Also see: Sample Client Letter: Rental Real Estate Safe Harbor.

IRS Releases Final 199A Regs and Related Guidance, Creates Safe Harbor for Rental Real Estate Activities

(Parker Tax Publishing January 30, 2019)

The IRS issued final and proposed regulations under Code Sec. 199A, along with a revenue procedure, which provides methods for calculating W-2 wages for purposes of calculating the Code Sec. 199A deduction. Simultaneously, the IRS also issued a notice containing a proposed revenue procedure that provides a safe harbor under which a rental real estate enterprise will be treated as a trade or business solely for purposes of the Code Sec. 199A deduction. REG-134652-18; Rev. Proc. 2019-11; Notice 2019-7.

Introduction

On January 18, 2019, amidst a longest federal government shutdown in history, the IRS surprised practitioners by releasing a plethora of Code Sec. 199A guidance, including 247 pages of eagerly anticipated final regulations. Key elements of the new guidance include the following:

(1) A new safe harbor for rental real estate claiming trade or business status, including real estate rentals to a commonly controlled trade or business that might not otherwise have qualified but excluding properties that have triple net lease arrangements and real estate used by the taxpayer as a residence for any part of the year under Code Sec. 280A.

(2) A requirement that each rental real estate enterprise maintain separate books and records in order to qualify for the safe harbor.

(3) Clarification that guaranteed payments for the use of capital under Code Sec. 707(c), payments for services under Code Sec. 707(a), and amounts received as reasonable compensation by an S shareholder are not includible in QBI.

(4) A rule that each partner's share of the unadjusted basis immediately after acquisition (UBIA) of qualified property is determined in accordance with how depreciation would be allocated for Code Sec. 704(b) book purposes, thus rejecting the use of Code Sec. 704(c) allocation methods for such determinations.

(5) Confirmation that qualified property contributed to a partnership or S corporation in a nonrecognition transaction (such as a like-kind exchange) should generally retain its UBIA on the date it was first placed in service by the contributing partner or shareholder.

(6) New rules allowing for aggregation of activities within a passthrough entity and accompanying guidance on reporting requirements.

(7) An exception - only for 2018 tax returns - to the rule that a taxpayer cannot make the initial choice to aggregate activities on an amended return.

(8) Ordering rules for previously disallowed losses or deductions (including under Code Secs. 465, 469, 704(d), and 1366(d)).

(9) A new rule requiring that an excess business loss under Code Sec. 461(l) is treated as an NOL carryover to be applied in future tax years in calculating qualified business income (QBI).

(10) A new three-year lookback period for the presumption that an employee who switches to independent contractor status remains an employee for purposes of Code Sec. 199A.

(11) Retention of the IRS's narrow interpretation of the "skills and reputation" clause from the proposed regs and a few minor adjustments to the definitions of other specified services trades or businesses (SSTBs).

(12) Elimination of the rule that a trade or business that provides more than 80 percent of its property or services to an SSTB with 50 percent or more overlapping ownership is treated as an SSTB (income from the provision of property or services to the related SSTB remains ineligible for the QBI deduction, however).

(13) A caution by the IRS about claiming that an activity is a trade or business for purposes of Code Sec. 199A where the taxpayer has not fulfilled Form 1099 reporting requirements with respect to the activity.

(14) Confirmation that deductions for self-employment tax, self-employed health insurance, and certain other retirement plan contribution deductions are considered attributable to a trade or business and thus reduce any QBI from such trade or business.

(15) Clarification that, where taxpayers have both positive and negative QBI from different businesses, the negative QBI offsets positive QBI prior to applying the wage and capital limitations.

An in-depth discussion of the new Code Sec. 199A guidance follows.

Background

Code Sec. 199A was enacted on December 22, 2017, by the Tax Cuts and Jobs Act of 2017 and applies to tax years beginning after 2017 and before 2026. It was subsequently amended by the Consolidated Appropriations Act of 2018 and those amendments apply retroactively to January 1, 2018.

Code Sec. 199A generally provides a 20 percent deduction for qualified business income (QBI) from sole proprietorships, S corporations, partnerships, and LLCs taxed as partnerships. Additionally, a deduction of 20 percent of qualified real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income is also available. Finally, Code Sec. 199A(g) provides that specified agricultural or horticultural cooperatives may claim a special entity-level deduction that is substantially similar to the domestic production activities deduction under former Code Section 199.

The QBI deduction, which is available to both itemizers and nonitemizers, is claimed by individuals on their personal tax returns as a reduction to taxable income. The Code Sec. 199A deduction may be taken by individuals and by some estates and trusts, but it is not available for wage income or for business income earned through a C corporation. For taxpayers whose taxable income exceeds a statutorily-defined amount (i.e., a threshold amount), Code Sec. 199A may limit the taxpayer's Code Sec. 199A deduction based on the following:

(1) the type of trade or business engaged in by the taxpayer;

(2) the amount of W-2 wages paid with respect to the trade or business (W-2 wages); and/or

(3) the UBIA of qualified property held for use in the trade or business.

