If there was one part of the Tax Cuts and Jobs Act (“TCJA”) that estate planners were especially pleased to see, it was the increase in the basic exclusion amount from $5.49 million, in 2017, to $11.18 million for gifts made, and decedents dying, in 2018.[i] However, many estate planners failed to appreciate the potential impact of an income tax provision that came late to the party and that was specifically intended to benefit the individual owners of pass-through entities (“PTEs”).

A Brief History

As it made its way through Congress, the TCJA was billed[ii] as a boon for corporate taxpayers, and indeed it was. The corporate tax rate was reduced from 35% to 21%. The corporate AMT was eliminated. The system for the taxation of foreign income was changed in a way that skews in favor of C corporations.

But what about the closely held business – the sole proprietorships, the S corps, the partnerships and LLCs that are owned primarily by individual taxpayers and that often represent the most significant asset in their estates?

These businesses are usually formed as PTEs for tax purposes, meaning that the net operating income generated by these entities is generally not subjected to an entity-level tax; rather, it flows through to the individual owners, who are taxed thereon as if they had realized it directly.

With the introduction of the TCJA, the owners of many PTEs began to wonder whether they should revoke their S corporation elections, or whether they should incorporate[iii] their sole proprietorships and partnerships.

In response to the anxiety felt by individual business owners, Congress enacted a special deduction for PTEs in the form of Sec. 199A.[iv] However, shortly after its enactment on December 22, 2017, tax advisers starting peppering the IRS with questions about the application of 199A.

The IRS eventually proposed regulations in August, for which hearings were held in mid-October.[v]

In September, House Republicans introduced plans for making Sec. 199A “permanent.” Then, during the first week of November, the Republicans lost control of the House.[vi]

Notwithstanding this state of affairs, the fact remains that 199A is the law for at least two more years,[vii] and estate planners will have to deal with it; after all, the income tax consequences arising from an individual’s transfer of an interest in a PTE in furtherance of their estate plan will either enhance or reduce the overall economic benefit generated by the transfer.

In order to better appreciate the application of 199A to such “estate planning transfers,” a quick refresher may be in order.

Sec. 199A Basics

Under Sec. 199A, a non-corporate taxpayer[viii] – meaning an individual, a trust, or an estate – who owns an interest in a PTE that is engaged in a qualified trade or business (“QTB”),[ix] may claim a deduction for a taxable year equal to 20% of their qualified business income (“QBI”)[x] for the taxable year.[xi]

This general rule, however, is subject to a limitation that, if triggered, may reduce the amount of the 199A deduction that may be claimed by the non-corporate taxpayer (the “limitation”).

What triggers the limitation? The amount of the taxpayer’s taxable income from all sources[xii] – not just the taxpayer’s share of the QTB’s taxable income. Moreover, if the taxpayer files a joint return with their spouse, the spouse’s taxable income is also taken into account.

Specifically, once the taxpayer’s taxable income exceeds a specified threshold amount, the limitation becomes applicable, though not fully; rather, it is phased in. In the case of a single individual, the limitation starts to apply at taxable income of $157,500 (the so-called “threshold amount”). The limitation is fully phased in when taxable income exceeds $207,500.[xiii]

This $157,500 threshold amount also applies to non-grantor trusts and to estates.

These thresholds are applied at the level of each non-corporate owner of the business – not at the level of the entity that actually conducts the business. Thus, some owners of a QTB who have higher taxable incomes may be subject to the limitations, while others with lower taxable incomes may not.

The Limitation

As stated earlier, the Sec. 199A deduction for an individual, a trust, or an estate for a particular tax year is generally equal to the 20% of the taxpayer’s QBI for the year.

However, when the above-referenced limitation becomes fully applicable, the taxpayer’s 199A deduction for the year is equal to the lesser of:

  • 20% of their QBI from a QTB, and
  • The greater of:
      • 50% of the W-2 Wages w/r/t such QTB, or
      • 25% of the W-2 Wages w/r/t such QTB plus 2.5% of the “unadjusted basis” of the “qualified property” in such QTB.

