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Republicans’ 2017 overhaul of the tax code created a new 20-percent deduction of qualified business income (QBI), subject to certain limitations, for pass-through entities (sole proprietorships, partnerships, limited liability companies, or S corporations). The controversial QBI deduction—also called the "pass-through" deduction—has remained an ongoing topic of debate among lawmakers, tax policy experts, and stakeholders.

The Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97), enacted at the end of 2017, created the new Section 199A QBI deduction for noncorporate taxpayers, effective for tax years beginning after December 31, 2017. However, under current law the QBI deduction will sunset after 2025. In addition to the QBI deduction’s impermanence, its complexity and ambiguous statutory language have created many questions for taxpayers and practitioners.

The IRS first released much-anticipated proposed regulations for the new QBI deduction, REG-107892-18, on August 8, 2018. The proposed regulations were published in the Federal Register on August 16, 2018. The IRS released the final regulations and notice of additional proposed rulemaking on January 18, 2019, followed by a revised version of the final regulations on February 1, 2019. Additionally, Rev. Proc. 2019-11 was issued concurrently to provide further guidance on the definition of wages. Also, a proposed revenue procedure, Notice 2019-7, was issued concurrently to provide a safe harbor under which certain rental real estate enterprises may be treated as a trade or business for purposes of Section 199A.

Wolters Kluwer recently interviewed Tom West, a principal in the passthroughs group of the Washington National Tax practice of KPMG LLP, about the Section 199A QBI deduction regulations. Notably, West formerly served as tax legislative counsel at the U.S. Department of the Treasury’s Office of Tax Policy. This article represents the views of the author only and does not necessarily represent the views or professional advice of KPMG LLP.

Wolters Kluwer: What is your general overview of the revised, final regulations for the Section 199A Qualified Business Income (QBI) or "pass-through" deduction?

Tom West: I think it is admirable that Treasury and IRS were able to publish these final regulations so quickly and address so many of the comments and questions that the proposed regulations generated. I think they realized how important this particular package was to so many taxpayers for the 2018 filing season and, while questions obviously remain, having these rules out in time to inform decisions for this year’s tax returns is helpful. In particular, the liberalized aggregation rules and the additional examples regarding certain specified service trades or businesses (SSTBs) are the most consequential in my mind.

Wolters Kluwer: What should taxpayers and practitioners keep in mind in consideration of relying on either the proposed or final regulations for the 2018 tax year?

Tom West: I have to imagine that when choosing between the two, for most taxpayers the final regulations will ultimately provide the better result. The ability to aggregate at the entity level, which was only provided in the final regulations, may be a key consideration for those taxpayers with more complicated or tiered structures. That said, I do think taxpayers need to be careful in their aggregation modeling because you are going to be stuck with your aggregation once you’ve filed. It may be that some taxpayers wait on getting locked into a particular aggregation and continue to study the new rules—and even wait on additional guidance that may be coming. However, it may be important to note that the final regulations provide that if an individual fails to aggregate, the individual may not aggregate trades or businesses on an amended return—other than for the 2018 tax year.

Wolters Kluwer: How is the removal of the proposed 80 percent rule regarding specified service trades or businesses (SSTBs) from the final regulations likely to impact certain taxpayers?

Tom West: First of all, I think the removal of this rule is a demonstration of two important dynamics. One, the critical importance of the engagement of taxpayers in the comment process, and, two, the government’s willingness to listen and adapt in their rule-making. I don’t know if there are particular industries or taxpayers who will be impacted, but I do know that the change is a very logical and appropriate one, and logic doesn’t always prevail in these processes, so I’m happy to give the regulators credit when it does.

Wolters Kluwer: Which industries may have been helped or hindered by the final regulations with respect to SSTB rules?

Tom West: I’m not sure specific industries were helped, but the biggest positive in terms of the SSTB final rules is the carryover from the proposed regulations of the treatment of the skill or reputation provision. Had Treasury and the IRS gone in a different direction, there was a risk of that provision swallowing the rest of the 199A regime—not to mention how much more subjective the already sometimes difficult SSTB determinations would have become.