The threshold amounts are subject to phase-in rules based upon taxable income above the threshold amount.

The Code Sec. 199A deduction relating to qualified REIT dividends and qualified PTP income is not limited by W-2 wages or UBIA of qualified property.

Observation: The IRS said it intends to issue, in the near future, proposed rules for applying Code Sec. 199A to specified agricultural and horticultural cooperatives and their patrons.

Trade or Business Definition

The calculation of QBI and, therefore, the benefits of Code Sec. 199A, are limited to taxpayers with income from a trade or business. In the final regulations, the IRS slightly reworded the definition of trade or business. Specifically, Reg. Sec. 1.199A-1(b)(14) defines "trade or business" as a trade or business under Code Sec. 162 (i.e., a Section 162 trade or business) other than the trade or business of performing services as an employee.

For purposes of Code Sec. 199A, the determination of whether an activity is a trade or business is made at the entity level. If a relevant passthrough entity (RPE) is engaged in a trade or business, items of income, gain, loss, or deduction from such trade or business retain their character as they pass from the entity to the taxpayer - even if the taxpayer is not personally engaged in the trade or business of the entity. Conversely, if an RPE is not engaged in a trade or business, income, gain, loss, or deduction allocated to a taxpayer from such entity will not qualify for the Code Sec. 199A deduction even if the taxpayer or an intervening entity is otherwise engaged in a trade or business. The final regulations define an RPE as a partnership (other than a PTP) or an S corporation that is owned, directly or indirectly, by at least one individual, estate, or trust. Other passthrough entities, including common trust funds and religious or apostolic organizations described in Code Sec. 501(d), are also treated as RPEs if the entity files a Form 1065, U.S. Return of Partnership Income, and is owned, directly or indirectly, by at least one individual, estate, or trust. A trust or estate is treated as an RPE to the extent it passes through QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, or qualified PTP income.

As was done in the proposed regulations, the final regulations extend the definition of a trade or business beyond the Code Sec. 162 definition. Solely for purposes of Code Sec. 199A, the rental or licensing of tangible or intangible property to a related trade or business is treated as a trade or business if the rental or licensing activity and the other trade or business are commonly controlled. This rule also allows taxpayers to aggregate their trades or businesses with the leasing or licensing of the associated rental or intangible property if all of the applicable requirements are met.

The IRS clarified that this rule does not apply to situations in which the rental or licensing is to a commonly controlled C corporation; it is limited to situations in which the related party is an individual or an RPE. Under the final regulations, the related party rules under Code Sec. 267(b) or Code Sec. 707(b) are used to determine relatedness for purposes of this special rule.

Rental Real Estate Activities as a Trade or Business

One of the biggest issues with respect to the Code Sec. 199A deduction is whether a taxpayer's rental real estate activity qualifies for the Code Sec. 199A deduction.

Caution: Although the text of the final regulations does not directly address the connection between claiming trade or business status for purposes of Code Sec. 199A and the obligation to comply with 1099 reporting requirements, the preamble warns taxpayers to "consider the appropriateness of treating a rental activity as a trade or business for purposes of section 199A where the taxpayer does not comply with the information return filing requirements under section 6041."

In the final regulations, the IRS rejected suggestions that, if a taxpayer's rental activity met the material participation tests in Reg. Sec. 1.469-5T, which determines whether a rental activity is a passive activity or not, the activity would also be considered a trade or business activity for purposes of Code Sec. 199A. The Reg. Sec. 1.469-5T material participation tests, the IRS said, are not a proxy to establish regular, continuous, and considerable activity that rises to the level of a trade or business for purposes of the Code Sec. 199A deduction.

In determining whether a rental real estate activity is a Code Sec. 162 trade or business, the IRS noted that the relevant factors might include, but are not limited to the following:

(1) the type of rented property (commercial real property versus residential property);

(2) the number of properties rented;

(3) the owner's or the owner's agents day-to-day involvement;

(4) the types and significance of any ancillary services provided under the lease; and

(5) the terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).

According to the IRS, providing bright line rules on whether a rental real estate activity is a Code Sec. 162 trade or business for purposes of Code Sec.199A is beyond the scope of the regulations. Additionally, the IRS declined to adopt a position deeming all rental real estate activity to be a trade or business for purposes of Code Sec. 199A. However, because the IRS did recognize the difficulties taxpayers and practitioners may have in determining whether a taxpayer's rental real estate activity is sufficiently regular, continuous, and considerable for the activity to constitute a Code Sec. 162 trade or business, it issued a proposed revenue procedure containing a safe harbor for rental real estate enterprises.

