June 26, 2020
IRS issues final regulations under IRC Section 199A on treatment of previously suspended losses and determining deductions for RICs and certain trusts
The IRS has issued final regulations (TD 9899) regarding the qualified business income (QBI) deduction under IRC Section 199A. Finalizing proposed regulations (REG-134652-18) published in the Federal Register in February 2019, these new rules provide guidance on: (1) the treatment of previously suspended losses included in QBI; and (2) determining the IRC Section 199A deduction for taxpayers holding interests in regulated investment companies (RICs), split-interest trusts, and charitable remainder trusts (CRTs).
The final regulations are effective for tax years beginning 60 days after June 25, 2020, when they were published in the Federal Register, but for tax years beginning on or before that date (i.e., August 24, 2020), taxpayers may continue to rely on the proposed regulations.
Added to the Code by the Tax Cuts and Jobs Act (TCJA), IRC Section 199A 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 (1) 20% of QBI from each "qualified trade or business" (QTB) conducted by a partnership, S corporation, and/or sole proprietorship, (2) 20% of qualified real estate investment trust (REIT) dividends, and (3) 20% of qualified publicly traded partnership (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, IRC 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 unadjusted basis immediately after acquisition (UBIA) of qualified property used in the trade or business. It also excludes SSTBs from the definition of a QTB. IRC Section 199A is generally effective for tax years beginning after December 31, 2017 and before January 1, 2026.
The February 2019 guidance package that contained the proposed regulations also included a set of final regulations (TD 9847), Notice 2019-07, and Revenue Procedure 2019-11 (see Tax Alert 2019-0218).
The proposed regulations addressed the treatment of previously disallowed losses (Prop. Reg. Section 1.199A-3 (2019)) and qualified REIT dividends earned through a RIC (Prop. Reg. Section 1.199A-3 (2019)), in addition to providing special rules applicable to trusts, including CRTs (Prop. Reg. Section 1.199A-3 (2019)).
The IRS received comments on the proposed regulations, but no hearing was requested or held. Some of those comments resulted in changes that are reflected in the final regulations.
The final regulations make substantive changes to two sections of the proposed regulations under Reg. Sections 1.199A-3 and 1.199A-6, both providing rules for calculating the IRC Section 199A deduction.
Specifically, changes have been made to:
Treatment of previously suspended losses included in QBI
Under Reg. Section 1.199A-3(b)(1)(iv), which was included in TD 9847, disallowed losses or deductions (including under IRC Sections 465, 469, 704(d) and 1366(d)) in a prior tax year and allowed in the current tax year are generally included in computing QBI, except to the extent the losses or deductions are disallowed, suspended, limited or carried over from tax years ending before January 1, 2018. For IRC Section 199A purposes, the allowed losses are taken in order from oldest to newest on a first-in, first-out (FIFO) basis. The proposed regulations expanded this rule by providing that: (1) previously disallowed losses or deductions are treated as losses from a separate trade or business in the year they are used to determine taxable income; and (2) attributes of the previously disallowed losses or deductions, including whether they are attributable to a trade or business and would otherwise be included in QBI, are determined in the year in which the loss or deduction is incurred.
Noting that taxpayers and practitioners have questioned whether losses disallowed under IRC Section 461(l) are not included in determining QBI in the year they are taken into account in determining taxable income, the preamble to the final regulations emphasizes that the "list of loss disallowance and suspension provisions in §1.199A-3(b)(1)(iv) is not exhaustive" and that as a general rule a previously disallowed or suspended loss is generally included in computing QBI in the year it is included in computing taxable income. The preamble states that the final regulations "clarify" this point in amending Reg. Section 1.199A-3(b)(1)(iv)(A) to reference specifically business losses disallowed under IRC Section 461(l) as previously disallowed losses that are included in the QBI computation in the year included in the taxable income computation.
If a taxpayer's taxable income exceeds the threshold amount defined in IRC Section 199A(e)(2), the taxpayer's IRC Section 199A deduction may be limited based on the: (1) type of trade or business conducted; (2) amount of W-2 wages paid with respect to the trade or business; and/or (3) the UBIA of qualified property held for use in the trade or business. These limitations are subject to phase-in rules (IRC Section 199A(b)(3)(B)) based on taxable income above the threshold amount.
