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Final pass-through deduction rules create planning opportunities

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Calculating taxThe IRS has released final regulations (TD REG-107892-18) on the pass-through deduction under Section 199A, and several favorable changes afford taxpayers important planning opportunities.

The final regulations were accompanied by a separate package of proposed regulations (REG-134652-18) that included relief for real estate investment trust (REIT) dividends, a revenue procedure for calculating W-2 wages (Rev. Proc. 2019-11), and a proposed revenue procedure with a rental real estate safe harbor (Notice 2019-07). Taken together, the final regulations and other guidance offer several favorable new rules and safe harbors, including changes to anti-abuse rules that should make it easier for taxpayers to segregate qualified and non-qualified activities into separate trades or businesses. However, the IRS retained several rules from the proposed regulations that received significant comments and criticism, including a rule that will deem any trade or business disqualified if as little as 5% of its gross receipts come from disqualified services. Some of the most significant developments in the overall guidance package include:

  • Relaxing anti-abuse rules that would have forced taxpayers to combine qualified trade or business activities with nonqualified trades or businesses in some circumstances.
  • Providing a safe harbor for determining if rental real estate activities rise to the level of a trade or business, but otherwise providing little additional guidance on the “trade or business” definition outside of commentary in the preamble
  • Allowing the deduction for REIT dividends received through a mutual fund (regulated investment company or RIC)
  • Allowing the election to aggregate trade or business activities at the partnership and S corporation level
  • Declining to provide S corporation banks with a blanket exception, but providing that mortgage lending activities qualify even if the loans are later sold.
  • Declining to change a rule excluding guaranteed payments for the use of capital from qualified business income

The final regulations are generally effective for tax years ending after the date they are published in the Federal Register, and publication is expected to resume quickly now that the government has reopened. Although final regulations will not be effective until published, certain anti-abuse rules are effective retroactively for tax years ending after Dec. 22, 2017, when Section 199A was enacted. For tax years ending in 2018, taxpayers can generally rely on either the final or the previously proposed regulations, but must rely on one or the other in their entirety. Rev. Proc. 2019-11 is effective for tax years ending after Dec. 31, 2017. The revenue procedure in Notice 2019-07 is proposed to be effective for tax years ending after Dec. 31, 2017, but taxpayers may rely on the safe harbor until the final revenue procedure is issued. The new proposed regulations are proposed to be effective for tax years ending after when they are published in final form, but taxpayers may rely on the proposed version until then.

Background Section 199A was added by the Tax Cuts and Jobs Act (TCJA) and offers a deduction of up to 20% for three types of pass-through income: REIT dividends, income from publicly traded partnerships (PTP), and qualified business income (QBI) from a trade or business. The deduction for QBI is subject to two strict limits: 1) It is not available for income from a list of disqualified activities, defined as specified service trades or businesses (SSTBs), and 2) it is limited if the taxpayer (or the taxpayer’s pass-through business) does not pay sufficient wages or invests in sufficient tangible depreciable property used in the business. Neither of these limits apply for taxpayers with taxable income less than $157,500 if single or $315,000 if filing jointly. The limitations phase in over the next $50,000 and $100,000 in income over these thresholds, respectively.

Qualifying income The statute makes the deduction available to taxpayers other than corporations, raising the question of whether REIT dividends received by a RIC, which is a corporation, can qualify for the deduction. The proposed regulations provide that a RIC receiving REIT dividends can pass on those amounts to shareholders as REIT dividends. Taxpayers can generally rely on these rules before they are finalized.

Grant Thornton Insight: Congressional Republicans have proposed a statutory technical correction that would specifically clarify that REIT dividends flowing through a RIC qualify for the deduction. The proposed regulations supply a favorable regulatory fix. The IRS based its interpretation on the legislative history of Section 199A and the fact that some RIC rules provide for treatment somewhat analogous to a flow-through in certain circumstances.
The deduction for QBI is subject to much more rigorous requirements than the deductions allowed for REIT and PTP income. QBI generally includes items of income, gain, deduction, and loss, including rental income, from a trade or business conducted in the United States that is not an SSTB. QBI specifically excludes dividends and capital gain and loss, and annuities and interest only qualify to the extent they are allocable or received in connection with a trade or business.

Gain or loss under Section 1231 that is treated as a net capital gain or loss does not qualify as QBI. The IRS acknowledged that Section 1231 presents challenges because the character of all Section 1231 gains and losses can change depending on whether the taxpayer has net gain or net loss. However, the IRS declined to provide any administrative relief or explicit rules for Section 1231. The preamble indicates that taxpayers should simply apply the general Section 1231 rules so that taxpayers will net Section 1231 gain and losses from various trades or businesses to determine the ultimate character.

