Treasury and the IRS issued final Code Section 199A regulations and other guidance (the “199A Guidance”) regarding eligibility for a deduction of up to 20 percent of qualifying active income for non-corporate taxpayers (the “199A Deduction”). The maximum 199A Deduction can reduce the current marginal ordinary income rate from 37% to 29.6%, making pass-through taxation more competitive with the reduced 21% corporate tax rate. The 199A Guidance clarifies many important questions regarding eligibility for and calculation of the 199A Deduction including:
- Confirming that the 199A Deduction applies to business income (not capital gain or investment interest) of all trade or businesses other than from a defined set of excluded Specified Service Trades or Businesses (“SSTB”), which are fairly narrowly defined services business such as in the fields of health, law, accounting, and others. The guidance further confirms that a nominal amount of business gross receipts from an SSTB (5% or 10% as applicable) results in the entire business not qualifying for the 199A Deduction.
- Setting forth the commonly used “Section 162” trade or business test to determine if income rises to the level of being eligible for the 199A Deduction, which requires “considerable, regular, and continuous activity” according to case law cited in the Preamble to the Final Regulations.
- Providing a safe harbor in related guidance for rental real estate to satisfy the Section 162 trade or business standard, but which excludes passive real estate investments using the “triple net lease” structure and requires significant record keeping requirements to substantiate eligibility.
- Clarifying that Section 199A applies separately for each trade or business, absent a voluntary aggregation election for entities that meet strict functional and operational integration tests and satisfy familiar Section 267(b) or 707(b) 50% or greater common ownership tests. Separate businesses are generally defined by the existence of separate books and records being kept or businesses operated through separate tax-regarded entities.
- Providing taxpayer favorable guidance that the 199A Deduction limitation relating to the unadjusted basis of tangible depreciable property is not reduced for tax-deferred transactions such as contributions to partnerships or corporations or in a Section 1031 like-kind exchange and such basis can also be obtained from a Section 743(b) adjustment upon the purchase of partnership interest.
Section 199A allows many owners of sole proprietorships, partnerships, S corporations, trusts, or estates to deduct up to 20 percent of their qualified business income (“QBI”), which is a concept for which taxpayers had requested guidance. In response, the IRS released final Section 199A regulations and a corrected version implementing the new qualified business income (QBI) deduction (the Section 199A Deduction). Concurrently, the IRS released three related guidance items: (i) proposed Section 199A regulations, (addressing the treatment of previously suspended losses and the treatment of real estate investment trust (REIT) dividends flowing through a Registered Investment Company (RIC)), (ii) Notice 2019-7 (new safe harbor to define rental real estate trade or business) and (iii) Rev. Proc. 2019-11 (providing three methods for calculating W-2 wages). The new guidance provides considerable guidance summarized below.
Section 199A Mechanics - Up to a 20% Reduction in Qualified Taxable Income
The Section 199A Deduction is available to non-corporate taxpayers with respect to their QBI for taxable years ending before January 1, 2025. In addition, eligible taxpayers are eligible for the 199A benefits with respect to their share of ordinary income dividends received from real estate investment trusts (REIT) and income allocations from publicly traded partnerships. The QBI deduction has additional restrictions for high-earning taxpayers with taxable income above $315,000 for joint returns and $157,500 for other filers. For high-earning taxpayers, the QBI deduction is capped at the greater of (1) 50% of W-2 wages paid; or (2) 25% of W-2 wages plus 2.5% of the unadjusted basis, immediately after acquisition (“UBIA”), of all depreciable qualified property used in the eligible trade or business.
QBI is, in general, the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, and excludes capital gains and losses, C corporation dividends, and interest income. While the 199A benefits are available to non-U.S. taxpayers, such taxpayers must earn income effectively connected with a U.S. trade or business to be eligible.