Wolters Kluwer: Are there any lingering, unanswered questions among taxpayers or practitioners that particularly stand out when determining what constitutes SSTB income?

Tom West: I think many taxpayers who have both SSTB and non-SSTB activities were hoping for more clarity, either in rules or examples, on how to acceptably segregate business lines or on when (or if) certain activities are inextricably tied together. There are also still lingering questions regarding when a trade or business is an SSTB—particularly in the field of health.

Wolters Kluwer: Were there any surprises in the final regulations?

Tom West: I don’t know if I’m surprised, knowing the concerns that led them to the decisions they made, but the fact that Treasury and IRS held the line on some of the SSTB-related rules is notable. I’m thinking specifically of the so-called "cliff" effect of the de minimis rule and the fact that owners of certain kinds of SSTB businesses, e.g., sports teams, are not allowed to benefit from the Section 199A deduction.

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Republicans’ 2017 overhaul of the tax code created a new 20-percent deduction of qualified business income (QBI), subject to certain limitations, for pass-through entities (sole proprietorships, partnerships, limited liability companies, or S corporations). The controversial QBI deduction—also called the "pass-through" deduction—has remained an ongoing topic of debate among lawmakers, tax policy experts, and stakeholders.

The Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97), enacted at the end of 2017, created the new Section 199A QBI deduction for noncorporate taxpayers, effective for tax years beginning after December 31, 2017. However, under current law the QBI deduction will sunset after 2025. In addition to the QBI deduction’s impermanence, its complexity and ambiguous statutory language have created many questions for taxpayers and practitioners.

The IRS first released much-anticipated proposed regulations for the new QBI deduction, REG-107892-18, on August 8, 2018. The proposed regulations were published in the Federal Register on August 16, 2018. The IRS released the final regulations and notice of additional proposed rulemaking on January 18, 2019, followed by a revised version of the final regulations on February 1, 2019. Additionally, Rev. Proc. 2019-11, I.R.B. 2019-9, 742, was issued concurrently to provide further guidance on the definition of wages. Also, a proposed Revenue Procedure, Notice 2019-7, I.R.B. 2019-9, 740, was issued, concurrently providing a safe harbor under which certain rental real estate enterprises may be treated as a trade or business for purposes of Section 199A.

Wolters Kluwer recently interviewed Tom West, a principal in the passthroughs group of the Washington National Tax practice of KPMG LLP, about the Section 199A QBI deduction regulations. Notably, West formerly served as tax legislative counsel at the U.S. Department of the Treasury’s Office of Tax Policy. This article represents the views of the author only and does not necessarily represent the views or professional advice of KPMG LLP.

Wolters Kluwer: Neither the proposed nor final regulations for Section 199A give guidance as to when rental real estate activity constitutes a Section 162 trade or business. How might the application of the safe harbor provided for in IRS Notice 2019-7 offer taxpayers clarity? And how might failure to qualify for the safe harbor impact the determination of whether the rental activity is a trade or business under Section 199A?

Tom West: The safe harbor is helpful but it appears to be intended for relatively smaller taxpayers who may have had questions about their activities rising to the level of a trade or business. I don’t think falling outside of the safe harbor is dispositive—especially in light of the recent policy statement from Treasury regarding sub-regulatory guidance.

Wolters Kluwer: Can you speak to the some of the complexity that may be involved in tax planning with respect to achieving the right balance between adequate W-2 wages and QBI?

Tom West: Other than for small taxpayers, there is only a benefit under Section 199A if the limitations are met. It does not do any good to have QBI but then have insufficient W-2 wages and qualified property to meet the limitations. So when taxpayers are evaluating what constitutes a qualified trade or business (or whether to aggregate qualified trades or businesses) they will need to determine the amount of W-2 wages with respect to each QTB. Aligning the W-2 wages with the QTB will be important—but the salary expense will also result in a reduction in the amount of QBI and therefore the amount of any Section 199A benefit—so modeling becomes critical. Consideration should also be given to any collateral consequences—for instance the impact of the alignment on allocation and apportionment for state taxes.