Safe Harbor for Rental Real Estate Enterprise to Be Treated as a Trade or Business

Notice 2019-7 contains a proposed revenue procedure which provides a safe harbor under which a rental real estate enterprise will be treated as a trade or business solely for purposes of Code Sec. 199A and the related regulations if certain conditions are satisfied. For this purpose, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.

Practice Aid: Sample Client Letter explaining the Code Sec. 199A safe harbor for rental real estate activities click here.

The individual or RPE relying on the safe harbor must hold the interest directly or through an entity disregarded as an entity separate from its owner. Taxpayers must either treat each property held for the production of rents as a separate enterprise or treat all similar properties held for the production of rents (with the exception of certain rental real estate arrangements that are excluded from the safe harbor provisions, as discussed below) as a single enterprise. Commercial and residential real estate may not be part of the same enterprise. Taxpayers may not vary this treatment from year-to-year unless there has been a significant change in facts and circumstances.

Observation: Thus, where a partnership holds both commercial and residential real estate, its activities will fail to satisfy the safe harbor conditions. As an alternative, one of the activities could be separated out of the partnership and into another partnership where an independent determination is made as to whether the enterprise qualifies for the safe harbor. However, even if an enterprise fails to satisfy the conditions spelled out in Notice 2019-7, it may still be treated as a trade or business for purposes of Code Sec. 199A if the enterprise otherwise meets the definition of a trade or business in Reg. Sec. 1.199A-1(b)(14).

Under the safe harbor and solely for the purposes of Code Sec. 199A, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the tax year with respect to the rental real estate enterprise:

(1) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.

(2) For tax years beginning prior to January 1, 2023, 250 or more hours of rental services are performed per year with respect to the rental enterprise. For tax years beginning after December 31, 2022, in any three of the five consecutive tax years that end with the tax year (or in each year for an enterprise held for less than five years), 250 or more hours of rental services are performed (as described in this revenue procedure) per year with respect to the rental real estate enterprise.

(3) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (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. Such records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement will not apply to tax years beginning before January 1, 2019.

Observation: While not entirely clear, most likely the 250-hour test must be met at the entity level for RPEs.

For purposes of the safe harbor, rental services include:

(1) advertising to rent or lease the real estate;

(2) negotiating and executing leases;

(3) verifying information contained in prospective tenant applications;

(4) collection of rent;

(5) daily operation, maintenance, and repair of the property;

(6) management of the real estate;

(7) purchase of materials; and

(8) supervision of employees and independent contractors.

Rental services may be performed by owners or by employees, agents, and/or independent contractors of the owners. The term "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.

There is an exception to this safe harbor, however. Real estate used by the taxpayer (including an owner or beneficiary of an RPE relying on this safe harbor) as a residence for any part of the year under Code Sec. 280A is not eligible for the safe harbor.

Observation: If a taxpayer owns a rental building and lives in one of the units of that building, a question arises as to whether the taxpayer's personal use taints the entire building or whether it's appropriate to carve out the personal residence and apply the safe harbor to the rest of the building. If that is not appropriate and the taxpayer is not entitled to use the safe harbor, there is nothing precluding a taxpayer from otherwise establishing that the rental real estate enterprise is a trade or business for purposes of Code Sec. 199A.

Notice 2019-7 also provides that real estate rented or leased under a triple net lease is not eligible for this safe harbor. For purposes of the safe harbor, a triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. This includes a lease agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.

Observation: Most large commercial properties have triple net lease arrangements, meaning such enterprises are not eligible for the safe harbor.

Compliance Tip: A taxpayer or RPE must include a statement, attached to the return on which it claims the Code Sec. 199A deduction or passes through Code Sec. 199A information, that the requirements in the proposed revenue procedure have been satisfied. The statement must be signed by the taxpayer, or an authorized representative of an eligible taxpayer or RPE, which states: "Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete." The individual or individuals who sign must have personal knowledge of the facts and circumstances related to the statement.

Treatment of Multiple Trades or Businesses Within an Entity

The IRS rejected practitioners' requests for guidance on safe harbors or factors to determine how to delineate separate Code Sec. 162 trades or businesses within an entity and when an entity's combined activities should be considered a single Code Sec. 162 trade or business. According to the IRS, specific guidance under Code Sec. 162 was beyond the scope of the Code Sec. 199A final regulations. However, the IRS did note that Reg. Sec. 1.446-1(d)(2) provides that no trade or business will be considered separate and distinct unless a complete separate set of books and records is kept for such trade or business.

