Final 199A Regs Address Suspended Losses Included in Qualified Business Income

(Parker Tax Publishing July 2020)

The IRS issued final regulations under Code Sec. 199A to provide guidance on the treatment of previously suspended losses included in qualified business income. The regulations also address the determination of the Code Sec. 199A deduction for taxpayers that hold interests in regulated investment companies, split-interest trusts, and charitable remainder trusts. T.D. 9899.

Background

Code Sec. 199A provides a deduction of up to 20 percent of qualified business income (QBI) from a U.S. trade or business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate. The Code Sec. 199A deduction may be taken by individuals and by some trusts and estates, but is not available for wage income or for income earned by a C corporation. Code Sec. 199A applies to tax years beginning after 2017 and before 2026.

If the taxpayer's taxable income exceeds the amount in Code Sec. 199A(e)(2) (threshold amount), the taxpayer's Code Sec. 199A deduction may be limited based on -

(1) the type of trade or business conducted;

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

(3) the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the trade or business (UBIA of qualified property).

These statutory limitations are subject to phase-in rules in Code Sec. 199A(b)(3)(B) based upon taxable income above the threshold amount (phase-in rules). Code Sec. 199A also provides individuals and some trusts and estates, but not corporations, a deduction of up to 20 percent of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, including qualified REIT dividends and qualified PTP income earned through passthrough entities. This component of the Code Sec. 199A deduction is not limited by W-2 wages or UBIA of qualified property. Overall, the Code Sec. 199A deduction is the lesser of (1) the sum of the combined QBI and qualified REIT and PTP components, or (2) an amount equal to 20 percent of the excess (if any) of the taxpayer's taxable income for the tax year over the taxpayer's net capital gain for the tax year.

On February 8, 2019, the IRS published final regulations (T.D. 9847) interpreting Code Sec. 199A (February 2019 Final Regulations). Along with the publication of the February 2019 Final Regulations, the IRS published proposed regulations (REG-134652-18) providing additional guidance relating to the treatment of previously suspended losses included in qualified business income and the determination of the Code Sec. 199A deduction for taxpayers that hold interests in regulated investment companies (RICs), split-interest trusts, and charitable remainder trusts (February 2019 Proposed Regulations).

Final Regulations

Last week, the IRS adopted the proposed regulations in REG-134652-18 with clarifying changes and additional modifications in response to practitioners' comments. The IRS stated that it also received comments on the February 2019 Final Regulations, and may address them in future guidance.

The final regulations contain amendments to Reg. Sec. 1.199A-3, relating to the treatment of suspended losses, and Reg. Sec. 1.199A-6, relating to additional rules for trusts and estates under Code Sec. 663.

Previously Suspended Losses Included in QBI

Reg. Sec. 1.199A-3(b)(1)(iv) provides that previously disallowed losses or deductions allowed in the tax year generally are taken into account for purposes of computing QBI to the extent the disallowed loss or deduction is otherwise allowed by Code Sec. 199A. These previously disallowed losses include, but are not limited to losses disallowed under sections 461(l), 465, 469, 704(d), and 1366(d), except to the extent the losses or deductions were disallowed, suspended, limited, or carried over from tax years ending before January 1, 2018. These losses are used, for purposes of Code Sec. 199A, in order from the oldest to the most recent on a first-in, first-out (FIFO) basis.

Previously disallowed losses or deductions are treated as losses from a separate trade or business in the year they are taken into account in determining taxable income. Further, the attributes of the previously disallowed losses or deductions, including whether they are attributable to a trade or business and whether they would otherwise be included in QBI, are determined in the year the loss or deduction is incurred.

Observation: The reference to Code Sec. 461(l) was not included in the proposed regulations and was added after practitioners questioned whether the exclusion of Code Sec. 461(l) from the list of loss disallowance and suspension provisions in Reg. Sec. 1.199A-3(b)(1)(iv) meant that losses disallowed under Code Sec. 461(l) are not considered QBI in the year the losses are taken into account in determining taxable income. Code Sec. 461(l) was enacted by the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) and applies to tax years beginning after December 31, 2020, and before January 1, 2026. It generally disallows an excess business loss for taxpayers other than C corporations. Any disallowed excess business loss is treated as a net operating loss (NOL) carryover for the tax year for purposes of determining any NOL carryover under Code Sec. 172(b) in subsequent tax years.

