Section 199A Final Regulations Issued on Eve of the 2018 Filing Season

Aggregation. The Proposed Regulations introduced the welcomed concept of permitting individuals with multiple trades or businesses to aggregate those trades or businesses for purposes of determining the §199A deduction. Through an aggregation election, taxpayers may combine the qualified business income, W-2 wages and unadjusted basis immediately before acquisition (“UBIA”) of qualified property of the aggregated entities for purposes of the §199A deduction computations. The aggregation option is available if one or more persons own at least a 50% interest in each of the trades or businesses to be aggregated. The Final Regulations have clarified that an individual need not have an interest in each such trade or business in order to participate in the aggregation. Rather the requirement is satisfied so long as one person, or group of persons, owns an interest in each trade or business.

In addition to aggregations by individuals, the Final Regulations also now permit an aggregation election at the passthrough entity level for businesses a passthrough entity operates directly or through lower tier passthrough entities. Such passthrough entity aggregations are binding on the partners. While an individual partner cannot subtract from the group of businesses which are aggregated at the passthrough entity level, they can add additional trades or businesses to that aggregation. The Final Regulations apply §267(b) and 707(b) for purposes of determining the existence of a 50% common interest, which is more taxpayer friendly than the related party rule adopted by the Proposed Regulations.[1] These, related party rules include siblings, adopted children and grandparents. 

 

Care must be taken in selecting the businesses to include in an aggregation. Some thought should be given to whether a particular business eligible for aggregation would make a positive contribution to the §199A deduction of the aggregated group. For instance, aggregation of a business with excess qualified business income and another business with excess W-2 wages and/or UBIA of qualified property would generally make sense. While an aggregation election must generally be made on a timely filed return, the IRS will allow late elections on an amended return for the 2018 tax year in recognition that many individuals and passthrough entities may be unaware of the aggregation rules.

 

Although the  Final Regulations keep the same basic requirements for aggregation they added some clarity to the aggregation rules with respect to real estate, but at a cost to many taxpayers who own both commercial and residential rental properties. In addition to meeting the related party requirement the properties to be aggregated also must meet two out of the following three additional requirements:
 

The reference to “property” in the first prong was added by the Final Regulations to make it clear that it applies to real estate. The second requirement will typically be satisfied with respect to closely-held properties. However, the first and third requirements may be problematic for some trades or businesses, including real estate activities. For instance, in Example 17 to paragraph (d) of Reg. §1.199-4, a partnership could not aggregate its residential condominium with its commercial rental office buildings, even though they shared centralized business elements because the Final Regulations deem commercial and residential properties to  not be the same type of property. Apparently the third alternative was not present in the facts of that example. On the other hand, Example 18 indicates that a residential condominium and a residential apartment building are the same type of property for the aggregation rule. The treatment of commercial real estate and residential real estate as not being the same for purposes of the aggregation rules is a considerable blow to the real estate rental industry. That leaves owners with a mix of both commercial rental properties and residential rental properties having to fit within the third alternative prong, in addition to the first prong, if they want to aggregate those properties for purposes of the §199A deduction.

Services or Property Provided to a Related SSTB. Under §199A, certain designated types of businesses, referred to as Specified Service Trades or Businesses (SSTB), are excluded from the deduction for a taxpayer with taxable income in excess of the threshold amount ($315,000 for married filing joint or $157,500 for other taxpayers). Under the Proposed Regulations, a trade or business which provided more than 80% of its property or services to an SSTB with 50% or more common ownership was also tainted as an SSTB in its entirety, regardless of the nature of the property or services it provided. The 50% common ownership rule is retained and §§267(b) and 707(b) are once again applicable for determining common ownership. However, the Final Regulations eliminate the 80% test and now only the portion of the trade or business of providing such property or services to the SSTB with 50% or more common ownership will be so tainted. The tainted part of the trade or business will be treated as a separate trade or business. Thus, it is now clear that the provision of such property or services to other unrelated parties can escape the SSTB taint.