Wolters Kluwer: According to a March 18, 2019, Treasury Inspector General for Tax Administration (TIGTA) report, Reference Number: 2019-44-022, IRS management indicated that the timeline related to the issuance of Section 199A guidance did not provide enough time for the IRS to develop a QBI deduction tax form. Although the IRS did create a worksheet, do you have a prediction on what key elements may be included on the new form once released?

Tom West: I do think that worksheets could be developed that would facilitate the reporting of Section 199A information—particularly through tiered structures—so as to ease the reporting burden and enhance compliance.

Wolters Kluwer: The IRS has estimated that nearly 23.7 million taxpayers may be eligible to claim the Section 199A deduction and that more than 22.2 million (94 percent) of those eligible taxpayers will not require a complex calculation for the deduction. What notable differences do you expect there are between "complex" and the majority of calculations?

Tom West: For taxpayers under the Section 199A income thresholds ($157.5K single, $315K joint), the deduction is very easy to calculate and claim. Those taxpayers don’t need to worry about being in an SSTB, how much wages they paid, or the basis of their property. Once those taxpayers hit those income thresholds though, even in the phase-out range, things very quickly get complex—and that’s as a consequence of the statute; it is not something that the regulators can change.

Wolters Kluwer: Do you anticipate the IRS will issue further guidance on the Section 199A deduction?

Tom West: I do. As I said at the top, I think part of the government’s motivation in finalizing these regulations so quickly was providing guidance to taxpayers ahead of the tax-filing season. And while for the majority of taxpayers who are below the 199A cap there is probably now sufficient guidance, I think there are still a lot of questions for those with more complex situations. Given the number of taxpayers who are eligible for this deduction, and the importance of Section 199A as the big benefit to non-corporate businesses in what the Administration views as a signature legislative achievement, I have to believe that the government will be responsive to taxpayers’ requests for additional help on this provision. However, given that the provision is due to sunset, it will be important that any guidance is forthcoming in fairly short order to be of any usefulness to taxpayers.

Wolters Kluwer: At this time, do you have any recommendations for taxpayers and practitioners moving forward?

Tom West: As people are going through their tax filings this year, I’d keep a list of issues, questions, and areas where additional guidance would be helpful. It often happens that problems with new legislation or regulations don’t reveal themselves until taxpayers have to put pencil to paper and track their real-world numbers through returns. We’ll all have that experience this year and, with those lists of issues and questions in hand, there may be an opportunity to approach the IRS and Treasury in the hopes of getting resolution going forward. Keeping that list could also help identify areas for tax planning and perhaps ease the complexity of filing for 2019.

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A bipartisan House bill has been introduced that would fix a GOP tax law drafting error known as the "retail glitch." The House bill, having over a dozen co-sponsors, is a companion measure to a bipartisan Senate bill introduced in March.

Immediate Expensing

The Restoring Investment in Improvements Act (HR 1869), sponsored by House tax writers Reps. Jimmy Panetta, D-Calif., and Jackie Walorski, R-Ind., would allow restaurants, retailers, and other leaseholders to immediately write off the cost of certain improvements. The Tax Cuts and Jobs Act (TCJA) ( P.L. 115-97), enacted at the end of 2017, inadvertently excludes qualified improvement property (QIP) from the new 100 percent bonus depreciation provision.

The measure is a "small but critical fix for our job creators, and technical corrections like this are a normal part of the process when Congress enacts major reforms," Walorski said in a recent press release. "This bipartisan, commonsense bill will allow restaurants, retailers, and other small businesses to unlock the full benefits of tax reform and continue driving our nation’s economic growth."

