Final Regulations on 20% Pass-Through Deduction Resolve Various Uncertainties
IRS and Treasury have released final regulations under Sec. 199A of the Internal Revenue Code (Code) regarding the 20% deduction for pass-through entities and certain individuals. The final regulations clarify important definitions, discuss computational issues, and provide anti-avoidance guidance. The final regulations also contain an anti-avoidance rule under Sec. 643 to treat multiple trusts as a single trust in certain cases, which will affect trusts and their beneficiaries.
Section 199A was added to the Code by the Tax Cuts and Jobs Act (TCJA). The new provision provides a deduction of up to 20% of income from a domestic trade or business operated as a sole proprietorship or through a partnership, S corporation, trust or estate. Only items attributable to a qualified trade or business are taken into account in determining the Sec. 199A pass-through deduction. Eligible taxpayers may claim the 20% deduction for the first time on their 2018 federal income tax returns. IRS and Treasury released the first set of proposed regulations under the new provision in August 2018. For more information on the initial proposed regulations under Sec. 199A, please see our prior Tax Release. Section 199A is effective for tax years beginning after December 31, 2017 and before January 1, 2026.
The final regulations modify and expand upon a variety of issues related to the new deduction. The Preamble to the final regulations addresses many of the comments that were received in response to the proposed regulations and provides significant insight into IRS and Treasury’s approach with respect to the new deduction. Below is a discussion of some of the areas where the final regulations provide new guidance:
- Qualified Items of Income, Gain, Deduction, and Loss – The final regulations add a definition of net capital gain for purposes of determining a taxpayer’s 20% limitation under Sec. 199A. The definition is consistent with the meaning provided in Sec. 1222(11) plus any qualified dividend income for the taxable year. Thus, a net Sec. 1231 gain is not treated as qualified business income. A hedging rule provides that income, deduction, gain, or loss from certain hedging transactions is trade or business income for purposes of the deduction. Payments under Sec. 707(a) or (c) to a partner for services are excluded, even where the service provider is engaged in its own separate trade or business.
- Relevant Passthrough Entity (RPE) – The proposed regulations provided that a trust or estate would be treated as an RPE to the extent it passes through qualified business income, W-2 wages, unadjusted basis immediately after acquisition (UBIA) of qualified property, qualified real estate investment trust (REIT) dividends or qualified publicly traded partnership (PTP) income. The final regulations state that other passthrough entities are also RPEs if they file Form 1065, U.S. Return of Partnership Income, and are owned, directly or indirectly, by at least one individual, estate, or trust. In addition, trades or businesses conducted by a disregarded entity (DRE) will be treated as conducted directly by the owner of the entity for purposes of Sec. 199A.
- Trade or Business – As with other administrative guidance offered in connection with several other tax reform changes, the final regulations adopt the Sec. 162 definition of a trade or business as the most appropriate standard for the Sec. 199A deduction. The Preamble to the final regulations acknowledges the significant uncertainty involved in using the Sec. 162 definition. In short, a facts and circumstances analysis under existing case law is necessary.
- Rental Real Estate Activities – Significant uncertainty exists regarding the trade or business treatment of rental real estate activities due to divergent case law. The final regulations decline to offer bright-line rules but present a non-inclusive list of relevant factors that may help to determine whether a rental real estate activity is a Sec. 162 trade or business. Notice 2019-7, released concurrently with the final regulations, details a proposed safe harbor to treat a real estate enterprise as a trade or business for purposes of Sec. 199A if at least 250 hours of rental services are performed each taxable year with respect to the enterprise. Each enterprise could include multiple similar properties. However, commercial and residential properties cannot be part of the same enterprise. Further, rental of a residence with more than 14 days of personal use or rental of property under a triple net lease are not eligible enterprises for the safe harbor. Failure to meet the safe harbor does not preclude the taxpayer from otherwise establishing that a rental real estate activity is a Sec. 162 trade or business.
- Renting Property to Related Persons – A special exception in the proposed and final regulations extends the definition of trade or business with respect to rental or licensing of tangible or intangible property to a related trade or business where the rental activity and other trade or business are commonly controlled. The final regulations limit this exception to scenarios in which the related party is an individual or an RPE (not a commonly controlled C corporation).
- Specified Service Activities Within an Entity – The final regulations clarify that specified service activities that exceed a 5% of gross receipts (10% for businesses with gross receipts under $25 million) de minimis threshold will disqualify the entire business from the Sec. 199A deduction. Taxpayers with greater than de minimis specified service activities should consider whether the activity can be segregated into a separate trade or business to avoid disqualification of the qualified activities. The final regulations analyze and provide examples of situations where a taxpayer may be operating multiple trades or businesses within a single entity and discuss specific circumstances in which trades or businesses will not be considered separate and distinct. Two key factors identified in the examples in the final regulations are 1) maintenance of separate books and records for each business line, and 2) each business line has separate employees who are unaffiliated with the specified service activity. Reasonable methods for allocation of items among multiple trades or businesses are also discussed.
