Thursday, January 24, 2019
As noted on Tuesday’s post, the Treasury issued final regulations for the qualified business income deduction (QBID) under I.R.C. §199A on January 18. This provision, of course, provides for a 20 percent deduction on business income received by a sole proprietor or member of a pass-through entity. On Tuesday, I discussed how the final regulations affected rental situations for farmers and ranchers and also how the final rules dealt with aggregation.
In today’s post, I look at numerous other issues associated with I.R.C. §199A and the final regulations that are important to farmers and ranchers
The rest of the story, so to speak, concerning the QBID final regulations and farmers and ranchers – that’s the topic of today’s post.
Proposed regulations. Under the proposed regulations, carryover losses that were incurred before 2018 and that are now allowed in years 2018-2025 will be ignored in calculating qualified business income (QBI) for purposes of the QBID. This is an important issue for taxpayers that have had passive losses that have been suspended under the passive loss rules. While this loss allocation rule is generally favorable, clarification was needed on a couple of points. For instance, could a taxpayer also ignore pre-2018 suspended losses for purposes of the Excess Business Loss rule under I.R.C. §461(l)?
Final regulations. The final regulations, consistent with the regulations issued under former I.R.C. §199, provide that any losses that are disallowed, suspended, or limited under I.R.C. §465 (passive loss rules) §704 and I.R.C. §1365 (or any other similar provision) are to be used on a first-in, first-out basis.
In addition, the final regulations clarify that an NOL deduction (in accordance with I.R.C. §172) is generally not considered to be in connection with a trade or business. Excess business losses (the amount over $500,000 (mfj)) are not allowed for the tax year. However, an Excess Business Loss under I.R.C. §461(l) is treated as an NOL carryover to the next tax year where it reduces QBI in that year. The carry forward becomes part of the taxpayer's NOL carryforward in later years. There is no mention whether this amount gets retested under I.R.C. §461(j) (involving subsidized farming losses). Under prior law, those disallowed losses retained their character in a later tax year. That is no longer the case and it appeared that the NOL generated under I.R.C. §461(l) would not be subject to other loss limitation provisions.
Included and Excluded Items
QBI includes net amounts of income, gain, deduction, and loss with respect to any qualified trade or business. I.R.C. §199A(c). Business-related items that constitute QBI include ordinary gains and losses from Form 4797; deductions that are attributable to a business that is carried on in an earlier year; the deduction for self-employed health insurance under I.R.C. §162(l); and the deductible portion of self-employment tax under I.R.C. §164(f). The final regulations affirm this. Treas. Reg. §1.199A-3(b)(1)(vi). The reduction of QBI for self-employed health insurance, for an S corporation shareholder or partner occurs at the entity level. It is removed for an S corporation, for example on Form 1120-S. It should not be deducted twice. If QBI were reduced by the amount of the I.R.C. §162(l) deduction on Form 1040, QBI would (incorrectly) be reduced twice.
The final regulations also clarify that the deduction for contributions to qualified retirement plans under I.R.C. §404 is considered to be attributable to a trade or business to the extent that the taxpayer’s gross income from the trade or business is accounted for when calculating the allowable deduction, on a proportionate basis.
The final regulations do not address how deductions for state income tax imposed on the individual’s business income or unreimbursed partnership expenses are to be treated. The final regulations also don’t mention whether the deduction for interest expense to a partnership interest or an S corporation interest is business related. Guaranteed payments for the use of capital in a partnership are not attributable to the partnership’s business, unless they are properly allocable to the recipient’s qualified trade or business (not likely). Also excluded from QBI are amounts that an S corporation shareholder receives as reasonable compensation or amounts a partner receives as payment for services under I.R.C. §§707(a) or (c).
Proposed regulations. The proposed regulations appeared to take the position that gain that is “treated” as capital gain is not QBI. Prop. Treas. Reg. 1.199A-3(b)(2)(ii)(A). This interpretation would exclude I.R.C. §1231 gain (such as is incurred on the sale of breeding livestock) from being QBI-eligible. But, it could also be argued that is an incorrect interpretation of the relevant Code provisions. It also is arguably inconsistent with the purpose of the QBID statute. I.R.C. §1222(3) defines long-term capital gain as the gain from the sale or exchange of a capital asset held for more than one year, if and to the extent the gain is taken into account in computing gross income. I.R.C. §1231(a)(1) treats the I.R.C. §1231 gains as long-term capital gain. I.R.C. §199A(a)(2)(B) neither modifies nor makes any other specification. Also, I.R.C. §1222(11) defines “net capital gain” as the excess of the net long-term capital gain for the year over the net short-term capital loss. None of the other provisions on I.R.C. §1222 mention I.R.C. §1231. Simply because, as the proposed regulations state, gain is “treated as” capital gain does not make it capital gain. Rather, “treated as” should be read in a manner that the tax on I.R.C. §1231 gain is computed in the same manner as capital gain. I.R.C. §1231 reflects gain on the disposition of a business asset. As such, the argument is, I.R.C. §1231 gain should be QBI because the purpose of I.R.C. §199A is to provide a lower tax rate on business income. Losses from the sale of short-term depreciable assets (Part II of Form 4797) should not reduce QBI if I.R.C. §1231 gains (Part 1 of Form 4797) are present.
Final regulations. So how did the final regulations deal with this issue? The final regulations remove the specific reference to I.R.C. §1231 and provide that any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss, including any item treated as one of these under any Code provision, is not taken into account as a qualified item of income, gain, deduction or loss. That’s comprehensives. It’s basically any item that is reported on Schedule D plus qualified dividends. Qualified dividends are specifically included in the term “capital gain” by reference to I.R.C. §1(h).
