Instead, Prop. Reg. Section 1.199A-6(d)(3)(v) (2019) provides that the recipient of the annuity or unitrust amount is entitled to the Section 199A deduction with respect to QBI, qualified REIT dividends, and qualified PTP income of the CRT to the extent distributed to the recipient. The 2019 Proposed Regulations include an example demonstrating the application of the ordering rules for purposes of determining the class of income distributed from a CRT to a beneficiary. QBI, qualified REIT dividends and qualified PTP income would be assigned to the class of income they would otherwise be assigned based on the tax rate on that income (without considering the characterization as QBI, qualified REIT dividend or qualified PTP income for purposes of Section 199A). The W-2 wages and UBIA of qualified property would be allocated based on each recipient's share of the CRT's total QBI (whether or not distributed) for that tax year. Any W-2 wages retained by the trust would not carry over to subsequent tax years.
The Preamble to the 2019 Proposed Regulations states that Treasury and the IRS do not believe the special rule for CRTs applies to other split-interest trusts, such as charitable lead trusts. Instead, such other split-interest trusts would be subject to the rules generally applicable to non-grantor trusts under Section 199A.
Finally, Prop. Reg. Section 1.199A-6(d)(3) (2019) would treat a single trust with multiple separate shares, as described in Section 663(c), as a single trust for purposes of determining whether the trust's taxable income exceeds the threshold amount.
Implications: The 2019 Proposed Regulations answer some questions existing after the issuance of the 2018 Proposed Regulations on the application of Section 199A to CRTs. The treatment is not altogether favorable, however, and questions remain unanswered. The disallowance of the Section 199A deduction at the CRT-level prevents CRTs from reducing ordinary income at the CRT-level, which means that more income is taxable to the annuity and unitrust recipients. CRTs would need to separately track from year-to-year the QBI, qualified REIT dividends and qualified PTP income, as well as any corresponding W-2 wages and UBIA of qualified property. The fact that W-2 wages retained by the trust would not carry over to subsequent tax years may cause annuity and unitrust recipients to have QBI with no W-2 wages. It is unclear why W-2 wages would not carry over while UBIA of qualified property would carry over. Finally, it is unclear whether income earned in a tax year ending before January 1, 2018, that would be treated as QBI, qualified REIT dividends or qualified PTP income would be treated as such if distributed in a tax year ending after January 1, 2018, and before January 1, 2026.
VIII. Treatment of multiple trusts (Treas. Reg. Section 1.643(f)-1)
Section 643(f) permits Treasury to prescribe regulations to prevent taxpayers from establishing multiple non-grantor trusts or contributing additional capital to multiple existing non-grantor trusts to avoid federal income tax. Among other requirements, Prop. Reg. Section 1.643(f)-1 (2018) required a "principal purpose" of establishing the trusts or contributing additional property to the trusts to be the avoidance of federal income tax. The Final Regulations implement Prop. Reg. Section 1.643(f)-1 (2018), but remove the definition of "principal purpose" and the examples illustrating the rule. In the Preamble, Treasury and the IRS indicate that they will continue to study whether the term "principal purpose," as well as other terms, should be defined or clarified. The Preamble sets forth Treasury and the IRS's view that arrangements involving multiple trusts entered into or modified before the effective date of the Final Regulations are subject to treatment under the statute and guidance provided in the legislative history to Section 643(f).
Implications: For the time being, the removal of the definition of a "principal purpose" is welcome relief for taxpayers because any significant tax benefit may have resulted in a "principal purpose" of tax avoidance even if the tax benefit was merely a by-product of non-tax planning. Unless or until additional guidance is issued on the meaning of the term "principal purpose," trusts with substantially the same grantors and substantially the same primary beneficiaries will need to assess whether they are potentially subject to Section 643(f) based on the statute and legislative history. Analyzing and enforcing Section 643(f) with respect to additions to an existing trust will be difficult. In addition, Section 643(f) refers to "the avoidance of tax imposed by this chapter" (i.e., chapter 1), while the Final Regulation refers more broadly to the avoidance of "federal income tax." Thus, the government's use of this regulation for abuses occurring outside of chapter 1 of the Internal Revenue Code may be subject to judicial challenge.
