Taxpayers and practitioners have patiently waited for additional guidance to help implement many important provisions of the comprehensive tax reform package passed at the end of 2017. One such provision was the new section 199A 20 percent deduction for qualified business income (QBI). This deduction is generally available for owners of pass-through businesses—partnerships, S corporations, and sole proprietorships, including LLCs classified for tax purposes as any of the former.
After the release of the proposed regulations, commentators inundated the Treasury Department and IRS with comments and suggestions to consider when finalizing the regulations. Final regulations were released in January 2019 responding to some of the commentary, while also raising new questions and issues for taxpayers and practitioners to consider.
This Insight will discuss these new final regulations, with a focus on how they differ from the proposed regulations released in August. Note that other guidance was also released relating to REIT dividends received by Regulations Investment Companies and certain ordering rules for suspended and/or disallowed losses.
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Summary of Important Changes
Here are some of the important changes and additional issues raised with this new guidance. A more in-depth discussion of these items follows.
There are several items consider when it comes to understanding the 20% pass-through deduction. We recently put together a webinar to help you understand the impact of Section 199A.
Rental Income as QBI
One consistent critique of the proposed regulations was that no further guidance was issued concerning the treatment of rental income under section 199A. The proposed regulations stated taxpayers should look to existing guidance to determine whether rental income stems from a trade or business (and thus is QBI) or whether it stems from something else (like an investment activity). The problem is that most of the case law and IRS guidance in this area is confusing and sometimes contradictory. Consequently, there was a lot of uncertainty concerning under what circumstances rental income qualifies for the section 199A deduction.
With the intent to quell some of the uncertainty, the final regulations (along with a Notice and a proposed Revenue Procedure, found here) provide a safe harbor allowing a “rental real estate enterprise” to “be treated as a trade or business for purposes of section 199A” if certain requirements are met. A 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.”
A rental real estate enterprise will be treated as a trade or business generating QBI if the following requirements are met during the taxable year.
Comment: Entities holding only a single real estate business may be able to satisfy this requirement without significant additional work. However, entities with multiple real estate trades or businesses, or a mix of real estate and other trades or businesses, may need to adapt their accounting systems by separately tracking each trade or businesses in order to meet this first requirement.
Comment: Helpfully, under the proposed Revenue Procedure, qualifying services can be performed by people holding various roles, including: owners, employees and independent contractors. But not all services necessarily qualify under the proposed Rev. Proc. Examples of qualifying services include: maintenance, repairs, collection of rents, payment of expenses, provision of services to tenants, and efforts to rent the property. Examples of non-qualifying services include: arranging financing, procuring property, reviewing financial statements or reports on operations, planning, managing, or contracting long term capital improvements, and traveling to and from the real estate. The IRS and Treasury Department indicated these services appear to be services performed in the “capacity as an investor.”
The real estate enterprise must maintain contemporaneous records regarding the hours of services performed, including a description of services along with specific dates and identification of the service provider.
Comment: A triple net lease, for purposes of section 199A and the proposed Revenue Procedure, generally includes a lease agreement requiring the tenant to pay all or a portion of the taxes, fees, and insurance and be responsible for maintenance activities in addition to rent and utilities.
Once rental income is treated as trade or business income for section 199A purposes, the IRS says it should be treated as a trade or business for other purposes of the code. This means all relevant IRS forms should be filed, including Forms 1099 when required.
A statement, signed under penalties of perjury, must be attached to the relevant tax return claiming the section 199A deduction (or passing through the section 199A information) that the above requirements are met.
One important point is that the IRS recognizes that a “rental real estate enterprise” failing to meet the safe harbor requirements “may still be treated as a trade or business for purposes of section 199A if the enterprise otherwise meets the definition of trade or business” under section 199A. It is certainly plausible that many rental trades or businesses falling outside of the proposed safe harbor will still produce income reasonably classified as QBI.
Establishing Separate Trades or Businesses
The section 199A deduction, and its various limitations, is computed at a trade or business level, meaning it is important for taxpayers to understand what constitutes a trade or business. The final regulations state taxpayers should look to existing guidance governing whether a business can have a separate method of accounting for determining whether a separate trade or business exists for section 199A purposes. This generally requires each distinct trade or business to maintain a “complete and separable set of books and records.”
If a single entity has income from a specified service trade or business (generally not eligible for the section 199A deduction) and income from a non-service business, it may be possible, under the right facts, to demonstrate that the single entity has two separate trades or businesses. The IRS and Treasury Department recognize this fact in the final regulations. While the service business may not qualify for the section 199A deduction, the other business could qualify if all requirements are satisfied.
Even though the section 199A deduction is generally specific to each trade or business, the proposed regulations permit businesses to be aggregated together via an election for purposes of the section 199A deduction, but only at the individual taxpayer level. Aggregation can potentially allow taxpayers to maximize their section 199A deduction. For instance, aggregation could allow wages from one business to be used as part of the limitations test for another business, provided those two businesses are properly aggregated. Among the requirements for aggregation are common control between the aggregated businesses (generally 50 percent or more common ownership) and certain relatedness between the aggregated businesses, like providing similar products and services.
The final regulations expand the usefulness of aggregation by allowing it at either the entity or individual taxpayer level. This is a taxpayer-friendly answer that may reduce the compliance burden associated with an aggregation election. There is a duty of consistency once an aggregation election is made and a disclosure must be made on the relevant tax return.
