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IRS Issues Final Regulation, Clarifying the New Qualified Business Income Deduction

  • February 15, 2019 by hamiltontharp
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The Treasury Department and the Internal Revenue Service recently issued final regulations and guidance addressing implementation of the new qualified business income (QBI) deduction (section 199A deduction). The guidance is an attempt to simplify this complicated deduction.Although one of the more complex changes in TCJA, this deduction has the potential to cut tax bills by up to one-fourth for eligible businesses. Below we have highlighted the major takeaways from the 247-page document released by the IRS last month.

If you are unfamiliar with this new deduction, which was created by the Tax Cuts and Jobs Act (TCJA), it allows entrepreneurs, self-employed individuals, and certain investors to deduct 20 percent of their business income from their taxable income. This is considered a “below-the-line” deduction, meaning it will not reduce your adjusted gross income.

Determining eligibility for this deduction depends on whether your business is considered a specified trade or business and is above or below the required threshold. The structure of your business also determines eligibility. Eligible structures include trust and estates, individuals, partnerships, s corporations and sole proprietors. The QBI deduction is not available for wage income or business income earned by a C corporation.

Calculating the QBI deduction also depends on whether a business is considered a “specified service.” A Specified Service Trade or Business (SSTB) includes services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or businesses in which the principal asset is the reputation of one or more employee (endorsements or appearance fees). It is important to note that the rules change if your business is not considered a specified service.

Understanding the Final Ruling Around 199A

Below we have listed the most pertinent details issued last month by the IRS:

  • Confirmation: Income from originating and selling mortgages is eligible for the deduction. Shareholders of mutual funds with real estate investment trust investments also qualify for the deduction.  
  • Confirmation: Individual REIT investors through mutual funds qualify for the deduction.
  • Confirmation: If companies have limited income (less than 10 percent) from ineligible activities, the company can still get a full deduction on all its profits.
  • Clarification: Organizations are prohibited from splitting their firms into different entities to lower their tax bills; however, if companies have income that qualifies and some that do not, they are permitted to delineate those activities to receive the deduction on the eligible income.
  • Clarification: Businesses can maximize their deduction by allowing companies to combine at the entity level or the owner level.
  • Clarification: New proposed regulations for taxpayers that hold interests in regulated investment companies (RICs), charitable remainder trusts, and split-interest trusts.

Safe Harbor for Rental Real Estate Enterprises

Also included in the final regulations, the IRS issued a proposed revenue procedure that provides a safe harbor for rental real estate enterprises to be considered a trade or business and qualify for the deduction. A rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.

According to Notice 2019-7, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the tax year:

  • Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise;
  • Real estate rental owners, or someone they hire, spend at least 250 hours a year on the business and keeps a record of their activities.
  • The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the hours of all services performed; description of all services performed; dates on which such services were performed; and who performed the services.

There are exceptions and exclusions to consider, including:

  • Rental services do not include financial or investment management activities.
  • Real estate used by the taxpayer as a resident for any part of the year is not eligible for this safe harbor.
  • Real estate rented or leased under a triple net lease is not eligible for this safe harbor.

While this deduction will make the rules more manageable for some businesses, these rules will require more planning and additional complexities for others, including larger pass-through entities.

There are still many questions left unanswered, such as:

  • Can publicly-traded partnership investments held through a mutual fund qualify for the deduction?
  • How much of a deduction is available to taxpayers with multiple trades and businesses that exist within the same entity?

The deduction is available for tax years beginning after December 31, 2017, and before January 1, 2026. There is speculation whether a future Congress will uphold individual provisions. To discuss your future options regarding the QBI deduction and your eligibility to take advantage of the real estate safe harbor, contact our office.

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