- Definition of Listed Specified Service Trades or Businesses – The nuances of what is in or out of certain specified service activities (i.e., health, performing arts, athletics, consulting, financial services, reputation/skills) are addressed in more detail in the examples contained in the final regulations. The final regulations clarify that the definition of performing arts includes writing for a performing art (e.g., screenplay or song) and film production. The final regulations also clarify that consulting in the fields of engineering and architecture is not a specified service trade or business.
- Asset Unadjusted Basis Limitation – The final regulations include modifications to the determination of the unadjusted basis immediately after acquisition (UBIA) limitation in the case of a Sec. 1031 exchange, a Sec. 1033 conversion, or a Sec. 168(i)(7) carryover basis transaction (such as a contribution of property to an RPE). In general, the rules allow the transferor’s UBIA to carry over, rather than resetting UBIA to be equal to the tax basis in the property. In addition, a Sec. 743 step-up pursuant to a Sec. 754 election creates additional UBIA to the extent it exceeds the original UBIA of the property. For property acquired from a decedent and immediately placed in service, the UBIA generally will be its fair market value at the time of the decedent’s death.
- Aggregation Election – The final regulations offer an expansion of the aggregation rules, allowing RPEs to make an aggregation election for multiple trades or businesses operated within the entity or for businesses operated through lower-tiered RPEs where the aggregation requirements are met. Aggregated trades or businesses are reported on a combined basis and the aggregation is binding upon the ultimate owners. The individual or upper-tiered RPE may aggregate additional trades or businesses with the lower-tiered RPE’s aggregation if the aggregation rules are otherwise satisfied. Whereas the proposed regulations provided rules to allow aggregation of trades or businesses on a 50% ownership test that must be maintained for the majority of the taxable year, the final regulations clarify that this must include the last day of the taxable year. The final regulations expand the related party attribution rule to include attribution under Secs. 267(b) and 707(b). Thus, familial attribution, including siblings, spouse, ancestors, and lineal descendants is permitted. In addition, the final regulations make it clear that there is no de minimis standard to otherwise allow aggregation. An aggregation election may be made in 2018 on an original or amended tax return, or in a future year on an original tax return. Thus, taxpayers could wait to make aggregation elections until after 2018, but once made, the elections are binding for all future years.
- Application to Trusts and Estates – The final regulations clarify the application of Sec. 199A to trusts and estates. The inclusion of trust distributions in taxable income is addressed, as well as the allocation of the deduction between trust or estate and beneficiaries. Consistent with the proposed regulations, Sec. 1.643(f)-1 provides that taxpayers cannot set up multiple trusts in certain cases with a principal purpose of tax avoidance, which includes the avoidance of the statutory threshold amounts under Sec. 199A. A charitable remainder trust beneficiary’s eligibility for the deduction is addressed in the new set of proposed regulations issued concurrently with the final regulations, which provide that the beneficiaries of a charitable remainder trust are eligible for the Sec. 199A deduction on their shares of distributed qualified income. However, the charitable remainder trust itself is not eligible for a Sec. 199A deduction.
IRS and Treasury declined to address many comments in the final regulations that they said were better determined under other relevant Code sections or were beyond the scope of the regulatory guidance.
Concurrently with the publication of final regulations, IRS released Rev. Proc. 2019-11, which finalizes the revenue procedure proposed in Notice 2018-64 on methods for calculating W-2 wages. As mentioned above, IRS also issued Notice 2019-7 proposing a safe harbor (based on hours worked and recordkeeping procedures) for determining when rental real estate activities rise to the level of a trade or business for purposes of Sec. 199A. IRS and Treasury also released another set of proposed regulations that taxpayers may rely on until final regulations are published. The proposed regulations provide for separate trade or business tracking of previously suspended losses that constitute qualified business income on a first-in, first-out basis. The proposed regulations allow the 20% deduction related to REIT dividends to be taken by shareholders who hold those interests through a Regulated Investment Company (RIC). Whether a similar treatment could be applied to PTPs presents novel issues and continues to be under consideration.
Business owners now have additional clarity for determining if they qualify for the new Sec. 199A deduction, and how to claim the deduction on their tax returns. The rules are complex and will require planning to ensure proper compliance and to obtain the greatest benefit from the new deduction. Because the final regulations are generally not applicable for 2018, the Preamble provides that taxpayers may rely on either the final or proposed regulations for taxable years ending in calendar year 2018. Either the proposed or final regulations must be used in their entirety, cherry-picking aspects of each set of regulations is not permissible.