Specified Service Trades or Businesses
Specified service trades or businesses (SSTBs), like businesses performing services in the fields of health, are generally not eligible for the section 199A deduction. The final regulations provide further guidance on the classification of SSTBs and also raise additional questions.
Health Services: Under the proposed regulations, health services mean medical services provided directly to a patient. The final regulations remove this focus on direct services, meaning indirect health services can now be part of a SSTB. This may result in more types of services being classified as health services under the final regulations as opposed to the proposed regulations.
Additionally, new examples recognize that certain businesses associated with other businesses performing services in the fields of health may still qualify for the section 199A deduction.
A new example recognizes that a “residential facility” performing “a variety of services to senior citizens who reside on campus” may not necessarily be involved in the performance of services within the field of health. Relevant facts in the example supporting this conclusion include:
Another new example recognizes that a private organization operating surgical centers that provide outpatient medical procedures is not performing services in the field of health. Relevant facts in the example supporting this conclusion include:
Certain types of retail pharmacists may qualify for the section 199A deduction. The final regulations state that the “sale of pharmaceuticals and medical devices by a retail pharmacy is not by itself a trade or business performing services in the field of health.” Further, the final regulations provide a contrasting example of a pharmacist that is involved in health services. That pharmacist, practicing in a hospital setting, responsible for “reviewing orders from physicians,” making “recommendations on dosing and alternatives to the ordering physician,” and “performing inoculations, checking for drug interactions, and filling pharmaceutical orders” is engaged in the performance of services within the field of health.
While these new examples may appear taxpayer-friendly, businesses with facts not exactly aligning with the examples should cautiously consider whether the examples can be relied upon. For example, many residential facilities performing services for senior citizens, and many surgical centers, often employ some healthcare professionals such as nurses. This fact could represent a material difference from the above examples and result in a business not necessarily being able to rely upon the examples.
Other Notable Changes for SSTBs: Several other notable changes in the final regulations include excluding taking deposits or making loans from the definition of financial services and concluding that originating loans is not treated as the “purchase of a security from the borrower in determining whether a lender is performing services consisting of dealing in securities.”
Providing Services to a SSTB: Under the proposed regulations, the income from a business providing 80 percent or more of its products and services to another business classified as a SSTB could result in all income being classified as coming from a SSTB, provided there is 50 percent common ownership between those businesses. The final regulations relax this requirement by providing if there is 50 percent common ownership, only the revenue generated by the related entity for products and services provided to the SSTB is tainted. If that entity provides products and services to third parties, that income is not tainted. For instance, a physician owns real property, and the physician medical practice rents 85 percent of the real property while an unrelated business rents the remaining 15 percent, the rental income from the unrelated business would not be considered income from a SSTB.
There are two limitation tests taxpayers must consider for purposes of computing the section 199A deduction, provided the taxpayers have taxable income exceeding certain threshold amounts (generally $315,000 for married taxpayers and $157,500 for single and head-of-household filers for 2018, and, as adjusted for inflation in later years). First, the section 199A deduction cannot exceed 50 percent of the wages paid as part of the business. There is an alternative test that looks to 25 percent of the wages paid plus 2.5 percent of the unadjusted basis in qualified property immediately before acquisition (UBIA). The UBIA calculation generally focuses on the cost basis of tangible depreciable business property.
The final regulations provide additional guidance on the application of the UBIA limitation.
Must Be Held at the End of the Year: The proposed regulations require UBIA to be held at the close of the taxable year to count towards the limitations test. Therefore, a calendar year taxpayer selling real property on Dec. 20 would not be able to use any of the basis associated with the real property as part of its UBIA calculation.
Taxpayers asked the Treasury Department and IRS for a pro-ration rule, but this was declined in the final regulations, meaning property must be held at the close of the taxable year for UBIA purposes. This rule could be troublesome when depreciation recapture items from the sale of trade or business property (generally treated as QBI) are triggered because the UBIA of the underlying property will not count towards the limitations test for that income.
Section 1031 Exchanges and UBIA: Generally, if no taxable boot is recognized, the UBIA of qualified like-kind property received in an exchange is the UBIA of the relinquished property.
Section 754 Adjustments and UBIA: Section 743(b) (but not section 734(b)) basis adjustments, relating to transfers of partnership interests, can qualify as a separate item of qualified property for UBIA purposes, placed in service when the partnership interest is transferred, so long as the FMV of the assets the basis adjustment attaches to, is greater than the UBIA of the property.
The deductions for self-employment tax, self-employed health insurance, and contributions to section 404 qualified retirements plans are considered “attributable to a trade or business” for purposes of computing QBI, meaning QBI is reduced by those amounts.
Reporting and Compliance
A relevant passthrough entity must state whether any trade or business is an SSTB and “separately identify or report an item of QBI, W-2 wages, or UBIA of qualified property.” Failure to do so results in the presumption that the omitted item is zero, no matter the profile of the ultimate taxpayer. For instance, failure to indicate an item is QBI could result in a disallowed deduction even if the ultimate taxpayer has taxable income under the threshold amounts. There are no exceptions. Note that this is a more generous rule than the proposed regulations. Those regulations provided that any omitted information caused all the items to be presumed to be zero.
The safe harbor for rental income is particularly useful for taxpayers falling within its guidelines. However, the additional guidance, perhaps inevitably, also raises many new and unanswered questions that taxpayers must grapple with before claiming the section 199A deduction.
Tax reform can be confusing and complicated.