In considering the application of this limitation, the IRS recognized that there are bona fide non-tax, legal or business reasons for holding certain properties – such as real estate – separate from the operating business, and renting it to such business. For that reason, the proposed regulations allow the owners of a QTB to consider the unadjusted basis of such rental property in determining the limitations described above – even if the rental activity itself is not a QTB – provided the same taxpayers control both the QTB and the property.[xiv]

Thus, assuming the presence of at least one QTB,[xv] much of the planning for 199A will likely involve the taxpayer’s “management” of (i) their taxable income (including their wages and their share of QBI) and, thereby, their threshold amount for a particular year, (ii) the W-2 Wages paid by the business, (iii) the unadjusted basis of the qualified property[xvi] used in the business, and (iv) the aggregation of QTBs.

Of the foregoing items, the management of the unadjusted basis of qualified property may be especially fruitful in the context of estate planning, as may the management of the threshold amount.

Unadjusted Basis

Generally speaking, the unadjusted basis of qualified property is its original basis in the hands of the QTB as of the date it was placed into service by the business.

Where the business purchased the property, its cost basis would be its unadjusted basis – without regard to any adjustments for depreciation or expensing subsequently claimed with respect to the property – and this amount would be utilized in determining the limitation on an owner’s 199A deduction.

However, where the property was contributed to a PTE in a tax-free exchange for stock or a partnership interest, the PTE’s unadjusted basis would be the adjusted basis of the property in the hands of the contributor at the time of the contribution – i.e., it will reflect any cost recovery claimed by such person.

In the case of an individual who acquires property from a decedent before placing it into service in a QTB, the stepped-up basis becomes the unadjusted basis or purposes of 199A.

However, if the qualified property is held in a partnership, no Section 754 adjustment made at the death of a partner will be taken into account in determining the unadjusted basis for the transferee of the decedent’s interest for purposes of 199A.[xvii]

Based on the foregoing, and depending upon the business,[xviii] a taxpayer who can maximize the unadjusted basis of the QTB’s qualified property will increase the likelihood of supporting a larger 199A deduction in the face of the limitation.

Toward achieving this end, there may be circumstances in which qualified property should be owned directly by the owners of the PTE (say, as tenants-in-common[xix]), rather than by the PTE itself, and then leased by the owners to the business.

For example, if a sole proprietor is thinking about incorporating a business, or converting it into a partnership by bringing in a partner, and the business has qualified property with a relatively low unadjusted basis (say, the original cost basis), the sole proprietor may want to retain ownership of the depreciable property and lease it (rather than contribute it) to the business entity, so as (i) to preserve their original unadjusted cost basis and avoid a lower unadjusted cost basis in the hands of the entity (based on the owner’s adjusted basis for the property) to which it would otherwise have been contributed, and (ii) to afford their successors in the business and to the property an opportunity to increase their unadjusted basis in the property, assuming it has appreciated – basically, real estate – after the owner’s death.

Trusts – the Threshold Amount

A non-grantor trust is generally treated as a form of pass-through entity to the extent it distributes (or is required to distribute) its DNI (“distributable net income;” basically, taxable income with certain adjustments) to its beneficiaries, for which the trust claims a corresponding distribution deduction. In that case, the income tax liability for the income that is treated as having been distributed by the trust shifts to the beneficiaries to whom the distribution was made.

To the extent the trust retains its DNI – i.e., does not make (and is not required to make) a distribution to its beneficiaries – the trust itself is subject to income tax.

In the case of a non-grantor trust, at least in the first instance, the 199A deduction is applied at the trust level. Because the trust is generally treated as an individual for purposes of the income tax, the threshold amount for purposes of triggering the application of the limitation is set at $157,500 (with a $50,000 phase-in range).

Distribution

However, if the trust has made distributions during the tax year that carry out DNI to its beneficiaries, the trust’s share of the QBI, W-2 Wages, and Unadjusted Basis of the QTB in which it owns an interest are allocated between the trust and each beneficiary-distributee.

