The Treasury Department recently issued proposed regulations that address the flow through of qualified business income to shareholders of Regulated Investment Companies (RICs) for purposes of Section 199A. This section of the Tax Cuts and Jobs Act (TCJA) allows for up to a 20% deduction on qualified business income from flow-through entities. However, one important area still in question is the treatment of qualified Publicly Traded Partnership (PTP) income for RICs and RIC shareholders.
Section 199A and the Blue Book
The TCJA provides that dividends from REITs and income from PTPs qualify for the 20% deduction. Section 199A describes qualified publicly traded income as the taxpayer’s allocable share of each qualified item of income, gain, deduction and loss from any PTP that is not taxed as a corporation plus any gain on disposition of the partnership interest that is treated as ordinary income under Section 751.
However, the way the TCJA was written created uncertainty as to whether a shareholder of a RIC that invests in REITs or PTPs would actually receive the 20% deduction. The intent became clear when the Joint Committee on Taxation released its explanatory “Blue Book” in December 2018. It states the intent of the TCJA was to treat an individual shareholder of a RIC that holds REITs or PTPs as if the shareholder held the investments directly, to the extent the income received by the RIC is qualified REIT dividends or qualified PTP income.
RIC Income from PTPs and Concerns Regarding Conduit Treatment
The preamble to the regulations provides further detail on the applicable calculations and reporting of REIT dividends. However, neither the preamble nor the proposed regulations provides for a conduit treatment of the deduction for qualified business income from PTPs to shareholders of a RIC.
>> Read a full discussion on proposed regulations for RICs holding REITs in “Proposed Regs Allow RICs to Pass REIT Income to Shareholders and Take Advantage of 20% Deduction.”
According to the Treasury Department and the IRS, unlike conduit treatment for qualified REIT dividends, qualified PTP income presents several complex issues for RICs and RIC shareholders that need to be addressed in drafting of regulations permitting conduit treatment. The Treasury Department and IRS are seeking public comments on how to address these issues.
Many of the issues described in the preamble relate to the concept of specified service trade or business (SSTB), as defined under Section 199A(d)(2). SSTB is a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees. Certain PTPs, especially financial-services based PTPs, may fall under the definition of an SSTB. Taxpayers receiving an allocation of income from an SSTB are only eligible for a deduction under Section 199A if the taxpayer’s taxable income before the Section 199A deduction is below the threshold amounts. For 2018, the Section 199A deduction for income from SSTBs begins to phase out at $315,000 of taxable income for married filing joint taxpayers ($157,500 for single) and fully phases out at $415,000 of taxable income ($207,500 for single).
The SSTB rules put RIC shareholders in an interesting situation where, depending on income levels, the income from a PTP may be eligible for the Section 199A deduction for one shareholder but not eligible for deduction by another. The Treasury and IRS believes there is no precedent for providing conduit treatment for a RIC in this manner, and the complexity may arguably go against the relative historic simplicity of taxation for RIC shareholders.
In addition, the treatment of losses for purposes of Section 199A may create challenges for RICs. These include:
- The inability to net losses from a SSTB against income from a non-SSTB (and vice versa),
- Carryover rules related to Section 199A losses,
- The interplay of losses inside the RIC and the payment of dividends to shareholders,
- The requirement to separate losses from each PTP, and
- The potential ability to offset losses from PTPs against qualified REIT dividends received.
Finally, Treasury and the IRS expressed concern that providing conduit treatment for qualified PTP income would also be conflicting with the general treatment of RICs as blockers to effectively connected income for non-U.S. RIC shareholders and unrelated business taxable income for tax exempt RIC shareholders. For PTP income to qualify for purposes of the 20% deduction, Section 199A(c)(3)(A)(i) requires that such income must be effectively connected with a U.S. trade or business. It is unclear if such treatment for qualified PTP income through a RIC would result in undesirable effects for some shareholders. In particular, the concern is that the conduit treatment of qualified PTP income would negate the blocker treatment of the RIC structure.
Considerations for Qualified PTP Income and Request for Comments
While the uncertainty regarding qualified PTP income treatment for Section 199A in a RIC structure will not be resolved in a timely manner for the issuance of the 2018 Forms 1099-DIV to investors, there will be further developments in the area. If Treasury and the IRS could overcome some of the concerns mentioned above, the potential tax benefits to shareholders of RICs with substantial PTP exposure could be significant. The Treasury Department and the IRS will continue to consider the appropriateness of conduit treatment of qualified PTP income and is seeking commentary on the issue, and in particular with regards to:
- Whether RICs have sufficient qualified items of PTP income, gain, deduction or loss to warrant a conduit regime that would permit RICs to pay qualified PTP dividends to shareholders;
- How to provide conduit treatment for qualified PTP income for taxpayers with income below the threshold amount or within the phase-out range, particularly where a RIC has qualified REIT dividends and a qualified PTP loss from an SSTB;
- How a RIC would treat losses of PTPs arising from SSTBs and non-SSTBs;
- Whether conduit treatment for qualified PTP income can be disregarded for purposes of determining the effectively connected income or unrelated business taxable income of certain RIC shareholders;
- Whether SSTB items are sufficiently rare or incidental for PTPs that a conduit regime for PTP income related dividends should exclude all SSTB items; and
- How to implement conduit treatment for qualified PTP income in a way that is consistent with the policy goal of preserving the overall relative simplicity of the tax treatment of investors in RICs while still achieving the policy goals of section 199A.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
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