On January 18, 2019, the IRS and U.S. Department of the Treasury (Treasury) released final regulations under Internal Revenue Code (IRC) Section 199A, i.e., the qualified business income (QBI) deduction. This highly anticipated guidance comes five months after the August 8, 2018, release of the proposed regulations for the deduction. Learn what was included in those proposed regulations in this previous BKD Thoughtware® article. The IRS and Treasury requested comments on all aspects of the proposed rules and a public hearing was held on October 16, 2018. The recently released Treasury Regulations §§1.199A-1 through 1.199A-6 are a culmination of feedback the IRS and Treasury have received and serve to help clarify the rules contained in the statute and proposed regulations. In this article, we’ll provide an overview of some of the key provisions from the proposed rules that were either changed or confirmed by the final regulations.
Trade or Business Definition
IRC §199A provides a deduction of up to 20 percent of QBI from a qualified trade or business of a noncorporate taxpayer. For this purpose, the proposed regulations define trade or business by reference to §162. The final rules retain and slightly reword this definition for purposes of §199A and maintain the special allowance for property rented or licensed to a commonly controlled trade or business that isn’t considered to otherwise “rise to the level of a §162 trade or business.” Such rental trades or businesses still may be considered trades or businesses for purposes of §199A; however, the final regulations modify the related-party attribution rules used to determine relatedness for this special rule and clarify that the rule doesn’t apply to property rented or licensed to a commonly controlled C corporation. Despite the large (albeit contradictory) body of case law from which the definition of a §162 trade or business is derived, many commenters on the proposed regulations requested further guidance to help determine whether an activity should be classified as a trade or business under §162, especially for rental real estate activities.
In the preamble to the final regulations, the IRS and Treasury decline to provide specific guidelines to help determine whether an activity rises to the level of a §162 trade or business, stating such guidance is beyond the scope of the regulations. However, the IRS and Treasury do reiterate that this determination is inherently a factual question. They point to the definitional requirements that have emerged from case law on the topic: The taxpayer must enter into and carry on the activity with a good faith intention to make a profit or with the belief a profit can be made from the activity through considerable, regular and continuous activity.
Proposed Rental Real Estate Safe Harbor
While the final regulations don’t provide an overall bright-line test for making the trade or business determination, Notice 2019-07, which was concurrently released with the final regulations, provides a proposed safe harbor under which a rental real estate enterprise1 may be treated as a trade or business for purposes of §199A. To qualify for treatment as a trade or business under this safe harbor, the rental real estate enterprise must satisfy the following requirements:
- Maintain separate books and records to reflect income and expenses for each rental real estate enterprise
- For taxable years beginning prior to January 1, 2023, at least 250 hours of rental services2 per year are performed by owners, employees, agents and/or independent contractors. For taxable years beginning after December 31, 2022, the 250-hour requirement shifts from a per-year basis to look at three of the last five consecutive taxable years
- For taxable years beginning after December 31, 2018, the taxpayer maintains contemporaneous records, including time reports, logs or similar documents, regarding all of the following:
- Hours of all services performed
- Description of all services performed
- Dates on which such services were performed
- Who performed the services
- The real estate must not be rented or leased under a triple net lease or used by the taxpayer as a residence for a length of time exceeding the greater of 14 days or 10 percent of the number of days the unit is rented at a fair rental rate
- The return must have a signed statement attached in which the taxpayer claims or passes through §199A information and affirms, under penalties of perjury, personal knowledge of the facts and circumstances related to the statement and that safe harbor requirements (1), (2) and (3) are met
The above requirements provide a safe harbor guideline for rental real estate enterprises to qualify as a trade or business for §199A; however, failing to satisfy these requirements doesn’t preclude the activity from treatment as a trade or business if the enterprise otherwise meets the previously discussed definition provided in the final regulations. The IRS and Treasury caution taxpayers that when making this determination they also should maintain consistency with other IRC provisions that use a trade or business standard that is the same or substantially similar to §162. For example, a taxpayer should consider the appropriateness of treating the rental of property as a trade or business for purposes of §199A where the taxpayer doesn’t comply with information return filing requirements, i.e., filing Forms 1099.
Other Operational Guidance
- The final regulations provide that “net capital gain” includes qualified dividend income. The overall deduction under §199A is limited to 20 percent of the excess of a taxpayer’s taxable income over its net capital gain. This flowchart provides a summary of this concept and some other operational aspects of the deduction.
- The preamble to the final regulations confirms a relevant pass-through entity (RPE) can conduct more than one §162 trade or business. As with the determination of whether an activity rises to the level of a trade or business, discussed above, the determination of whether a single entity has multiple trades or businesses is a factual determination. However, the preamble provides multiple trades or businesses generally will not exist within an entity unless each trade or business keeps complete and separable sets of books and records.