Calculating Qualified Business Income

A main component of the Code Sec. 199A deduction is the calculation of qualified business income (QBI). Reg. Sec. 1.199A-3(b) defines the term "qualified business income" as, for any tax year, the net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business of the taxpayer, provided the other requirements of Reg. Sec. 1.199A-3 and Code Sec. 199A are satisfied (including, for example, the exclusion of income not effectively connected with a U.S. trade or business). In the final regulations, the IRS clarified what does and does not constitute QBI for purposes of the Code Sec. 199A deduction.

Capital Gain Definition for Purposes of Section 199A Deduction

The Code Sec. 199A deduction is limited to the lesser of the taxpayer's combined QBI or 20 percent of the excess of a taxpayer's taxable income over the taxpayer's net capital gain for the tax year. To address how net capital gain is calculated for purposes of calculating the Code Sec. 199A deduction, the final regulations add a definition of net capital gain. In Reg. Sec. 1.199A-1(b)(3), the term "net capital gain" for purposes of Code Sec. 199A is defined as net capital gain within the meaning of Code Sec. 1222(11) plus any qualified dividend income for the tax year.

Practice Tip: This definition of net capital gain does not include net Code Sec. 1231 gain, which is treated as capital gain under the rules of Code Sec. 1231. Thus, any Code Sec. 1231 gain which may be treated as capital gain for other purposes is excluded from QBI.

All Guaranteed Payments Are Excluded from QBI. The IRS rejected arguments that guaranteed payments for the use of capital under Code Sec. 707(c) should be includible in QBI because Code Sec. 199A(c)(4) excludes from QBI only guaranteed payments paid to a partner for services rendered with respect to a trade or business. According to the IRS, although Code Sec. 199A is silent with respect to guaranteed payments for the use of capital, Code Sec. 199A does limit the deduction to income from qualified trades or businesses, and guaranteed payments for the use of capital are not attributable to the trade or business of a partnership because they are determined without regard to the partnership's income. Consequently, the IRS found that such payments should not generally be considered part of the recipient's QBI. Rather, for purposes of Code Sec. 199A, guaranteed payments for the use of capital should be treated in a manner similar to interest income. Under Code Sec. 199A, interest income other than interest income which is properly allocated to trade or business is specifically excluded from qualified items of income, gain, deduction or loss.

The final regulations also clarify that amounts received by a shareholder of an S corporation as reasonable compensation or by a partner as a payment for services under Code Sec. 707(a) or Code Sec. 707(c) are not taken into account as qualified items of income, gain, deduction, or loss, and thus are excluded from QBI.

Ordering Rule for Previously Disallowed Losses. Previously disallowed losses or deductions (including under Code Secs. 465, 469, 704(d), and 1366(d)) allowed in the tax year are taken into account for purposes of computing QBI so long as the losses were incurred in a tax year beginning after January 1, 2018. Because previously disallowed losses incurred for tax years beginning before January 1, 2018, cannot be taken into account for purposes of computing QBI, the final regulations provide an ordering rule for the use of such losses. Specifically, any losses disallowed, suspended, or limited under the provisions of Code Secs. 465, 469, 704(d), and 1366(d), or any other similar provisions, are used, for purposes of Code Sec. 199A, in order from the oldest to the most recent on a FIFO basis. Prop. Reg. Sec. 1.199A-3(b)(1)(iv), issued in conjunction with the final regulations, treats previously suspended losses as losses from a separate trade or business for purposes of Code Sec. 199A.

Excess Business Losses. While a deduction under Code Sec. 172 for a net operating loss (NOL) is generally not considered to be with respect to a trade or business (and thus not taken into account in determining QBI), the final regulations provide that an excess business loss under Code Sec. 461(l) is treated as an NOL carryover to the following tax year and is taken into account for purposes of computing QBI in the subsequent tax year in which it is deducted.

Treatment of Other Deductions. While a number of practitioners asked that the final regulations exclude certain expenses from the QBI calculation, such as deductions for self-employment tax, retirement plan contribution deductions, and self-employed health insurance deductions, the IRS rejected these requests as being inconsistent with the statutory language of Code Sec. 199A. The IRS also declined to address whether deductions for unreimbursed partnership expenses, the interest expense to acquire partnership and S corporation interests, and state and local taxes are attributable to a trade or business, saying such guidance was beyond the scope of the final regulations.

W-2 Wage and UBIA Limitations

If a taxpayer's taxable income exceeds a statutorily-defined threshold amount, Code Sec. 199A(b)(2) limits the amount of the taxpayer's Code Sec. 199A deduction for each qualified trade or business to the lesser of:

(1) 20 percent of the taxpayer's QBI with respect to the qualified trade or business, or

(2) the greater of (i) 50 percent of the W-2 wages with respect to the qualified trade or business, or (ii) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of all qualified property.

