As discussed in our prior alert, the proposed Section 199A regulations provided welcome guidance regarding the application of the pass-through deduction across related entities but left many questions unanswered. Recently issued final regulations clarify aggregation procedures, narrow the anti-abuse provisions and provide additional examples of the limitations on specified service trades or businesses (SSTBs). Recognizing the difficulty in determining whether a rental real estate enterprise qualifies as a trade or business under the regulations, the IRS has concurrently issued safe harbor guidance, discussed separately here. In addition, the IRS separately issued Revenue Procedure 2019-11, which details alternative approaches to calculating W-2 wages for purposes of the pass-through deduction limitations, as well as proposed regulations regarding the treatment of previously suspended losses and other issues.
Section 199A generally permits a deduction for up to 20 percent of qualified business income from pass-through entities and up to 20 percent of real estate investment trust (REIT) dividends and publicly traded partnership income. For taxpayers with taxable income exceeding certain thresholds, the deduction is not available for SSTBs, and the deductible amount for other businesses is limited based on W-2 wages and property basis.
Because many taxpayers have been eagerly awaiting these regulations for the purposes of preparing their 2018 tax returns, the IRS has taken the somewhat unusual position of permitting taxpayers to rely on either the proposed regulations or these final regulations for taxable years ending during 2018. The anti-abuse provisions, however, continue to apply retroactively to the statute's Dec. 22, 2017, date of enactment.
Entity-level aggregation permitted
The proposed regulations included rules allowing taxpayers to aggregate businesses for the purposes of calculating the deduction and applying the wage and property limitations if the same person or group of persons owns a majority of the businesses for the majority of the tax year. As finalized, the regulations expand these aggregation rules to entities, allowing widely held private equity funds and other pass-throughs to aggregate trades or businesses operated directly or through lower-tier entities. Although owners of entity-level aggregators may be able to add trades or businesses to the lower-tier aggregation, owners cannot "break up" these aggregated businesses for the purposes of calculating their deduction.
The final regulations provide other details regarding the application of the aggregation rules:
- For the purposes of determining majority ownership, the attribution rules have been expanded from the proposed regulations to include additional family members, as well as shareholder-corporation, partner-partnership, and trust-beneficiary relationships.
- The "majority of the tax year" must include the last day of the tax year, limiting the aggregation options for midyear transfers and dispositions.
- Taxpayers and entities that delay the decision to aggregate will not be prohibited from doing so in a later tax year.
- Although the decision to aggregate generally may not be made based on hindsight through the filing of an amended return, this prohibition will be waived for 2018.
Anti-abuse: Easing of restrictions for entities under common control with an SSTB
As proposed, the regulations provided three limitations on businesses under common control with an SSTB; only one of these has been retained in a modified form:
- Where the entities are under common control (applying the same attribution rules applicable for aggregation purposes), the portion of the property or services provided to the SSTB is treated as part of the SSTB, regardless of the percentage. This replaces the proposed limitation, which completely disallowed the deduction if the SSTB proportion was 80 percent or more.
- The final regulations eliminate the restriction whereby a business sharing expenses with an SSTB would be deemed to be part of the SSTB if its receipts comprised less than 5 percent of the combined total.
Defining the SSTB
The final regulations generally declined to narrow the fields identified as SSTBs:
- Health: Whether businesses such as assisted living or surgical center operations may be separated from direct treatment or other health services is based on facts and circumstances. Veterinary services and physical therapy are included as a health SSTB, but the retail sale of pharmaceuticals or medical devices is not.
- Performing arts: The writer of a song or a screenplay integral to the creation of performing arts is engaged in an SSTB.
- Consulting: Because engineering or architecture services are specifically not SSTBs under the statute, they are not an SSTB even if they otherwise meet the definition of consulting services.
- Athletics: Operation of an athletic team, including ticket sales and the sale of broadcast rights, is an SSTB.
- Financial services: Taking deposits and making loans is not an SSTB, but arranging lending transactions is a financial service SSTB.
Multiple businesses and the de minimis exception
The final regulations retain the de minimis exception, allowing up to 10 percent of annual gross receipts attributable to SSTBs if the total does not exceed $25 million, or 5 percent for trades or businesses with gross receipts in excess of $25 million. Although examples confirm this exception has an all-or-nothing effect on the qualification of the business, the regulations do recognize the distinction between a business with SSTB receipts and the circumstance where a taxpayer may have a qualifying business separate and distinct from the SSTB. This determination must be based on facts and circumstances, but because taxpayers must keep separate books and records for separate businesses, those on the cusp of the de minimis cutoff may want to review this option.
Determining the unadjusted basis immediately after acquisition of qualified property
The final regulations provide additional guidance for calculating the unadjusted basis immediately after acquisition (UBIA) of qualified property for purposes of the deduction limitation, including:
- Determining UBIA for property transferred in a nonrecognition transaction, including pursuant to sections 351, 721, 1031, and 1033.
- Section 743(b) basis adjustments should be treated as qualified property to the extent they reflect an increase in the fair market value of the underlying property.
- A taxpayer who transfers an interest in a pass-through entity prior to the close of the entity's tax year is not entitled to a share of the entity's UBIA. Taxpayers relying on allocations of UBIA for the availability of the pass-through deduction should expect to be limited in the year of disposition.
In addition, the final regulations provide answers to other questions raised by commenters, including:
- Computational rules reduce the incentive to shift wages: In calculating the total deduction, negative qualified business income offsets positive qualified business income before the wage and capital limitations are applied; wages and UBIA from trades or businesses that produced net negative qualified business income are not taken into account and are not carried over to subsequent tax years.
- Personal deductions are not so personal: An individual taxpayer's deductible portions of self-employment tax, self-employed health insurance, and qualified retirement plan contributions are considered attributable to the trade or business and proportionately reduce qualified business income.
- Trust distributions reduce taxable income: For purposes of determining whether a trust exceeds the $157,500 taxable income threshold ($207,500 for full phase-out), taxable income is reduced by distributions to beneficiaries.
- There is a three-year lookback for independent contractors: If a former employee is classified as an independent contractor despite providing the same or similar services, the IRS will consider the prior three years of employment status in evaluating whether the individual should nonetheless be treated as an employee for purposes of Section 199A.
While the final regulations include considerable refinement from the proposed guidance, they do not significantly depart from the general approach to applying Section 199A. However, taxpayers planning to elect aggregation may wish to revisit their analysis in light of the final rules to determine the most advantageous approach.