On January 18, 2019, the Department of the Treasury issued Final Treasury Regulations interpreting the 20% pass-through deduction created by the Tax Cuts and Jobs Act (TCJA).
In conjunction with the final regulations, Treasury also released new Proposed Regulations, Revenue Procedure 2019-11 and Notice 2019-07. The proposed regulations provide guidance on the treatment of previously suspended losses that constitute qualified business income and also provide guidance on the determination of the section 199A deduction for taxpayers that hold interests in regulated investment companies, charitable remainder trusts and split-interest trusts.
Revenue Procedure 2019-11 provides methods for calculating W-2 wages for purposes of section 199A. Notice 2019-07 contains a proposed revenue procedure that provides a safe harbor under which a rental real estate enterprise will be treated as a trade or business for purposes of section 199A.
The 20% pass-through deduction, subject to a number of rules and limitations, provides sole proprietors, owners of S Corporations and partnerships, and certain trusts and their beneficiaries with a deduction equal to 20% of the qualified business income earned by a qualified trade or business. Calendar-year taxpayers will begin applying these new rules in the coming months as the pass-through deduction is effective for tax years beginning after December 31, 2017.
The final regulations maintain the overall framework of the proposed regulations (released August 8, 2018), but make certain important clarifications and revisions. For an overview of the basic mechanics of the pass-through deduction, please see our tax alert “Utilizing the New 20% Pass-Through Tax Deduction.” Our tax alert titled “U.S. Treasury Issues Proposed Regulations Addressing the New Sec. 199A 20 Percent Pass-Through Tax Deduction” discussed the proposed regulations issued on August 13, 2018.
Qualified Trade or Business
Only a qualified trade or business is eligible for the pass-through deduction, therefore a taxpayer must be engaged in a trade or business in order to claim the Sec. 199A deduction. The final regulations continue to adopt Sec. 162’s definition of a trade or business for purposes of the pass-through deduction (with a limited exception for a rental or licensing activity with a related taxpayer).
This definition has created some confusion with respect to rental real estate activities and whether such activities constitute a trade or business eligible for the pass-through deduction. In the preamble to the final regulations, Treasury declined to provide a bright line rule to make this determination and instead indicated that taxpayers should consider whether the activity is sufficiently regular, continuous, and considerable to constitute a Sec. 162 trade or business.
However, to assist taxpayers in making this determination, Treasury released a proposed revenue procedure in Notice 2019-07 concurrently with the issuance of the final regulations. The proposed revenue procedure contains a safe harbor under which rental real estate activities will be treated as a trade or business solely for purposes of Sec. 199A. To meet the safe harbor test, 250 hours of “rental services” must be performed with respect to the rental real estate enterprise each year by an owner, employee, agent, or independent contractor.
Rental services include (i) advertising to rent or lease; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collection of rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors. However, “rental services” does not include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations; planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate.
The proposed revenue procedure requires the taxpayer to maintain contemporaneous records (for tax years beginning on or after January 1, 2019), including time reports or logs, to document the hours, dates, and descriptions of services performed and who performed such services. Taxpayers must also keep separate books and records for each rental real estate enterprise. Real estate rented under a triple net lease is not eligible for this safe harbor. The taxpayer relying on this safe harbor must attach a statement to their tax return stating, under penalty of perjury, that they have met the requirements of the safe harbor.
A failure to meet the rental real estate activities safe harbor does not preclude a taxpayer from taking the position that their rental real estate activities constitute a trade or business under Sec. 162, therefore allowing a Sec. 199A deduction. However, the final regulations indicate that Treasury considers income earned from a rental real estate enterprise with minimal activity (such as rental under a net lease) to be ineligible for the Sec. 199A deduction. Taxpayers engaged in rental real estate activities should document time spent performing rental activities to ensure that they can take advantage of the safe harbor.
Determination of Basis in Qualified Property
A taxpayer’s “unadjusted basis immediately after acquisition” (UBIA) of certain qualified property used in a trade or business can limit the amount of pass-through deduction available to a business’s owner. The amount is generally equal to the cost basis of purchased qualified property used by the business that is either (i) still depreciable under the property’s applicable recovery period, or (ii) was placed into service within the prior 10 years.
The proposed regulations provided that a partnership’s special basis adjustments under 743(b) could not be treated as separate qualified property that increase a business’s UBIA. The final regulations modify this rule and allow Sec. 743(b) basis adjustment to be treated as qualified property to the extent that the basis adjustment reflects an increase in the fair market value of the underlying property.
