The Tax Cuts and Jobs Act (TCJA) included a favorable deduction for businesses that operate as pass-through entities, with income that is “passed through” to owners and taxed as individual income. The IRS issued proposed regulations for the qualified business income deduction (QBID), or Section 199A deduction, in August 2018. Now, it has released final regulations and additional guidance, which provide clarity on who qualifies for the deduction and how to calculate it.
Explaining the Qualified Business Income Deduction
The QBID generally allows partnerships, limited liability companies, S Corporations and sole proprietorships to deduct up to 20% of qualified business income received. The calculation is performed for each qualified business and aggregated. If a taxpayer’s taxable income exceeds $157,500 ($315,000 for joint filers), a limit on the deduction begins phasing in. Under the limit, the deduction cannot exceed the greater of:
- 50% of the business’s W-2 wages, or
- 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified business property.
The deduction is further limited for specified service trades or businesses (SSTBs). SSTBs include, among others, businesses involving law, financial, health, brokerage and consulting services, as well as any business (other than engineering and architecture) where the principal asset is the reputation or skill of an employee or owner.
Safe Harbor Clarifications for Owners of Rental Real Estate
One of the lingering questions related to the QBID was whether it was available for owners of rental real estate. The latest guidance (found in IRS Notice 2019-07) includes a proposed safe harbor, which allows certain real estate enterprises to qualify as a business for purposes of the deduction. Taxpayers can rely on the safe harbor until a final rule is issued.
Generally, individuals and entities that own rental real estate directly meet this safe harbor if:
- Separate books and records are kept for each rental real estate enterprise;
- At least 250 hours of operational services are performed each year for the enterprise by the owner or their employees and contractors;
- For tax years after 2018, the taxpayer maintains contemporaneous records showing the hours of all services performed, the services performed, the dates they were performed and who performed them; and
- A statement affirming meeting these tests is attached to the tax return signed under penalties of perjury.
Be aware that rental real estate used by a taxpayer as a residence for any part of the year is not eligible for the safe harbor as well as property leased under a triple net lease.
Although the safe harbor is an answer to the request by many practitioners and taxpayers for clarity in when a rental business will qualify for the QBID, the bar appears to be set way higher than needed. The regulations clarify that taxpayers still may treat rentals as qualified trades or businesses based on their individual facts and circumstances.
Modifications Made to Aggregation of Business Rules
It’s not unusual for small business owners to operate more than one business. The proposed regulations include rules allowing an individual to aggregate multiple businesses that are owned and operated as part of a larger, integrated business for purposes of the W-2 wages and UBIA of qualified property limitations, thereby maximizing the deduction. The final regs retain these rules with some modifications.
For example, the proposed rules allow a taxpayer to aggregate trades or businesses based on a 50% ownership test, which must be maintained for a majority of the taxable year. The final regulations clarify that the majority of the taxable year must include the last day of the taxable year.
The final regs also allow a “relevant pass-through entity” — such as a partnership or S Corporation — to aggregate businesses it operates directly or through lower-tier pass-through entities to calculate its deduction, assuming it meets the ownership test and other tests. (The proposed regs allow these entities to aggregate only at the individual-owner level.) Where aggregation is chosen, the entity and its owners must report the combined qualified business income, wages and UBIA of qualified property figures.
A taxpayer who doesn’t aggregate in one year can still choose to do so in a future year. Once aggregation is chosen, though, the taxpayer must continue to aggregate in future years, unless there’s a significant change in circumstances.
Favorable Changes to Unadjusted Basis Immediately After Acquisition in Qualified Property
The final regs also make some very favorable changes regarding the determination of UBIA in qualified property. The proposed regs adjust UBIA for nonrecognition transactions (where the entity doesn’t recognize a gain or loss on a contribution in exchange for an interest or share), like-kind exchanges and involuntary conversions.
Under the final regs, UBIA of qualified property generally remains unadjusted as a result of these transactions. Property contributed to a partnership or S Corporation in a nonrecognition transaction generally will retain its UBIA on the date it was first placed in service by the contributing partner or shareholder. The UBIA of property received in a like-kind exchange is generally the same as the UBIA of the relinquished property. The same rule applies for property acquired as part of an involuntary conversion.
New Rules and Revised Limitations for Certain Specified Service Trades or Businesses
Many of the comments the IRS received after publishing the proposed regs sought further guidance on whether specific types of businesses are SSTBs. The IRS, however, found such analysis beyond the scope of the new guidance. It pointed out that the determination of whether a particular business is an SSTB often depends on its individual facts and circumstances.
Nonetheless, the IRS did establish rules regarding certain kinds of businesses. For example, it states that veterinarians provide health services (which means they are subject to the SSTB limits), but real estate and insurance agents and brokers do not provide brokerage services (so are not subject to the limits).
The proposed regs generally treat a business that provides more than 80% of its property or services to an SSTB as an SSTB if the businesses share more than 50% common ownership. The final regs eliminate the 80% rule. As a result, when a business provides property or services to an SSTB with 50% or more common ownership, the portion of that business providing property or services to the SSTB will be treated as a separate SSTB.
The final regs also remove the “incidental to an SSTB” rule. The proposed rule requires businesses with at least 50% common ownership and shared expenses with an SSTB to be considered part of the same business for purposes of the deduction — if the business’s gross receipts represent 5% or less of the total combined receipts of the business and the SSTB.
It is important to note, though, that businesses with some income that qualifies for the deduction and some that does not can still separate the different activities by keeping separate books to claim the deduction on the eligible income. For example, banking activities (taking deposits, making loans) qualify for the deduction, but wealth management and similar advisory services do not, so a financial services business could separate the bookkeeping for these functions and claim the deduction on the qualifying income.
The IRS and Treasury have made a significant effort to provide this guidance before the first affected returns are filed. While there are still clarifications needed and a number of planning techniques that have now emerged and will need further examination, all in all we are in a much better position to move forward and help business owners take advantage of this opportunity.
Read more on the proposed regs in “Proposed Regulations Clarify Tax Reform’s Business Income Deduction for Pass-Through Entities.”
Contact a member of your service team, or contact Mike Kolk at email@example.com for further discussion.
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.