Section 199A Final Regulations and Other Guidance Released
On Friday, January 18, the Treasury and the IRS released final regulations regarding the new deduction permitting many owners of pass-through entities to deduct up to 20 percent of qualified business income (“QBI”), more commonly known as the Section 199A deduction. Additional guidance released concurrently with the final regulations included:
- Notice 2019-07, providing a safe harbor for rental real estate enterprises to be treated as a trade or business,
- Revenue Procedure 2019-11, which provides guidance on the available methods for calculating W-2 wages, and
- Proposed regulations (REG-134652-18) regarding the treatment of previously suspended losses and interests in regulated investment companies, charitable remainder trusts, and split-interest trusts.
The following summary highlights the impact of the final regulations and additional guidance:
Notice 2019-07 – Real Estate Safe Harbor
- A proposed revenue procedure that provides a safe harbor for real estate enterprises to be classified as a trade or business only for 199A purposes and only if the following requirements are met:
- Separate books and records and bank accounts are maintained.
- At least 250 hours of services are performed each year with respect to the enterprise.
- Services include maintenance, repairs, collection of rent, payment of expenses, tenant services, effort to collect rent, purchase of material, etc.
- Services do not include financial or investment management activities, such as arranging financing, procuring property, studying and reviewing financial statements or reports on operations, or hours spent traveling to and from the real estate.
- Taxpayer maintains contemporaneous records, including time reports, logs, or similar documents to substantiate claim.
- Explicitly ineligible for the safe harbor:
- Real estate used by the taxpayer as a residence for any part of the year.
- Triple net leases.
Definition of Net Capital Gain
- The final regulations provide a definition for net capital gains for purposes of Section 199A as the excess of net long-term capital gain for the taxable year over the net short-term capital loss for such year plus any qualified dividend income.
162 Trade or Business
- Confirms Section 199A is limited to taxpayers with income from a trade or business as defined under Section 162. The final regulations point to Higgins v. Commissioner and Commissioner v. Groetzinger for additional clarification on what constitutes a trade or business (i.e., profit motive, regular and continuous activity, etc.).
Multiple Trades or Businesses within one Entity
- Confirms 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.
- The preamble to the Final regulations stipulates that a complete and separable set of books and records must be kept for each distinguishable trade or business.
Allocation of Unadjusted Basis Immediately After Acquisition (“UBIA”) to Partners
- 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. § 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 qualified property held by an S corporation, the final regulations state that a shareholder’s share of qualified property is 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.
Like-Kind Exchanges/Involuntary Conversions/Non-Recognition Transactions
- There is no change from the proposed regulations of the depreciable period of transferred property; taxpayer will “step-in-the-shoes” of the previous taxpayer.
- UBIA of qualified like-kind property in a Section 1031 like-kind exchange is the UBIA of the relinquished property. This differs from the proposed regulations which previously stipulated the taxpayer compute UBIA based on the adjusted basis of the replacement property at the time of the exchange.
- However, if a taxpayer either receives money or property not of a like-kind to relinquish the property (other property) or provides money or other property, the taxpayer’s UBIA in the replacement property is adjusted.
- The rules are similar to an involuntary conversion under Section 1033, except that appreciation is the difference between the fair market value of the converted property on the date of the conversion over the fair market value of the converted property on the date of acquisition by the taxpayer.
- In regards to certain non-recognition transactions under Section 168, such as a Section 721 transaction, 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. This differs from the proposed regulations which stipulated 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.
Section 743(b) Basis Adjustments
- The final regulations have changed the treatment of Section 743(b) basis adjustments, which are now treated as UBIA to the extent the Section 743(b) basis adjustment reflects an increase in the fair market value of the underlying qualified property.
- Depreciable period starts when the transfer of the partnership interest occurs.
- Any losses disallowed, suspended, or limited under Sections 465, 469, 704(d), and 1366(d), or any other similar provisions, shall be used in order from the oldest to the most recent on a FIFO basis.