The final regulations made certain additional technical modifications to rules governing allocation of UBIA amongst partners, treatment of property contributed to partnerships and S Corporations, and treatment of property acquired in a Sec. 1031 like-kind exchange.
The proposed regulations permitted individuals to aggregate multiple separate trades or businesses, which will help some taxpayers to maximize the available pass-through deduction by combining the available W-2 wages and UBIA between separate aggregated businesses. The final regulations largely maintained these rules as they apply to individuals, with certain minor modifications.
The final regulations also expanded the aggregation regime to allow pass-through entities (not just the ultimate individual owners) to aggregate trades and businesses at the entity level. Entities may aggregate trades or businesses operated directly or through lower-tiered entities. Upper-level entities and individuals may not subsequently disaggregate these trades or businesses. However, they may further aggregate additional trades or businesses with the lower-tier aggregation.
In order to aggregate trades and businesses the following requirements must be met:
- The same person or group (directly or indirectly) must own at least 50% of each aggregated trade or business for a majority of the taxable year, including the last day of the taxable year.
- All items attributable to each trade or business must be reported on returns with the same taxable year, not taking into account short taxable years.
- None of the aggregated trades or businesses is a specified service trade or business.
- The taxpayer must establish two of the three factors demonstrating the existence of a larger integrated business:
- The businesses provide products, property or services that are the same or customarily offered together;
- The businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources; and/or
- The businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies).
Aggregation must be disclosed on the aggregating taxpayer’s originally filed tax return. An initial aggregation may not be made on an amended return (except for the 2018 tax year). The taxpayer must continue to aggregate unless there is a material change in circumstances.
Specified Service Trade or Business (SSTB)
The law provides that certain enumerated SSTBs are not eligible for the pass-through deduction (unless the individual owners’ taxable income is below a threshold amount).
The final regulations provide additional guidance on each type of SSTB. Please see the Chart of SSTB Guidance Under Final Regulations at the end of this alert for a summary of this guidance.
The final regulations retain the proposed regulations’ interpretation of the law’s catchall provision that defines SSTB to include any trade or business where the principal asset is the reputation or skill of one or more employees or owners. This provision continues to apply only in three relatively narrow circumstances:
- A trade or business in which a person receives fees, compensation, or other income for endorsing products or services;
- A trade or business in which a person licenses or receives fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or other symbols; or
- Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.
The final regulations also maintain the de minimis rule that allows trades or businesses to perform certain minimal amounts of SSTB activities without being treated as a SSTB. If less than 10% of the gross receipts of the trade or business are attributable to SSTB activities, then the trade or business will not be treated as a SSTB. For businesses with gross receipts greater than $25 million, the de minimis rule threshold is lowered to 5%.
The final regulations modify the proposed regulations’ anti-abuse rules intended to prevent taxpayers from segregating certain back-office and administrative functions from a SSTB or shifting income via rental or other expenses. The modified rule provides that, if a business provides property or services to an SSTB and that has 50% or more common ownership, the portion of the trade or business providing such property or services will be treated as a separate SSTB with respect to related parties.
The final regulations also removed an anti-abuse rule that treated a business as a SSTB if it had common ownership and shared expenses with a SSTB.
The regulations require pass-through entities to separately report, for each trade or business, the amounts of qualified business income, W-2 wages, UBIA of qualified property, and whether each business is a SSTB. An entity that aggregates multiple trades or businesses may report the aggregated amounts.
The proposed regulations included a rule that presumed that all amounts would be zero if an entity failed to separately report or identify such items. The final regulations modified this presumption to provide that only the unreported item will be presumed to be zero. The final regulations also permit the information to be reported on an amended or late filed return for any open tax year.
- The statute includes a limitation that prevents a taxpayer from claiming a pass-through deduction in excess of taxable income over a taxpayer’s net capital gain. The final regulations clarify that net capital gain, for this purpose, includes qualified dividends treated as investment income. Accordingly, certain taxpayer’s with large qualified dividend income and other capital gains relative to their taxable income may be limited in their ability to take the Sec. 199A deduction.
