Tuesday, January 22, 2019
Last August, the Treasury issued proposed regulations under I.R.C. §199A that was created by the Tax Cuts and Jobs Act (TCJA) enacted in late 2017. REG-107892-18 (Aug. 8, 2018). The proposed regulations were intended to provide taxpayers guidance on planning for and utilizing the new 20 percent pass-through deduction (known as the QBID) available for businesses other than C corporations for tax years beginning after 2017. It expires for years beginning after 2025. While some aspects of the proposed regulations are favorable to agriculture, other aspects created additional confusion, and some issues were not addressed at all (such as the application to agricultural cooperatives).
A public hearing on the final regulations was held in Washington, D.C. on October 16, 2018 and the Treasury released the final QBID regulations on January 18, 2019. The final regulations provide much needed guidance on several key points.
Today’s post does not provide an overview of the 199A provision (for that background information you can read my prior post here https://lawprofessors.typepad.com/agriculturallaw/2018/01/the-qualified-business-income-qbi-deduction-what-a-mess.html and here https://lawprofessors.typepad.com/agriculturallaw/2018/03/congress-modifies-the-qualified-business-income-deduction.html. What I am focusing on today is the impact of the final regulations on farm and ranch businesses - that’s the topic of today’s post.
Multiple businesses. The proposed regulations did provide a favorable aggregation provision that allows a farming operation with multiple businesses (e.g., row-crop; livestock; etc.) to aggregate the businesses for purposes of the QBID. This was, perhaps, the best feature of the proposed regulations with respect to agricultural businesses because it allows a higher income farming or ranching business to make an election to aggregate their common controlled entities into a single entity for purposes of the QBID. This is particularly the case with entities having paid no wages or that have low or no qualified property. Entities with cash rental income already qualified the income as QBI via common ownership (common ownership is required to aggregate) Once the applicable threshold for 2018 ($157,500 for a single filer; $315,000 for a married filing joint return) is exceeded, the taxpayer must have qualified W-2 wages or qualified property basis to claim the QBID. Aggregation, in this situation, may allow the QBID to be claimed (assuming the aggregated group has enough W-2 wages or qualified property).
Proposed regulations. Common ownership is required to allow the aggregation of entities to maximize the QBID for taxpayers that are over the applicable income threshold. Prop. Treas. Reg. §1.199A-4(b). “Common ownership” requires that each entity has at least 50 percent common ownership. But, the common ownership rule does not require every person involved to have an ownership in every trade or business that is being aggregated, or that you look to the person’s lowest percentage ownership. For example, person A could have a 1 percent ownership interest in entity X and a 99 percent ownership interest in entity Y, and an unrelated person could have the opposite ownership (99 percent in x and 1 person in Y) and the entities would have common ownership of 100 percent (the group of people have 50 percent or more common ownership).
But, there was a potential snag with the definition, and it concerned a family attribution rule that could pose issues for farming operations involving family members with multiple generations. The proposed regulations limited family attribution to just the spouse, children, grandchildren and parents. See Prop. Treas. Reg. §1.199A-4(b)(3). In other words, the proposed regulations limited common ownership to lineal ancestors and descendants. Excluded were siblings – which are often involved in farming and ranching businesses. One way to plan around the lack of sibling attribution, for example, was to have one child own 100 percent of one business and another child of the same parent own 100 percent of another business. In that situation, the parent is deemed to have 100 percent ownership of both businesses even though there is no sibling attribution. The two businesses could be aggregated, even though there is no sibling attribution, as long as at least one parent is alive.
The proposed regulations were also unclear concerning whether (for taxpayers over the applicable income threshold) it mattered if the entities are on a calendar or fiscal year-end. In order to elect to aggregate entities together, the proposed regulations required all of the entities in a combined group must have the same year-end, and none can be a C corporation. But, rental income paid by a C corporation in a common group could be QBI if the C corporation was part of that combined group. If this reading were correct, that meant that the rental income could qualify as QBI. That interpretation is beneficial to farming and ranching businesses – many are structured with multiples entities, at least one of which is a C corporation.
Final regulations. Fortunately, the final regulations provide that siblings are included as related parties via I.R.C. §§267(b) and 707(b). Including siblings in the definition of common ownership for QBID purposes will be helpful upon the death of the senior generation of a farming or ranching operation. In addition, the final regulations retain the 50 percent test and clarify that the test must be satisfied for a majority of the tax year, at the year-end, and that all of the entities of a combined group must have the same year-end.