Incidental Commonly-Controlled Trade or Business. The Proposed Regulations provided that a trade or business that is incidental to an SSTB trade or business, and under common control with the SSTB trade or business, would also be treated as an SSTB. For this rule, any such trade or business constituting 5% or less of total revenues was considered incidental and, therefore, subject to the taint. The Final Regulations have changed that and provide that any portion of non-SSTB revenues can qualify for non-SSTB treatment, even if it constitutes less than 5% of total revenues. This is welcome relief for businesses which have revenues below 5% from a non-SSTB trade or business. It will still be necessary to demonstrate that the smaller activity is a separate trade or business from the SSTB.

Establishing Separate Trades or Businesses. Although not explicitly required by the Proposed Regulations, the Preamble to the Proposed Regulations cited Reg. §1.446-1(d), as providing that separate trades or businesses for purposes of permitting separate accounting methods exist only if complete and “separate” sets of books and records are maintained. The corrected Final Regulations have replaced the word “separate” with the correct wording “separable”,  apparently so as to dispel any confusion as to whether there is a different standard from the §446 regulations. This seems to imply a more relaxed books and records requirement whereby it is not actually necessary to maintain separate books and records so long as separate books and records can be produced. Interestingly, Notice 2019-07, issued in conjunction with the release of the Final Regulations, requires “separate” books and records for qualification for a new real estate rental trade or business safe harbor. An example in the Final Regulations addresses a situation in which an LLC provides veterinarian services performed by a licensed staff, which constitutes an SSTB. The LLC also sells its own line of organic dog food at the clinic and online. The example concludes that the veterinarian services and the dog food sales constitute separate trades or businesses. The LLC separately invoiced for veterinary services and for dog food sales. It maintained separate books and records for the two activities. It also had separate employees for the dog food business who were unaffiliated with the veterinary clinic. Thus, the LLC’s dog food trade or business was not tainted by the veterinarian services SSTB activity.

The best practice will be to maintain separate books and records. Thus, where an individual or passthrough entity desires to take the position that it has multiple trades or businesses, some of which are not an SSTB, it is advisable that they maintain separate books and records and otherwise maintain formalities of separateness, including separate bank accounts, separate employees, where possible, and consistent treatment as separate businesses. It may be helpful to at least keep those separate businesses in separate disregarded entities. The Preamble to the Final Regulations cautions that failure to comply with the §6041 information return requirements for a purported rental trade or business is one instance of possible inconsistent trade or business treatment.

Inclusion of §743 Basis Adjustments in UBIA of Qualified Property. The amount of the §199A deduction may in some cases be increased to the extent that the taxpayer has UBIA in certain tangible depreciable property, including depreciable real property (“qualified property”). The Proposed Regulations did not treat basis adjustments under §743(b) as qualified property. Under the Final Regulations §743(b) basis adjustments with respect to the transfer of a partnership interest at death, or upon a sale of a partnership interest, are allowed in determining the UBIA to the extent such basis adjustment reflects an increase in the fair market value of the property from the original UBIA of the property. The Final Regulations clarify, however, that prior depreciation deductions of the partnership, or a predecessor owner of the qualified property in a carryover basis transaction, will not be restored for purposes of determining the excess 743(b) basis adjustment.  The excess §743(b) basis adjustment is treated as a separate item of qualified property which is placed in service when the transfer of the partnership interest occurs. 

UBIA of Property Acquired from a Decedent. The Final Regulations further clarify that if qualified property acquired from a decedent is immediately placed in service it will have UBIA equal to the fair market value of the property on the date of death under §1014. For purposes of the UBIA rules, a new depreciation period commences on the date of death. Therefore, estates may now reap a §199A benefit from any step-up in basis of qualified property at death.

 

The Final Regulations provide needed clarification on several fronts as the first major filing season under the §199A regime begins. However, many taxpayers, and their advisors, will be left grappling with how to apply the §199A rules in some instances.

 

For questions regarding the §199A deduction or the Final Regulations, please contact Tom Hineman at 214-744-3700.

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