- For taxpayers with taxable income within the phase-in range, QBI from a specified service trade or business (SSTB) must be reduced by the applicable percentage before the netting and carryover rules are applied.
- Trades or businesses conducted by a disregarded entity are treated as conducted directly by the owner of the entity for purposes of §199A.
Determination of Unadjusted Basis Immediately After Acquisition (UBIA) of Qualified Property
Fully Depreciated Qualified Property
The August 8 proposed regulations provide that each partner’s share of the UBIA of qualified property is based on how gain would be allocated to the partners under §§704(b) and (c) in the case of qualified property held by a partnership that doesn’t produce tax depreciation during the year. The IRS and Treasury received comments regarding the administrative burden this proposed approach would place on taxpayers, especially regarding the required adherence to §704(c). Accordingly, the final regulations provide that each partner’s share of the UBIA of qualified property is determined in accordance with how depreciation would be allocated for §704(b) purposes on the last day of the taxable year.
The IRS and Treasury requested comments regarding appropriate methods for accounting for nonrecognition transactions, including rules to prevent the manipulation of the depreciable period of qualified property using transactions between related parties. As a result of comments received, the final regulations provide that, for purposes of §199A, a transferee’s UBIA in qualified property received in a nonrecognition transaction is the same as the transferor’s UBIA in the property, decreased by the amount of money received by the transferee or increased by the amount of money paid by the transferee. Similar rules would apply when determining the UBIA of qualified property received in a §1031 like-kind exchange. These favorable changes reduce the mathematical complexity to the calculation of the UBIA of qualified property.
Partnership Special Basis Adjustments Under §§743(b) & 734(b)
The IRS and Treasury originally proposed that partnership special basis adjustments wouldn’t be treated as separate qualified property for purposes of §199A. BKD and other commenters argued §743(b) basis adjustments should be treated as qualified property to the extent the adjustment reflects an increase in the fair market value of the underlying qualified property. In response, the final regulations allow “excess §743(b) basis adjustments” equal to the excess of the partner’s §743(b) basis adjustment with respect to each item over an amount representing the partner’s §743(b) basis adjustment with respect to the property calculated as if the adjusted basis of all of the partnership’s property was equal to the UBIA of such property. This amount is treated as a separate item of qualified property placed in service when the transfer occurs.
Transfer of Ownership in an RPE
The definition of qualified property under §199A includes the requirement that the property must be held by, and available for use in, the qualified trade or business at the close of the taxable year. Lacking from the statute and proposed regulations was guidance regarding the application of this definition in the case of taxpayers who transfer their ownership in an RPE prior to the close of the applicable taxable year. The preamble to the final regulations clarifies that a taxpayer who transfers an interest in an RPE prior to the close of the RPE’s taxable year isn’t entitled to a share of UBIA from the RPE.
Qualified Property Acquired from a Decedent
The final regulations provide that the UBIA of qualified property acquired from a decedent and immediately placed in service will generally be the fair market value at the date of the decedent’s death. In addition, a new depreciable period for the property will commence as of that date.
Determination of QBI
Previously Disallowed Losses
The final regulations provide a taxpayer-friendly ordering rule for determining which portion of a previously disallowed loss can be taken into account for purposes of §199A when a taxpayer has losses which originated both before and after January 1, 2018. Any losses disallowed, suspended or limited—including under the provisions of §§465, 469, 704(d) and 1366(d)—will be taken into consideration on a first in, first out basis for purposes of §199A.
The proposed regulations didn’t provide clear guidance regarding whether a taxpayer should consider certain deductions as being attributable to a trade or business, such as the deductible portion of self-employment taxes, self-employed health insurance premiums and retirement contributions related to Schedule C, E or F, when calculating QBI. The IRS and Treasury conclude in the final regulations that these deductions are considered attributable to a trade or business to the extent the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction.
Section 1231 Gains & Losses
Despite acknowledging the added challenges in applying §1231 in the context of calculating QBI, which you can read about in BKD’s comment letter on the August 8 proposed regulations, the IRS and Treasury affirm the proposed treatment of §1231 gains and losses in the context of §199A. For purposes of calculating QBI, taxpayers must continue to net their §1231 gains and losses from their multiple trades or businesses to determine whether they have excess gain (which characterizes all of the gain or loss as capital and is thus excluded from QBI) or excess loss (which characterizes all of the gain or loss as ordinary and is thus included in QBI).