Despite numerous objections, the IRS declined to change a proposed rule that excludes guaranteed payments for the use of capital from QBI. Payments under Section 707(a) to a partner other than in the capacity of a partner also remain excluded from QBI. The IRS also retained a rebuttable presumption that would treat certain independent contractors who were formerly employees as employees for purposes of Section 199A.

Defining a trade or business QBI must come from an activity that rises to the level of a trade or business, and the wage and asset tests must be applied separately for each trade or business. The determination of whether an activity rises to the level of a trade or business, and whether activities represent one or more than one trade or business, is crucial. The proposed regulations provided that the determination of whether a trade or business exists is generally made under Section 162, but that renting tangible or intangible property to a trade or business under common control is always considered a trade or business.

The IRS acknowledged in the preamble to the final regulations that the trade or business determination under Section 162 is highly factual and relies on case law and guidance that can be ambiguous, particularly for rental real estate. Still, the IRS chose not to expand the Section 162 standard in the text of the final regulations. Instead, the IRS proposed a separate safe harbor for rental real estate and used the preamble to offer informal insight into how the IRS views the general issue.

The proposed safe harbor under Notice 2019-07 will treat a rental real estate activity as a trade or business if at least 250 hours of services are performed during the year by owners, employees, and independent contractors on activities such as maintenance, repairs, rent collection, tenant services, and efforts to rent the property. Hours spent in the owner’s capacity as an investor will not count. The safe harbor requires separate books and records and is not available for triple net leases or property the taxpayer uses as a principal resident for at least 14 days.

The preamble to the final regulations provides more general information on the trade or business determination. It indicates the IRS does not believe it would be appropriate to rely on the rules in Treas. Reg. Sec. 1.446-1(d) for determining whether separate trades or businesses exist. Nevertheless, the IRS then said it would look at the issue specifically through the lens of some of the rules under Section 446. According to the preamble, the IRS believes that multiple trades or businesses will generally not exist within an entity unless different methods of accounting could be used for each trade or business and separate books and records are kept. The preamble went on to say that a trade or business would not be considered separate and distinct if they use different accounting methods to shift profits and losses in a way that doesn’t reflect income. The IRS said it would look for consistency in whether a taxpayer treats an activity as a trade or business under Section 199A and other areas such as Form 1099 reporting, though there is no actual consistency requirement in the regulations.

Grant Thornton Insight: The preamble to the final regulations offers several specific restrictions on whether the IRS will consider separate trades or businesses to exist, but these rules are not actually in the regulations themselves, even as examples. The language of the regulations provides almost no guidance on the determination of trade or business besides the reference to Section 162, which leaves some uncertainty. The trade or business determination is especially important because a trade or business is required to qualify for the deduction, and taxpayers with SSTBs may seek to establish that such SSTBs are separate trades or businesses for any qualifying activities.
Wage and asset test For taxpayers over the income threshold, the deduction for QBI is limited to the greater of either (1) 50% of the owner’s allocable share of W-2 wages paid by the business or (2) 25% of those W-2 wages share plus 2.5% of the owner’s allocable share of the unadjusted basis immediately after acquisition (UBIA) of qualified property.

Qualified property includes all depreciable tangible property used to generate QBI for which the depreciable period is not finished, but applying a minimum depreciable period of 10 years. UBIA is determined on the day the property is placed is service and is generally defined as cost basis under Section 1012.

The final regulations include several notable changes to the determination of UBIA. Under the final regulations, a partner’s share of UBIA in qualified property is allocated in accordance with how depreciation would be allocated on the last day of the taxable year for Section 704(b) purposes. The final regulations removed all Section 704(c) allocation treatment that the proposed regulations had included. The IRS also adjusted the UBIA rules for owners who contribute property to a partnership or S corporation in a nonrecognition transaction, providing that the property will generally retain its UBIA on the date it was placed in service, with adjustments for any amounts received or paid. Similar rules will apply for a Section 1031 like-kind exchange. Perhaps most favorably, the IRS agreed to allow basis adjustments under Sections 743(b) to be treated as qualified property to the extent the adjustment represents an increase in the fair market value of the underlying qualified property. A Section 734(b) adjustment, however, is not considered an acquisition of qualified property under the final regulations.

Grant Thornton Insight: The final regulations retain a rule that allows taxpayers with multiple trades or businesses to net negative QBI amounts against positive amounts on a pro rata basis before applying the wage an asset test. The Joint Committee on Taxation released a general explanation of TCJA (commonly referred to as the “Bluebook”) that indicated the statute was actually intended to require the taxpayer to reduce total QBI negative QBI amounts after any reductions for the wage and asset tests. The IRS had already submitted the final regulations to the Office of Management and Budget for review by the time the Bluebook was released, but the IRS presumably could have pulled them to take the less favorable JCT approach if desired.
Aggregating activities for the wage and asset test The IRS has provided rules to allow taxpayers to elect to aggregate activities that would be considered separate trades or businesses under Section 162 into a single trade or business for purposes of the asset and wage tests. Trades or businesses may be aggregated under the proposed rules if the following four requirements are satisfied:

