Final Regulations Issued on the Qualified Business Deduction - IRC Sec. 199A
The much-anticipated IRC Sec. 199A final regulations have been released. Along with the final regulations, IRS Notice 2019-07 was released to answer some of the lingering questions on whether rental real estate is a trade of business and therefore eligible for the qualified business income (QBI) deduction.
The final regulations adopted most of the provisions contained in the proposed regulations with a few exceptions. The final regulations, along with the commentary, encompassed a whopping 247 pages. But they did provide some insight and clarity on some of the most pressing issues in applying IRC Sec. 199A, which the proposed regulations failed to do. The final regulations added some new provisions and struck out some. Provided below is a summary of the provisions contained in the final regulations.
Revisions to “Crack-n-Pack” Strategy
After IRC Sec. 199A was initially passed, taxpayers and practitioners alike contemplated a strategy to separate out parts of what otherwise would be an integrated specified service trade or business (SSTB), such as the administrative functions, in an attempt to qualify those separated parts for the pass-through deduction. The proposed regulations contained an anti-abuse provision whereby an SSTB includes any trade or business that 1) provides 80% or more of its property or services to an SSTB; and 2) if there is 50% or more common ownership of the trades or businesses. Under this provision, if the amount of property or services provided exceeded 80%, 100% of the income was tainted as an SSTB.
Example: Law Firm AB is a partnership that provides legal services and employs its own administrative staff. Law Firm AB divides into two partnerships, Law Firm A and Admin Staff B. Law Firm A provides legal services to clients. Admin Staff B employs the administrative staff and through a contract with Law Firm A provides administrative services to Law Firm A, which comprises 82% of Admin Staff B’s total revenue (18% of revenue is to an unrelated law firm). Law Firm A and Admin Staff B have the same owners.
Under the proposed regulations, 100% of Admin Staff B’s income would be considered an SSTB and therefore ineligible for the QBI deduction, since the 80% threshold above was exceeded. Treasury viewed this as very harsh and, accordingly, in the final regulations removed the 80% threshold.
Assuming the same facts as the example above, under the final regulations, 18% of Admin Staff B’s taxable income would be considered non-SSTB and therefore eligible for the QBI deduction.
Specified Service Trade or Business (SSTB)
The proposed regulations described which SSTB’s are ineligible for IRC Sec. 199A. The final regulations provide further clarity on what is or isn’t an SSTB. Examples include:
- The sale of pharmaceutical and medical devices by a retail pharmacy is not by itself a trade or business performing services in the field of health (not an SSTB).
- For purposes of IRC Sec. 199A, veterinary services are considered the performance of services in the field of health (SSTB).
- Physical therapists are still within the field of health (SSTB).
- The final regulations remove the requirement that medical services be provided directly to the patient (SSTB).
- For example, a radiologist who may not be patient-facing would still be ineligible for IRC Sec. 199A.
- The final regulations clarify that the provision of financial services does not include taking deposits or making loans (not an SSTB).
- The Treasury Department and the IRS declined to define investment for purposes of IRC Sec. 199A, but noted that commission-based sales of insurance policies generally will not be considered the performance of services in the field of investing and investing management.
Safe Harbor – Rental Real Estate
For decades, the IRS has declined to define when a rental real estate operation rises to the level of a trade or business. The IRS issued Notice 2019-07, which created a safe harbor for purposes of IRC Sec. 199A. If the qualifications are met, the operations would be deemed a trade for business for the QBI deduction. The IRS notice states, however, that if an enterprise fails to satisfy the requirements of this safe harbor, the rental real estate enterprise may still be treated as a trade or business for purposes of IRC Sec. 199A if the enterprise otherwise meets the definition of trade or business. To meet the safe harbor, the following requirements must be satisfied:
- Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
- For taxable years beginning prior to 1/1/2023, 250 or more hours of rental services are performed per year with respect to the rental enterprise;
- For taxable years beginning after 12/31/2022, in any three of the five consecutive taxable years that end with the taxable year, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise; and
- The taxpayer maintains records – including time reports, logs, or similar documents – regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services.
Rental services for purpose of this revenue procedure include:
- Advertising to rent or lease the real estate;
- Negotiating and executing leases;
- Verifying information contained in prospective tenant applications;
- Collection of rent;
- Daily operation, maintenance and repair of the property;
- Management of the real estate;
- Purchase of materials; and
- Supervision of employees and independent contractors.
Most importantly, rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners.
The term rental services does not include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate.
The taxpayer must attach a statement to the tax return stating the requirements of the safe harbor have been met.
Note: Real estate leased under a triple net lease is not eligible for the safe harbor.
De Minimis Rule
The proposed regulations stated that for a trade or business with gross receipts of $25 million or less for the taxable year, a trade or business is not an SSTB if less than 10% (5% more than $25 million of gross receipts) of the gross receipts of the business are attributable to a specified service field. If an entity “failed” this test, the entire income of the entity would be tainted and, therefore, not eligible for the QBI deduction. The final regulations and preamble to the final regulations addressed this issue. If the entity has separate or “separable” books/records and separate employees, it will generally not taint all the receipts (if the de minimis limit is exceeded). In a revised document, the IRS changed the wording contained in the preamble from separate to separable. A truly separate set of books and records is a much higher bar than merely separable.