Practitioners also requested guidance on how the phase-in rules apply when a taxpayer has a suspended or disallowed loss or deduction from a Specified Service Trade or Business (SSTB). The IRS addressed this issue in Reg. Sec. 1.199A-3(b)(iv)(C)(2). According to the IRS, whether an individual has taxable income at or below the threshold amount, within the phase-in range, or in excess of the phase-in range, the determination of whether a suspended or disallowed loss or deduction attributable to an SSTB is from a qualified trade or business is made in the year the loss or deduction is incurred. If the individual's taxable income is at or below the threshold amount in the year the loss or deduction is incurred, and such loss would otherwise be QBI, the entire disallowed loss or deduction is treated as QBI from a separate trade or business in the subsequent tax year in which the loss is allowed. If the individual's taxable income is within the phase-in range, then only the applicable percentage of the disallowed loss or deduction is taken into account in the subsequent tax year. If the individual's taxable income exceeds the phase-in range, none of the disallowed loss or deduction is taken into account in the subsequent tax year.

Example: Ann is unmarried and a 50 percent owner of LLC, an entity classified as a partnership for federal income tax purposes. In 2018, Ann's allocable share of loss from LLC is $100,000 of which $80,000 is negative QBI. Under Code Sec. 465, $60,000 of the allocable loss is allowed in determining Ann's taxable income. Ann has no other previously disallowed losses under Code Sec. 465 or any other provision of the Code for 2018 or prior years. Because 80 percent of Ann's allocable loss is attributable to QBI ($80,000/$100,000), Ann reduces the amount she takes into account in determining QBI proportionately. Thus, Ann will include $48,000 of the allowed loss in negative QBI (80% x $60,000) in determining her Code Sec. 199A deduction in 2018. The remaining $32,000 of negative QBI is treated as negative QBI from a separate trade or business for purposes of computing the Code Sec. 199A deduction in the year the loss is taken into account in determining taxable income.

Example: Bob is unmarried and a 50 percent owner of LLC, an entity classified as a partnership for federal income tax purposes. After allowable deductions other than the Code Sec. 199A deduction, Bob's taxable income for 2018 is $177,500. In 2018, LLC has a single trade or business that is an SSTB. Bob's allocable share of loss is $100,000, all of which is suspended under Code Sec. 465. Bob's allocable share of negative QBI is also $100,000. Bob has no other previously disallowed losses under Code Sec. 465 or any other provision of the Code for 2018 or prior years. Because the entire loss is suspended, none of the negative QBI is taken into account in determining Bob's Code Sec. 199A deduction for 2018. Further, because the negative QBI is from an SSTB and Bob's taxable income before the Code Sec. 199A deduction is within the phase-in range, Bob must determine the applicable percentage of the negative QBI that must be taken into account in the year that the loss is taken into account in determining taxable income. Bob's applicable percentage is 100 percent reduced by 40 percent (the percentage equal to the amount that Bob's taxable income for the taxable year exceeds Bob's threshold amount ($20,000 = $177,500 - $157,500) over $50,000). Thus, Bob's applicable percentage is 60 percent. Therefore, Bob will have $60,000 (60% x $100,000) of negative QBI from a separate trade or business to be applied proportionately to QBI in the year(s) the loss is taken into account in determining taxable income, regardless of the amount of taxable income and how rules under Reg. Sec. 1.199A-5 apply in the year the loss is taken into account in determining taxable income.

RICs with Interests in REITs and PTPs

If a RIC has certain items of income or gain, Code Sec. 851 through 860G provides rules under which the RIC may pay dividends that a shareholder in the RIC may treat in the same manner (or a similar manner) as the shareholder would treat the underlying item of income or gain if the shareholder realized it directly (conduit treatment). The February 2019 Proposed Regulations included rules providing conduit treatment for qualified REIT dividends earned by a RIC and the final regulations adopt those proposed rules.

