David Stewart: Welcome to the podcast. I’m David Stewart, editor in chief of Worldwide Tax Daily. This week: Unfinished business. We previously talked about the section 199A deduction for qualified business income. But since it’s such a large issue, we’re still learning about how it works. So we’re bringing back Tax Notes Today legal reporter Eric Yauch to talk about some of the issues we haven’t covered yet. Eric, welcome back to the podcast.
Eric Yauch: Hey, Dave. Thanks for having me back.
David Stewart: Eric why don’t you start by giving listeners just an overview of section 199A and what we know so far.
Eric Yauch: Sure, Dave, 199A was add to the code to provide some parity for the corporate rate cut from 35 percent to 21 percent. And what 199A does is it provides passthrough business owners a 20 percent right off for certain qualified business income. It’s important to keep in mind that this right off applies to all business owners up to certain income thresholds. As soon as you get above these thresholds, then the income from some services doesn’t qualify like law, health, accounting. And income from services that do qualify are limited by wages paid to employees in unadjusted basis and property. And so this is very complex, it’s very granular, and we got the first round of proposed rules on the broader aspects of this is gonna work in August. And the IRS received over 300 comments, they had a hearing, it was packed, and they got a lot of feedback from the tax community, and they put out final rules in January, I think, January 18. And this is on just the broader aspects of the regime. One of the big changes in the final rules is that they allow aggregation, so you can combine wages and basis of property from other businesses into one to maximize your 199A write-off. So they allowed that at the energy level in the final rules not just at the individual level which was welcome. It’s also important to note that for the 2018 filing season taxpayers can rely on either the proposed or final regulations when filing the tax returns.
David Stewart: All right, so let’s get into some of the issues we haven’t discussed yet. Did the IRS address how rental real estate would be treated in the final rules?
Eric Yauch: So I think it’s important to back up and focus on the fact that in the proposed regulations the IRS relied on section 162 definition of what’s a trade or business. Now, for most businesses that made sense, but for rental real estate, it’s been complex and pretty confusing for the past 40…50 years. And so in a lot of comments on the proposed regulations, the main issue, even at the IRS hearing on 199A focused on the fact that passive rental real estate needed some more meat on the bones as to whether they could use the 199A write-off. So on the same day as the final regulations came out on 199A, the IRS issued a notice with a proposed revenue procedure. What that did was it created a safe harbor for rental real estate as a three-pronged test, a 250 hour active conduct test. And it was meant to give taxpayers guidance on whether the real estate rental income qualified for 199A. But there are some quirks in it, though. Services provided by agents such as like mowing grass, or performing maintenance, they count toward the 250 hour requirement, but driving to the properties does not count toward that 250 hour requirement. I think taxpayers were a little surprised by…kinda like the one-off items like that. But the biggest issue with rental real estate is whether a triple net lease qualifies. A safe harbor says that a triple net lease doesn’t qualify under the safe harbor, but that doesn’t mean it can’t qualify as a trade or business under 162. Now, it defines a triple net lease as one where the lessee pays taxes, insurance, and is responsible for maintenance in addition to rent. Now, one question is: What if there’s a maintenance fee in the lease but the lessee even fixes their own toilet, does that not mean it’s a triple net lease? And so I think people are a little bit frustrated with that and frankly a lot of people said that there is actually no scenario where the safe harbor would actually apply. The proposed regulations also said that one trade or business could be conducted across multiple entities but the safe harbor is entity-specific. So taxpayers have wondered what the outcome would be if there are like 10 regarded partnerships across the same tier with common management. On their own it may not be a trade or business, but across all the entities on that tier it may be. So finding out when a triple net lease would rise to the level of a trade or business would be helpful.
David Stewart: Now, what more do we know about the limitations on what business owners can use section 199A?
