In a highly-anticipated release, the IRS provided a final set of guidelines for a complex area of the tax reform—Section 199A, the 20 percent qualified business income (QBI) deduction.
The new QBI deduction, created by the Tax Cuts and Jobs Act, allows many owners of sole proprietorships, partnerships, S corporations, trusts, or estates to deduct up to 20 percent of their qualified business income. Eligible taxpayers can also deduct up to 20 percent of their qualified real estate investment trust (REIT) dividends and publicly traded partnership (PTP) income.
The QBI deduction is generally available to eligible taxpayers with 2018 taxable income at or below $315,000 for joint returns and $157,500 for other filers. Those with incomes above these levels are still eligible for the deduction but are subject to limitations, such as the type of trade or business, the amount of W-2 wages paid in the trade or business and the unadjusted basis immediately after acquisition of qualified property. These limitations are described in the final regulations.
Discussed below are the highlights of what was approved, denied and what needs future advisement.
The IRS noted in the final regulations that the items below will reduce QBI when calculating the 20 percent deduction:
- Half of self-employment tax deduction
- Self-employed health insurance deduction
- Retirement plan contributions attributable to a trade or business
This reduction applies only to the extent QBI was taken into account to determine these deductions.
Defining Rental Real Estate as Trade or Business
One of the biggest concerns raised was to determine what qualifies as a trade or business, specifically regarding rental real estate activities. The IRS offered a safe harbor, providing that a rental activity will rise to the level of a trade or business if it:
- Maintains separate books and records
- Spends 250 or more hours performing rental services per year
- Keeps time logs to support hours spent on rental services (beginning in 2019)
This safe harbor is good news for a number of rental property owners; however, many do not keep time logs and may not meet the 250 hours test. Time spent by property managers, maintenance contractors and others all count towards the number of hours.
If the taxpayer does not meet the safe harbor, the business may still rise to the level of a trade or business under established definitions based on facts and circumstances. These circumstances are generally more taxpayer friendly since there are cases that qualify for a variety of rental activities. An exception would be a triple net lease arrangement.
The final regulations expanded the aggregation rules, permitting partnerships and S Corporations to report multiple trades or businesses on a combined basis.
Aggregation is an option, but not mandatory, for qualified taxpayers. It may be beneficial to combine a business that has high income but low wages with another business that has high wages and low net income, allowing the aggregation of total wages to increase the overall deduction.
Specified Service Trades or Businesses (SSTB)
The IRS provided further interpretation modifying and clarifying disqualified and non-disqualified service businesses in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics and financial management. Final guidance confirmed that if specified service activities exceed a certain threshold, it will render the entire business a specified service trade or business.
Unadjusted Basis Immediately After Acquisition (UBIA)
The final regulations made significant modifications on how to establish the asset basis used to calculate the QBI deduction.
The IRS has revised the rule for determining the unadjusted basis immediately after acquisition (UBIA) in nonrecognition exchanges, specifically section 351 or 721 exchanges. Similar revisions have also been applied to section 1031.
Basis Adjustments on Partnership Interests
With regard to section 734, the IRS preserved the original proposed regulations, wherein the distribution of money or property by a partnership is not considered an “acquisition” as related to 199A purposes and therefore does not result in UBIA for the partnership.
The IRS did, however, change certain regulations surrounding section 743, adjustments reflecting the transfer of partner interest from one person to another. The final regulations state that a partner with a section 743(b) adjustment can consider the partner’s ‘excess section 743(b) adjustment’ as a separate item of qualified property placed in service at the time the transfer of a partnership interest occurs.
The QBI deduction is available in tax years beginning after Dec. 31, 2017, where eligible taxpayers will be able to claim it for the first time on their 2018 Form 1040.
Taxpayers may rely on the initial regulations proposed in August 2018 for tax years ending in 2018, as the final guidelines issued in January 2019 will be applicable to tax years ending after they are published in the Federal Register, which was on February 8, 2019.
This update on the final guidance issued for the 199A deduction for pass-through entities only begins to untangle one of the most complex areas of the tax reform. Please contact me at firstname.lastname@example.org of (805) 963-7811 should you have any questions or want to know more about this information.