Pass-through entities on January 18 received final and new proposed regulations on how to qualify for a new 20% tax deduction on certain types of income, the IRS stated in a package of guidance.
The final rules, adopting with modification proposed regulations (REG-107892-18) released in August, provide guidance on how pass-through entities can aggregate income with costs to qualify for the new deduction under tax code Section 199A, created by the 2017 tax act, Pub. L. No. 115-97. Additionally, the final regulations provide an anti-avoidance rule under Section 643 to treat multiple trusts as a single trust. Proposed regulations, issued concurrently, would provide guidance on the treatment of previously suspended losses that constitute qualified business income. The proposed regulations would also provide guidance on determining Section 199A deductions for taxpayers that hold interests in regulated investment companies, charitable remainder trusts, and split-interest trusts. The IRS stated that the final regulations are effective on and generally applicable to taxable years ending after the date of publication in the Federal Register. However, taxpayers may rely on the rules in Treasury Regulations Section 1.199A-1 through Section 1.199A-6, in their entirety, or on Proposed Regulations Section 1.199A-1 through Section 1.199A-6, in their entirety, for taxable years ending in calendar year 2018. A copy of the final rules is available here. A copy of the new proposed regulations is available here.
The IRS made a series of changes to make it simpler for businesses to determine if they can or can’t get the tax break, a senior Treasury official said when the package was released.
For example, the regulations include a test for rental real estate owners to know if they can get the tax break. If they meet the test, they will be treated as a trade or business solely for the purpose of Section 199A. IRS explained in Notice 2019-07 (available here) that to qualify for treatment as a trade or business under the safe harbor, a rental real estate enterprise would have to satisfy the requirements of the proposed revenue procedure, including the maintenance of separate books and records to reflect income and expenses, maintenance of contemporaneous records, and for taxable years beginning before January 1, 2023, 250 hours or more of rental services performed per year. After December 31, 2022, the 250 hour requirement would apply to any three of five consecutive taxable years, the IRS noted. If an enterprise fails to satisfy the requirements, the rental real estate enterprise would still be treated as a trade or business for purposes of Section 199A if the enterprise otherwise meets the definition of trade or business in Treasury Regulations Section 1.199A-1(b)(14). The proposed revenue procedure is proposed to apply generally to taxpayers with taxable years ending after December 31, 2017, the IRS stated. However, until the revenue procedure is published in final form, taxpayers may use the safe harbor described in the proposed revenue procedure for purposes of determining when a rental real estate enterprise may be treated as a trade or business solely for purposes of Section 199A.
The new rules also make clear that companies can’t use a tax planning technique called “crack and pack” to avoid limits on the new tax break. Professional service providers had hoped to use the technique to get around the income limits set for owners of pass-through businesses.
The strategy would have allowed them to split their firms into different entities to lower their tax bills. For example, an accounting firm could have put all of its secretarial staff into one entity and its accountants into another to get the full deduction on the income tied to the administrative work. But companies with some income that qualifies and some that doesn’t can still delineate those different activities, such as through separate accounting books, to get the deduction on the eligible income. For example, banking activities qualify for the deduction but wealth management advising doesn’t, so a bank with some investment advising can separate the bookkeeping for those two units and still get the deduction on the qualifying income.
The deduction is limited for employers who pay low wages or hire few workers. The rules make it easier for related pass-through businesses to maximize their deduction by allowing companies to combine at the entity level or at the owner level. For example, two related businesses — one with a lot of employees but little profit, and another with a lot of profit but few wages — could aggregate their payroll and income to get a bigger tax break.
The rules retain a provision meant to simplify record-keeping if companies only have a small amount of income from ineligible activities, such as health or law. If less than 10 percent of the income is from ineligible sources, the company can still get the full deduction on all its profits.
Despite Treasury effort in making it more clear how the law is implemented, not all questions have been addressed. One comment already received by Treasury notes that it is still unclear how to apply the law is still unclear in cased where a taxpayer has multiple trades and businesses held within the same entity. By way of example, the commenter said it is not clear how much of a deduction would be available to an optometrist who sees patients, which is a service business subject to the cap, and also grinds lenses, which is a manufacturing business that is not.