A qualified trade or business is any trade or business, except for any SSTB, which includes 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. The SSTB limitation does not apply if a taxpayer’s taxable income is below $315,000 for a married couple filing a joint return, or $157,500 for all other taxpayers. Comparison of Proposed and Final Section 199A Regulations
Comparison of Proposed and Final Section 199A Regulations
|Major Topic||Proposed Regulations||Final Regulations & Notice 2019-7|
|Definition of “trade or business”||Section 162 trade or business standard. A trade or business of being an employee is excluded. Rental of tangible property that does not rise to the level of a Section 162 trade or business for purposes of Section 199A unless the property is rented to a trade or business which is commonly controlled.||Adopted proposed regulations framework and rejected requests to treat all rental real estate as part of a trade or business.|
|Determination of single vs. multiple trades or businesses||Not directly addressed||The final regulations clarify that to have businesses be considered separate, they must have a complete and separate set of books and records for each separate business. However, the regulations also observe that a trade or business can generally not be conducted through multiple entities (although looking through disregard entities), and therefore suggest that the optional aggregation rules is the method taxpayers must use to combine multiple trades or businesses across multiple entities. Thus, although a real estate developer may consider their interests in various lower-tier JVs as the same business, the regulations are saying that to treat as a single business for Section 199A purposes the developer will generally be limited to the voluntary aggregation rules.|
|Aggregation of multiple trades or business||Aggregation requires a 50% or more related ownership and requires the satisfaction of 2 out of 3 of the following prongs: (A) The trades or businesses provide products, or services that are the same or customarily offered together. (B) The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources. (C) The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies).||Final regulations keep same aggregation framework (rejecting requests for a more liberal test). Regulations clarified the following: (i) the 50% related test applies the traditional Section 267(b) and 707(b) standard; and (ii) added “property” to the first prong to more clearly allow application to real estate (first prong now says “[t]he trades or businesses provide products, property, or services that are the same or customarily offered together.” (emphasis added)|
|Specified service trade or business (SSTB)||A trade or business (determined before the application of the aggregation rules) is not an SSTB if its gross receipts in a taxable year are $25 million or less and less than 10% of its gross receipts is attributable to the performance of services in an SSTB (including activities incident to the performance of those services), or its gross receipts in a taxable year are more than $25 million and less than 5% of its gross receipts is attributable to the performance of services in an SSTB (including activities incident to the performance of those services). These rules provide essentially a “cliff effect”: if a taxpayer’s receipts from banned services for a business that has less than $25 million of gross receipts is 11%, then none of the income from that business is allowed to use the Section 199A Deduction. If a trade or business (that would not otherwise be treated as an SSTB) has 50% or more common ownership with an SSTB, including related parties (within the meaning of sections 267(b) or 707(b)), and has shared expenses with the SSTB, then such trade or business is treated as incidental to and, therefore, part of the SSTB if the gross receipts of the trade or business represents no more than 5% of the total combined gross receipts of the trade or business and the SSTB in a taxable year.||Final regulations confirmed the cliff effect such that greater than 5% or 10% (as applicable) of gross receipts of a business being derived from SSTBs taints the entire business from being eligible for the 199A Deduction. Final regulations removed the rule that would have treated a trade or business (that would not otherwise be treated as an SSTB) that has 50 % or more common ownership with an SSTB as incidental to and, therefore, part of the SSTB if the gross receipts of the trade or business represents no more than 5% of the total combined gross receipts of the trade or business and the SSTB in a taxable year.|
|Rental real estate - Safe Harbor||Unclear how active a taxpayer had to be with respect to rental properties to qualify for 199A benefits.||Final regulations rejected taxpayer requests for a broad inclusion of all rental real estate as satisfying the Section 199A business requirements, causing concern that passive real estate investments using the “triple net lease” structure may not be eligible for the 199A Deduction. Notice 2019-7 provides for a safe harbor for real estate rentals (other than triple-net leases) involving over 250 annual rental service hours (which excludes financial or investment management activities, such as arranging financing and procuring property). Counts qualifying hours performed by employees, agents, and/or independent contractors of the owners. Taxpayers must maintain separate books and records for the rental business and contemporaneous hours logs including (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. The proposed revenue procedure, included in Notice 2019-7, allows individuals and entities who own rental real estate directly or through a disregarded entity to treat a rental real estate enterprise as a trade or business for purposes of the QBI deduction if certain requirements are met. Taxpayers can rely on this safe harbor until a final revenue procedure is issued.|
|Unadjusted basis of property immediately before acquisition for purposes of computing 199A amount||Used the taxpayer’s adjusted basis in the property immediately prior to a transfer (in the case of a partnership), or prior to a 1031 exchange to determine property’s basis for 199A purposes.||No reduction in UBIA in a tax-free transaction such as a Section 1031 like-kind exchange or a Section 721 transfer of property to a partnership. Also, the final regulations provide that basis in depreciable property under Section 743(b) upon the acquisition of a partnership interest creates UBIA to the extent the adjustment is not duplicative of UBIA inside the partnership.|
|W-2 Considerations||Partnership guaranteed payments received by a partner for services rendered with respect to the trade or business are not taken into account as a qualified item of income, gain, deduction, or loss. The term W-2 wages includes the total amount of wages as defined in section 3401(a) plus the total amount of elective deferrals.||The final regulations confirm that partnership guaranteed payments neither create favorable W-2 wages nor are they considered allocations to carry out the Section 199A Deduction. The final regulations provide that W-2 wages are not reduced by elective deferrals (such as retirement plan deferrals). New Rev. Proc. 2019-11 provides three alternative methods for computing W-2 wages: (1) elective deferrals to Simplified Employee Pensions, simple retirement accounts, and other qualified plans; (2) amounts reported on W-2s for statutory employees should not be included in the calculation of W-2 wages; (3) W-2 wages include amounts paid to S Corporation shareholders and common-law employees.|
|Registered Investment Company (“RIC”) Considerations||RIC dividends generally do not qualify for the 199A Deduction although REIT dividends do qualify. The proposed regulations did not address the question of whether a RIC could flow through the 199A Deduction from RIC income that relates to underlying REIT stock owned by the RIC.||Allow a look through approach to allow RICs to pass through the 199A Deduction from REIT dividends indirectly earned by RIC shareholders when the RIC owns REIT stock. The new proposed regulations also address mechanical issues relating to losses from publicly traded partnerships and the determination of the 199A Deduction for taxpayers who hold interests in charitable remainder trusts and split-interest trusts.|