  • Each aggregated trade or business itself rises to the level of a trade or business
  • The same group of persons owns a majority interest in each of the businesses for the majority of the year
  • None of the aggregated business are SSTBs
  • All of the businesses share the same taxable year
  • The aggregated businesses meet two of the following three factors:
    • Same or similar products or products customarily provided together
    • Share facilities or centralized business elements (like back-office functions)
    • Operated in coordination with or reliance on the other businesses

Thanks to numerous requests, the final regulations allow this aggregation election to be made at the entity, as well as the individual level. Taxpayers are not required to aggregate, and the final regulations provide that failure to aggregate is itself not an aggregation election. This means that taxpayers who decline to aggregate in one year can still elect to aggregate in future years. The election generally cannot be made on an amended return, except for the 2018 taxable year. However, once aggregated, taxpayers cannot change the election unless there is a material change in circumstances such as the acquisition of a new business.

Grant Thornton Insight: The aggregation rules provide helpful flexibility. The ability to aggregate at the entity level should reduce the administrative burden for some taxpayers. However, there is some question as to how generously the IRS will interpret its standards for aggregation. The final regulations include an example in which commercial and residential rental activities cannot be aggregated because they are considered different activities, a surprising and unfavorable interpretation.
Disqualified activities The statute provides a specific list of SSTB activities that do not qualify for the pass-through deduction, and many of these were interpreted fairly narrowly by the proposed regulations. The final regulations generally retain most of definitions of these activities, with some notable exceptions:

  • Health – The final regulations add an example that illustrates how an assisted living facility providing services not directly related to a medical field can qualify for the deduction. The final regulations also decline to remove veterinary practices from the definition of health services.
  • Consulting – The final regulations provide that certain staffing firms will not be considered consulting. In addition, architects and engineering activities will not be considered consulting.
  • S corporation banks – The IRS declined to provide a blanket exception from the SSTB rules for banking, but did make it easier for S corporation banks to avoid being designated an SSTB. Under the final regulations, originating and selling a loan is not considered dealing in securities. In addition, taking deposits, making loans and entering into financing contracts is not considered a financial service. S corporation banks that perform investing and investment management could still be considered an SSTB, but could also separate these activities into a separate trade or business.

Anti-abuse and de minimis rules for SSTBs The final regulations retain an unfavorable “cliff” rule that treats an entire trade or business as an SSTB when only a minimal amount of actual gross receipts are derived from SSTB activities. Under the final regulations, a trade or business with up to $25 million in gross receipts can have no more than 10% of its gross receipts from an SSTB activity before it is considered an SSTB. If gross receipts are greater than $25 million, the allowance is just 5%.

However, taxpayers have the opportunity to plan around this cliff rule. In certain circumstance, taxpayers may be able to separate two or more activities into separate trade or businesses and thereby segregate SSTB activities in a manner that allows other non-SSTB activities to qualify for the deduction. The final regulations remove two proposed anti-abuse rules that would have made this type of planning more difficult. These discarded rules would have designated an otherwise qualified trade or business as an SSTB if it shared 50% common ownership with an SSTB and provided 80% or more of its services to the SSTB or shared expenses with the SSTB and its gross receipts were no more than 5% of the combined gross receipts. Under the final regulations, there are no rules that recharacterize an otherwise qualified activity as an SSTB based on its relationship to an SSTB, but a qualified business is not eligible for the deduction on revenue from providing property or services to an SSTB with 50% or more common ownership.

Grant Thornton Insight: The ability to separate SSTB activities from qualified activities presents an excellent planning opportunity. To benefit, taxpayers would need to establish truly respected separate trades or businesses, and the qualified activity would need to be receiving revenue from unrelated sources. The rules will not provide a benefit for carving out qualified services that are simply provided back to a related SSTB.
Next steps Taxpayers now have final rules that resolve most of the technical issues created by Section 199A, as well as new proposed regulations and safe harbors. Although taxpayers sought better results on a handful of issues, the guidance as a whole is favorable. Taxpayers should analyze the rules for opportunities to structure investments and activities in beneficial ways. In addition, taxpayers should determine if they would benefit from making any elections on their 2018 returns, such as aggregating trade or business activities. Partnerships and S corporations should prepare to fulfill the reporting obligations needed at the entity level for owners to claim the deductions.

For more information contact:
Grace Kim
Principal
Washington National Tax Office
T +1 202 521 1590

Jose Carrasco
Senior Manager
Washington National Tax Office
T +1 202 521 1552

Dustin Stamper
Managing Director
Washington National Tax Office
T +1 202 861 4144
 
Bryan Keith
Managing Director
Washington National Tax Office
T +1 202 861 4116
To learn more visit gt.com/tax

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