NEW REGULATIONS, NEW UNDERSTANDINGS: TAKING ADVANTAGE OF THE SECTION 199A DEDUCTION WITH RESTRICTIONS IMPOSED BY SECTION 643(F).

• Author: Gabuardi, Victor
• Position: Internal Revenue Code

1. INTRODUCTION

   The Tax Cuts and Jobs Act (the "TCJA") issued in December 2017, made an impact on practitioners and their clients. (1) The effect of the TCJA was felt for the first time in 2018, making significant changes throughout the code. (2) Of the many changes, Section 199A of the Internal Revenue Code (the "IRC") was a newly enacted deduction generally allowing up to a twenty percent deduction on qualified business income ("QBI"). (3) There were no regulations issued for guidance at the time the TCJA was enacted. (4) It was not until August 16, 2018 that the proposed regulations were issued. (5) However, such proposals were withdrawn after they received much criticism. (6) The final regulations on Section 199A were ultimately issued on February 8, 2019. (7) Despite the final regulations being issued, much confusion and lack of guidance still remain. (8)

   Trusts are commonly used for asset protection (9) and with the new changes, there are still various ways to use trusts to help taxpayers reduce and save money on their income tax return, especially business owners. Of the numerous uses for trusts, including control over family businesses, (10) taking advantage of the Section 199A deduction may be a brief - compared to the potential grand scheme of the life of a trust--but popular use for a trust regarding the grantor and the beneficiaries of the same. (11) The focus of this Article will be on the finalized regulations and the use and practicality of trusts to apply for the Section 199A deduction. Furthermore, trust drafters will need to be aware of the family dynamics as the Section 199A regulations--along with the anti-abuse rules--incorporate the multiple trust rule stated in Section 643(f) and reiterated in the Section 1.643(f)-1 regulations. (12)

   This Article explores the intricacies and benefits of the Section 199A deduction and a general description of the final regulations. Part II of this Article discusses the Section 199A deduction, the technicalities, and operational component of the same. (13) Part III of this Article discusses how individuals and relevant passthrough entities ("RPE") have the ability to aggregate similar businesses they own to either qualify or even maximize on their Section 199A deduction. (14) Part IV of this Article discusses the Section 199A calculation for RPEs and trusts, including the difference for trusts in calculating the Section 199A deduction before and after the final regulations. (15) Finally, Part V concludes with a summary of the main takeaways the final regulations left tax planners with.

2. SECTION 199A DEDUCTION

   1. HOW THE STATUTE OPERATES

      Generally, it appears there are six scenarios on how the statute operates, each one triggering different parts of the statute. (16) There six scenarios are: (1) operating a qualified trade or business and generating taxable income under threshold amount and has no W-2 wages with no qualified property; (2) operating in a specified service trade or business and generating taxable income less than the threshold amount; (3) operating a qualified trade or business and generating taxable income over threshold amount by more than $50,000 (or $100,000 in the case of jointly filed returns); (4) operating a specified service trade or business and generates income over threshold amount by more than $50,000 (or $100,000 in the case of a joint filed return); (5) operating a qualified trade or business and the taxable income is over the threshold amount but not more than $50,000 (or $100,000 in the case of a joint filed return); and (6) operating a specified service trade or business and generating taxable income over threshold amount but not more than $50,000 (or $100,000 in the case of a joint filed return). (17) The Section 199A deduction states that taxpayers other than corporations are allowed a deduction equal to the lesser of either the combined qualified business income amount of the taxpayer or twenty percent of the excess of the taxable income of the taxpayer over the net capital gain of the taxpayer in that same year. (18) Section 199A(b)(1) states combined qualified business income amount is defined the amount in Section 199A(b)(2) plus "[twenty] percent of the aggregate amount of the qualified REIT dividends and qualified publicly traded partnership income of the taxpayer for the taxable year." (19) Section 199A(b)(2) determines the deductible amount for any qualified (20) trade or business as the lesser of either "[twenty] percent of the taxpayer's qualified business income (21) with respect to the qualified trade or business," (22) or "the greater of [fifty] percent of the W-2 wages with respect to the qualified trade or business, or the sum of [twenty-five] percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition ("UBIA") of all qualified property." (23)