The final regulations also specify that aggregation for 2018 can be made on an amended return. The aggregation election can be made in a later year if it was not made in the first year.
Rental Activities – What’s Business Income?
One of the big issues for farmers and ranchers operating as sole proprietorships or as a pass-through entity is whether land rental income constitutes QBI. The proposed regulations confirmed that real estate leasing activities can qualify for the QBID without regard to whether the lessor participates significantly in the activity. That’s particularly the case if the rental is between “commonly controlled” entities. But, the proposed regulations could also have meant that the income a landlord receives from leasing land to an unrelated party (or parties) under a cash lease or non-material participation share lease may not qualify for the QBID. If that latter situation were correct it could mean that the landlord must pay self-employment tax on the lease income associated with a lease to an unrelated party (or parties) to qualify the lease income for the QBID. Thus, clarification was needed on the issue of whether the rental of property, regardless of the lease terms will be treated as a trade or business for aggregation purposes as well as in situations when aggregation is not involved. That clarification is critical because cash rental income may be treated differently from crop-share income depending on the particular Code section involved. See, e.g., §1301.
Proposed regulations. The proposed regulations also contained an example of a rental of bare land not requiring any cost on the landlord’s part. See Prop. Treas. Reg. §1.199A-1(d)(4), Example 1. This seemed to imply that the rental of bare land to an unrelated third party qualifies as a trade or business. Another example in the proposed regulations also seemed to support this conclusion. Prop. Treas. Reg. §199A-1(d)(4), Example 2. Apparently, this means that a landlord’s income from passive triple net leases (a lease where the lessee agrees to pay all real estate taxes, building insurance, and maintenance on the property in addition to any normal fees that are expected under the agreement) should qualify for the QBID. But, existing caselaw is generally not friendly to triple net leases being a business under I.R.C. §162. Clarification on this point was also needed.
Unfortunately, the existing caselaw doesn’t discuss the issue of ownership when it is through separate entities and, on this point, the Preamble to the proposed regulations created confusion. The Preamble says that it's common for a taxpayer to conduct a trade or business through multiple entities for legal or other non-tax reasons, and also states that if the taxpayer meets the common ownership test that activity will be deemed to be a trade or business in accordance with I.R.C. §162. But, the Preamble also stated that "in most cases, a trade or business cannot be conducted through more than one entity.” So, if a taxpayer has several rental activities that the taxpayer manages, the Preamble raised a question as to whether those separate rental activities can’t be aggregated unless each rental activity is a trade or business. It also raised a question as to whether the Treasury would be making the trade or business determination on an entity-by-entity basis. If so, triple net leases might not generate QBI. But, another part of the proposed regulations extended the definition of trade or business beyond I.R.C. §162 in one circumstance when it referred to “each business to be aggregated” in paragraph (ii). Prop. Treas. Reg. §1.199A-4(b)(i). This would appear to mean that the rental of property would be treated as a trade or business for aggregation purposes. See Prop. Treas. Reg. §199A-1(b)(13).
Final regulations. So how did the final regulations deal with the issue of passive lease income? For starters, the bare land rent example in the proposed regulations was eliminated. Unfortunately, no further details were provided on the QBI definition of trade or business. That means that each individual set of facts will be key with the relevant factors including the type of rental property (commercial or residential); the number of properties that are rented; the owner’s (or agent’s) daily involvement; the type and significance of any ancillary services; the terms of the lease (net lease; lease requiring landlord expenses; short-term; long-term; etc.). Certainly, the filing of Form 1099 will help to support the conclusion that a particular activity constitutes a trade or business. But, tenants-in-common that don’t file an entity return create the implication that they are not engaged in a trade or business activity.
The final regulations clarify (unfortunately) that rental paid by a C corporation cannot create a deemed trade or business. That’s a tough outcome as applied to many farm and ranch businesses and will require some thoughtful discussions with tax/legal counsel about restructuring rental agreements and entity set-ups. Before the issuance of the final regulations, it was believed that land rent paid by a C corporation could still qualify as a trade or business if the landlord could establish responsibility (regularity and continuity) under the lease. Landlord responsibility for mowing drainage strips (or at least being responsible for ensuring that they are mowed) and keeping drainage maintained (i.e., tile lines), paying taxes and insurance and approving cropping plans, were believed to be enough to qualify the landlord as being engaged in a trade or business. That appears to no longer be the case.