Similarly, Panetta highlighted the negative impact that the loss of immediate expensing has caused many small businesses. "Our bill will allow restaurants, retailers, and other businesses to make the improvements they need to keep their stores competitive and safe and plan for the future," he said.

Although the "retail glitch" measure has solid bipartisan support, Democrats in general have seemed hesitant to fix any errors in the GOP tax law. To that end, House Ways and Means Committee Chairman Richard Neal, D-Mass., has said he would like to hold a hearing on technical corrections for the TCJA. The committee’s March 27 hearing on the TCJA did not specifically address technical corrections.

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The House on April 9 approved by voice vote a bipartisan, bicameral IRS reform bill. The IRS bill, which now heads to the Senate, would redesign the IRS for the first time in over 20 years.

IRS Reform

The Taxpayer First Act of 2019 (HR 1957), as amended, cleared the House Ways and Means Committee by voice on April 2. The House and Senate both introduced the bicameral, bipartisan measure on March 28. If enacted, the bill would make numerous reforms to the IRS, some of which include modernizing antiquated information technology systems and enhancing taxpayer services and identity protections.

"With a new tax code, it is time for a new tax administrator," House Ways and Means Committee ranking member Kevin Brady, R-Tex., said in an April 9 statement. "I applaud the House for passing the Taxpayer First Act—a bold step to redesign the IRS to be an agency with one singular mission: putting taxpayers first."

The IRS Reform bill has been "years in the making," Brady said on April 9, echoing a joint statement that he and Ways and Means Chairman Richard Neal, D-Mass., along with other bipartisan tax writers recently issued. "The House Ways and Means Committee and the Senate Finance Committee have carefully and thoughtfully developed this legislation over several years, after numerous hearings and roundtables, in a bipartisan, bicameral manner," the lawmakers said.

AICPA Applauds Taxpayer First Act

The American Institute of CPAs (AICPA) issued an April 9 statement commending the House for passing HR 1957. "The AICPA appreciates the bipartisan recognition by members of the U.S. House of Representatives for bringing the Internal Revenue Service into the 21st Century," Edward S. Karl, vice president of taxation, said in a statement on behalf of the AICPA. "The AICPA has long been interested in and active in working to find ways to modernize the IRS so that it can better serve the needs of taxpayers and tax practitioners."

Free File Alliance

However, the bipartisan, bicameral bill has not advanced without its share of criticism. Several Democratic lawmakers have criticized a provision within the bill that would codify the Free File Alliance, which is an agreement between the IRS and certain tax preparation companies that includes the IRS being unable to directly assist in tax return preparation.

"Again and again in my service in the Senate I have battled the tax-preparation software industry to simplify filing taxes for the typical American," Senate Finance Committee (SFC) ranking member Ron Wyden, D-Ore., said in an April 9 statement. "During the debate on the tax administration bill, my staff pushed back on a prohibition on the agency competing with private tax preparation services, and I will continue to push for my proposal for the pre-filed ‘simple’ return and the principle that a taxpayer should not have to use a private company to pay their taxes online," he added.

Looking Ahead

It remains unclear when the Senate will take up the Taxpayer First Act bill. However, the bill is presently expected on Capitol Hill to easily be approved in the Senate.

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Proposed regulations address gains that may be deferred when taxpayers invest in a qualified opportunity fund (QOF). Taxpayers may generally rely on these new proposed regulations. The IRS has also requested comments.

The proposed regulations also withdraw and replace placeholder provisions in an earlier set of proposed regulations ( REG-115420-18). These concern:

the definition of "substantially all"regulations
transactions that can trigger includible gain;
the timing and amount of deferred gain that is included;
treatment of leased property used in the qualified opportunity zone (QOZ) business;
use of QOZ business property in the QOZ;
sourcing of income to the QOZ business; and
the reasonable period for a QOF to reinvest proceeds from the sale of qualifying assets.

