The “Tax Cuts and Jobs Act” (TCJA) signed into law in late 2017 represented the most substantial tax reform legislation since 1986. This legislation contained the following two brand new provisions that are attracting tremendous attention:
- The New 20% Deduction Under Section 199A (“20% 199A Deduction”). This 20% 199A Deduction is one of the most significant and far-reaching provisions of the “Tax Cuts And Jobs Act” (TCJA), and available to owners of a broad range of businesses and other investors. The IRS has estimated that over 20 million taxpayers took this deduction on their 2018 tax returns. As with most major new tax provisions, the actual statutory provisions of section 199A left many unanswered questions and gray areas. In response to that uncertainty, the IRS has recently provided important guidance by: 1) Issuing lengthy and detailed Final 199A Regulations (“Final 199A Regs”), and 2) Releasing other miscellaneous section 199A guidance (including a new Revenue Procedure that helps determine whether net income from a rental real estate activity qualifies for the 20% 199A Deduction).
- New Tax Incentives For Investing In Qualified Opportunity Funds (“QOFs”). TCJA also enacted §1400Z creating a brand new set of tax incentives for taxpayers who invest in Qualified Opportunity Funds which own qualified property in certain financially-distressed geographical areas (designated as “Qualified Opportunity Zones” or “QOZs”). The new tax incentives offer an opportunity for taxpayers to invest in these “Qualified Opportunity Funds” (“QOFs”) which, in turn, will allow them to defer otherwise taxable gain they have previously generated. The Treasury Department has designated over 8,700 census tracts as QOZs. There are designated QOZs in all 50 states, the District of Columbia, and several U.S. territories. In October 2018, the IRS released its first set of Proposed Regulations under §1400Z and released a second set of Proposed Regulations in April 2019.
We are sending you this letter to give you an overview and provide you with the latest guidance on these two critically important provisions. Even though the IRS has released guidance on both of these provisions, we are still waiting for further IRS clarifications. For example, in late 2018 the IRS issued lengthy “proposed regulations” on Qualified Opportunity Funds (which we highlight in this letter). However, these proposed regulations could be replaced with “final regulations” in the near future which could provide additional guidance. We closely monitor these IRS releases on an ongoing basis, so please feel free to call our firm for the latest IRS notifications, announcements, and regulations regarding the 20% 199A Deduction and Qualified Opportunity Funds.
Caution! We suggest you call our firm before implementing any tax planning technique discussed in this letter. You cannot properly evaluate a particular planning strategy without calculating your overall tax liability with and without that strategy. This letter contains ideas for Federal income tax planning only. State income tax issues are not addressed.
THE 20% 199A DEDUCTION (INCLUDING THE LATEST IRS GUIDANCE)
OVERVIEW – BASICS OF THE 20% 199A DEDUCTION FOR “QUALIFIED BUSINESS INCOME”
Before discussing the new 199A guidance, let’s first review the basics of the 20% 199A Deduction as it relates to “Qualified Business Income” (QBI):
Who Qualifies For The 20% 199A Deduction With Respect To “Qualified Business Income” (QBI)? Taxpayers who may qualify for this 20% 199A Deduction are generally taxpayers that report “Qualified Business Income” (QBI) as: Individual owners of S corporations or partnerships; Sole Proprietors; Trusts and Estates; and Certain beneficiaries of trusts and estates. Planning Alert! The 20% 199A Deduction: 1) Reduces an individual’s “taxable income,” 2) Does not reduce the individual’s “adjusted gross income, and 3) Is allowed in addition to an individual’s itemized deductions or standard deduction.
Rules For 20% 199 A Deduction For QBI Are Much Simpler For Taxpayers With 2019 “Taxable Income” Of $160,700 Or Below ($321,400 Or Below If Filing Joint Return). Computing the 20% 199A Deduction for QBI for some taxpayers can be extremely tricky. However, as you read the following discussion, you will discover that certain provisions that could otherwise limit the amount of the 20% 199A Deduction, do not apply to taxpayers with 2019 “Taxable Income” (excluding the 20% 199A Deduction) of $160,700 or below ($321,400 or below if married filing jointly). Caution! For married individuals filing separately, this Taxable Income threshold is $160,725 or below.
