Since the Tax Cut and Jobs Act’s (“TCJA”) passage in December 2017, IRS and Treasury have been hard at work analyzing all the statutory changes that overhaul large parts of the Tax Code. This has been a monumental task for sure. The changes resulting from the TCJA are intended to simplify tax reporting for some (mostly low-income) taxpayers, but have the opposite affect for others.
One of the most complex areas of change under the TCJA that is projected to impact a huge number of taxpayers (IRS estimates as many as 24 million) is the new Section 199A 20% QBI (“ Qualified Business Income”) Deduction. While this new provision is expected to yield large tax savings for many taxpayers, the planning, analysis, calculations and reporting involved can be quite time-consuming. This will undoubtedly increase tax preparation costs for many taxpayers nationwide looking to reap the substantial benefits.
We’ve discussed Section 199A in prior newsletters, but to summarize briefly:
Taxpayers with certain types of income that meet the Qualified Business Income (“QBI”) requirements from U.S. trades or businesses other than C-Corporations are eligible to take a deduction from taxable income of up to 20% of that taxable income. QBI can result from direct trade/business activity, rental activities, or from passthrough activities on Schedule K-1.
There are many complex rules and limitations on this deduction, additional complex calculations for many taxpayers, and additional tax reporting and recordkeeping involved. The deduction does not offset income taxed at capital gain rates for example, and for taxpayers with taxable income over $157,500 ($315,000 joint) certain types of QBI referred to as Specialized Service Trade or Business (“SSTB”) income is not eligible for the deduction. Additionally, for taxpayers over these income thresholds, the deduction is capped by 50% of allocable wages or the sum of 25% of allocable wages plus 2.5% of Unadjusted Basis Immediately after Acquisition (“UBIA”) of certain depreciable business assets.
There has been much confusion around certain terms under the statute, including what constitutes trade or business income meeting the QBI requirements, what types of activities fall under the SSTB category, aggregation and segregation rules, etc. Fortunately, the past several weeks have seen a flood of useful guidance on Section 199A from IRS and Treasury, starting with Final Regulations published in January that overhaul many provisions in the Proposed Regulations released in 2018. Notice 2019-07 was also published recently, which provides a new safe-harbor for certain rental activities to qualify.
Some of the highlights of the 248 page set of Final 199A Regulations include:
- Clarification that material participation is not required.
- QBI should be reduced by owner health insurance, retirement contributions and ½ of SE tax.
- Clarification that only currently deductible items reduce QBI. Thus, suspended losses for example do not reduce QBI.
- Wages paid by a PEO or management companies in some cases can be treated as qualifying wages for the common law employer entity for which they are paid.
- Clarification that partnership guaranteed payments are not treated as wages but are still required to reduce QBI where allocable. Planning tip: As guaranteed payments are highly undesirable for Sec 199A purposes, look for other ways to compensate partners, perhaps through a management company or other entity.
- Expansion of related parties under the attribution rules to apply the much more liberal IRC 267(b) or 707(b) tests.
- UBIA can be increased by “excess IRC 743(b) adjustments” relating to Section 754 elections on partnerships.
- UBIA on property received in an IRC 1031 exchange is increased by additional amounts invested and reduced by certain “excess boot” amounts received.
- The new ability for passthrough entities to make an aggregation election. Although this is binding on the passthrough owners and may not be advisable in most cases, we believe.
- The regs provide several examples of situations where services do or do not fall under SSTB classification in health fields, financial services and other categories.
These regulations, through their lengthy preamble and certain sections are perhaps as telling in what they decline to state on certain positions. They also lay groundwork for how to build a stronger case for aggregating certain businesses where optimal or segregating businesses where more beneficial.
Planning tip: A non-SSTB activity (for example sale of pet food and supplies by a veterinarian) can in many cases be “carved-out” from an SSTB under the same business entity when the non-SSTB activity takes certain steps like maintaining separate books and records, having separate space/facilities, having separate employee(s), and invoicing separately for products and services.
Also, for tax year 2018 only, taxpayers are allowed to choose which set of regs, the proposed or final regs, they rely on for certain tax positions, permitting the ability to optimize in many situations for 2018 only.
The new rental safe harbor under Notice 2019-07 may be helpful for many landlords to qualify their rental activities for the Sec 199A deduction. The safe-harbor requirements include:
- Separate books and records.
- 250 hours of rental services, defined in Notice, for each “rental real estate enterprise”. Can be performed by agents, officers or employees, not just owner.
- Contemporaneous records on services must be kept starting in 2019.
- For rental real estate enterprise determination, can aggregate commercial properties with each other and residential properties with each other but not mixed commercial/residential.
- True triple‐net leases do not qualify, unless there is 50% or more common control with a trade or business under the attribution rules (IRC 267(b) or 707(b)) as provided under Final Reg 1.199A‐1(b)(14). Planning tip: consider slightly modifying leases to avoid true triple-net lease qualification, or consider providing additional services.
- Rental or licensing of property to a C Corporation does not qualify
- Signed perjury statement required with return.
It should be noted that while the safe-harbor may be useful for many taxpayers, failure of a rental activity to meet all the safe-harbor requirements does not necessarily preclude its treatment for QBI purposes.
We will continue working to apply all the Section 199A rules as favorably as possible for our clients. Many planning opportunities exist to reap substantial tax savings.
If you have questions on how you can best benefit, please contact one of our experienced team of professionals. Due to the complexities involved, we strongly advise consulting your tax advisor before attempting to apply the Section 199A rules to your specific situation.