Code Sec. 199A(b)(7) provides that in the case of any qualified trade or business of a patron of a specified agricultural or horticultural cooperative, the amount determined under Code Sec. 199A(b)(2) with respect to such trade or business is reduced by the lesser of:

(1) 9 percent of so much of the qualified business income with respect to such trade or business as is properly allocable to qualified payments received from such cooperative, or

(2) 50 percent of so much of the W-2 wages with respect to such trade or business as are so allocable.

The threshold amount, for any tax year beginning in 2018, is $157,500 (or $315,000 in the case of a taxpayer filing a joint return).

The definition of W-2 wages in the final regulations includes amounts paid to officers of an S corporation and common-law employees of an individual or RPE. Amounts paid as W-2 wages to an S corporation shareholder cannot be included in the recipient's QBI. However, these amounts are included as W-2 wages for purposes of the W-2 wage limitation to the extent that the requirements of Reg. Sec. 1.199A-2 are otherwise satisfied.

The IRS noted that the Code does not address how the W-2 wages and UBIA of qualified property limitations should be applied when taxpayers have both positive and negative QBI from different businesses. The final regulations clarify that in such cases the negative QBI should offset positive QBI prior to applying the wage and capital limitations.

In conjunction with the issuance of final Code Sec. 199A regulations, the IRS also issued Rev. Proc. 2019-11 which provides methods for calculating W-2 wages for purposes of calculating the Code Sec. 199A deduction. Rev. Proc. 2019-11 updates previous guidance issued on this topic in Notice 2018-64. Under Rev. Proc. 2019-11, W-2 wages include:

(1) the total amount of wages as defined in Code Sec. 3401(a);

(2) the total amount of elective deferrals (within the meaning of Code Sec. 402(g)(3));

(3) the compensation deferred under Code Sec. 457; and

(4) the amount of designated Roth contributions (as defined in Code Sec. 402A).

Alternatives Methods for Calculating W-2 Wages

Rev. Proc. 2019-11 provides three methods for calculating W-2 wages, as defined in Code Sec. 199A(b)(4) and Reg. Sec. 1.199A-2, for purposes of Code Sec. 199A(b) and the regulations thereunder. The first method (the unmodified Box method) allows for a simplified calculation while the second and third methods (the modified Box 1 method and the tracking wages method) provide greater accuracy.

In calculating W-2 wages for a tax year under the methods described in Rev. Proc. 2019-11, only wages properly reported on Forms W-2 that meet the applicable rules of Reg. Sec. 1.199A-2(b) are included. Specifically, Reg. Sec. 1.199A-2(b)(2)(i) provides that, except as provided in Reg. Sec. 1.199A-2(b)(2)(iv)(C)(2) (concerning short tax years that do not include December 31) and Reg. Sec. 1.199A-2(b)(2)(iv)(D) (concerning remuneration for services performed in the Commonwealth of Puerto Rico), the Forms W-2 or any subsequent form or document used in determining the amount of W-2 wages are those that are issued for the calendar year ending during the person's tax year for wages paid to employees (or former employees) of the person for employment by the person.

The final regulations also provide that employees of the person are limited to employees of the person as defined in Code Sec. 3121(d)(1) and (2) (i.e., officers of a corporation and employees of the person under the common law rules).

Observation: As a result, Forms W-2 provided to statutory employees described in Code Sec. 3121(d)(3) (i.e., Forms W-2 in which the "Statutory Employee" box in Box 13 is checked) should not be included in calculating W-2 wages under any of the methods described in Rev. Proc. 2019-11.

Allocation of UBIA Qualified Property Held by an RPE

Under the proposed regulations, in the case of qualified property held by an RPE, each partner's or shareholder's share of the UBIA of qualified property was an amount that bore the same proportion to the total UBIA of qualified property as the partner's or shareholder's share of tax depreciation bore to the RPE's total tax depreciation with respect to the property for the year. In the case of a partnership with qualified property that did not produce tax depreciation during the year, each partner's share of the UBIA of qualified property would be based on how gain would be allocated to the partners pursuant to Code Sec. 704(b) and Code Sec. 704(c) if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property.

Several practitioners suggested that only Code Sec. 704(b) should be used for this purpose, arguing that the use of Code Sec. 704(c) allocation methods would be unduly burdensome and could lead to unintended results. The IRS agreed and revised the final regulations to provide that each partner's share of the UBIA of qualified property is determined in accordance with how depreciation would be allocated for Code Sec. 704(b) book purposes under Reg. Sec. 1.704-1(b)(2)(iv)(g) on the last day of the tax year. To the extent a partner has depreciation expense as an ordinary deduction and as a rental real estate deduction, the allocation of the UBIA should match the allocation of the expenses.

