Practitioners have been waiting for filing season guidance on Section 199A, which provides a 20 percent deduction for qualified business income of pass-through entities. Although proposed regulations were issued on Aug. 8, 2018, a number of issues awaited clarification. On Jan. 18, 2019, the Treasury and Internal Revenue Service issued final regulations, additional proposed regulations, and a notice containing a revenue procedure, designed to clarify additional issues.
“An important part of the final regs was the aggregation rules,” said Howard Wagner, a partner at the national tax office of Top 10 Firm Crowe. “If a partnership or S corporation has multiple trades or businesses, they can now be aggregated if certain tests are met. Allowing aggregation at the entity level is huge. It will greatly simplify compliance.”
“Every industry went to the service wanting them to add examples to the regs to show that their industry was qualified. Not everyone got what they wanted,” he continued. “A lot of industry groups put out press releases or newsletters saying they were good, but you need to dig a little deeper and examine what they are actually doing in light of the regulations.”
Triple net leases are generally not eligible for the deduction, but this is more a product of how the statute was written, rather than a decision on the part of the IRS, according to Wagner. “It works off the IRS definition of a trade or business,” he said.
Always more questions ...
“The regs that came out last August answered many questions, but they created some new issues,” said David Mellem, a Green Bay, Wisconsin-based practitioner and educator. “The final regs answered some of the new questions, and created additional issues.”
When the proposed regulations came out last August, one of the questions was whether a rental was a business, Mellem indicated.
“Instructors were doing the best they could to answer this,” he said. “Initially it appeared they were leaving rentals out, then it used wording on ‘rentals rising to the level of a business.’ But it didn’t define ‘rising to the level of a business’ — the preamble said to look at case law, which is contradictory. The only clarity was a self-rental to a commonly controlled business, which is eligible for the [qualified business income] deduction. The final regs said, ‘Look at our notice and revenue procedure.’ The notice basically said that a rental may rise to the level of a business — look at case law, but it also gave a safe harbor provision. If you meet the safe harbor test your rentals will be considered a business.”
The safe harbor rule states that it doesn’t apply to triple net leases or vacation home rentals, Mellem indicated. “That doesn’t mean that a triple net lease does not rise to the level of a business, but it does mean that they don’t qualify for safe harbor treatment. But in my experience it would be difficult for a triple net lease to rise to the level of a business because the landlord collects rent and does nothing else. It would be hard to show that the landlord is working enough for his activities to rise to the level of a business.”
“Remember that a taxpayer who meets the safe harbor rules can treat income from the rental property as QBI,” he said. “If the taxpayer doesn’t meet the safe harbor rules, the rental property may still qualify for QBI if it meets the definition of a trade or business — in other words, you can still argue about the issue.”
The safe harbor test includes aggregation rules, minimum hours of service rules, a definition of rental services, and contemporaneous records rules. To use the safe harbor, the taxpayer must attach a statement to the tax return that the requirements of Section 3.03 of Revenue Procedure 2019-7 have been met. The statement must be signed by the taxpayer or the pass-through entity’s authorized representative, under “penalties of perjury.”
Roger Harris, president of Padgett Business Services, has “one minor concern” with the safe harbor provision. In a Feb. 11, 2019, letter to the IRS, he suggested that the safe harbor election be made without requiring a taxpayer signature.
“Given the taxpayer is consenting to everything contained in the electronic return by signing Form 8879, the need for a signature on the safe harbor election seems redundant and poses a burden on the tax preparer and the taxpayer,” he said. “Many other elections that are required to be filed with the return do not require a signature.”
Harris observed that many tax software programs allow the election to be electronically filed without the signature, and predicted that this may cause returns to be filed without the required signature.
If the service believes a signature is necessary, Harris suggests reducing the burden by treating the election similarly to that of the signature requirement on Form 8879: “Perhaps the election statement could be attached to the return without a signature, but the signed copy received prior to filing and held at the preparer’s office along with the signed Form 8879.”
Aggregation of properties is permitted, so long as commercial and residential properties are grouped separately, according to Mellem. “Under the safe harbor rules, the taxpayer must either treat each rental as a separate activity, or treat all similar rentals as a single activity. Commercial and residential are not similar.”
“Once this treatment is made, it must continue unless there has been a significant change in facts and circumstances,” he said. “For example, a taxpayer with three residential rentals can’t choose to combine two out of the three. They have to keep each one separate or combine all three.”
Hatred, and confusion
“The IRS hated giving the 199A pass-through deduction to rental property,” said Beanna Whitlock, a Canyon Lake, Texas-based practitioner and educator, and former IRS director of National Public Liaison. “They have traditionally denied rental property activity as being a trade or business. Even with the safe harbor provision, they had to admonish taxpayers to file 1099s if this was a trade or business.”
“The history of filing 1099s for rental property goes back to 2010,” she said. “Later, under President Obama, Congress repealed the requirement for rental property owners to file 1099s. The IRS is quick to say in Rev. Proc. 2019-7 that the trade or business definition is only for Code Section 199A — well, guess what, taxpayers can say the same thing.”
“One of the most confusing parts of the deduction is the definition of a specialized service trade or business,” said Tom Wheelwright, chief executive of WealthAbility, a CPA network.
Income from specified service trades or businesses is qualified for the deduction only if the taxpayer is below an applicable income threshold. A specified service business is a business that involves 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 or trading, dealing in securities, partnership interests or commodities, or any business whose principal asset is the reputation or skill of one or more of the owners or employees.
“In the recently released regulations, the IRS provides a bright-line test that says that if a business has less than $25 million of gross receipts and less than 10 percent of its gross receipts are from SSTB services, then the business is not an SSTB,” he explained. “This would apply, for example, where a pharmacist — an SSTB service provider — owned their own pharmacy that sells retail goods, including pharmaceuticals, and also provides health care services, such as flu shots. The regulations suggest that so long as the gross receipts from the flu shots and other related health services (not the drug costs, just the services of providing the inoculations) are less than 10 percent, the entire pharmacy business is exempt from the SSTB limitations.”
Many “simple” 199A filing situations turn out to be not so simple, Mellem cautioned. “My client, a partner, had what I thought was a simple deduction. But we ended up reducing his QBI by the 179 deduction we took on his 1040, then reduced it by [unreimbursed partnership expenses], and reduce it further by a pro rata share of his guaranteed payments. The guaranteed payments are not QBI but they are subject to the self-employment tax.”