   2. THE THRESHOLD AMOUNT AND MODIFICATIONS TO SECTION 199A DEDUCTION

      Section 199A allows the deduction stated above without modification if an individual does not exceed the $157,000--subject to inflation--threshold amount. (24) The phase in limit of Section 199A(b)(3)(B) generally provides two alternatives once the threshold is exceeded but does not exceed $207,500 for single returns and $415,000 for those filing jointly. (25) Where Section 199A(b)(2)(A) is greater than Section 199A(b)(2)(B) then the determination of deductible amount for each trade or business under Section 199A(b)(2) shall be applied without regard to the Section 199A(b)(2)(B) amount. (26) However, we must reduce the Section 199A (b)(2)(A) amount by the Section 199A(b)(3)(B)(ii) amount. (27) The Section 199A(b)(3)(B)(ii) reduction amount in Section 199A(b)(2)(A) requires one to: use the difference between the Section 199(b)(2)(A) and Section 199A(b)(2)(B). (28) However, where the Section 199A(b)(2)(B) amount is greater than the Section 199A(b)(2)(A) amount, the deduction shall be calculated without any special adjustment. (29)

   3. OWN A TRADE OR BUSINESS--AND GUESS WHAT, RENTAL IS INCLUDED

      The initial reaction to there being a trade or business was confusing at first and guidance was subsequently issued stating that, not only will a trade or business for Section 199A deduction be the same as the Section 162 definition for a trade or business, but it will also include rental real estate enterprise activity ("REEA"). (30) So long as the such activity meets the safe harbor requirements, the same will be eligible to qualify for the Section 199A deduction for both individuals and RPEs. (31) As reminded in the IRS' notice, this is only a safe harbor and if the Section 199A deduction is being claimed but fails to meet the defined activity level of a REEA, one may have a more difficult time claiming the deduction. (32)

      An REEA is defined as "an interest in real property held for the production of rents and may consist of an interest in multiple properties [and] must hold the interest directly or through an entity disregarded as an entity separate from its owner under Section 301.7701-3." (33) Additionally, taxpayers must treat each REEA property as a separate or individual properties which are similar as a single enterprise. (34) The example provided distinguishing similar or separate use is commercial and residential real property. (35) To qualify for the REEA safe harbor certain elements must be met. (36)

      The safe harbor includes: (37) (1) each property or separate enterprise having their own books and records evidencing income and expenses; (2) for tax years ending prior to January 1, 2023, at least 250 hours of rental services (38) are performed on each rental enterprise and for years ending subsequent to that for any three of the five consecutive years, the 250-hour minimum is met; (39) and (3) and starting this year, the taxpayer maintains and contemporaneously updates its records. (40) As a final note, rental property used as a personal residence or vacation home, including triple net leases are not eligible to qualify for the safe harbor. (41)

   4. A SLIGHT FOCUS ON WHAT A SPECIFIED SERVICE TRADE OR BUSINESS ("SSTB") REALLY IS--AND, OH YEAH, DON'T BE AN EMPLOYEE

      As generally stated above, (42) taxpayers with a specified service trade or business are limited in taking advantage of the Section 199A deduction once a taxpayer is within the "phase-in" range, which would reduce the amount allowable to deduct, or above the phase-in range, which would phase-out the taxpayer and prevent any deduction at all. (43) However, there are specified tests for qualifying under the de minims rule exception to the SSTB phase out split between those that make over $25 million. (44) For those who have gross receipts of at least $25 million, if those that have less than ten percent of the activities attributed to those specifically excluded under the regulations then such activities will not be considered a SSTB. (45) For those in excess of the $25 million in gross receipts, the taxpayer will be considered as having a SSTB if at least five percent of the activities of the trade or business are attributed to activities enumerated in the statute. (46)

      Additionally, one should be wary to those trades or businesses providing services or property to a SSTB because such are subject to the regulations as well. (47) Specifically, if a trade or business is commonly owned by at least fifty percent ownership through related parties pursuant to Sections 267 and 707(b), and such trade or business provides services or property to a SSTB, then such portion of ownership will be considered as a SSTB for Section 199A purposes. (48) For example--as provided in the regulations--Partnership 1 operates a SSTB and Partnerships 2 and 3 do not. (49) However, the partners of Partnership 1 are also the partners of Partnerships 2 and 3, which also provide services and property to Partnership 1. (50) Because of the common ownership, Partnerships 2 and 3 will...