The IRS also agreed that qualified property contributed to a partnership or S corporation in a nonrecognition transaction should generally retain its UBIA on the date it was first placed in service by the contributing partner or shareholder. Accordingly, the final regulations provide that, solely for the purposes of Code Sec. 199A, if qualified property is acquired in a transaction described in Code Sec. 168(i)(7)(B) (i.e., certain carryover basis transactions such as Code Sec. 1031 and Code Sec. 1033 transactions), the transferee's UBIA in the qualified property is the same as the transferor's UBIA in the property, decreased by the amount of money received by the transferee in the transaction or increased by the amount of money paid by the transferee to acquire the property in the transaction.

Reporting Rules

The proposed regulations provided that an RPE must determine and separately report QBI, W-2 wages, UBIA of qualified property, and whether the trade or business is an SSTB for each of the RPE's trades or businesses. The final regulations allow an RPE to aggregate its trades or businesses provided the rules of Reg. Sec. 1.199A-4 are satisfied. An RPE that chooses to aggregate can report combined QBI, W-2 wages, and UBIA of qualified property for the aggregated trade or business. This aggregation must be maintained and reported by all direct and indirect owners of the RPE, including upper-tier RPEs.

Under the proposed regulations, if an RPE failed to separately identify or report any QBI, W-2 wages, UBIA of qualified property, or SSTB determinations, the owner's share (and the share of any upper-tier indirect owner) of QBI, W-2 wages, and UBIA of qualified property attributable to trades or businesses engaged in by that RPE would be presumed to be zero.

In response to comments, the IRS agreed that all of an RPE's items related to Code Sec. 199A should not be presumed to be zero because of a failure to report one item. For example, the IRS said, an RPE may have sufficient W-2 wages and send out that information, but decline to provide information for UBIA of qualified property because it is not necessary or is an insignificant amount. Accordingly, the final regulations retain the reporting requirement but revise the presumption to provide that if an RPE fails to separately identify or report an item of QBI, W-2 wages, or UBIA of qualified property, the owner's share of each unreported item of positive QBI, W-2 wages, or UBIA of qualified property attributable to trades or businesses engaged in by that RPE will be presumed to be zero. The final regulations also provide that such information can be reported on an amended or late-filed return for any open tax year.

However, the IRS said it remains concerned that RPEs do not have sufficient information to determine an ultimate owner's taxable income or whether the ultimate owner will require W-2 wage or UBIA of qualified property information for the RPE's trades or businesses in order to determine the owner's Code Sec. 199A deduction. Conversely, the RPE itself, not its ultimate owners, is in the best position to determine the RPE's Code Sec. 199A items. Accordingly, the final regulations do not contain a special reporting rule for RPEs based on whether the RPE's owners have taxable income below the threshold amounts. Similarly, the IRS declined to create a reporting exception based on whether an RPE has non-corporate owners. Finally, the IRS noted that a trade or business that is not effectively connected with the United States produces no QBI, W-2 wages, or UBIA of qualified property and thus has no reporting requirement under Reg. Sec. 1.199A-6.

Trade or Business of Performing Services as an Employee

According to the IRS, many practitioners expressed support for the rule in the proposed regulations that an individual who was previously treated as an employee and is subsequently treated as other than an employee while performing substantially the same services to the same person, or a related person, will be presumed to be in the trade or business of performing services as an employee for purposes of Code Sec. 199A. However, the IRS said, many others requested clarification of the rule.

While the IRS said it believes that the presumption is necessary to prevent misclassifications, it agreed that some clarification of the presumption was necessary. In accordance with the commenters' suggestions, the final regulations provide a three-year look back rule for purposes of the presumption.

Under the final regulations, an individual may rebut the presumption by showing records, such as contracts or partnership agreements, that are sufficient to corroborate the individual's status as a non-employee for three years from the date a person ceases to treat the individual as an employee for federal employment taxes. Finally, the final regulations contain an additional example demonstrating the application of the presumption for the situation in which an employee has materially modified his relationship with his employer such that the employee can successfully rebut the presumption.

Specified Services Trades or Businesses

The Code Sec. 199A deduction may be limited or unavailable for taxpayers involved in a specified service trade or business (SSTB). Code Sec. 199A(d)(2) defines the term "specified service trade or business" as any trade or business:

(1) which is described in Code Sec. 1202(e)(3)(A) (applied without regard to the words "engineering, architecture,") or which would be so described if the term "employees or owners" were substituted for "employees" therein, or

(2) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

As a result, SSTBs include any trade or business involving the performance of services in the fields of health; law; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; investing and investment management; trading; dealing in securities, partnership interests, or commodities; or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.