This allocation is based on the relative proportion of the DNI of the trust that is distributed, or that is required to be distributed, to each beneficiary, or that is retained by the trust. In other words, each beneficiary’s share of the trust’s 199A-related items is determined based on the proportion of the trust’s DNI that is deemed distributed to the beneficiary.

The individual beneficiary treats these items as though they had been allocated to them directly from the PTE that is engaged in the QTB.

Following this allocation, the trust uses its own taxable income for purposes of determining its own 199A deduction, and the beneficiaries use their own taxable incomes.

Based on the foregoing, a trustee may decide to make a distribution in a particular tax year if the trust beneficiaries to whom the distribution is made are in a better position to enjoy the 199A deduction than are the trust and the other beneficiaries.[xx]

In any case, the beneficiaries to whom a distribution is not made may object to the trustee’s decision notwithstanding the tax-based rationale.

Of course, where the trustee does not consider the tax attributes of an individual beneficiary, and makes a distribution to such individual which pushes them beyond the threshold amount, or disqualifies their SSTB from a 199A deduction, the beneficiary may very well assert that the trustee did not act prudently.

Limitations Applied to Non-grantor Trusts

The 199A threshold and phase-in amounts are applied at the level of the non-grantor trust.[xxi]

Because of this, the IRS is concerned that taxpayers will try to circumvent the threshold amount by dividing assets among multiple non-grantor trusts, each with its own threshold amount.

In order to prevent this from happening, the IRS has proposed regulations that introduce certain anti-abuse rules.[xxii]

Specifically, if multiple trusts are formed with a “significant purpose” – not necessarily the primary purpose – of receiving a deduction under 199A, the proposed regulations provide that the trusts will not be “respected” for purposes of 199A.[xxiii] Unfortunately, it is not entirely clear what this means: will the trusts not qualify at all, or will they be treated as a single trust for purposes of the deduction?

In addition, two or more trusts will be aggregated by the IRS, and treated as a single trust for purposes of 199A, if:

  • The trusts have substantially the same grantor(s),
  • Substantially the same “primary” beneficiary(ies), and
  • “A” principal purpose for establishing the trusts is the avoidance of federal income tax.

For purposes of applying this rule, spouses are treated as one person. In other words, if a spouse creates one trust and the other spouse creates a second trust, the grantors will be treated as the same for purposes of the applying this anti-abuse test, even if the trusts are created and funded independently by the two spouses.[xxiv]

If the creation of multiple trusts results in a “significant income tax benefit,” a principal purpose of avoiding tax will be presumed.

This presumption may be overcome, however, if there is a significant non-tax (or “non-income tax”) purpose that could not have been achieved without the creation of separate trusts; for example, if the dispositive terms of the trusts differ from one another.

Grantor Trust

The application of 199A to a grantor trust is much simpler because the individual grantor is treated as the owner of the trust property and income, and the trust is ignored, for purposes of the income tax.[xxv] Thus, any QTB interests held by the trust are treated as owned by the grantor for purposes of applying 199A.

In other words, the rules described above with respect to any individual owner of a QTB will apply to the grantor-owner of the trust; for example, the QBI, W-2 Wages, and Unadjusted Basis of the QTB operated by the PTE in which the trust holds an interest will pass through to the grantor.

Planning?

As we know, many irrevocable trusts to which completed gifts have been made are nevertheless taxed as grantor trusts for income tax purposes. The grantor has intentionally drafted the trust so that the income tax liability attributable to the trust will be taxed to the grantor, thereby enabling the trust to grow without reduction for income taxes, while at the same time reducing the grantor’s gross estate for purposes of the estate tax.

This may prove to be an expensive proposition for some grantors, which they may remedy by renouncing the retained rights or authorizing the trustee to toggle them on or off, or by being reimbursed from the trust (which defeats the purpose of grantor trust status).

The availability of the 199A deduction may reduce the need for avoiding or turning off grantor trust status, thus preserving the transfer tax benefits described above. In particular, where the business income would otherwise be taxed at a 37% federal rate,[xxvi] the full benefit of 199A would yield a less burdensome effective federal rate of 29.6%.