In addition, within a few months the IRS expects to address administrative rules for a QOF that fails to maintain the required 90-percent investment standard, as well as information reporting requirements.

Finally, the IRS expects to revise Form 8996, Qualified Opportunity Fund, for 2019 and subsequent tax years. These revisions may require additional information, including the employer identification number (EIN) for the QOF business, and the amounts invested by QOFs and QOZ businesses located in particular QOZs.

"Substantially All" for QOZ Business

The 2018 regulations provided that a trade or business satisfies the "substantially all" test for a QOZ business if at least 70 percent of its tangible property is qualified opportunity zone business property. The new proposed regulations generally extend this 70-percent threshold to the "substantially all" tests for use. However, in the holding period context, the "substantially all" threshold is 90 percent.

Original Use of Purchased Tangible Property

The proposed regulations generally provide that the "original use" of tangible property acquired by purchase by any person starts on the date when that person or a prior person:

first places the property in service in the qualified opportunity zone for purposes of depreciation or amortization; or
first uses the property in the qualified opportunity zone in a manner that would allow depreciation or amortization if that person were the property’s owner.

Used tangible property will satisfy the original use requirement with respect to a QOZ so long as the property has not been previously used (that is, has not previously been used within that QOZ in a manner that would have allowed it to depreciated or amortized) by any taxpayer

In addition, a building or other structure that has been vacant for at least five years before being purchased by a QOF or QOZ business satisfies the original use requirement. Improvements made by a lessee to leased property satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis of the improvements.

Land can be treated as QOZ business property only if it is used in a trade or business of a QOF or QOZ business. The holding of land for investment does not give rise to a trade or business, and the land cannot be QOZ business property. Anti-abuse rules determine whether unimproved land can be qualifying property. However, other purchased real property generally must be substantially improved, determined on an asset-by-asset basis.

Leased Tangible Property in QOZ

Leased tangible property may be QOZ property if:

the lease is entered into after 2017; and
substantially all of the property’s use is in a QOZ during substantially all of the lease period.

However, the first-use requirement does not apply to leased tangible property. The leased property can generally also be acquired from a related person, though several conditions apply. The proposed regulations also provide methods for valuing the leased property.

QOZ Businesses

The proposed regulations:

provide that in determining whether a substantial portion of intangible property of a QOZ is used in the active conduct of a trade or business, a substantial portion is at least 40 percent;
address real property that straddles a QOZ;
provide three safe harbors and a facts-and-circumstances test for determining whether a corporation or partnership derives at least 50 percent of its gross income from the active conduct of a qualified business;
define "trade or business" by reference to Code Sec. 162, except that the ownership and operation (including leasing) of real property used in a trade or business can also be the active conduct of a trade or business; and
provide a safe harbor for working capital.

Other Business Rules

The proposed regulations also address:

Section 1231 gains;
relief regarding the 90 percent asset test, including relief for newly contributed assets and QOF reinvestments;
the amount of an investment for purposes of the deferral election;
inclusion events, the timing on basis adjustments, includible amounts, and special rules for partnerships and S corporations;
gifts and bequests;
exceptions for disregarded transfers and some nonrecognition transactions;
distributions and contributions;
consolidated return provisions;
holding periods and tacking rules;
anti-abuse rules;
special rules for Indian tribes and tribally leased property.

Comments Requested; Public Hearing Scheduled

A public hearing on the proposed regulations is scheduled for 10 am on July 9, 2019, at the New Carrollton Federal Building in Latnham, MD. Public comments may be mailed or hand-delivered to the IRS, or submitted via the Federal eRulemaking Portal at www.regulations.gov (indicate IRS and REG-120186-18).

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The IRS has provided a safe harbor for professional sports teams to avoid the recognition of gain or loss when trading players and/or draft picks. Under the safe harbor provision, the traded player’s contract or the traded draft pick would have a zero basis.

