New IRS guidance fills in four more pieces of the 199A deduction puzzle:
- The IRS modified and finalized proposed regs that it issued last August.
- New proposed regs provide rules for previously disallowed losses, RICs with interests in REITs, and certain trusts and estates.
- A new proposed revenue procedure adds a safe harbor for treating a rental real estate enterprise as a trade or business.
- The IRS finalized three methods for calculating W-2 wages that it proposed last year.
Taxpayers can generally rely on all of these new final and proposed rules.
Final Regulations Adopt, Modify 2018 Proposed Regs
The final regulations largely adopt the proposed regulations in NPRM REG-107892-18 (August 16, 2018), but with substantial modifications.
One hoped-for change didn’t happen. Under the final regs, all items treated as capital gain or loss, including Section 1231 gains and losses, are still excluded from qualified business income (QBI). Taxpayers should continue to apply the Section 1231 netting and recapture rules when calculating the Code Sec. 199A deduction.
On a happier note, the final regulations drop the incidental specified service trade or business (SSTB) category. Under this rule, an SSTB included a non-SSTB if both businesses were commonly owned and shared expenses, and the non-SSTB’s gross receipts were no more than 5% of the businesses’ combined gross receipts.
Other Changes in Final 199A Regs
The final regulations adjust several of the proposed regs for estates and trusts. Most significantly, the final regs remove the definition of “principal purpose” under the anti-abuse rule that allows the IRS to aggregate multiple trusts. The IRS is taking this issue under advisement. Also, in applying the threshold amount, an estate or trust no long excludes distributions from taxable income. Instead, the entity calculates taxable income after taking into account any distribution deduction under Code Secs. 651 or 661.
The final regulations retain the presumption that an employee continues to be an employee while doing the same work for the same employer. However, they provide a new three-year look back rule. The final regs also allow the worker to rebut the presumption by showing records, such as contracts or partnership agreements, that corroborate the individual’s status as a non-employee.
Some other changes include the following:
- Taxpayers must use disallowed, limited or suspended losses in order from the oldest to the newest, on a FIFO (first in, first out) basis.
- A relevant pass-through entity (RPE) may aggregate businesses.
- If an RPE fails to report an item, only that item is presumed to be zero, and an amended return may report the missing information.
- The S and non-S portions of an electing small business trust (ESBT) are a single trust for purposes of determining threshold amounts.
Proposed 199A Regs for QBI, RICs, Trusts and Estates
Taxpayers may rely on proposed regulations that cover three broad topics.
First, in calculating QBI, taxpayer should treat previously disallowed losses as losses from a separate trade or business. In addition, if a taxpayer has losses that relate to a publicly traded partnership (PTP), they must be treated as losses from a separate PTP. Taxpayers determine the attributes of the disallowed loss in the year the loss is incurred.
Second, a regulated investment company (RIC) that receives qualified REIT dividends may pay Section 199A dividends. The IRS continues to consider permitting conduit treatment for qualified PTP income received by a RIC, and seeks public comment on this issue.
Finally, the proposed regulations provide rules for:
- charitable remainder unitrusts and their beneficiaries;
- split-interest trusts, and
- separate shares.
Rental Real Estate Safe Harbor for 199A Deduction
The proposed revenue procedure in Notice 2019-7 provides a safe harbor for taxpayers to treat a rental real estate enterprise as a trade or business for purposes of Section 199A. Taxpayers may rely on this safe harbor for any tax year beginning after 2017. Relevant pass-through entities may also use the safe harbor.
A rental real estate enterprise must satisfy three conditions to qualify for the safe harbor.
First, separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise.
Second, at least 250 or more hours of rental services must be performed per year with respect to the rental enterprise. For tax years beginning after December 31, 2022, this test can be satisfied in any three of the five consecutive tax years that end with the tax year.
Third, the taxpayer must maintain contemporaneous records of relevant items, including time reports, logs, or similar documents. However, this requirement does not apply to tax years that begin during 2018. Relevant items include:
- hours of all services performed;
- description of all services performed;
- dates the services were performed; and
- who performed the services.
W-2 Wages for 199A Deduction
Finally, Rev. Proc. 2019-11 allows taxpayers to use one of three methods to calculate W-2 wages for purposes of the Code Sec. 199A deduction:
- unmodified Box method,
- modified Box 1 method, or
- tracking wages method.
These are the same methods that the IRS identified in the Revenue Procedure that it proposed in Notice 2018-64, I.R.B. 2018-35, 347. The unmodified Box method is simplest, but the other two methods are more accurate.
The IRS requests comments on the proposed regulations and the proposed safe harbor. The IRS must receive the comments and any requests for public hearing within 60 days after the proposed regs are published in the Federal Register.