In addition to more “traditional” grantor trusts – which are treated as such because the grantor has retained certain rights with respect to the property contributed to the trust – there are other trusts to which the grantor trust rules may apply and which may, thereby, lend themselves to some 199A planning.

For example, a trust that holds S corporation stock may qualify as a subchapter S trust for which the sole current beneficiary of the trust may elect under Sec. 1361(d) (a “QSST” election) to be treated as the owner of such stock under Sec. 678 of the Code.[xxvii] Or a trust with separate shares for different beneficiaries, each of which is treated as a separate trust for which a beneficiary may elect treatment as a QSST.

Another possibility may be a trust that authorizes the trustee to grant a general power of appointment to a beneficiary as to only part of the trust – for example, as to a portion of one of the PTE interests held by the trust – thereby converting that portion of the trust into a grantor trust under Sec. 678.[xxviii]

What’s Next?

It remains to be seen what the final 199A regulations will look like.[xxix] That being said, estate planners should have enough guidance, based upon what has been published thus far, to advise taxpayers on how to avoid the anti-abuse rules for non-grantor trusts, how to take advantage of the grantor trust rules, and how to maximize the unadjusted basis for qualified property.

Hopefully, the final regulations will provide examples that illustrate the foregoing. Absent such examples, advisers will have to await the development of some Sec. 199A jurisprudence. Of course, this presupposes that 199A will survive through the 117th Congress.[xxx]


[i] The exclusion amount increases to $11.4 million in 2019. It is scheduled to return to “pre-TCJA” levels after 2025. See the recently proposed regulations at REG-106706-18.

[ii] Pun intended. P.L. 115-97.

[iii] Or “check the box” under Reg. Sec. 301.7701-3.

[iv] This provision covers tax years beginning after 12/31/2017, but it expires for tax years beginning after 12/31/2025.

[v] More recently, the IRS announced its 2018-2019 priority guidance project, which indicated that it planned to finalize some of the regulations already proposed, but that more regulations would be forthcoming; it also announced that a Revenue Procedure would be issued that would address some of the computational issues presented by the provision.

[vi] Thus, we find ourselves at the end of November 2018 with a provision that expires after December 31, 2025, for which the issued guidance is still in proposed form.

[vii] Through the next presidential election.

[viii] The deduction is not determined at the level of the PTE – it is determined at the level of each individual owner of the PTE, based upon each owner’s share of qualified business income.

[ix] In general, a QTB includes any trade or business other than a specified service trade or business (“SSTB”) and the provision of services as an employee.

If an individual taxpayer does not exceed the applicable taxable income threshold (described below), their QBI from their SSTB will be included in determining their 199A deduction. If the taxpayer exceeds the applicable threshold and phase-in amounts, none of the income and deduction items from the SSTB will be included in determining their 199A deduction.

[x] Basically, the owner’s pro rata share of the QTB’s taxable income.

[xi] This deduction amount is capped at 20% of the excess of (i) the owner’s taxable income for the year over (ii) their net capital gain for the year.

[xii] Business and investment, domestic and foreign.

[xiii] In the case of a joint return between spouses, the threshold amount is $315,000, and the limitation becomes fully applicable when taxable income exceeds $415,000.

[xiv] Consistent with this line of thinking, and recognizing that it is common for taxpayers to separate into different entities, parts of a business that are commonly thought of as a single business, the IRS will also allow individual owners – not the business entities themselves – to elect to aggregate (to treat as one business) different QTBs if they satisfy certain requirements, including, for example, that the same person or group of persons control each of the QTBs to be aggregated.

It should be noted that owners in the same PTEs do not have to aggregate in the same manner. Even minority owners are allowed to aggregate. In addition, a sole proprietor may aggregate their business with their share of a QTB being conducted through a PTE.

[xv] Whether a QTB exists or not is determined at the level of the PTE. An owner’s level of involvement in the business is irrelevant in determining their ability to claim a 199A deduction. A passive investor and an active investor are both entitled to claim the deduction, provided it is otherwise available.