“Qualified Business Income.” “Qualified Business Income”(QBI) – that is generally eligible for the 20% 199A Deduction – is defined as the net amount of qualified items of income, gain, deduction, and loss with respect to “any” trade or business other than: 1) Certain personal service businesses known as “Specified Service Trades Or Businesses”(described in more detail below), and 2) The Trade or Business of performing services “as an employee.”
- QBI Generally Does Not Include: 1) Dividends (although Qualified REIT Dividends separately qualify for the 20% 199A Deduction), investment interest income, short-term capital gains, long-term capital gains, income from annuities, commodities gains, foreign currency gains, etc.; 2) Reasonable compensation paid by an S corporation to a shareholder; 3) Any “guaranteed payment“ paid to a partner by the partnership; or 4) Any amount allocated or distributed by a partnership to a partner for services rendered to a partnership where it is ultimately determined that the partner was acting other than in his or her capacity as a partner.
W-2 Wage And Capital Limitation On The Amount Of The 20%Of QBI Deduction. Generally, the amount of your 20% of QBI Deduction with respect to each Qualified Trade or Business may not exceed the greater of: 1) 50% of your allocable share of W-2 wages allocated to the QBI of each “Qualified Trade or Business,” or 2) The sum of 25% of your allocable share of W-2 wages with respect to each “Qualified Trade or Business” plus 2.5% of your allocable share of unadjusted basis of tangible depreciable property held by the business at the close of the taxable year.
- Owners With Taxable Income Below Specified Thresholds Are Exempt From The W-2 Wage And Capital Limitation! For 2019, an otherwise qualifying taxpayer is entirely exempt from the W-2 Wage And Capital Limitation if “Taxable Income” (computed without regard to the 20% 199A Deduction) is $160,700 or below ($321,400 or below if married filing jointly). Caution! For 2019, the Wage and Capital Limitation phases in ratably as a taxpayer’s Taxable Income goes from more than $160,700 to $210,700, or from more than $321,400 to $421,400 (if filing jointly).
Business Income From “Specified Service Trade Or Businesses” (SSTBs)Generally Does Not Qualify For The 20% 199A Deduction For Owners Who Have “Taxable Income” Above Specified Thresholds. Based on your “Taxable Income” (before the 20% 199A Deduction), all or a portion of your business income from a so-called “Specified Service Trade or Business” (i.e., certain service-type operations discussed in more detail below) may not qualify for the 20% 199A Deduction. More specifically, if your “Taxable Income“ for 2019 (before the 20% 199A Deduction) is $160,700 or below ($321,400 or below if married filing jointly), “all” of the business income from your “Specified Service Trade or Business” (SSTB) is eligible for the 20%199A deduction. However, if for 2019, your “Taxable Income” is $210,700 or more ($421,400 or more if married filing jointly), “none” of your SSTB income qualifies for the 20% 199A Deduction. Caution! If for 2019, your “Taxable Income” is between $160,700 and $210,700 (between $321,400 and $421,400 if married filing jointly), only “a prorata portion” of your SSTB income will be eligible for the 20% 199A Deduction. Planning Alert! If your Taxable Income for 2019 is $160,700 or less ($321,400 or less if married filing jointly), you are provided two major benefits with respect to the 20% 199A Deduction for Qualified Business Income (QBI): 1) Your SSTB income (if any) is fully eligible for the 20% 199A deduction, and 2) You are completely exempt from the W-2 Wage and Capital Limitation.