According to the IRS, many practitioners requested that the final regulations provide guidance on whether specific trades or businesses constitute SSTBs. However, the IRS declined to issue such guidance because the determination of whether a particular trade or business is an SSTB is factually dependent.

While some practitioners argued that the meaning of "performance of services" in the various fields should be limited to the definitions provided in Reg. Sec. 1.448-1(T)(e)(4), the IRS rejected this argument. The IRS noted that while Reg. Sec. 1.448-1T(e)(4) is referenced in the legislative history to Code Sec. 199A, Code Sec. 199A itself does not reference Code Sec. 448 and existing guidance under Code Sec. 448 is not a substitute for guidance under Code Sec. 199A. The IRS also said that the intent of Code Sec. 448 and the intent of Code Sec. 199A are different; Code Sec. 199A looks to the trade or business of performing services involving one or more of the listed fields, and not the performance of services themselves, in determining whether a trade or business is an SSTB. In addition, the designation of a trade or business as an SSTB applies to owners of the trade or business, the IRS noted, regardless of whether the owner is passive or participated in any specified service activity. Accordingly, the IRS said it is both necessary and consistent with the statute and the legislative history to expand the definitions of the fields of services listed in Code Sec. 199A(d)(1) and (2) and Reg. Sec. 1.199A-5 beyond those provided in Reg. Sec. 1.448-1T(e)(4).

In response to a practitioner suggestion that the final regulations include a franchising example to clarify that a franchisor will not be considered to be an SSTB based solely on the selling of a franchise in a listed field of service, the final regulations include such an example.

The final regulations also added two rules of general application. First, the final regulations specify that the rules for determining whether a business is an SSTB within the meaning of Code Sec. 199A(d)(2) apply solely for purposes of Code Sec. 199A and therefore, may not be taken into account for purposes of applying any other provision of law, except to the extent that another provision expressly refers to Code Sec. 199A(d). Second, the final regulations include a hedging rule that is applicable to any trade or business conducted by an individual or an RPE. The hedging rule provides that income, deduction, gain, or loss from a hedging transaction entered into in the normal course of a trade or business is included as income, deduction, gain, or loss from that trade or business.

Health Field Services. The IRS agreed with comments that skilled nursing, assisted living, and similar facilities provide multi-faceted services to their residents and should not necessarily be categorized as an SSTB. According to the IRS, whether such a facility and its owners are in the trade or business of performing services in the field of health requires a facts and circumstances inquiry that is beyond the scope of the final regulations. However, the final regulations provide an additional example of one such facility offering services that the IRS does not believe rises to the level of the performance of services in the field of health. The final regulations also provide an additional example of an outpatient surgical center demonstrating a fact pattern that the IRS does not believe is a trade or business providing services in the field of health. The IRS agreed with practitioners that the sale of pharmaceuticals and medical devices by a retail pharmacy is not by itself a trade or business performing services in the field of health; however, the IRS said, some services provided by a retail pharmacy through a pharmacist are the performance of services in the field of health. The final regulations provide an additional example of a pharmacist performing services in the field of health. The IRS agreed with the comments of one practitioner, who stated that defining services in the field of health by proximity to patients could lead to arbitrary results and who suggested that technicians who operate medical equipment or test samples, but are not required to exercise medical judgment, should not be considered as performing services in the field of health. Accordingly, the final regulations remove the requirement that medical services be provided directly to the patient. The final regulations did not, however, adopt a suggestion that technicians who operate medical equipment or test samples are not considered to be performing services in the field of health as the IRS considered this a question of fact. However, the final regulations added an additional example related to laboratory services.

Accounting. The IRS rejected multiple suggestions seeking to limit the types of activities, such as bookkeeping and tax return preparation, that would be considered accounting services. The IRS noted that the provision of services in the field of accounting is not limited to services requiring state licensure. It is based on a common understanding of accounting, which includes tax return and bookkeeping services. Whether a real estate settlement agent is engaged in the performance of services in the field of accounting depends on the facts and circumstances including the specific services offered and performed by the trade or business.

Performing Arts. According to the IRS, multiple commenters stated that the definition of performance of services in the field of performing arts should be limited to the definition in Reg. Sec. 1.448-1T(e)(4)(iii). The IRS declined to limit the definition to the one in that regulation. The IRS also rejected arguments that writers should fall outside the definition of the performance of services in the field of performing arts because writing does not require a skill unique to the creation of performing arts and writers create a wide variety of works not intended to be performed before an audience. According to the IRS, to the extent that a writer is paid for written material that is integral to the creation of the performing arts, such as a song or screenplay, the writer is performing services in the field of performing arts.

