IRC Sec. 199A: What You Always Wanted To Know
At long last, the Treasury has released final IRC Sec. 199A regulations.
Here are highlights on IRC Sec. 199A, also known as the 20% pass-through deduction or qualified business income (“QBI”) deduction.
IRC Sec. 162 Trade or Business
In order to receive the 20% deduction, your business must rise to the level of an IRC Sec. 162 trade or business. There is no statutory or regulatory definition of a “trade or business.” As such, we must refer to the courts. In Higgins v. Commissioner, the Supreme Court stated that determining whether a trade or business exists requires an examination of facts in each case. In Commissioner v. Groetzinger, the Supreme Court provided two requirements: (1) Taxpayer’s primary purpose for engaging in the activity must be for profit (“profit motive”); and (2) Taxpayer must be involved in the activity with “continuity” and “regularity.”
IRC Sec. 199A does not require that an individual materially participate in the IRC Sec. 162 trade or business. Rather, IRC Sec. 199A is dependent on whether the individual has QBI from a trade or business.
IRC Sec. 162 Exception: You can treat your commonly controlled self-rental as an IRC Sec. 162 trade or business for purposes of the IRC Sec. 199A deduction.
Real Estate Safe Harbor
A rental real estate enterprise is eligible for the 20% deduction provided it meets these safe harbor requirements: (1) maintains separate books and records for each rental real estate enterprise; (2) has 250 or more hours of rental services performed annually (may be performed by owners, employees, agents, and/or independent contractors of the owners) with respect to the rental real estate enterprise; and (3) maintains contemporaneous records, including time reports, logs or similar documents providing hours, dates and descriptions of all services performed and who perforExmed the services.
For the safe harbor, you must either treat each rental property as a separate enterprise or treat all similar rental properties as a single enterprise. Commercial and residential real estate cannot be part of the same enterprise. Here’s what is ineligible for the safe harbor:
- Triple net leases.
- Property held in a real estate partnership or any multiple-member entity. The safe harbor is only available if you own the property directly or through a disregarded entity, such as a single-member LLC.
- Property used by taxpayer as a residence during any part of the year.
If you do not meet the safe harbor, you can still treat your rental real estate enterprise as a trade or business, provided your business rises to the level of an IRC Sec. 162 trade or business. The final regulations do not provide factors for making this determination; however, here are several factors from the law external to the final regulations to help determine whether you have a trade or business in the context of real estate:\
- Type of rented property (commercial real property versus residential property).
- Number of properties rented.
- Owner’s (or his/her agent’s) day-to-day involvement.
- Types and significance of any ancillary services provided under the lease.
- Terms of the lease (e.g., net versus traditional, short-term versus long-term).
Hedge Funds: Trader Versus Investor
If you are a trader fund, you meet the criteria as an IRC Sec. 162 trade or business. However, you also fall into the “field of trading,” which is a specified service trade or business (“SSTB”). Additionally, any investment-type income from the trader fund will retain its character. Therefore, it will not be treated as QBI.
If you are an investor fund, you do not meet the criteria as an IRC Sec. 162 trade or business, nor does it matter, because your income will be investment-type income, and consequently, it will not be treated as QBI.
Specified Service Trade or Business
If your business is an SSTB and your taxable income exceeds $415,000 for married filing jointly and $207,500 for all others, view the SSTB chart below to determine if you are eligible for the deduction.
One Entity with Multiple Service Lines
Under the statute, what do you do when one business offers a mix of non-SSTB and SSTB services? The regulations addressed this with the creation of a de minimis rule. You are not an SSTB if gross receipts are $25mm or less, and less than 10% of those gross receipts are attributable to the performance of specified services; or gross receipts are more than $25mm, and less than 5% of those gross receipts are attributable to the performance of specified services.
Example 1 – ABC LLC sells computer equipment (non-SSTB service) and also provides advice and counsel for business marketing (SSTB service). ABC LLC has gross receipts of $2mm and $50,000 of it is attributable to the SSTB service. Because SSTB revenue is less than 10% of total revenue, none of it is treated as SSTB revenue.
Example 2 – Assume the same facts as Example 1, except that $500,000 of it is attributable to the SSTB service. Because SSTB revenue is 10% or more of total revenue, 100% of it is treated as SSTB revenue.
One Entity with Multiple Trades or Businesses
An entity can have more than one IRC Sec. 162 trade or business Whether a single entity has multiple trades or businesses is a factual determination. Consider these factors when making this determination:
- Maintains separate books and records for each business.
- Separates employees who are unaffiliated with the other business.
- Separately invoices for its services and/or sales for each business.
- Operates each business separate and distinct.
Example 3 – Assume the same facts as Example 2, except that ABC LLC maintains separate books and records, employees, invoices and operations for its computer equipment business (non-SSTB) and its consulting business (SSTB). Although SSTB revenue is 10% or more of ABC LLC’s total revenue, the computer equipment business is not considered an SSTB due to the fact that it is a separate trade or business under IRC Sec. 162; while the consulting business is deemed to be an SSTB since it’s in the “field of consulting.”
Multiple Entities with Common Ownership
Per the statute, what do you do when multiple related businesses have a structure with one or more non-SSTBs and one or more SSTBs? The regulations came up with an “anti-crack and pack” rule. In this rule, a portion of your non-SSTB is treated as SSTB if non-SSTB has 50% or more common ownership with an SSTB and non-SSTB provides property or services to an SSTB. Common ownership includes direct or indirect ownership by related parties within the meaning of IRC Secs. 267(b) or 707(b).
Example 4 – Law Firm is an S corporation that provides legal services, owns its own office building, and employs its own administrative staff. Law Firm divides into three S corporations (crack and pack). S1, an SSTB, performs legal services. S2 owns the office building and rents the entire building to S1. S3 employs the administrative staff and through a contract with S1 provides administrative services to S1 in exchange for fees. Because S2 and S3 have 50% or more common ownership with an SSTB, S2 provides its entire property to an SSTB, and S3 provides all of its services to an SSTB, all three businesses are treated as SSTBs.
Example 5 – Assume same facts as in Example 4, except that S2 rents 85% of the building to S1 (SSTB) and 15% to an unrelated party (non-SSTB). As such, S2 is treated 85% as SSTB and the remaining 15% of S2’s leasing activities will not be treated as an SSTB. S1 and S3 are treated 100% as SSTBs since their facts did not change.
The regulations allow both individuals and relevant pass-through entities (“RPEs”) to aggregate provided they meet all five tests below:
- Control – One person, or group of persons, directly or indirectly by attribution under IRC Secs. 267(b) or 707(b), own 50% or more of each trade or business.
- Majority – The control test above must exist for a majority of the tax year and be commonly controlled on the last day of the year.
- Same-Year – All of the items attributable to each trade or business must use the same tax year, not taking into account short tax years.
- Non-SSTB – None of the trades or businesses to be aggregated are SSTBs.
- Connection – Must satisfy as least two of these three conditions: (1) Businesses provide products, property, or services that are the same, or customarily offered together; (2) Businesses share facilities or significant centralized business elements; (3) Businesses operate in coordination with, or reliance on, other businesses in the aggregated group.
Once you aggregate two or more trades or businesses, you must consistently report the aggregated trades or businesses in all subsequent years. The aggregation is irrevocable unless there is a material change in the facts and circumstances. You may add a newly created or acquired trade or business to an existing aggregated trade or business. For the 2018 tax year only, you can elect to aggregate on an amended return.
If you own a business and/or receive a pass-through Schedule K-1, contact your tax advisor for a full analysis of how these new laws might affect your business.