- The final regulations permit a relative pass-through entity (“RPE”) to aggregate trades or businesses it operates, directly or indirectly through lower-tier RPEs. Individuals must maintain these aggregated groups, if an aggregation election has been made. If applicable and meet the requirements, additional trades or businesses may be added to the passed-through aggregated group at the individual level.
- Failure to aggregate trades or businesses in the current tax year will not prohibit the taxpayer from aggregating in the future.
- For 2018 only, taxpayers will be permitted to make initial aggregations on an amended 2018 tax return.
Specified Service Trade or Business
- Songwriters, authors, screenplay writers, that are integral to the creation of a performing art, are classified as an SSTB.
- Only brokers dealing in securities as defined in Section 475(c)(2) are considered to be included within the SSTB trade or business of performing brokerage services.
- Clarification that a franchisor will not be considered an SSTB based solely on the selling of a franchise in a listed field of service.
- The final regulations specify that the definition of dealing in commodities for purposes of Section 199A is dealing in financial instruments. As such, producers, processors, grain merchants, or handles of commodities are not designated as a SSTBs.
- Second, the final regulations include a hedging rule that is applicable to any trade or business conducted by an individual or an RPE. The hedging rule provides that income, deduction, gain, or loss from a hedging transaction entered into in the normal course of a trade or business is included as income, deduction, gain, or loss from that trade or business.
SSTB Special Rules
- $25 million de minimis threshold is retained; if a taxpayer has gross receipts of $25 million or less, a trade or business is considered a SSTB if more than 10 percent of gross receipts are attributable to SSTB (5 percent if over $25 million in gross receipts).
- Modification of the anti-abuse rule stipulating that if a trade or business has 50 percent or more common ownership with an SSTB, then that and that trade or business provides 80 percent or more of its property or services to the commonly owned SSTB, then the income is treated as SSTB income. The 80 percent threshold has been removed, such that any percentage of the trade or business providing property or services to the SSTB will now be treated as SSTB income, while the remaining percentage will not be SSTB.
- The incidental to SSTB rule has been removed in the final regulations. Previously, trades or businesses that have both 50 percent common ownership and shared expenses with an SSTB would be treated as an SSTB pursuant to gross receipts thresholds.
Performing Services as an Employee
- The final regulations implemented a three year look-back starting with the date the person ceases be an employee, stating that the individual will be treated as performing services as an employee for that three-year period and would not be eligible for the Section 199A deduction on that income received. This may be rebutted by showing records, such as contracts or partnership agreements, if the individual is truly performing services in a capacity other than as an employee.
- Failure to report any item of QBI, W-2 wages, UBIA or SSTB information does not presume all items to be zero. For example, an RPE may have sufficient W-2 wages and send out that information but decline to provide information for UBIA of qualified property. This clarified some prior guidance that non-disclosure of one item may revert all remaining items to zero.
- Information can be reported on an amended or late filed return for any open tax year.
Proposed Regulations (REG-134652-18)
- The proposed regulations provide guidance on conduit treatment of qualified REIT dividends; however, the Treasury Department and the IRS continue to consider whether it is appropriate to provide for conduit treatment of qualified PTP income.
- The proposed regulations provide rules under which a Regulated Investment Company (“RIC”) that receives qualified REIT dividends may pay Section 199A dividends. A non-corporate shareholder receiving Section 199A dividends would treat them as qualified REIT dividends under Section 199A(e)(3), provided the shareholder meets the holding period requirements for its shares in the RIC.
Although Treasury and the IRS largely adopted the language provided within the 199A proposed regulations issued in August 2018, you should be aware of the updates and amendments to the language within the final 199A regulations, in addition to the additional guidance released. For example, you should now consider the RPE aggregation rules, which may impact the RPE’s reporting requirements. Please reach out to the Credits & Accounting Methods National 199A team for more information about eligibility and guidance for the Section 199A deduction.