[xvi] Basically, depreciable tangible property that is used in the QTB for the production of QBI, and for which the “depreciation period” has not yet expired.

[xvii] The Section 754 adjustment is not treated as a new asset that is placed into service for these purposes. Compare Reg. Sec. 1.743-1(j)(4).

[xviii] For example, is it labor- or capital-intensive?

[xix] Of course, this presents its own set of issues.

[xx] Of course, this assumes that the trustee has the relevant beneficiary information on the basis of which to make this decision, which may not be feasible.

[xxi] For purposes of determining whether the trust’s taxable income exceeds these amounts, the proposed regulations provide that the trust’s taxable income is determined before taking into account any distribution deduction. Query whether this represents a form of double counting? The distributed DNI is applied in determining the trust’s threshold, and it is applied again in determining the distributee’s.

[xxii] Under both IRC Sec. 199A and Sec. 643(f).

[xxiii] Prop. Reg. Sec. 1.199A-6(d)(3).

[xxiv] Prop. Reg. Sec. 1.643(f)-1.

[xxv] IRC Sec. 671 through 679.

[xxvi] The new maximum federal rate for individuals after the TCJA.

[xxvii] See Reg. Sec. 1.1361-1(j).

[xxviii] A so-called “Mallinckrodt trust.”

[xxix] The proposed regulations also address the treatment of ESBTs under Sec. 199A. According to the proposed regulations, an ESBT is entitled to the deduction. Specifically, the “S portion” of the ESBT takes into account its share of the QBI and other items from any S corp owned by the ESBT.

The grantor trust portion of the trust, if any, passes its share to the grantor-owner.

The non-S/non-grantor trust portion of the trust takes into account the QBI, etc., of any other PTEs owned by the trust. Does that mean that the ESBT is treated as two separate trusts for purposes of the 199A rules? It is not yet clear.

[xxx] January 2021 to January 2023.

This is the fourth[i] and final in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction/

Earlier posts considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one , the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A, https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ , and the meaning of “qualified business income.” https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-three/. Today, we turn to the calculation of the deduction, the limitations on the amount of the deduction, and some special rules.

 Threshold and Phase-In Amounts

Let’s assume for the moment that our taxpayer (“Taxpayer”) is a married individual, files a joint return with their spouse, and owns an equity interest in a qualified trade or business (“QTB”) that is conducted through a pass-through entity (“PTE”), such as a sole proprietorship,[ii] a partnership, or an S corporation.

At this point, Taxpayer must determine their joint taxable income for the taxable year.[iii]

There are three categories of taxpayers for purposes of Section 199A – those whose joint taxable income[iv]:

  • does not exceed $315,000 (the “threshold”),
  • exceeds $315,000 but does not exceed $415,000 (the “phase-in range”),[v] and
  • exceeds $415,000.[vi]

 

 

 

Below the Threshold

If Taxpayer falls within the first category – joint taxable income that does not exceed $315,000 – they determine their Section 199A deduction by first calculating 20% of their QBI with respect to their QTB (Taxpayer’s “combined QBI amount”).[vii] For this first category of taxpayer, their share of income from a specified service trade or business (“SSTB”) qualifies as QBI.

Taxpayer must then compare their

  • combined QBI amount (determined above) with
  • an amount equal to 20% of the excess of:
    • their taxable income for the taxable year, over
    • their net capital gain for the year.

The lesser of these two amounts is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain. Taxpayer’s Section 199A deduction is equal to the lesser of these two amounts.

Thus, if Taxpayer’s only source of income was their QTB, Taxpayer would be entitled to claim the full “20% of QBI” deduction, with the result that their QBI would be subject to an effective top federal income tax rate of 29.6%[viii]

Above the Threshold and Phase-In

If Taxpayer falls within the third category – joint taxable income for the taxable year in excess of $415,000 – they face several additional hurdles in determining their Section 199A deduction.[ix] It is with respect to these taxpayers that the application of the Section 199A rules becomes even more challenging, both for the taxpayers and their advisers.

To start, no SSTB in which Taxpayer has an equity interest will qualify as a QTB as to Taxpayer.