Consulting. The IRS agreed with a comment that the final regulations include an additional example relating to staffing firms. The commenter recommended that the example provide that a business that assists other businesses in meeting their personnel needs by referring job applicants to them does not engage in the performance of services in the field of consulting when the compensation for the business referring job applicants is based on whether the applicants accept employment positions with the businesses searching for employees. With respect to another practitioner who suggested that the final regulations clarify whether services provided by engineers and architects could be considered to be an SSTB if their services meet the definition of consulting services, the IRS added a rule which provides that services within the fields of architecture and engineering are not treated as consulting services for purposes of Code Sec. 199A. The IRS declined to adopt a practitioner's recommendation to limit the consulting field based on NAICS codes. The IRS noted that Reg. Sec. 1.199A-5(b)(2)(vii) excludes the performance of services other than providing advice and counsel from the field of consulting. At issue, the IRS said, is whether advice and counsel is provided in the context of the provision of goods or services (that are not otherwise SSTBs). This is a question of facts and circumstances, the IRS observed, and consulting services that are separately billed are generally not considered to be provided in the context of the provisions of goods or services.

Athletics. The IRS also declined to exclude from the definition of athletic services sports clubs and sports owners. While sports club and team owners are not performing athletic services directly, the IRS said, that is not a requirement of Code Sec. 199A, which looks to whether there is income attributable to a trade or business involving the performance of services in a specified activity, not who performed the services. The final regulations provide that the performance of services in the field of athletics does not include the provision of services by persons who broadcast or otherwise disseminate video or audio of athletic events to the public.

Financial Services. The final regulations clarify that the definition of financial services does not include taking deposits or making loans. The IRS declined, however, to categorically exclude services provided by insurance agents from the definition of financial services as financial services such as managing wealth, advising clients with respect to finances, and the provision of advisory and other similar services that can be provided by insurance agents. However, the IRS noted that the provision of these services to the extent that they are ancillary to the commission-based sale of an insurance policy will generally not be considered the provision of financial services for purposes of Code Sec. 199A.

Reputation/Skill. The IRS noted that while many practitioners expressed support for the position in the proposed regulations that reputation or skill was intended to describe a narrow set of trades or businesses not otherwise covered by the other listed SSTBs, other practitioners disagreed with the definition in the proposed regulations, expressing concern that the narrowness of the definition is contrary to the language of the statute and Congressional intent. The final regulations retain the proposed rule limiting the meaning of the reputation or skill clause to fact patterns in which an individual or RPE is engaged in the trade or business of receiving income from endorsements, the licensing of an individual's likeness or features, and appearance fees.

De Minimis Rule. The proposed regulations provided that for a trade or business with gross receipts of $25 million or less for the tax year, a trade or business is not an SSTB if less than 10 percent of the gross receipts of the trade or business are attributable to a specified service field. The percentage is reduced to 5 percent in the case of trades or businesses with gross receipts in excess of $25 million. After considering all of the comments, the IRS chose to retain the 5-percent threshold in the final regulations as it is a de minimis threshold that is generally consistent with prior regulations under the Code in similar circumstances and thus such a standard should be familiar to affected entities.

Services or Property Provided to an SSTB by a Trade or Business with Common Ownership. In the proposed regulations, the IRS provided special rules for service or property provided to an SSTB by a trade or business with common ownership. A trade or business that provides more than 80 percent of its property or services to an SSTB is treated as an SSTB if there is 50 percent or more common ownership of the trades or businesses. In cases in which a trade or business provides less than 80 percent of its property or services to a commonly owned SSTB, the portion of the trade or business providing property to the commonly owned SSTB is treated as part of the SSTB with respect to the related parties.

Some practitioners suggested that the rule automatically treating a trade or business that provides more than 80 percent of its goods or services to a commonly owned SSTB as an SSTB is unnecessary, as there are no abuse concerns regarding the portions of goods or services provided to a third party. The IRS agreed and removed the 80 percent rule in the final regulations. Accordingly, the final regulations provide that if a trade or business provides property or services to an SSTB and there is 50 percent or more common ownership of the trade or business, the portion of the trade or business providing property or services to the 50 percent or more commonly-owned SSTB will be treated as a separate SSTB with respect to related parties.

Incidental to a Specified Service Trade or Business. Under the proposed regulations, if a trade or business (that would not otherwise be treated as an SSTB) has both 50 percent or more common ownership with an SSTB and shared expenses with an SSTB, then the trade or business is treated as incidental to and, therefore, part of the SSTB, if the gross receipts of the trade or business represent a certain percent of the total combined gross receipts of the trade or business and the SSTB in a tax year. Practitioners recommended that this rule be removed because it is unnecessary and causes administrative difficulties for taxpayers who must determine whether a trade or business is incidental in order to apply the rule. In accordance with the comments, the IRS removed this rule from the final regulations.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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