Eric Yauch: Well, Dave, I think that’s a good question, and it’s important to keep in mind that above certain income thresholds, some services that are listed in section 1202(e)(3)(A) – health, law, accounting – the income from those services doesn’t qualify as QBI. But the IRS said, “look, you can have one entity with multiple trades or businesses.” And one thing people wondered is “okay, what if I have a business where I have both barred service income and an acceptable service income within the same business?” What would happen then? The IRS in the final rules kept a de minimis threshold where basically if you have $25 million or less of gross receipts, if at least 10 percent or less of the income are from barred services, your whole business won’t be tainted and you’re okay. If you’re over $25 million, then that 10 percent threshold is 5 percent. So I think it’s probably helpful here to use an example. Okay, let’s say that you have a business where there’s banking. For some reason, banking is not a barred financial service because it’s listed in 1202(e)(3)(B). So banking income qualifies as QBI, okay? But wealth management income doesn’t, that’s barred. So let’s say, you have one entity that does banking and wealth management. If their gross receipts are, let’s say, $26 million a year, and only 3 percent of the income is from wealth management services, that whole business won’t be tainted by the fact that they earn only 3 percent from wealth management services. But now people are thinking to themselves, “wait a second.” Okay, let’s say like in the future that business expands. And they still have $26 million of gross receipts, but now 8 percent of their income is from wealth management services. Now that percentage of barred income is now over 5 percent, this now has a cliff effect, and the whole business is tainted, all right? Now, one thing that the final rules did say is, “look, you can separate trades or businesses, even within the same entity.” So now that the focus has shifted to separating barred service businesses from acceptable businesses, and so now people are thinking to themselves, “look, if I’m that bank and I am doing banking and wealth management, I have 3 percent now, so my business isn’t barred yet, but in the future I may grow my wealth management business. Does it make sense to this year start separating those trades or businesses because down the line, once we cross that threshold, it may be a little bit more challenging to say we truly are separate.” So now, I think like a lot of passthrough owners and practitioners are turning to experts in accounting methods to figure out, under section 446, just how separate those businesses have to be to truly be treated as separate from 199A. So the focus now is on separating businesses and people are saying “look, let’s call out these experts and figure out just how separate they have to be.” The answer isn’t black and white, as you can imagine. Some people are saying, “look, it helps to have separate income statements between those businesses, separate balance sheet on a transactional basis, sometimes it even helps to have separate legal entities, even if they’re just disregarded entities.” Others say “we also like to see a distinct product or service line that have different customers, separate employees, separate management,” and the list goes on. And so it’s not an exact science, and if you’re thinking about separating your trades or businesses so one can take advantage of 199A while the other you’re pretty sure cannot, make sure that you read all the cases and IRS guidance on this and consult with the accounting methods experts to see if you really can.
David Stewart: All this sounds pretty complicated. Now, we’re recording this in early May, so filing season has just finished out. How did that filing season go?
Eric Yauch: So I think, after speaking to practitioners past the April 15th deadline, the consensus is it was a pretty rough go for everybody, but honestly I think that was to be expected because it was the first filing season implementing the TCJA and 199A. So some of the issues that practitioners ran into was the fact that the K-1s our clients were getting from different partnerships were pretty inconsistent. Like just the fact of how you list stuff on the K-1 was all pretty different from entity to entity. And one thing that came up is whether income from a lower tier partnership that is not a barred service, but it flows up through a partnership that is a barred service, then it flows up to an individual. So you have good income flowing through an upper tier bad-income business to the individual. Can that QBI from that lower tier still qualify for 199A? And that’s kind of an open question and it seems like some people say because on the K-1 it’s business by business, it would make sense that the individual could use that lower tier qualified income and it would still be eligible for 199A. Other practitioners said one big issue is that partners within the same partnership disagree as to whether their business was in barred business. So you have some partners saying, “look, I don’t think we’re in wealth management and it’s not barred,” and others would say, “I think we are, I’m gonna be more conservative.” So I think after the dust settles and we get through the extension season as well, and everyone looks back on how the filing season went, I think that we’re gonna see like a lot more guidance, I think we’re gonna see software updates, and hopefully next year, and the years after, it gets a little smoother.
David Stewart: All right now, you mentioned open question that leads me to my next question. I understand the IRS updated their frequently asked questions web page on 199A. What happened there?
Eric Yauch: Yeah, so this was a pretty big deal. So on April 11th as far as we know the IRS updated their FAQ on 199A. And they expanded their questions quite a bit and most practitioners at least didn’t see it until after the filing deadline. And when they saw it, they were a little bit surprised by what was in it. For example, the last question-and-answer on there was FAQ number 33. It stated that an S corporation who owns greater than 2 percent of the company may have to reduce QBI twice for self-employed health insurance write-offs. Once at the entity level and then again at the shareholder level. So when people found this – I think it was a few days after filing season had already ended – I got a lot of calls and emails from people. And what was interesting is that some people said “look, FAQ 33 was a surprise. We didn’t do it that way for our clients and so there are gonna be quite a few returns where we just didn’t follow what the FAQ said in question-and-answer 33.” Others said, “I’ll be honest, I didn’t see the FAQ and it’s a little bit frustrating that this wasn’t highlighted. But now that I read question 33 it actually does make sense. And this is what the final regulations say and this is just the way us corporations operate and people should just kinda deal with it.” And so there’s just kind of back and forth where, to this day, Dave, I’m still getting emails about this and people are still pretty frustrated. And so if they’re making a substantive policy change – which some claim that they are – this needs to be, I guess, highlighted in an email whether it’s, you know, maybe you put it in a notice or something, and then others say “look, this is just the way it goes. It was merely a clarification, people should just deal with it.” And so, there’s still some bitter disagreement about this.