Moreover, there are other limitations, in addition to the ones described above, that must be considered in determining the amount of Taxpayer’s Section 199A deduction.

N.B.

Before turning to these limitations, it is important to note the following:

  • the application of the threshold and phase-in amounts is determined at the level of the individual owner of the QTB[x], which may not be where the trade or business is operated; and
  • taxpayers with identical interests in, and identical levels of activity with respect to, the same trade or business may be treated differently if one taxpayer has more taxable income from sources outside the trade or business than does the other;
    • for example, a senior partner of a law firm, who has had years to develop an income-producing investment portfolio, vs a junior partner at the same firm, whose share of partnership income represents their only source of income.[xi]

Limitations

The additional limitations referred to above are applied in determining Taxpayer’s “combined QBI amount.”

Specifically, the amount equal to 20% of Taxpayer’s QBI with respect to the QTB must be compared to the greater of:

  • 50% of the “W-2 wages” with respect to the QTB, or
  • The sum of (i) 25% of the W-2 wages plus (ii) 2.5% of the unadjusted basis (“UB”) of qualified property immediately after the acquisition of all qualified property (“a” and “b” being the “alternative limitations”).

The lesser of Taxpayer’s “20% of QBI” figure and the above “W-2 wages-based” figure may be characterized as Taxpayer’s “tentative” Section 199A deduction; it is subject to being further reduced in accordance with the following caps:

  • The Section 199A deduction cannot be greater than 20% of the excess (if any) of:
    • Taxpayer’s taxable income for the taxable year, over
    • Taxpayer’s net capital gain for the year.
  • The resulting amount – i.e., the tentative deduction reduced in accordance with “a” – is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain.

Taxpayer’s Section 199A deduction is equal to the lesser of the two amounts described in “b”, above.

Applied to Each QTB

Under the PR, an individual taxpayer must determine the W-2 wages and the UB of qualified property attributable to each QTB contributing to the individual’s combined QBI. The W-2 wages and the UB of qualified property amounts are compared to QBI in order to determine the individual’s QBI component for each QTB.

After determining the QBI for each QTB, the individual taxpayer must compare 20% of that trade or business’s QBI to the alternative limitations for that trade or business.

If 20% of the QBI of the trade or business is greater than the relevant alternative limitation, the QBI component is limited to the amount of the alternative limitation, and the deduction is reduced.

The PR also provide that, if an individual has QBI of less than zero (a loss) from one trade or business, but has overall QBI greater than zero when all of the individual’s trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the limitations based on W-2 wages and UB of qualified property.

The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the limitation based on W-2 wages and UB of qualified property, the net income with respect to each trade or business (as offset by the apportioned losses) is the taxpayer’s QBI with respect to that trade or business.

The W-2 wages and UB of qualified property from the trades or businesses which produced negative QBI for the taxable year are not carried over into the subsequent year.

W-2 Wages

The PR provide that, in determining W-2 wages, the common law employer (such as a PTE) may take into account any W-2 wages paid by another person – such as a professional employer organization – and reported by such other person on Forms W-2 with the reporting person as the employer listed on the Forms W-2, provided that the W-2 wages were paid to common law employees of the common law employer for employment by the latter.[xii]

Under this rule, persons who otherwise qualify for the deduction are not limited in applying the deduction merely because they use a third party payor to pay and report wages to their employees.

The W-2 wage limitation applies separately for each trade or business. Accordingly, the PR provides that, in the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined to be in the same proportion to total W-2 wages as the ordinary business deductions associated with those wages are allocated among the particular trades or businesses.

W-2 wages must be properly allocable to QBI (rather than, for example, to activity that produces investment income). W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.

Where the QTB is conducted by a PTE, a partner’s or a shareholder’s allocable share of wages must be determined in the same manner as their share of wage expenses.

Finally, the PR provide that, in the case of an acquisition or disposition of (i) a trade or business, (ii) the major portion of a trade or business, or (iii) the major portion of a separate unit of a trade or business, that causes more than one individual or entity to be an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity.

