IRS Finalizes 20% Passthrough Deduction Regulations

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The 20% passthrough deduction enacted in the Tax Cuts and Jobs Act (TCJA) in December 2017 includes a new tax break for business owners operating as a sole proprietor or through a passthrough entity such as an LLC or S corporation (LMC TCJA Alert #4). The law lets some of those taxpayers deduct 20% of their business's earnings when calculating their taxable income.

 

Taxpayers and their advisors sought further guidance to implement the complex rules in the law, and the IRS provided proposed regulations last August (LMC TCJA Alert #19). On January 18, 2019, the agency finalized those regulations and simultaneously released additional assistance. The final regulations adopted most of the rules from the proposed ones with minor revisions. The other documents, in the form of new proposed regulations, a Revenue Procedure, and an IRS Notice, provide helpful support for several issues.

 

W-2 Wages

One of the factors that limits the passthrough deduction is based on the eligible W-2 earnings paid by the business to its employees. Revenue Procedure 2019-11 provides taxpayers with three allowable methods to determine how those wages are calculated for purposes of the limitation. The first method, the unmodified box method, is the simplest, but the other two provide more accurate results.

 

Real Estate as a Trade or Business

The passthrough deduction is only allowed for income when an activity is treated as a "trade or business." Investment income does qualify, even when the profits are earned through a passthrough entity. Many taxpayers wondered whether the activity of renting real estate to tenants rises to the level of a trade or business eligible for the passthrough deduction, or is considered merely an investment. Decades of court cases and IRS rulings have led to ambiguous conclusions, but the issue has become more urgent with the passage of TCJA.

 

IRS Notice 2019-07 creates a new safe harbor that allows some real estate entities to be treated as a trade or business. The safe harbor allows taxpayers to claim the passthrough deduction for real estate income if they meet specific conditions, without making a general conclusion of whether real estate constitutes a trade or business.

 

A new tax term, with a new acronym, was created. The Rental Real Estate Enterprise, or RREE, constitutes one or more properties. Residential and commercial properties may not be mixed in the same RREE (creating questions about mixed-use buildings with first-floor stores and upstairs apartments). RREEs will be used by individual taxpayers that own rental properties as well as passthrough entities like partnerships and S corps.

 

In order to qualify for the safe harbor as a trade or business:

  • The RREE must keep separate books and records for the RREE's property or properties
  • 250 or more hours of rental services must be provided to the RREE per year by its owners, employees, agents, and independent contractors. The rules specify the services that qualify
  • The RREE must keep contemporaneous and detailed time records (does not apply for 2018)
  • Triple net leases are not eligible

 

Other New Rules

The final regulations and accompanying pronouncement make other, mostly taxpayer-friendly, changes. The new proposed regulations address REITs, RICs, trusts, and suspended losses. Other rules address related-party attribution, businesses under common control, and ordering rules for limitations. The IRS reversed its earlier position that the additional tax basis that may be added to a property when a taxpayer buys a business cannot be included in the 2.5%-of-asset limitation test. The final regulations enable a passthrough entity to elect to aggregate its own activities, while the proposed regulations limited aggregation to the owner level.

 

Contact your LMC professional for information about how the new passthrough deduction provisions affect you. All our prior Tax Cuts and Jobs Act Alerts are available on the Updates page of our website.

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