Friday, February 28, 2020
Just over a year ago, the Treasury issued corrected Final Regulations concerning the Qualified Business Income Deduction (QBID) of I.R.C. §199A. Those final regulations were intended to clear up some of the then-existing confusion over certain aspects of the QBID. One thing that the Final Regulations did not do, however, was provide a precise definition of what constitutes a “trade or business” for QBID purposes. The 20 percent QBID applies to ordinary income from a qualifying “trade or business” that is not conducted by a C corporation. But what qualifies as a trade or business? It’s a trade or business defined as such under I.R.C. §162 (except for the trade or business of performing services as an employee). This question keeps coming up in emails and calls that I receive. It seems as if the factual scenarios are endless.
“Trade or business for QBID purposes – it’s the topic of today’s post.
The term “trade or business” in the Code ranges from “no involvement” for purposes of farm income averaging in I.R.C. §1301 to material participation on a regular, continuous and substantial basis for purposes of the passive activity loss rules of I.R.C. §469. But, the definitional standard for the QBID is I.R.C. §162. I.R.C. §162 states, “There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business…”. I.R.C. §162. In an early case attempting to define a trade or business activity, the U.S. Supreme Court distinguished between a trade or business and an investment activity and concluded that engaging in an activity merely for pecuniary gain or to increase personal holdings without devoting a major portion of time to the activity did not amount to a trade or business activity. Snyder v. Comr., 295 U.S. 134 (1935). In addition, the taxpayer in Snyder was not truly engaged in buying and selling securities for a living.
Snyder indicates that merely engaging in an activity with intent to make a profit is not a trade or business without the presence of other factors. This remains an argument that the IRS incorrectly asserts with respect to Conservation Reserve Program (CRP) rental income where IRS has attempted to claim since 2003 that a landowners signature on a CRP contract is sufficient to constitute a trade or business resulting in the CRP payments being subject to self-employment tax in the landowner’s hands. CCM 200325002 (Jun. 20, 2003). It lost that argument in Morehouse v. Comr., 769 F.3d 616 (8th Cir. 2014), rev’g., 140 T.C. 350 (2013), but issued a non-acquiescence (A.O.D. 2015-002, I.R.B. 2015-41 (Oct. 13, 2015)) and incorrectly states the status of the law in Publication 225 where it claims that CRP rents must always be reported on Schedule F and be subjected to self-employment tax (except for taxpayers that are also receiving Social Security retirement or disability payments).
Simply stated, more than a signature on a contract is required for an activity to rise to the level of a trade or business. The U.S. Supreme Court has consistently held for many years that the determination of whether a taxpayer is carrying on a trade or business “requires an examination of the facts of each case.” In Higgins v. Comr., 312 U.S. 212 (1941), the Court held that managing and preserving one’s personal estate was not a business activity. The Court reached the same result in City Bank Farmers Trust v. Helvering, 313 U.S. 121 (1941) when it held that simply collecting interest and clipping coupons coupled with very few reinvestments did not constitute a trade or business. More recently, the Court said that a full-time gambler who wagered for himself personally was engaged in a trade or business for purposes of self-employment tax based on the entire facts of the taxpayer’s situation. Comr. v. Groetzinger, 480 U.S. 23 (1987). In Groetzinger, the court said that the presence of a trade or business activity was to be determined based on the facts of each case and that its presence was to be determined based on whether the taxpayer’s involvement in the activity is regular and continuous, and whether the primary purpose of the activity is for income or profit. Both of those factors must be present for a trade or business to exist. Importantly, the Final QBID regulations cite to these two tests of Groetzinger. See also S.C.A. Memo. 200120037 (Mar. 30, 2001).
In 1988 (the year after the Supreme Court decided Groetzinger), the Tax Court elaborated on Groetzinger in a hobby loss case involving an Illinois horse breeding activity and pointed out (for purposes of deducting expenses under I.R.C. §162) that the taxpayer must be engaged in the activity with the primary purpose and intent of making a profit. Seebold v. Comr., T.C. Memo. 1988-183. Whether a taxpayer has a profit intent, the Tax Court said, is to be determined based on an objective analysis of the factors of the situation and not on the taxpayer’s personal statement(s) of intent.
What About Land Leases?
For farmers and ranchers, a primary question is whether a land rental arrangement will generate a QBID. While the answer to the question is fact-based, the Final Regulations contain four factors designed to guide taxpayers and courts on whether a real estate activity rises to the level of a trade or business. The first factor focuses on the type of real estate involved – whether it is commercial, residential, condominium or personal. The second factor addresses the number of properties (or tracts) the taxpayer leases out. The third factor looks at the degree of daily involvement of the landlord in the rental activity. That involvement can be either personally or via an agent. Because the trade or business standard for I.R.C. §199A routes through I.R.C. §162 rather than I.R.C. §1402, imputation of an agent’s activity is not blocked as it is under I.R.C. §1402. The fourth factor concerns the type of the lease – the length of the lease and whether it is a triple-net lease, etc.
Planning points. Simply renting land out under a cash lease with the landlord doing nothing more than collecting the rent is not enough to qualify the rental income as qualified business income (QBI). While a single rental can qualify as a trade or business (see Hazard v. Comr., 7 T.C. 372 (1946), the landlord must do more than collect the rent check. See, e.g., Neill v. Comr., 46 B.T.A. 197 (1942). The same is true for passive investments in oil and gas interests – merely collecting the royalty income from the investment is not a trade or business activity. While a triple-net lease would normally not result in the landlord being engaged in a trade or business activity with respect to the rental activity under the Groetzinger test of the QBID regulations (for lack of satisfying the regularity and continuity requirement), such a lease is not automatically disqualified from generating QBI. But, a triple-net lease will likely have to be modified or aggregated with other qualifying activities to qualify the income for the QBID In addition, under Notice 2019-7, 2019-09 I.R.B. 740 and associated Rev. Proc. 2019-38, 2019-42 I.R.B. 942 the IRS created a safe harbor for rental real estate activities on an annual basis. Treas. Reg. §1.199A-1 through Treas. Reg. §1.199A-6. The final rental safe harbor was issued in September of 2019. A triple net lease is not disqualified from using the optional safe harbor. Failure to satisfy the safe harbor requirements is not fatal to a determination that the rental activity fails the trade or business standard.
The rub for many farm landlords is to create QBI from rental income without triggering self-employment tax. On this point, it is important to note that the requirement for self-employment tax is material participation under the lease. That’s a different standard than the trade or business standard for QBI which is profit intent along with regularity and continuity. Another way of stating this is that a rental activity can produce QBI without triggering self-employment tax. That’s a key point. Some minimal involvement in the rental activity is required to convert cash rent into QBI. Entering into a written lease with the tenant that details the minimal involvement (such as consultation on cropping decisions; mowing of lanes; fence maintenance; inspecting the property, etc.) by the landlord is important. Maintaining a calendar of activities and involvement of the landlord (even via an agent) concerning the rental is also key.
I.R.C. §162 establishes a test for the existence of a trade or business that is a lower hurdle than that applicable for self-employment tax. Most farm/ranch land rental income will likely be deemed to be a trade or business under the I.R.C. §162 standard and qualify as QBI. However, existing lease agreements may need to be modified and put in writing if presently an oral. Documenting landlord involvement is critical. At the same time, making sure a landlord’s involvement is not significant enough to trigger self-employment tax is also essential to many farm landlords.