On January 18, 2019, in response to many comments regarding last summer’s proposed regulations, the IRS issued final and new proposed regulations concerning the Code Section 199A pass-through deduction. At the same time, the IRS issued a revenue procedure dealing with the calculation of W-2 wages and a welcome proposed revenue procedure providing a safe harbor for rental real estate activities.

Highlights of the new IRS guidance follows:

Safe Harbor for Rental Real Estate Enterprises—Notice 2019-7

In response to comments the IRS received dealing with whether rental activities are a trade or business, a proposed revenue procedure has been issued that provides a safe harbor.

For purposes of the safe harbor, a rental real estate enterprise must be held directly or through a disregarded entity. Similar properties can be aggregated. Commercial and residential properties cannot be part of the same enterprise. Properties not eligible for the safe harbor include properties rented under a triple net lease and those used as a personal residence for any part of the year.

To qualify for the safe harbor:

Separate books and records must be maintained for each enterprise.

Rental services of 250 hours or more must be performed with respect to the enterprise. The services may be performed by employees, agents, or independent operators. Financial or investment management activities are not counted. (Note—a three out of five year rule will apply post 2022.)

Contemporaneous records must be maintained—but the IRS has granted an exception to this requirement for 2018 only.

Final Regulations—Specified Service Trade or Business (SSTB)

The proposed regulations provided that a trade or business that provided more than 80% of its property or services to an SSTB is a SSTB if there is 50% or more common ownership. The final regulations eliminate the 80% rule and modify the common ownership rule by stating that only the portion of the business providing property or services to the commonly owned SSTB will be treated as a separate SSTB.

To the extent a writer is paid for written material integral to the creation of performing arts (e.g., a song or screenplay), the writer is performing services in the field of performing arts and is an SSTB.

Final Regulations—Trade or Business of Being an Employee

The proposed regulations provided that an individual previously treated as an employee and subsequently treated as a non-employee while performing substantially the same services will be presumed to still be an employee for purposed of Section 199A. The final regulations provide that this presumption only applies for 3 years subsequent to the change in status. Additionally the final regulations allow a worker to rebut the IRS presumption.

Final Regulations—Net Capital Gain

The regulations define net capital gain as net capital gain under Section 1222(11) plus any qualified dividend income. Despite the new definition the regulations still exclude Section 1231 gains and losses from Section 199A qualified business income.

Final Regulations—Definition of Trade or Business

The proposed regulations provided that the rental or licensing of property to a related trade or business is a trade or business if common control exists. The final regulations clarify this rule by limiting this to situations in which the related party is an individual or real property enterprise.

Final Regulations—Unadjusted Basis Immediately After Acquisition (UBIA)

For purposes of the 2.5% of the unadjusted basis Section 199A  deduction limit, the final regulations provide that each partner’s share of UBIA is determined in accordance with how depreciation would be allocated for 704(b) purposes. Contributions of property to partnerships or S corporations should retain their UBIA status on the date they were placed in service by the contributing partner or shareholder. Basis generally carries over.

Section 743(b) basis adjustments should be treated as qualified property to the extent the adjustment reflects an increase in the property’s FMV. The final regulations refine the definition of a section 743 adjustment for Section 199A purposes.

Final Regulations—Suspended Losses

The proposed regulations provided that previously suspended losses or deductions (e.g., due to at risk, basis, or passive activity rules) allowed during the year are taken into account for purposes of computing qualified business income so long as the losses were incurred post 2017. The final regulations provide that the losses are used on a FIFO basis.

Final Regulations—Deductions Taken into Account

For purposes of Section 199A, the regulations provide that deductions such as the deductible portion of the tax on self-employment income and the deduction for contributions to qualified retirement plans are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction. The IRS did not address here unreimbursed partnership expenses, interest expense to acquire pass-though entity interests, and state and local taxes attributable to a trade or business.

Proposed Regulations—Section 199A Dividends by Regulated Investment Companies (RICs)

Reflecting conduit treatment RICs that receive qualified REIT dividends may pay Section 199A dividends. However the IRS reserved for another day conduit treatment for qualified PTP income received by a RIC.

Proposed Regulations—Trusts

A trust, regardless of the number of separate shares it has for multiple beneficiaries will be treated as a single trust for purposes of determining the Section 199A threshold amount. To the extent a taxable beneficiary receives distributions of DNI which includes Section 199A items the beneficiary applies its own threshold to these items.

Methodology for Computing W-2 Wages-Revenue Procedure 2019-11

The IRS has provided three methods for calculating W-2 wages for purposes of the Section 199A limits:

Unmodified box method—use the lesser of total entries in box 1 or box 5 of all Forms W-2

Modified box 1 method—subtract from totals in box 1 of all Forms W-2 amounts that are not wages for withholding purposes (e.g., supplemental unemployment compensation) and add totals reported in box 12 of Forms W-2 that are coded D, E, F, G, and S

Tracking wages method—use total wages subject to withholding and reported on Forms W-2 plus the totals reported in Forms W-2 box 12 and coded D, E, F, G, and S

The unmodified box method may be the simplest but the others may provide more accuracy.

The final regulations adopted many of the rules described in the proposed regulations but with revisions, clarifications and additional examples based on comments received. This guidance is timely and welcome for what promises to be a most interesting tax season for practitioners and their clients.

Ed Morris, CPA, is a senior consultant in the tax group at Marks Paneth LLP. His broad background includes serving clients in the theatrical, manufacturing, real estate and retail industries as well as exempt organizations and professional services firms. His expertise includes individual and corporate taxation, mergers and acquisitions, and tax accounting methods. Over the years he has worked at both global and regional accounting firms. He was a partner at Rosenberg, Neuwirth & Kuchner, CPAs, P.C., a Manhattan-based accounting firm that combined with Marks Paneth LLP in 2013. He is a member and former chair of the NYSSCPA Closely Held and S Corporations Committee and has written and spoken on various tax issues. He can be reached at emorris@markspaneth.com.