HIGHLIGHTS OF FINAL 199A REGS AND OTHER RECENT IRS GUIDANCE
With this overview in mind, the following is a survey of key highlights from the Final 199A Regs and other recent IRS guidance regarding the 20% 199A Deduction:
IRS Provides 250-Hour Safe Harbor For Rental Real Estate. In order for any business activity to generate “Qualified Business Income” (QBI), it first must be determined that the activity constitutes a “trade or business.” For Federal income tax purposes, there has always been uncertainty whether and when a specific “real estate rental” activity would be considered a “trade or business.” In response to that uncertainty, the IRS released guidance that presumes a rental real estate activity is a “trade or business” for purposes of the 20% 199A Deduction if the owner, employees, and independent contractors provide 250 or more hours of qualifying services with respect to the rental property during the tax year. Planning Alert! Failing to satisfy this 250-hour safe harbor only means the rental real estate activity will not be “presumed” to be a “trade or business” for purposes of the 20% 199A Deduction. For those who fail to satisfy this safe harbor, depending on the facts, it would still be possible that the owner could successfully argue that the rental real estate activity constitutes a “trade or business” under general common law principles or using another safe harbor (i.e., the self-rental safe harbor). Caution! This 250-hour safe harbor contains several rules and requirements, including:
- Hours-Of-Services Included In The 250-Hour Test. Generally, the safe harbor is satisfied if the taxpayer can properly document that at least 250 hours of services were provided to the rental real estate activity during the current tax year. Hours that will count toward the 250-hour test include rental services performed by: owners of the rental real estate (including owners of a partnership or S corporation that owns the rental real estate), employees, agents, and/or independent contractors of the owners. For example, if the owner of the rental real estate hires a management company to manage the property, the hours spent by the management company should count toward the 250-hour test since the management company would most likely be an “agent” and/or “independent contractor” of the owner. Moreover, the types of qualifying rental services include: Advertising to rent or lease the real estate; Negotiating and executing leases; Verifying information contained in prospective tenant applications; Collection of rent; Daily operation, maintenance and repair of the property (including the purchase of materials and supplies); Management of the real estate; Supervision of employees and independent contractors.
- Documenting Hours Of Service. For tax years beginning after 2019, taxpayers relying on the 250-hour safe harbor must keep contemporaneous records (e.g., time reports, logs, or similar documents) of the following: 1) Hours of all services performed; 2) Description of all services performed; 3) Dates on which such services were performed; and 4)Who performed the services. These records must be available for inspection by the IRS upon request. Planning Alert! Even though this “contemporaneous record” requirement does not technically apply until the 2020 tax year, for 2019 – taxpayers presumably will need some form of reasonable support that documents the hours of service they are claiming.
- Certain Rental Real Estate Is Not Eligible For The 250-Hour Safe Harbor. The 250-hour safe harbor is not available for a rental real estate activity, if: 1) The rental real estate is used by the taxpayer during the year as a residence for more than the greater of 14 days or 10% of the days the property was rented to others; or 2) The real estate is rented or leased under a “triple net lease” (i.e., a lease that requires the lessee to pay property taxes, fees, insurance, and maintenance for the leased real estate).
Guidance On The Determination Of “Qualified Business Income” (QBI). “Qualified Business Income” (QBI) is commonly generated as pass-through income to an S corporation shareholder or a partner in a partnership, or as self-employed business income of a sole proprietor. The Final 199A Regs and other recent IRS guidance have provided additional information regarding the impact of the following selected items on the computation of QBI:
- “For AGI” Deduction Of One-Half Of The Self-Employment Tax By A Self-Employed Taxpayer. Generally, a self-employed individual is allowed a “For AGI” (i.e., above-the-line) deduction for one half of the self-employment tax (S/E Tax) paid with respect to self-employed income. The Final 199A Regs clarify that this deduction for one half of the S/E Tax reduces QBI to the extent the S/E Tax was attributable to S/E income included in the individual’s QBI.
- “For AGI” Deduction For Health Insurance Premiums By Self-Employed Taxpayers. If you are a self-employed individual, you are generally allowed a “For AGI” deduction for health insurance premiums you paid for yourself, your spouse, and your dependents (the insurance can also cover your child who was under age 27 at the end of 2019, even if not your dependent). The Final 199A Regs generally clarify that this deduction for health insurance premiums reduces QBI to the extent this deduction was attributable to S/E income included in your QBI.