David Stewart: All right, well, I guess that leaves room for additional guidance. Are we expecting more guidance in the near future?
Eric Yauch: Yeah, and the IRS has said repeatedly that they plan to expand guidance on this. We still have regs out there that are gonna be finalized on the treatment of real estate investment trusts and publicly traded partnerships. We still have the 199A and cooperative regs that are at OIRA right now. And the IRS said, “look, even we though we put out final regs on the basic stuff on how to use 199A, we’re open to changing stuff and providing more guidance down the line.” Just last week an IRS official said, “we know that people are struggling with what’s a health service provider that’s barred from using 199A. We’re open to putting out industry specific guidance on various aspects.” So that’s, I guess, more clear next year on how to use 199A for these businesses, and what they want is your feedback. I also think it’s important to keep in mind that the IRS put out so much guidance implementing the TCJA in such short time, and it was really comprehensive. People were overall pretty happy with it and it was almost downright impressive that they got this much guidance out. And they also kept up with their other projects that they had prior to the TCJA being passed. So they have been working around the clock, they are gonna continue to work, and they’re open to change. So if you have comments on something that didn’t go well last filing season, tell the IRS, because they’re all ears right now.
David Stewart: All right, and we’re all ears for any additional guidance, so we’ll have to have you back as we get more.
Eric Yauch: You know what, Dave? I think that by the time we’re all getting comfortable with this, around 2025, it’ll expire that next year.
David Stewart: Okay, well, Eric, thanks for being here.
Eric Yauch: Thanks, Dave.
David Stewart: And now, Coming Attractions. Each week we preview commentary that’ll be appearing in the next issue of the Tax Notes Magazines. We’re joined by Executive Editor for Commentary Jasper Smith. Jasper, what will you have for us?
Jasper Smith: In Tax Notes, Laura Barzilai and Dustin Anderson consider when section 382’s limit on net operating losses applies by examining the definition of stock and where instruments with equity characteristics fall within it. Also, David Saltzman and Adam Stella examine how the golden parachute rules jive with the ones regarding GILTI, emphasizing that section 280G’s disallowance of some deductions will result in higher GILTI.
In State Tax Notes, “Retro SALT” is a new series that will revisit noteworthy State Tax Notes articles from the archives. The first installment will be a reprint of a 1996 commentary on the MTC’s National Nexus Program Bulletin 95-1 by Richard D. Pomp and the late Michael McIntyre, with an intro by Michael Mazerov. Separately, Alysse McLoughlin and Kathleen Quinn discuss misconceptions regarding GILTI.
And in Tax Notes International, Steve Suarez discusses recent developments in court cases that illustrate the Canada Revenue Agency’s efforts to expand its powers to obtain taxpayer information, while Paul Tadros argues against the EU’s placement of Trinidad and Tobago on its tax havens list.
As always, we also want to remind listeners of the June 30th deadline for our student writing competition. For more information, visit taxnotes.com/contest.
David Stewart: You can read all that and a lot more in the May 13th editions of Tax Notes, State Tax Notes, and Tax Notes international.
That’s it for this week. You can follow me on Twitter at @TaxStew, that’s S-T-E-W. If you have any comments, questions, or suggestions for a future episode, you can email us at podcast@taxanalysts.org. And as always, if you like what we’re doing here, please leave a rating or review wherever you download this podcast. We’ll be back next week with another episode of “Tax Notes Talk.”
Tax Analysts Inc. does not provide tax advice or tax preparation services. The information you have seen and heard today represents the views of the presenters, which may not be the same as those of Tax Analysts Inc. It may include information obtained from third parties, and Tax Analysts Inc. makes no warranties or representations of any kind, and is not responsible for any inaccuracies. Nothing in the podcast constitutes legal, accounting, or tax advice. The tax laws change frequently, and neither Tax Analysts Inc. nor the presenters, can guarantee that any information seen or heard is accurate. Also, due to changing tax laws, any information broadcast or downloaded after its original air date may no longer represent the current views of the presenters. If you have any specific questions about any legal or tax matter, you should always consult with your attorney or tax professional.
All content in this broadcast is protected under U.S. and international laws. Copyright © 2019 Tax Analysts Inc. Unauthorized recording, downloading, copying, retransmitting, or distributing of any part of the podcast is strictly prohibited. All rights reserved.