Untangling tax reform: final section 199A regulations

The IRS recently released final section 199A regulations for the 20 percent pass-through deduction enacted under the Tax Cuts and Jobs Act (TCJA). This deduction provides a break to business owners who pay the related income taxes on their respective returns, similar to the relief for corporations that reduced the corporate rate to 21 percent.

For taxable years beginning after Dec. 31, 2017, and before Jan. 1, 2026, noncorporate taxpayers (individuals, trusts and estates) may take a deduction of up to 20 percent of qualified business income (QBI) from partnerships, S corporations and sole proprietorships, plus 20 percent of qualified REIT dividends and publicly traded partnership income. For individual taxpayers in the maximum bracket, if the deduction is allowed at the full 20 percent, it effectively reduces their tax rate to 29.6 percent. This Tax Alert discusses the key elements of the final regulations.

Key takeaways

• The regulations provide a safe harbor for rental real estate to be treated as a trade or business solely for purposes of section 199A. See our previous Tax Alert on this issue.
• They allow for an increase for the purchase price of a partnership interest attributable to the appreciation of such property as part of the qualified property amount.
• The regulations permit aggregation at the entity level, in addition to aggregation at the individual level. The proposed regulations only allowed aggregation at the individual level.

Definition of a trade or business for section 199A purposes

In order to be eligible for the 20 percent QBI deduction, a taxpayer’s activities must first rise to the level of a “trade or business.” The new regulations do not define trade or business but generally rely on existing case law. In short, the taxpayer must demonstrate, based on all the facts and circumstances, that they are involved in activity on a regular, continuous and substantial basis with the primary purpose of making a profit.

• Self-rentals (where the taxpayer rents or leases its real estate or other assets to its operating business) will be treated as a trade or business if the rental is to a trade or business conducted by the individual or to a commonly controlled pass-through entity. Self-rentals to C corporations do not qualify for this treatment.
• Multiple trades or businesses may exist within one entity based on all facts and circumstances. No single factor is determinative; however, a trade or business is not considered separate and distinct unless, at a minimum, separate books and records are maintained.

Aggregation rules

For taxpayers above certain taxable income thresholds, the deduction is limited to 20 percent of QBI from each qualified business, or the “limitation amount,” whichever is less. The “limitation amount” is the greater of 1) 50 percent of the taxpayer’s share of W-2 wages from the qualified trade or business, or 2) 25 percent of W-2 wages plus 2.5 percent of the basis of qualifying property, whichever is greater. Multiple trades or business may be aggregated if they meet certain requirements. This allows taxpayers to combine QBI, W-2 wages and qualified basis for purposes of the section 199A calculation, which in many cases may result in a larger QBI deduction.

• In response to numerous comments, the final regulations allow aggregation of trades or businesses at the entity level. A relevant pass-through entity (RPE) can aggregate trades or businesses it operates directly or through lower-tier entities. Individuals or upper-tier RPEs cannot separate trades or businesses that have been aggregated by a lower-tier entity. Each entity in a tiered structure is subject to disclosure and reporting requirements.
• Trades or businesses must be aggregated on an original return; however, for the 2018 tax year only, trades or business can be aggregated on an amended return.

Basis of qualified property

For purposes of the limitation amount described above, qualified property is tangible property subject to depreciation — land and inventory do not qualify. Taxpayers use their share of the “unadjusted basis immediately after acquisition” (UBIA) in computing their limitation. UBIA generally is the basis on the date the property is placed in service and, for section 199A purposes, is not reduced for depreciation. Special rules are in place for property acquired by like-kind exchange or by involuntary conversion. There are additional procedures with respect to how basis in partnership interests and assets are used for purposes of the calculation.

The final regulations modify the proposed regulations to allow section 743(b) adjustments to qualify for UBIA purposes. (Section 743 adjustments arise when a partner purchases a partnership interest from another partner.) Conversely, section 734(b) basis adjustments that occur when a partnership redeems a partner for payments in excess of their tax capital do not result in an increased UBIA.

Calculation of QBI

The final regulations include several technical clarifications regarding the calculation of QBI:

• An ordering rule now exists for the use of previously suspended losses. Losses suspended under the at-risk, passive activity, and/or basis rules are included in the QBI calculation on a first-in, first-out basis if the losses were incurred in a tax year beginning after Jan. 1, 2018.
• Deductions such as the deductible portion of the self-employment tax, the self-employed health insurance deduction and for contributions to qualified retirement plans are considered attributable to a trade or business and, thus, can reduce QBI.
• The Preamble confirms the section 1231 rules remain the same as outlined in the proposed regulations for purposes of section 199A. The section 1231 determination — i.e., capital gain or ordinary loss — is made at the individual level by netting all section 1231 gains and losses.
  
• How section 199A will interact with the new excess business loss rules, which limit business losses for noncorporate taxpayers to $250,000 per year (single), $500,000 (married filing jointly), remains an open issue. The Preamble acknowledges taxpayers will need guidance on the interaction of section 199A and section 461(l), but notes “these issues are beyond the scope of these regulations and will be considered in future guidance.” Unfortunately, guidance on section 461(l) is not expected before June.
• Caution! Final section 1231 treatment is determined at the individual level. Accordingly, taxpayers may need to adjust the QBI number reported on Schedule K-1s received after they make this determination.

Specified service trades or businesses

For taxpayers above certain taxable income thresholds, income from specified service trades or businesses (SSTBs) is not eligible for the 20 percent deduction. SSTBs are businesses in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, dealing, and any trade or business where the principal asset is the reputation or skill of its employees or owners.

• A de minimis rule was put in place to help taxpayers determine whether two or more separate trades or businesses are being operated in order to take advantage of the 20 percent deduction. Taxpayers can also bifurcate income between property or services provided to a commonly controlled SSTB and property/services provided to unrelated parties. Additionally, the regulations modified the definition of services in the field of health, removing the requirement that medical services be provided directly to the patient. This change could potentially subject more providers to the SSTB restrictions (such as radiologists).
• Nursing and assisted care facilities: The Preamble acknowledges that nursing homes and assisted living facilities provide multifaceted services, but declined to rule on whether these facilities are SSTBs in all cases. A facts-and-circumstances analysis is required. However, the regulations include an example in which all health and medical services are billed separately by providers and the owner of the facility does not employ any healthcare professionals. In this example, the owner is not considered to perform services in the field of health.

Reporting and disclosure

• If the 20 percent pass-through deduction information is not included on taxpayers’ Schedule K-1s, the IRS will presume the amounts are zero and can therefore reduce any deduction at the taxpayer level. However, if the necessary information is not included on an originally filed entity return, taxpayers can report QBI, W-2 wages and UBIA on an amended return.

For related insights and in-depth analysis, see our Tax Reform Resource Center.

For more information on these topics, or to learn how Baker Tilly tax specialists can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely.  The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.