- “For AGI” Deduction For Retirement Plan Contributions By Self-Employed Taxpayers And Partners. If you are a self-employed individual or a partner in a partnership, you are generally allowed a “For AGI” deduction for contributions made on your behalf to a qualified retirement plan (e.g., SEP Plan, SIMPLE Plan, Other Qualified Retirement Plan). The Final 199A Regs generally clarify that this deduction for contributions to a retirement plan reduces QBI to the extent the retirement plan contribution was attributable to income included in your QBI.
- “For AGI” Deduction By A Partner Who Is Not Reimbursed For The Payment Of Partnership Expenses. Generally, a partner is entitled to a “For AGI” deduction for out-of pocket business expenses the partner pays on behalf of the partnership. Historically, the IRS has generally taken the position that a partner may deduct business expenses paid on behalf of the partnership only if there is an agreement (preferably in writing) between the partner and the partnership providing that those expenses are to be paid by the partner, and that the expenses will not be reimbursed by the partnership. The Final 199A Regs expressly declined to address to what extent (if any) “deductions for unreimbursed partnership expenses” impact the determination of a partner’s QBI. However, on its website, the IRS posted a “Q&A” that stated: “To determine the total amount of QBI, the taxpayer must consider deductions not reported on Schedule K-1 that are related to the trade or business. This could include unreimbursed partnership expenses ….” [Emphasis added]. Planning Alert! The “Draft” Instructions to the “2019” Form 8995 (“Qualified Business Income Deduction Simplified Computation”) also states: “To figure the total amount of QBI, the taxpayer must consider all items that are related to the trade or business. This includes … unreimbursed partnership expenses ….” [Emphasis added].
- Impact Of The “For AGI” 179 Deduction Taken By A Partnership Or S Corporation On The Owner’s QBI. Subject to certain limitations (e.g., dollar caps, taxable income limitation), a taxpayer may elect to take an immediate deduction for the cost of 179 property (e.g., business equipment, furniture and fixtures, certain business vehicles, etc.). If an S corporation or partnership elects to take the 179 deduction with respect to the purchase of qualifying business property, the potential limitations that could cap the amount of the 179 deduction for that year must be applied twice (i.e., once at the pass-through entity level, and a second time at the owner level). Since this double application of the 179 deduction limitations could result in a pass-through entity’s 179 deduction not being limited at the entity level, but being capped at the pass- through owner’s level, some asked whether the 179 deduction taken by a pass-through entity reduced the QBI generated by that entity. The Final 199A Regs do not address this issue. However, on its website, the IRS posted a “Q&A” that appears to confirm that a 179 deduction from a pass-through entity (that is attributable to pass-through QBI from that entity) reduces the QBI only to the extent the 179 deduction is not limited on the owner’s return (e.g., the 179 deduction would presumably not offset the pass-through QBI for that tax year if and to the extent the 179 deduction was limited by the owner’s dollar caps or the owner’s taxable income limitation).
Clarification Of Selected SSTB Issues. As discussed previously, based on your “Taxable Income” (before the 20% 199A Deduction), all or a portion of your business income from a so called “Specified Service Trade or Business” (SSTB) may not qualify for the 20% 199A Deduction. An SSTB is generally defined as a trade or business activity involved in the performance of services in the fields of: health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or any trade or business involving the services of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. An “SSTB” does not include the performance of architectural or engineering services. Caution! The Final 199A Regs provide significant guidance on SSTBs, including many examples of the types of businesses that would or would not be classified as SSTBs. This IRS guidance is far too lengthy to cover in detail in this letter. However, the following are selected SSTB anti-abuse rules that the Final 199A Regs clarified:
- 5%/10% De Minimis Rule Is All Or Nothing. Before the Final 199A Regs, the IRS had proposed a de minis safe harbor for a trade or business that generated both SSTB income and non-SSTB income. This proposed safe harbor basically provided that a trade or business would not be treated as an SSTB if less than 10% of its overall gross receipts was generated by an SSTB activity. For trades or businesses with overall gross receipts exceeding $25 million, the 10% de minimis safe harbor is reduced to 5% of overall gross receipts. Until the Final 199A Regs were released, the IRS had not specifically addressed how a trade or business with SSTB income exceeding the 10%/5% threshold would be classified. Planning Alert! Unfortunately, the Final 199A Regs make it clear that, if a taxpayer’s SSTB gross receipts exceed the 10%/5% de minimis threshold, the entire trade or business is treated as an SSTB!