IX. Effective date
The Final Regulations under Section 199A will generally apply to tax years ending after the date the Final Regulations are published in the Federal Register. For tax years ending in 2018, however, taxpayers may elect to use either the Final Regulations, in their entirety, or the 2018 Proposed Regulations, in their entirety. The Final Regulation contain five anti-abuse rules, which apply retroactively to tax years ending after December 22, 2017, the date of the TCJA's enactment. The provisions of Treas. Reg. Section 1.643-1, which prevent abuse through the use of trusts, apply retroactively to tax years ending after August 16, 2018, the date of publication of the 2018 Proposed Regulations.
Implications:Taxpayers' ability to rely on the 2018 Proposed Regulations is important as many taxpayers, notably RPEs, had begun preparing their 2018 tax returns before the release of the Final Regulations. Taxpayers choosing to rely on the 2018 Proposed Regulations may not use provisions of the Final Regulations, however, unless an independent basis exists for the position.
The 2019 Proposed Regulations explicitly state that taxpayers may rely on the 2019 Proposed Regulations until final regulations are published in the Federal Register, provided that the taxpayer applies the 2019 Proposed Regulations in their entirety.
The Final Regulations and 2019 Proposed Regulations, along with Notice 2019-07 and Revenue Procedure 2019-11, generally provide welcome guidance on issues in the 2018 Proposed Regulations. The proposed revenue procedure articulated in Notice 2019-07 will provide certainty for some taxpayers with rental real estate activities that qualify for its safe harbor. The ability to apply Treas. Reg. Section 1.199A-4's aggregation rules at the RPE level will be welcomed by many taxpayers, including those operating through tiered-RPEs. Taxpayers will also likely appreciate the removal of the incidental rule in Treas. Reg. Section 1.199A-5. Furthermore, RICs holding REIT shares and their shareholders will likely benefit from the fact that qualified REIT dividends may be passed through to RIC shareholders under the 2019 Proposed Regulations.
As discussed, however, the recent guidance leaves significant questions unanswered and raises new questions. The enumerated standards for determining what activities constitute a trade or business will often provide insufficient guidance to determine with certainty whether activities constitute a trade or business and when activities constitute multiple trades or businesses for Section 199A purposes. Clarifying statements made in the Preamble regarding SSTB definitions that were not reflected in the text of the Final Regulations may lead to confusion and examination controversy. Furthermore, the Final Regulations' rules on excess Section 743 basis adjustments, likely meant to be taxpayer-favorable, create uncertainties.
In all, taxpayers and their advisors need to carefully consider the recently released Section 199A guidance when determining whether - and to what extent - they (or their owners) are eligible for the Section 199A deduction for qualified business income.
1 For purposes of this Tax Alert, a "taxpayer" refers to a taxpayer that may claim a Section 199A deduction. An RPE refers to an entity whose owners may be eligible for a Section 199A deduction.
2 This same principle is stated in the Preamble to the final regulations under the Section 1411 net investment income tax (NIIT).
3 A qualified property's depreciable period ends 10 years after the taxpayer first placed the property in service, or the last day of the last full year that the applicable recovery period applies to that property under Section 168, whichever is later.
4 Treas. Reg. Section 1.199A-2(a)(3)(iv)(B) defines an excess section 743(b) basis adjustment as an amount determined with respect to each item of qualified property equal to the excess of the partner's Section 743(b) basis adjustment with respect to each item over an amount that would represent the partner's Section 743(b) basis adjustment with respect to the property, but calculated as if the adjusted basis of all of the partnership's property was equal to the UBIA of such property.
5 The purpose of aggregating trades or businesses is to allow the individual to treat the aggregated trades or businesses as a single trade or business for purposes of applying the wage and property limitations in calculating the QBI component.