 UB of Qualified Property

The PR provides that “qualified property” means (i) tangible property of a character subject to depreciation that is held by, and available for use in, a trade or business at the close of the taxable year, (ii) which is used in the production of QBI, and (iii) for which the depreciable period has not ended before the close of the taxable year.

“Depreciable period” means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property without regard to whether any bonus depreciation was claimed with respect to the property. Thus, it is possible for a property to be treated as qualified property even where it is no longer being depreciated for tax purposes.

The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased or contributed.

UB is determined without regard to any adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense (for example, under Sec. 179 of the Code). Therefore, for purchased or produced qualified property, UB generally will be its cost as of the date the property is placed in service.

For qualified property contributed to a partnership in a “tax-free” exchange for a partnership interest and immediately placed in service, UB generally will be its basis in the hands of the contributing partner, and will not be changed by subsequent “elective” basis adjustments.

For qualified property contributed to an S corporation in a “tax-free” exchange for stock and immediately placed in service, UB generally will be its basis in the hands of the contributing shareholder.[xiii]

Further, for property inherited from a decedent and immediately placed in service by the heir, the UB generally will be its fair market value at the time of the decedent’s death.

In order to prevent trades or businesses from transferring or acquiring property at the end of the year merely to manipulate the UB of qualified property attributable to the trade or business, the PR provides that property is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the deduction.

For purposes of determining the depreciable period of qualified property, the PR provide that, if a PTE acquires qualified property in a non-recognition exchange, the qualified property’s “placed-in-service” date is determined as follows: (i) for the portion of the transferee-PTE’s UB of the qualified property that does not exceed the transferor’s UB of such property, the date such portion was first placed in service by the transferee-PTE is the date on which the transferor first placed the qualified property in service; (ii) for the portion of the transferee’s UB of the qualified property that exceeds the transferor’s UB of such property, if any, such portion is treated as separate qualified property that the transferee first placed in service on the date of the transfer.

Thus, qualified property acquired in these non-recognition transactions will have two separate placed in service dates under the PR: for purposes of determining the UB of the property, the relevant placed in service date will be the date the acquired property is placed in service by the transferee-PTE (for instance, the date the partnership places in service property received as a capital contribution); for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the transferor first placed the property in service (for instance, the date the partner placed the property in service in their sole proprietorship).

The PR also provide guidance on the treatment of subsequent improvements to qualified property.[xiv]

Finally, in the case of a trade or business conducted by a PTE, the PR provide that, in the case of qualified property held by a PTE, each partner’s or shareholder’s share of the UB of qualified property is an amount that bears the same proportion to the total UB of qualified property as the partner’s or shareholder’s share of tax depreciation bears to the entity’s total tax depreciation attributable to the property for the year.[xv]

Computational Steps for PTEs

The PR also provide additional guidance on the determination of QBI for a QTB conducted by a PTE.

A PTE conducting an SSTB may not know whether the taxable income of any of its equity owners is below the threshold amount. However, the PTE is best positioned to make the determination as to whether its trade or business is an SSTB.

Therefore, reporting rules require each PTE to determine whether it conducts an SSTB, and to disclose that information to its partners, shareholders, or owners.

In addition, notwithstanding that PTEs cannot take the Section 199A deduction at the entity level, each PTE must determine and report the information necessary for its direct and indirect individual owners to determine their own Section 199A deduction.

Thus, the PR direct PTEs to determine what amounts and information to report to their owners and the IRS, including QBI, W-2 wages, and the UB of qualified property for each trade or business directly engaged in.

The PR also require each PTE to report this information on or with the Schedules K-1 issued to the owners. PTEs must report this information regardless of whether a taxpayer is below the threshold amount.