- Guidance For Outside Owners Of Rental Property Leased To A 50%-Commonly-Controlled SSTB. Before the Final 199A Regs, the IRS had proposed an SSTB anti-abuse rule that generally provided that a business is treated as generating SSTB income if the business provides services or property to another 50%-Commonly-Controlled SSTB. For example, assume that Partner “A” and Partner “B” are the sole owners of AB Law Firm (an SSTB), and are also the two sole owners of a separate LLC (AB LLC) that leased the office building to the AB Law Firm. In that situation, the rental income generated by the 50%- commonly-controlled AB LLC would also be treated as SSTB income. However, this proposed anti-abuse rule did not specifically address the treatment of an owner who was not included in the 50% commonly controlled test. For example, assume in the previous hypothetical the LLC that owned the office building was owned equally by A, B, and C (ABC LLC) which, in turn, leased the office building to the AB Law Firm (owned equally by A and B). Assuming C is not an attorney and is unrelated to A and B, the Final 199A Regs appear to provide that, since A and B are both a member of the 50%-Commonly Controlled group, their respective shares of ABC LLC’s rental income would be treated as SSTB income. However, C’s share of ABC LLC’s rental income would not be treated as SSTB income because C was not a member of the 50%-commonly-controlled group.
Guidance For Owners Of Rental Property That Is Only Partially Leased To A 50%-Commonly-Controlled SSTB. As in the immediately-preceding example, let’s again assume that A and B are the sole owners of AB Law Firm (an SSTB), and are also the two sole owners of a separate LLC (AB LLC) that owns an office building (Office Building). However, unlike the previous example, now assume that AB LLC leases only 80% of the Office Building to AB Law Firm and leases the remaining 20% to D (an unrelated third party). The Final 199A Regs say that only 80% of the rental income generated by AB LLC is treated as SSTB income. The remaining 20% of the rent would not be treated by AB LLC as SSTB income because that 20% portion of the Office Building was not leased to a 50%-Commonly-Controlled SSTB.
THE NEW “QUALIFIED OPPORTUNITY FUNDS” (QOFs) PROVISIONS AND TAX BENEFITS
General Tax Benefits Of Investing In “Qualified Opportunity Funds” (QOFs). Generally, new section 1400Z allows taxpayers to defer capital gains (long-term or short-term) to the extent the gains are invested in a QOF within 180 days of realizing the capital gain. In addition, if the investment in the QOF is held for at least 5 years – then 10% of the original deferred capital gain is essentially eliminated. If the QOF investment is held at least 7 years – then 15% of the original deferred capital gain is eliminated. Moreover, for qualified investments in a QOF held for at least 10 years, the taxpayer may elect to exclude any gain that arose after the taxpayer initially purchased the QOF investment. Observation! All remaining deferred gain reflected in the investment in a QOF must be fully recognized on the earlier of 1) The date the taxpayer sells the QOF investment, or 2) December 31, 2026. Thus, the remaining deferred gain must be fully recognized no later than December 31, 2026, even if the taxpayer still holds the QOF investment on December 31, 2026.
- Planning Alert! Even in the best case scenario, 85%of the original deferred capital gain will be taxed no later than December 31, 2026 at whatever capital gains rates exist in 2026. If the current effective maximum long-term capital gain rate of 23.8% (including the 3.8% net investment income tax) is increased between now and 2026, the increase in the capital gains rates would dilute the tax benefit of the tax deferral.