- The proposed regulations created a rule that individuals who change their status from employees to non-employees and continued to provide the same services to their former employer are presumed to be in the trade or business of performing services as an employee and therefore ineligible to take advantage of the pass-through deduction. The final regulations keep this rule with certain modifications. The final regulations provide that the presumption only applies during the three years after the individual ceases being treated as an employee. The presumption is rebuttable upon a showing of non-employee status via records, such as contracts or partnership agreements, that provide sufficient evidence to corroborate the individual’s status as a non-employee.
- The preamble to the final regulations indicate that taxpayers may still rely on the final regulations, in their entirety, or on the proposed regulations issued in August, 2018, in their entirety, for taxable years ending in calendar year 2018.
Chart of SSTB Guidance under Final Regulations
Below is a list of statutory SSTBs with additional guidance from the final regulations concerning what types of businesses are included under the definition of each SSTB and, therefore, are not eligible for the pass-through deduction unless its individual owners’ taxable income is below a threshold amount.
|Field||Includes||Does not Include|
|Health||Physicians, pharmacists, dentists, veterinarians, physical therapists, psychologists and other similar healthcare professionals performing services in their capacity as such.||Non-medical services such as the operation of health clubs (gyms) or health spas or businesses that provide payment processing or the research, testing and manufacture or sales of pharmaceuticals or medical devices.
Facilities such as surgical centers that provide improved real estate and equipment but do not directly provide treatment or diagnostic care to service recipients.
|Law||Services by lawyers, paralegals, legal arbitrators, and mediators in their capacity as such.||Services that do not require skills unique to the field of law such as printers, delivery services, or stenographers.|
|Accounting||Accountants, enrolled agents, return preparers, financial auditors and similar professionals.|
|Actuarial Science||Actuaries and similar individuals.||The preamble to the final regulations notes that this does not include services by analysts, economists, mathematicians and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events.|
|Performing Arts||Individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors and similar professionals.||Services that do not require skills unique to the creation of performing arts, such as the maintenance and operation of equipment or facilities for use in the performing arts or services by persons who broadcast or disseminate video or audio of performing arts.|
|Consulting||Provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.
Consulting includes lobbying (i.e., influencing government, government agencies, legislators, or government officials).
|Performance of other services such as sales or the provision of training and educational courses.
Furthermore, consulting does not include the performance of consulting services that are embedded in, or ancillary to, the sale of goods or the performance of non-SSTB services if there is not a separate payment for consulting services.
Services within the fields of architecture and engineering.
|Athletics||Performance of services by individuals who participate in athletic competition such as athletes, coaches and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards and racing.||Services that do not require skills unique to athletic competition, such as the maintenance and operation of equipment or facilities for use in athletic events or services by persons who broadcast or disseminate video or audio of athletic events to the public.|
|Financial Services||Managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings, bankruptcy restructurings and raising financial capital by underwriting, or acting as a client’s agent in the issuance of securities. The regulations specifically mention financial advisors, investment bankers, wealth planners and retirement advisors. Also covered is arranging lending transactions between a lender and borrower.||Taking deposits or making loans.
Insurance is not treated as a financial service for purposes of Sec. 199A.
|Brokerage Services||Services by stock brokers and similar professionals in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee.||Services provided by real estate agents and brokers, or insurance agents and brokers.|
|Investing and Investment Management||The receipt of fees for providing investing, asset management, or investment management services, including providing advice with respect to buying and selling investments.||Directly managing real property.|
|Trading||Trading in securities, commodities, or partnership interests which is determined by taking into account all relevant facts and circumstances including the source and type of profit associated with the activity.
Whether a person trades for their own account or for the account of others is irrelevant.
|Taxpayers who engage in hedging transactions in the normal course of their non-trading trade or business.|
|Dealing in Securities, Partnership Interests and Commodities||Regularly purchasing and selling securities, partnership interests or commodities from, and to, customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities, partnership interests, or commodities with customers in the ordinary course of a trade or business.||Performance of services to originate a loan.
Dealing in commodities is generally limited to a trade or business that is dealing in financial instruments. Excluded from dealing in commodities is the sale of commodities in the active conduct of a commodities business as a producer, processor, merchant, or handler of commodities. Also excluded is entering certain hedging transactions in the normal course of such active commodities businesses. Generally, commodities must be held as inventory and the sale of commodities held as investment or speculation will not qualify for this exclusion.
Taxpayers who engage in hedging transactions in the normal course of their non-dealing trade or business.
Please contact your Mazars USA LLP professional for additional information.