Proposed regulations. The proposed regulations provided that “brokering” is limited to trading securities for a commission or a fee. Prop. Treas. Reg. §199A-5(b)(2)(x). Clarification was needed to ensure that brokering of commodities did not constitute a specified service trade or business (SSTB). An SSTB is eligible for the QBID, but under a different set of rules that apply to non-SSTB businesses (such as farms and ranches). For instance, the concern was that under the proposed regulations a person who acquired a commodity (such as wheat or corn for a hog farm), and transported it to the ultimate buyer might improperly be considered to be dealing in commodities. This would have resulted in the income from the activity treated from an SSTB. None of the commodity income would have been eligible for the QBID for a high-income taxpayer.
Final regulations. This is also an important issue for private grain elevators. A private grain elevator generates income from the storage and warehousing of grain; it also generates income from the buying and selling of grain. Is the private elevator’s buying and selling of grain “commodity dealing” for purposes of I.R.C. §199A? If it is, then a significant portion of the elevator’s income will not qualify for the QBID. Clarification was needed to distinguish that these various services involved do not constitute an SSTB making the income non-QBI.
The final regulations clarify that the brokering of agricultural commodities does not constitute an SSTB and does so by pointing to I.R.C. §954.
The final regulations specify that the IRS may provide for methods of computing taxable wages. Simultaneously with the release of the final regulations, the IRS issued Rev. Proc. 2019-11. The Rev. Proc. notes that it applies only for QBID purposes, and recites the W-2 wages definition from the proposed regulations. Thus, statutory employees that a have a Form W-2 with Box 13 marked are not W-2 wages for QBID purposes. Also, wages paid in-kind to agricultural labor are not eligible W-2 wages, but wages paid to children under age 18 are. I explained this distinction in an earlier post that you can read here: https://lawprofessors.typepad.com/agriculturallaw/2018/08/the-qualified-business-income-deduction-and-w-2-wages.html.
The proposed regulations set forth three methods for computing W-2 wages – unmodified box method; modified box 1 method; and the tracking wages method. The Rev. Proc. also provided special rules to use for a short tax year which requires the use of the tracking wages method.
Multiple Trades Or Businesses
The final regulations follow the approach of the proposed regulations concerning a taxpayer that has multiple trades and businesses. Items of QBI that are properly allocable to more than a single trade or business must be allocated among the several trades or businesses to which they are attributed using a reasonable method based on the facts. That method is to be consistently applied each year. The same concept applies for individual items.
Income Tax Basis
Proposed regulations. Under I.R.C. §199A, higher income taxpayers compute their QBID in accordance with a wages/qualified property (QP) limitation. The amount of QP that is used in the limitation is tied to the what is known as the “unadjusted basis in assets” (UBIA). However, the proposed regulations raised some questions about UBIA that needed clarified.
For instance, Prop. Treas. Reg. §1.199A-4(b), Example 3, needed modified. When a tax-free contribution of property to a corporation is involved, the transferor’s unadjusted basis should continue to be the UBIA. The placed-in-service date would be the date that the transferor originally placed the property in service. I.R.C. §351 should simply be viewed as a continuation of the taxpayer’s holding. The only difference is that the asset is being held via the S corporation. Indeed, the tax attributes of the contributed asset remain unchanged. Likewise, the transferor’s depreciation history with respect to the contributed asset carries into the S corporation. Thus, the unadjusted basis should also carry into the corporation.
Final regulations. The final regulations clarify that the UBIA of property received in either an I.R.C. §1031 or 1033 exchange is the UBIA of the relinquished property. In addition, the placed-in-service date of the replacement property is the service date of the relinquished property. Similar concepts apply for transfers that are governed by I.R.C. §§351, 721 and 731.
The final regulations also take the position that property contributed to a partnership or S corporation under the non-recognition rules retains the UBIA of the contributor. In addition, an I.R.C. §743(b) adjustment is QP to the extent of an increase in fair market value over original cost. For entities, the UBIA is measured at the entity level, and the property must be held by the entity as of the end of the entity’s tax year. As for a decedent’s estate, the fair market value of property that is received from a decedent pegs the UBIA and the new depreciation period (for purposes of the computation of the limitation) is reset as of the date of the decedent’s death.
The final regulations specify that a non-grantor trust that is established for “a primary purpose” of avoiding income tax under I.R.C. §199A will be considered to be aggregated with trust settlor/grantor for QBID purposes. In addition, distributable net income (DNI) transferred from a non-grantor trust to a beneficiary is treated as having been received by the beneficiary. This could lead to an increase in the creation of non-grantor, irrevocable, complex trusts.
The final regulations also did not place any limitation on the use of irrevocable trusts that are considered to be owned by the beneficiary(ies). See I.R.C. §678. However, this does not necessarily mean that there should be a rush to create irrevocable trusts. The IRS, supported by the courts, often view the substance of a transaction as more controlling than form when it believes that the entity was created primarily for tax avoidance purposes. See, e.g., Helvering v. Gregory, 293 U.S. 465 (1935).
Under the final regulations, a veterinarian is engaged in the provision of health care and, therefore, is an SSTB. But, no clarity was given as to the treatment of insurance salesmen – they are often statutory employees However, the final regulations do contain a three-year lookback period on the reclassification of workers from employee (W-2) status to independent contractor (Form 1099) reporting. Employees do not have QBI, but independent contractors can.
The final regulations are effective upon being published in the Federal Register. But, in general, a taxpayer can rely on either the final or proposed regulations for tax years that end in 2018. Some parts of the final regulations apply to tax years ending after December 22, 2017, or to tax years ending after August 16, 2018. However, these situations apply to the anti-abuse rules, including the anti-abuse rules that apply to trusts.