- Example. Assume that a taxpayer sold a capital asset on July 1, 2019 for $110 with a basis of $10 (realizing a $100 qualifying capital gain). The taxpayer could defer 100% of the $100 capital gain by investing $100 (i.e., the “amount” of the gain) in a QOF within 180 days of the sale that triggered the $100 gain. If the QOF investment is held at least 5 years and then sold, the taxpayer could exclude $10 of the deferred gain (i.e., 10% x deferred gain of $100). If instead, the QOF investment is held at least 7 years, the taxpayer could exclude $15 of the deferred gain (i.e., 15% x deferred gain of $100). If the taxpayer still owns the QOF investment on December 31, 2026, on that date the taxpayer will have to recognize $85 of deferred gain (the original deferred gain of $100 less 15% of the $100 gain as a result of holding the investment for at least 7 years). Further assume in this example that the taxpayer held the QOF investment (originally purchased for $100) for 10 years, and then sold it for $140 generating a $40 gain. The taxpayer could exclude the entire $40 gain. Practice Alert! As mentioned above, assuming that the taxpayers holds the QOF investment for at least 7 years, at a minimum 85% of the original deferred capital gain will be taxed no later than December 31, 2026 (which is the date that all of the then outstanding deferred gains must be recognized). Thus, it appears that a taxpayer would have to purchase the interest in the QOF before the end of 2019 in order to meet the 7-year holding period by December 31, 2026.
Taxable Gains Eligible For The Tax Benefits Of Investing In A QOF. Generally, a gain on the sale of an asset is “eligible” for the tax benefits of section 1400Z only if the gain: 1) Is “treated as a capital gain” for federal income tax purposes; 2) Would otherwise have been recognized (except for qualifying for the tax benefits under §1400Z) for federal income tax purposes before January 1, 2027,AND 3) Does not arise from a sale or exchange with a related party. Planning Alert! A capital gain that results from a taxpayer selling “goodwill” as part of the sale of an operating business could qualify for the tax benefits of §1400Z.
- Capital Gains Under §1231 May Also Qualify. According to “proposed” regulations issued by the IRS in October, 2018, a “net” capital gain arising from the sale of §1231 property for the tax year qualifies for the tax benefits of §1400Z. Section 1231 property is generally defined as property held in a “trade or business” for “more than one year” that is either: 1) Subject to the allowance for depreciation under §167 (e.g., depreciable business equipment, buildings, vehicles); or 2) Non-depreciable real property (e.g., the real estate lot on which a building used in a business stands). A “net” §1231 gain (qualifying for the tax benefits of §1400Z) occurs if the taxpayer’s total “gains” recognized by taxpayer from the sale of §1231 property for the taxable year exceeds the taxpayer’s total “losses” from §1231 property. Planning Alert! Generally, when a capital asset is sold, the 180-day re-investment period under §1400Z begins on the date the asset is sold. However, according to the proposed regulations: “[T]he 180-day [Re-Investment] Period …. with respect to any capital gain net income from section 1231 property for a taxable year begins on the last day of the taxable year.” [Emphasis added].
- Example Of “Net” §1231 Gain. Assume that for the tax year a taxpayer had a single §1231 gain of $100 (from the sale of Office Building) and a single §1231 loss of <$80> (from the sale of a Residential Apartment Building). In this situation, the taxpayer would have a “net” §1231 gain of $20 ($100 less $80). According to the proposed regulations, only the “net” §1231 gain of $20 would be eligible for deferral by investing in a QOF. In addition, the 180-day re-investment period would begin on the last day of the taxable year during which the sales of §1231 property occurred.
- Planning Alert! If you need a more detailed explanation of the tax benefits of investing in Qualified Opportunity Fund, please call our Firm.
The requirements that must be satisfied in order to qualify for the 20% 199A Deduction or the tax benefits of investing in a Qualified Opportunity Fund are extensive and extremely technical. The information contained in this material represents only a general overview of selected aspects of those two provisions, and should not be relied upon without an independent, professional analysis of how any of the matters discussed may apply to a specific situation. If you need additional information on either of these provisions that we did not address in this letter, please contact us. In addition, please call us before implementing any planning ideas discussed in this letter, or if you need additional information.
Disclaimer: Any tax advice contained in the body of this material was not intended or written to be used, and cannot be used, by the recipient for the purpose of promoting, marketing, or recommending to another party any transaction or matter addressed herein. The preceding information is intended as a general discussion of the subject addressed and is not intended as a formal tax opinion. The recipient should not rely on any information contained herein without performing his or her own research verifying the conclusions reached. The conclusions reached should not be relied upon without an independent, professional analysis of the facts and law applicable to the situation.