Qualified Real Estate Investment Trust (REIT) Dividends
The proposed regulations provide an anti-abuse rule requiring the stock from which a REIT dividend is received to meet a 45-day holding period to qualify for the deduction under §199A. The final regulations clarify that this requirement is met by holding the stock for no fewer than 45 days—not necessarily 45 days prior to the REIT dividend.
The proposed regulations provide rules to allow taxpayers to aggregate trades or businesses provided certain requirements are satisfied, including a 50 percent ownership test. The final regulations clarify the 50 percent ownership requirement must be maintained for a majority of the taxable year, including the last day of the year, and a C corp may constitute part of that group. In addition, the final regulations broaden the rules for determining common ownership to include the attribution rules of §§267 and 707.
The final regulations clarify that a taxpayer’s failure to aggregate trades or businesses will not be considered an aggregation under this rule, i.e., later aggregation is not precluded. However, while taxpayers who fail or choose not to aggregate in year one can still choose to aggregate in year two or another future year, they generally can’t amend returns to choose to aggregate for year one unless there is a material change in circumstances that would cause a change to the aggregation. The final regulations do provide relief for taxpayers who inadvertently failed to aggregate, or properly report an intended aggregation, on returns filed for the first taxable year after this new provision became law by allowing initial aggregations to be made on amended returns for the 2018 taxable year. In addition, the final regulations provide that in cases where the commissioner has disaggregated trades or businesses as a result of an inappropriate aggregation, those trades or businesses may be not be reaggregated for the three subsequent taxable years.
The IRS and Treasury originally proposed that aggregation would be available solely at the noncorporate taxpayer level; however, the final regulations permit an RPE to aggregate trades or businesses it operates directly or through lower-tier RPEs. The resulting aggregation must be reported by the RPE and all owners of the RPE and can’t be disaggregated by an upper-tier RPE or the ultimate taxpayer. Additional trades or businesses may be added to the original aggregation, if appropriate and if all other aggregation rules are satisfied.
Rules Applicable to SSTBs
The IRS and Treasury declined to provide definitive guidance in response to comments requesting whether a specific trade or business should be considered an SSTB, stating such a determination depends on whether the facts and circumstances demonstrate the principal asset is the reputation or skill of the employees or owners or the trade or business is in one of the following fields:
- Actuarial Science
- Brokerage Services
- Investment Management
- Financial Services
- Performing Arts
Nevertheless, the final regulations do provide several new examples to help clarify the application of the SSTB rules for common service businesses. Additional examples provided in the final regulations include, among others, fact patterns for a residential facility that provides a variety of services to senior citizens who reside on campus, an outpatient surgical center and a franchisor who sells a franchise in a listed service field. The final regulations also clarify that veterinary medicine and physical therapy are considered in the field of health and, to the extent a writer is paid for written material that is integral to the creation of the performing arts, e.g., a song or screenplay, the writer is performing services in the field of performing arts.
Regarding the treatment of services performed by banks, the final regulations provide that, to the extent a bank operates a single trade or business that’s involved in the performance of services listed as SSTBs outside of the de minimis exception, the bank’s single trade or business will be treated as an SSTB. However, any RPE may operate more than one trade or business and segregate specified service activities from an existing trade or business if the specific service activities rise to the level of a §162 trade or business.
The IRS and Treasury agree with comments received regarding limiting the definition of dealing in commodities for purposes of §199A. The final regulations limit the definition to trades or businesses that deal in financial instruments or otherwise don’t engage in substantial activities with respect to physical commodities such as producing, processing or handling.
De Minimis Rule
The proposed regulations include a de minimis rule to provide relief to taxpayers whose gross receipts from SSTB activities are below certain thresholds. In the final regulations, the IRS and Treasury reiterate that trades or businesses with gross income from a specified service activity in excess of the de minimis threshold are considered SSTBs because §199A looks to whether the trade or business involves the performance of services in the list of SSTBs. Other than providing an additional example demonstrating the result in which a trade or business has income from a specific service activity in excess of the de minimis threshold, the IRS and Treasury made no changes to this proposed rule.
Services or Property Provided to an SSTB
The proposed regulations provide an anti-abuse provision that states 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. If the trade or business provides less than 80 percent of its property or services to an SSTB and there is 50 percent or more common ownership of the trades or businesses, that portion of the trade or business of providing property or services to the commonly owned SSTB is treated as part of the SSTB.
In response to comments received, the IRS and Treasury address this special rule in the final regulations by clarifying that the rule applies only to those who make up the 50 percent test. The final regulations also remove the 80 percent rule and provide that if a trade or business provides property or services to an SSTB and there is 50 percent or more common ownership, the portion of the trade or business providing property or services to the commonly owned SSTB will be treated as a separate SSTB. Further, in response to comments received, the final regulations also eliminate the proposed rule that treats a trade or business with both 50 percent or more common ownership with an SSTB and shared expenses with an SSTB as “incidental to,” and therefore part of, the SSTB.