Example: Animal Care LLC provides veterinarian services and also develops and sells its own line of organic pet food at its clinic. The veterinarian services are considered to be the performance of services in the field of health. Animal Care LLC separately invoices for its veterinarian services and the sale of its organic dog food. Animal Care LLC maintains separate books and records for its veterinarian clinic and its development and sale of its dog food. Animal Care LLC also has separate employees who are unaffiliated with the veterinary clinic and who only work on the formulation, marketing, sales and distribution of the organic dog food products. Animal Care LLC treats its veterinary practice and the dog food development and sales as separate trades or businesses for purposes of IRC Sec. 162 and 199A. Animal Care LLC has gross receipts of $3 million; $1 million of the gross receipts is attributable to the veterinary services, an SSTB.
Under the proposed regulations, all of the income from Animal Care LLC would be considered an SSTB. Under the final regulations, although the gross receipts from the services in the field of health exceed 10% of Animal Care LLC’s total gross receipts, the dog food development and sales business is not considered an SSTB since the veterinary practice and the dog food development and sales are considered separate trades or businesses under IRC Sec. 162.
The de minimis threshold is applied to each trade or business of an entity separately, not in the aggregate to all the trades or businesses of the entity. Therefore, to the extent that an entity has more than one trade or business, the presence of a specified service activity in one of those trades or business will not cause the entity’s other trades or businesses to be considered SSTBs.
Incidental to a SSTB
The proposed regulations contained an anti-abuse provision that disqualified a non-SSTB business in the situation where you had 1) two businesses – one SSTB and one non-SSTB; 2) businesses had at least 50% common ownership; 3) both businesses share expenses; and 4) the non-SSTB business’ gross receipts were 5% or less of the combined gross receipts. The classic example in the proposed regulations was the eye doctor who sells eye glasses. Good news to all those eye doctors; the final regulations eliminated this rule!
Generally, the QBI deduction is computed for each of the taxpayers' qualified businesses. However, taxpayers with more than one business can aggregate those businesses and determine the deductible amount for the aggregated business if the following requirements are met:
- The same person or group of persons owns (directly or indirectly) 50% or more of each trade or business for a majority of the tax year. Lineal family attribution applies.
- The items of each trade or business are reported on tax returns with the same tax year (not taking into account short tax years).
- None of the businesses are an SSTB.
- Based on the facts and circumstances, the trades or businesses satisfy at least two of the following factors: (a) they provide products and services that are the same or customarily offered together; (b) they share facilities, personnel or other business resources; and (c) they operate in coordination with, or reliance upon, each other (for example, supply chain interdependencies).
Aggregation is allowed but not required. Taxpayers (individuals, trusts or estates) choosing to combine two or more businesses must consistently do so in all future tax years (unless there is a change in the facts and circumstances). Aggregating businesses allows the taxpayer to treat the aggregated group as a single business for purposes of calculating QBI and applying the wage/investment limit. It can allow an individual with high taxable income to claim a larger QBI deduction when otherwise subject to the wage/investment limit. For example, aggregating one business with substantial QBI but little or no W-2 wages and another business with minimal QBI but considerable W-2 wages can result in a substantial QBI deduction, while keeping them separate would result in a lower deduction or even no deduction.
Under the final regulations, the following modifications have been made:
- For the 50% ownership rule, IRC Secs. 707(b) and 267(b) were added. This now allows brother/sister attribution.
- An attribution election can now be made at the entity level if the entity meets the provisions of #4 above. Note: If an entity makes an aggregation election, it is binding on all shareholders and partners.
- For the 2018 tax year only, an aggregation election can be made on an amended tax return.
Employees and Independent Contractors
Income from W-2 wages are specifically excluded from being eligible QBI income. When IRC Sec. 199A was written into law, there was speculation whether an employee can convert to independent contractor status and claim the QBI deduction. The proposed regulations quashed this idea and stated if the same relationship exists between an employer and the person, they will be presumed to be an employee, disqualifying the person’s wages from being taken into account for QBI. The final regulations take this rule a step further and state that if a person changes to independent contractor status for their employer, they will be under the presumption of being an employee for a period of three years from the change in status.
The presumption above can be overturned if the employee-turned-independent contractor can prove a true independent contractor relationship exists between the person and the company.
Suspended Losses and QBI
The regulations state that losses or deductions disallowed in a prior year will be taken into account for purposes of computing QBI under IRC Sec. 199A in the current year. The freed-up losses will be used on a first-in first-out (FIFO) basis. It is important to keep in mind that losses or deductions that were disallowed, suspended, limited or carried over from taxable years ending before January 1, 2018 (under IRC Secs. 465, 469, 704(d), and 1366(d)), are not taken into account in a later taxable year for purposes of computing QBI.
IRC Sec. 743(b) Step-Up Adjustment and UBIA
The proposed regulations did not allow either IRC Sec. 743(b) or IRC Sec. 734(b) step-up adjustments to count toward computing the unadjusted basis for immediately after acquisition known as UBIA. The final regulations took a partial 180 and now allow an incoming partner to count an IRC Sec. 743(b) adjustment as UBIA. However, there was a drafting error in final regulations that seemed to allow a partnership’s prior depreciation to count as additional UBIA. Note: This was addressed and fixed in a corrected version of the final regulations.
Reliance on Proposed Regulations for 2018 Tax Year
IRC Sec. 199A final regulations were issued on January 18, 2019. The IRS recognized that the final regulations were issued late and, therefore, taxpayers may rely on the proposed regulations or the final regulations for the taxable years ending in calendar-year 2018.