The preamble notes that Treasury and the IRS are aware of questions from taxpayers and practitioners on how to apply the phase-in rules when a taxpayer has a suspended or disallowed loss or deduction from an SSTB. The preamble explains that if an individual's taxable income is:
The final regulations provide an example to illustrate these distinctions. The preamble further notes that the final regulations provide an example illustrating a rule that was generally retained from the proposed regulations, providing that if a loss or deduction is partially disallowed, QBI must be proportionately reduced.
RICs with interests in REITs and PTPs
The final regulations adopt rules from the proposed regulations that provide conduit treatment for qualified REIT dividends earned by RICs. The proposed regulations did not provide conduit treatment for qualified PTP income earned by a RIC, but the IRS asked for comments on whether and how to provide conduit treatment for qualified PTP income. The preamble to the final regulations indicates that the IRS continues to consider the comments it received, including:
Special rules for trusts and estates
Reg. Section 1.199A-6 provides guidance that some entities, including trusts and estates, might need to compute the entity's IRC Section 199A deduction or the passthrough information for each owner or beneficiary to enable them to compute their deduction. Special rules for trusts and estates reside in Reg. Section 1.199A-6.
Reg. Section 1.199A-6(d)(3)(ii) provides that a trust's or estate's QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income are allocated to each beneficiary and to the trust or estate based on the relative proportion of its distributable net income (DNI) for the tax year. The proposed regulations added a subsection (d)(3)(iii), which provides that a trust described in IRC Section 663(c) with substantially separate and independent shares for multiple beneficiaries will be treated as a single trust for purposes of determining whether the trust's taxable income exceeds the threshold amount. In response to comments requesting guidance on the interaction between IRC Section 199A and the separate-share rule of IRC Section 663(c), the final regulations clarify that a trust or estate described in IRC Section 663(c) with substantially separate and independent shares for multiple beneficiaries will be treated as a single trust or estate, not only for purposes of determining whether the entity's taxable income exceeds the threshold amount, but also in determining taxable income, net capital gain, net QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income for each trade or business, and computing the W-2 wage and UBIA of qualified property limitations.
The final regulations provide that the allocation of these items to the separate shares of a trust or estate described under IRC Section 663(c) will be governed by the rules under IRC Section 663(e) and any additional guidance that may be published in the Internal Revenue Bulletin.
The final regulations make no change to Prop. Reg. Section 1.199A-6(d)(3)(v), which provides rules that allow a taxable recipient of a unitrust or an annuity amount from a CRT described in IRC Section 664 to determine its IRC Section 199A deduction by taking into account QBI, qualified REIT dividends or qualified PTP income.
It was disappointing that the IRS and Treasury declined to adopt conduit treatment to qualified PTP income earned by a RIC while adopting such treatment for qualified REIT dividends earned by a RIC. The result is that an investment in a PTP is not on equal footing with an investment in a REIT, a result that seems inconsistent with the intent of Congress. Nonetheless, it is encouraging that the IRS and Treasury are continuing to consider adopting conduit treatment for PTP income earned by a RIC.
The finalization of the rules pertaining to passthrough of REIT income through RICs is welcome, although the IRS could have also included common trust funds (CTFs) in the same rule, but did not do so. So, it would appear that CTFs operate as a complete 199A blocker, but RICs only block non-REIT dividend items. A peculiar outcome.
The loss ordering rules were finalized without notable change. The examples are helpful flushing out the intent of the rule, but stay in the shallow end of the pool in terms of dealing with the real complexity addressing suspended QBI attributes in IRC Sections 465 and 469 when the definition of activity for each of the three provisions varies widely. Hopefully the IRS will follow through on their statement in the preamble that more guidance will come in the next edition of the form instructions.
With regard to the trust provisions, the final regulations were in line with expectations. There appeared to be a glitch in the proposed regulations regarding the treatment of UBIA retained in the trust. The proposed regulations only stated that W-2 wages retained by the CRT are lost but did not mention anything about the UBIA. The final regulations retain the same language as the proposed regulation, so the mystery about the treatment of UBIA remains.