“That’s All Folks!”[xvi]

With the series of posts ending today, we’ve covered most aspects of the new Section 199A rule, as elaborated by the PR, though the following points are also worth mentioning:

  • the Section 199A deduction has no effect on the adjusted basis of a partner’s interest in a partnership;
  • the deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation or the S corporation’s accumulated adjustments account;
  • the deduction does not reduce (i) net earnings from self-employment for purposes of the employment tax (for example, a partner’s share of a partnership’s operating income), or (ii) net investment income for purposes of the surtax on net investment income (for example, a shareholder’s share of an S corporation’s business in which the shareholder does not materially participate); and
  • for purposes of determining an individual’s alternative minimum taxable income for a taxable year, the entire deduction is allowed, without adjustment.

Stay tuned. Although taxpayers may rely upon the PR, they are not yet final. A public hearing on the PR is scheduled for October 16; the Republicans recently proposed to make the deduction “permanent” (whatever that means); midterm elections are scheduled for November 6; we have a presidential election in 2020; the deduction is scheduled to disappear after 2025. Oh, bother.

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[i] Yes, I know – where has time gone? The fourth already? Seems like just yesterday, I was reading the first. Alternatively: Oh no, not another! It’s like reading . . . the Code? Where are those definitions of SSTB covered? The first or the second installment?

[ii] Including a single-member LLC that is disregarded for tax purposes.

[iii] Of course, we are only considering taxable years beginning after December 31, 2017, the effective date for Section 199A of the Code.

[iv] Regardless of the source or type of the income.

[v] See EN ix, below.

[vi] For our purposes, it is assumed that Taxpayer has no “qualified cooperative dividends,” no “qualified REIT dividends,” and no “qualified publicly traded partnership income.”

[vii] If Taxpayer has more than one QTB, this amount is determined for each such QTB, and these amounts are then added together.

[viii] I.e., 80% of the regular 37% rate.

[ix] Yes, we skipped the second category – taxpayers with taxable income in excess of the threshold amount but within the phase-in range amount.

The exclusion of QBI (for SSTBs), W-2 wages, and UB of qualified property from the computation of the Section 199A deduction is subject to a phase-in for individuals with taxable income within the phase-in range.

[x] Thus, we look at the taxable income of the individual member of the LLC or shareholder of the S corporation – not at the taxable income of the entity.

[xi] Compare to the passive activity loss rules (material participant or not?), and the net investment income surtax rules (modified adjusted gross income in excess of threshold; material participant?).

[xii] In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person.

[xiii] The PR also provide special rules for determining the UB and the depreciable period for property acquired in a “tax-free” exchange.

Specifically, for purposes of determining the depreciable period, the date the exchanged basis in the replacement qualified property is first placed in service by the trade or business is the date on which the relinquished property was first placed in service by the individual or PTE, and the date the excess basis in the replacement qualified property is first placed in service by the individual or PTE is the date on which the replacement qualified property was first placed in service by the individual or PTE. As a result, the depreciable period for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.

Thus, qualified property acquired in a like-kind exchange will have two separate placed in service dates under the PR: for purposes of determining the UBIA of the property, the relevant placed in service date will be the date the acquired property is actually placed in service; for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the relinquished property was first placed in service.

[xiv] Rather than treat them as a separate item of property, the PR provides that, in the case of any addition to, or improvement of, qualified property that is already placed in service by the taxpayer, such addition or improvement is treated as separate qualified property that the taxpayer first placed in service on the date such addition or improvement is placed in service by the taxpayer for purposes of determining the depreciable period of the qualified property. For example, if a taxpayer acquired and placed in service a machine on March 26, 2018, and then incurs additional capital expenditures to improve the machine in May 2020, and places such improvements in service on May 27, 2020, the taxpayer has two qualified properties: The machine acquired and placed in service on March 26, 2018, and the improvements to the machine incurred in May 2020 and placed in service on May 27, 2020.

[xv] In the case of qualified property of a partnership that does not produce tax depreciation during the year (for example, property that has been held for less than 10 years but whose recovery period has ended), each partner’s share of the UB of qualified property is based on how gain would be allocated to the partners if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property. In the case of qualified property of an S corporation that does not produce tax depreciation during the year, each shareholder’s share of the UB of the qualified property is a share of the UB proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.

[xvi] And so ended every episode of Looney Tunes. Thank you Mel Blanc.