Value of Professional Sports Contracts

Professional sports teams enter into contracts with their personnel (e.g., managers, coaches, players, etc.). Typical personnel contracts provide an agreed-upon amount of compensation for a certain duration of service. The value of such a contract may fluctuate based on a variety of factors, including:

player performance;
the changing needs of the team and of other teams;
a player’s effect on fan attendance; and
the number of years until a player becomes a free agent and is able to sign a contract to play for any team in a league.

Other considerations affecting the value of a player contract include:

the size of the team’s market (i.e., whether a smaller city or a major urban population);
the cost of player development; and
the impact of injuries and slumps on player performance.

In most cases, teams do not trade personnel contracts or draft picks unless the team thinks that it is receiving contracts of an equal or greater value. Because each party believes that they are receiving personnel contracts or draft picks of an equal or greater value, it is difficult to assign a monetary value to them. Accordingly, the IRS developed a safe harbor whereby each team is able to treat the traded contracts or draft picks as having a basis of zero, thus avoiding the recognition of gain or loss on the trade.

Safe Harbor Requirements

In order to use the safe harbor, professional sports teams must meet the following requirements:

all teams involved in the trade must use the safe harbor;
teams may only trade personnel contracts, draft picks, and/or cash;
personnel contracts and/or draft picks cannot be Code Sec. 197 intangibles; and
the financial statements of all teams involved in the trade must not reflect assets or liabilities resulting from the trade other than cash.

Application

Sports teams using the safe harbor will not recognize any gain or loss if they only trade personnel contracts or draft picks. However, teams that receive cash in a trade will recognize the amount of cash received as gain. In addition, the team providing cash to another team in the trade will receive basis in the personnel contract or draft pick equal to the amount of cash that it provided. A team providing cash to another team in a trade for two or more draft picks or personnel contracts must allocate its basis to each personnel contract or draft pick received from the other team by dividing the basis by the number of personnel contracts or draft picks received.

In certain cases, a team may have unrecovered basis in a draft pick or personnel contract under Code Sec. 167(c). In those instances, the team may recognize gain or loss based on the difference between the unrecovered basis and any cash received.

Effective Date

Teams may use the safe harbor for any trades involving personnel contracts or draft picks entered into after April 10, 2019. However, teams may choose to apply these rules in any open tax year.

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In many parts of the country, residential property has seen steady and strong appreciation for some time now. In an estate planning context, however, increasing property values could mean a potential increase in federal estate tax liability for the property owner's estate. Many homeowners, who desire to pass their appreciating residential property on to their children and save federal estate and gift taxes at the same time, have utilized qualified personal residence trusts.

What is a QPRT?

The qualified personal residence trust, referred to as a "QPRT," is an estate planning technique used to transfer a personal residence from one generation to the next without incurring federal estate tax on the trust property. This type of irrevocable trust allows a homeowner to make a future gift of the family home or a vacation property to his or her children, while retaining the right to continue living in the home for a term of years that the homeowner selects.

Creating a QPRT

The homeowner transfers title to his or her residence into trust for a set time period (for example, 10 years), but retains the right to live in the house during the trust term. At the end of the term, the trust property is distributed to the donor's children without passing through the donor's estate, thereby avoiding federal estate tax on the trust assets. However, if the donor wishes to continue living in the residence after the end of the trust term, the donor must pay fair market rent to his or her children, the new owners of the residence.

Gift tax advantage

Through the use of a QPRT, the full value of your residence can be transferred to your children. However, for federal gift tax purposes, the property is valued at a discount. The actual value of the gift (and the gift tax savings) depends upon your age, the length of the QPRT term, and the federal interest rates in effect at the time you transfer the house to the trust. For example, the longer the trust term, the lower the gift value for gift tax purposes and the greater the gift tax savings. Also, the higher the applicable federal interest rate, the greater the potential gift tax savings.

If you would like to discuss how a QPRT might work for you as part of your overall estate plan, or if you currently have an established QPRT and you wish to review its effect in light of current interest rates and other factors, please do not hesitate to contact this office.

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