The final regulations retain the proposed rule that an individual who was previously treated as an employee and is subsequently treated as other than an employee while performing substantially the same services to the same, or related, person will be presumed, for three years, to be in the trade or business of performing services as an employee for purposes of §199A. However, the final rules provide a look-back rule whereby individuals may rebut that presumption by showing records to corroborate their nonemployee status.
Special Reporting Rules for RPEs
Under the proposed regulations, if an RPE fails to separately identify or report any QBI, W-2 wages, UBIA of qualified property or SSTB determinations, the owner’s share of all items would be presumed to be zero. In response to comments received, the IRS and Treasury revised this rule in the final regulations stating if an RPE fails to separately identify or report one of these items, it’s only the unreported item of positive QBI, W-2 wages or UBIA of qualified property that’s presumed to be zero. This information also can be reported to owners on an amended or late-filed return for any open tax year.
Application to Trusts & Estates
The final regulations also modify and clarify provisions relating to the application of §199A to trusts and estates:
- The final regulations clarify that the S and non-S portions of an electing small business trust are treated as a single trust for purposes of determining the threshold amount.
- The provision excluding distributions from taxable income for purposes of determining whether taxable income for a trust or estate exceeds the threshold amount was removed, and the final regulations specifically provide that the taxable income of the trust or estate is determined after taking into account any distribution deduction under §§651 or 661.
- The final regulations clarify that the anti-abuse rule provided in the proposed regulations applies to the creation of even one single trust with a principal purpose of avoiding or using more than one threshold amount. When the rule applies, the trust will be aggregated with the grantor or other trust from which it was funded for purposes of determining the threshold amount for calculating the deduction under §199A.
- Lastly, the final regulations remove the definition of “principal purpose” and the related examples in response to concerns raised in the comments received while Treasury and the IRS continue to evaluate the need for further guidance. Treasury and the IRS continue to believe it is appropriate to look to §643(f) and the guidance thereunder for the treatment of arrangements involving multiple trusts.
Other §199A Guidance Released
The IRS also simultaneously released proposed guidance regarding the treatment of real estate dividends received from regulated investment companies and finalized guidance providing methods to determine W-2 wages for purposes of §199A, which was originally proposed in August 2018 in Notice 2018-64.
Concurrent to the release of the final regulations under §199A, the IRS and Treasury released additional proposed regulations under that code section relating to previously suspended losses and the determination of the deduction for taxpayers that hold interests in regulated investment companies (RIC), charitable remainder trusts and split-interest trusts. The new proposed regulations provide that previously disallowed losses are treated as loss from a separate trade or business to address situations where losses relate to a trade or business that is no longer in existence. Also, because a RIC is a subchapter C corp, a shareholder in a RIC would not be eligible to take a §199A deduction with respect to certain income of, or distributions from, the RIC. This is the case even when the distributions are attributable to qualified publicly traded partnership income received by the RIC; however, the IRS and Treasury do make an exception for the distribution of qualified REIT dividends. As a result of this conduit treatment, noncorporate shareholders of RICs, such as mutual funds, can treat these amounts as qualified REIT dividends for purposes of §199A provided they meet the holding period requirements for the shares in the mutual fund.
Effective immediately, taxpayers may rely on the rules provided in Treas. Reg. §§1.199A-1 through 1.199A-6 and use the safe harbor described in Notice 2019-07 for purposes of determining when a rental real estate enterprise may be treated as a trade or business under §199A. Alternatively, taxpayers may continue to rely on the proposed regulations issued in August 2018, in their entirety, for taxable years ending in calendar year 2018. The anti-abuse rules in Treas. Reg. §§1.199A-2, 1.199A-3, 1.199A-5 and 1.199A-6 apply to taxable years ending after December 22, 2017.
Taxpayers also may rely on the concurrently released amendments to §§1.199A-3 and 1.199A-6, which are proposed to apply to taxable years ending after the date of their publications final regulations in the Federal Register.
Contact Julia or your trusted BKD tax advisor if you have questions.
1 For purposes of this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties ↩
2 For purposes of this safe harbor, rental services include: advertising to rent or lease the real estate, negotiating and executing leases, verifying information contained in prospective tenant applications, collecting rent, performing daily operational tasks, maintaining and repairing the property, supervising employees and independent contractors, managing the real estate and purchasing materials. Rental services do not include financial or investment management activities or hours spent traveling to and from the real estate ↩