Notice 2019-7. Along with the release of the final regulations, the IRS issued Notice 2019-7. The Notice is applicable for tax years ending after December 31, 2017 and can be relied upon until the final Revenue Procedure is published. The Notice provides tentative guidance and a request for comments on the sole subject of when and if a rental activity (termed as a “rental real estate enterprise) will be considered to be an active trade or business. The Notice also provides a safe harbor. While real estate rented or leased under a triple net lease is not eligible under the safe harbor (unless common control allows it), a taxpayer who has an active business of entering into and selling triple net leases may still be considered to be sufficiently active to qualify as a trade or business under existing case law.
The Notice defines a triple net lease to include an agreement that requires the tenant to pay taxes, fees, and insurance, and to be responsible for maintenance in addition to rent and utilities, and includes leases that require the tenant to pay common area maintenance expenses, which are when a tenant pays for its allocable portion of the landlord’s taxes, fees, insurance, and maintenance activities which are allocable to the portion of the property rented. The definition seems to leave open the ability to avoid triple net lease status by having the tenant be responsible for some portion of the maintenance, taxes, fees, insurances, and other expenses that would normally be payable by a landlord. However, failure to meet the safe harbor does not fully preclude the lease from generating QBI.
Note: For landowners receiving annual “wind lease” income for aerogenerators on their farmland, even though the income is received as part of a common controlled group, the actual income is not paid by any member of the controlled group. It is essentially triple net lease income with no services provided by the farmer (or spouse). This income will not be QBI, given the inability of the landowner to provide “services” under the lease agreement.
An individual may rely on the safe harbor, as well as a partnership or S-corporation that owns the applicable interest in the real estate that is leased out (such as farmland). As noted above, the final regulations take the position that the lessor entity must be a pass-through entity (or a sole proprietorship) that owns the real estate directly or through another entity that is disregarded for income tax purposes. Rent that is paid by a C corporation doesn’t count.
Each individual taxpayer, estate or trust can elect to treat each separate property as a separate enterprise, or all similar properties as a single enterprise, for purposes of applying the safe harbor rules, except that commercial and residential real estate cannot be considered as part of the same enterprise for testing purposes. In other words, all commercial rents can be netted as one single enterprise, and all residential rentals can be netted as another enterprise. But, real estate that is under a triple net lease, and real estate used as a residence by the taxpayer cannot be part of an aggregated enterprise for testing purposes because they cannot qualify to be included in the safe harbor.
The Notice specifies that for each separate enterprise, certain requirements must be satisfied each year for the enterprise’s income to be eligible for the safe harbor:
- Maintenance of separate books and records to reflect the income and expenses for each enterprise.
- Aggregate records for properties that are grouped as a single enterprise.
- Contemporaneous records (similar to auto logs) of time reports, logs, etc., with respect to services performed and the party performing the services with respect to tax years beginning January 1, 2019. The requirement is inapplicable to 2018 returns or fiscal year filers for years ending before 2020.
- For tax years 2018 through 2022, 250 or more hours of “rental services” must be performed to qualify the property for the safe harbor in each calendar year. Rental services include time spent by owners, employees, agents, and independent contractors of the owners, which can include management and maintenance companies who have personnel who keep and provide contemporaneous records. Rental services also include advertising to rent or lease properties; negotiating and executing leases; verifying tenant information; collecting rent; daily management and repairs; buying materials and supervising employees and independent contractors.
The safe harbor requirements will most likely be easier to satisfy by taxpayers having multiple properties, and cannot be used by a taxpayer that rents their personal residence(s) out for part of the year. While most rental house scenarios, cash rents and crop shares won’t qualify for the safe harbor, they may qualify under common control without regard to any hour requirement, or they can still generate QBI based on the overall facts and circumstances.
Thursday’s post will continue the discussion of the impact of the final QBI regulations on farming and ranching businesses. In that post, I will look a little further into the trade or business issue, discuss W-2 wages, and examine how the final regulations address the unadjusted basis in assets (UBIA) issue for QBI purposes. In addition, I will comment on numerous miscellaneous provisions, including the treatment of capital gains and the deductions that reduce QBI, just to name a couple. Also, I will take a look at how the final regulations treat commodity transactions, and how they apply to trusts and estates.