The February 2019 Proposed Regulations did not provide conduit treatment for qualified PTP income earned by a RIC. Instead, the preamble to the February 2019 Proposed Regulations requested comments on issues relating to whether and how to provide conduit treatment for qualified PTP income, including the treatment of items attributable to an SSTB of a PTP allocated to a RIC and the treatment of losses of a PTP allocated to a RIC. While the IRS received several comments addressing conduit treatment for qualified PTP income earned by a RIC, it decided to continue evaluating whether it is appropriate and practicable to provide conduit treatment for qualified PTP income or other income of a RIC.

Special Rules for Trusts and Estates

Reg. Sec. 1.199A-6 provides guidance that certain specified entities (including trusts and estates) need in computing the Code Sec. 199A deduction and in providing information to beneficiaries or owners. The IRS received comments requesting guidance on the interaction between Code Sec. 199A and the separate share rule in Code Sec. 663(c). In particular, practitioners requested guidance on the allocation of QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income of a trustor estate to beneficiaries and the trust or estate based on distributable net income (DNI). Practitioners noted differences in the allocation of overall DNI to beneficiaries of a trust or estate under Code Secs. 643(a) and Code Sec. 663(c) and asked about the allocation of these items in circumstances involving tax-exempt income and charitable deductions, as well as situations in which no DNI is allocated to a beneficiary. Practitioners asserted that under Reg. Sec. 1.663(c)-2(b)(5), deductions, including the Code Sec. 199A deduction, attributable solely to one share are not available to any other separate share of the trust or estate. Practitioners recommended that the allocation of QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income of a trust or estate be based on the portion of such items that are attributable to the income of each separate share. In addition, practitioners recommended that Reg. Sec. 1.663(c)-2(b) be amended to clarify how gross income not included in accounting income is allocated among separate shares.

In Reg. Sec. 1.199A-6(d)(3)(iii), the IRS clarified the separate share rule by providing that, in the case of a trust or estate described in Code Sec. 663(c) with substantially separate and independent shares for multiple beneficiaries, the trust or estate will be treated as a single trust or estate not only for purposes of determining whether the taxable income of the trust or estate exceeds the threshold amount but also in determining taxable income, net capital gain, net QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, and qualified PTP income for each trade or business of the trust or estate, and computing the W-2 wage and UBIA of qualified property limitations. The IRS stated that further clarification of the separate share rule under Code Sec. 663 was beyond the scope of the final regulations. Accordingly, the final regulations provide that the allocation of these items to the separate shares of a trust or estate described in Code Sec. 663(c) will be governed by the rules under Code Sec. 663(e) and such guidance as may be published in the Internal Revenue Bulletin.

In Reg. Sec. 1.199A-6(d)(3)(v), the IRS adopted without change rules under which the taxable recipient of a unitrust or annuity amount from a charitable remainder trust described in Code Sec. 664 can take into account QBI, qualified REIT dividends, or qualified PTP income for purpose of determining the recipient's Code Sec. 199A deduction.

The final regulations apply to tax years beginning after August 24, 2020. However, taxpayers may choose to apply these final regulations to tax years beginning on or before August 24, 2020. Alternatively, taxpayer who chose to rely on the February 2019 Proposed Regulations for tax years beginning on or before August 24, 2020, may continue to do so for such years. However, taxpayers who choose to apply any section of the final regulations or continue to rely on any section of the February 2019 Proposed for tax years beginning on or before August 24, 2020, must follow the rules of the applicable section in a consistent manner for each year.

For a discussion of the rules for calculating the Code Sec. 199A deduction, see Parker Tax ¶151,500. For a discussion of the tax treatment of Code Sec. 199A qualified REIT dividends and qualified PTP income, see Parker Tax ¶154,400. For a discussion of special rules for trusts and estates under Code Sec. 199A, see Parker Tax ¶154,740.

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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