New Section 199A: Structuring Real Estate Transactions to Take Advantage of the Qualified Business Income Deduction

Transcription

1 Presenting a 90-minute encore presentation featuring live Q&A New Section 199A: Structuring Real Estate Transactions to Take Advantage of the Qualified Business Income Deduction THURSDAY, JANUARY 17, pm Eastern 12pm Central 11am Mountain 10am Pacific Today s faculty features: Cliff Capdevielle, Managing Attorney, Moskowitz, San Francisco Lorraine White, Partner, Tax Services, Grant Thornton, Philadelphia The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions ed to registrants for additional information. If you have any questions, please contact Customer Service at ext. 1. NOTE: If you are seeking CPE credit, you must listen via your computer phone listening is no longer permitted.

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5 New Section 199A: Structuring Real Estate Transactions to Take Advantage of the Qualified Business Income Deduction Cliff Capdevielle Lorraine White

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7 199A Deduction The new tax code provides a deduction for certain pass-through business entities in the United States. It permits these businesses to deduct 20% of their qualified business income (QBI). This is an answer to C Corporations getting a new flat rate of 21% under IRC 11(b) (no longer a graduated tax rate) and elimination of the alternative minimum tax. The new Section 199A deduction is available to non-professional service business and non-investments conducted in the United States: Sole proprietors S Corporations LLCs and partnerships Qualified cooperatives Trusts and estates Real estate investors Real estate investment trusts (REITS) 7

8 199A Deduction Limitations on Specified Businesses The benefits under Section 199A are limited for businesses that provide services in the fields of: Health Law Accounting Actuarial science Performing arts Consulting Athletics Financial services Brokerage services Investing and investment management Not an all inclusive list: Any other trade or business the principal asset of the business is the reputation or skill of one or more of its employees 8

9 199A Deduction Deduction for combined qualified business income amount (subject to taxable income limitation) 20% of the taxpayer's QBI with respect to the trade or business, (subject to the W-2 wage limitation and also asset limitations), plus 20% of the aggregate amount of the taxpayer's qualified REIT dividends and qualified publicly traded partnership income. Exceptions to the limitations described above if taxable income does not exceed a certain threshold amounts at the individual level. 9

10 199A Deduction Defining Qualified Business Income (QBI) The proposed regulations do not create a new definition of a "trade or business" but refer the Section 162 Income, gain, deduction and losses effectively connected with each qualified business within the United States or Puerto Rico, BUT Does not include income or loss from investment items Long-term capital gains and losses Dividends and dividend equivalents Interest UNLESS properly allocable to the qualified business Gain or loss on an asset held in a business under Section 1231 does not qualify as QBI because the IRS determined that there is no exception for the exclusion for capital gain or loss Section 1231 losses treated as ordinary income on the other hand reduce QBI Solely for the purpose of 199A the rental or licensing of tangible or intangible property to a trade or business under common control is considered a trade or business even if it would not have risen to a level of a trade or business on its own 10

11 199A Deduction Does Investment In Real Estate Qualify? Real estate income can qualify for the 20% deduction under Section 199A if: It is qualified business income per IRC 199A(c)(1) The investor(s) operates a real estate business The proposed regulations makes simply owning rental real estate not enough to qualify for 199A. A substantial amount of time must be spent working regularly in the business if the real estate activity is only an investment it will not qualify). For example, a triple net lease (where the tenant essentially does everything, e.g., not only pays rent to the landlord, but also handles all the maintenance and repairs, and even pays the taxes) may be viewed by the IRS as an investment and not a business. It therefore would not qualify under IRC 199A, unless it is a REIT to which Congress specially gave the 199A deduction. Note that Proposed Regulation 1.99A-1(b)(13) allows for the aggregation of time spent on multiple real estate holdings. 11

12 199A Deduction Does Investment In Real Estate Qualify? Other indications that the real estate investment should be treated as a business to qualify for IRC 199A: Working on the premises Making or supervising repairs and maintenance Interviewing tenants as to their satisfaction with the property and its maintenance Investigating the area near the property to determine competition as to rents, size of property, maintenance, amenities, and other reasons for tenants staying on the property Seeking new properties and tenants Making financial arrangements for the property(ies), such as refinancing, negotiating prices of services, paying bills, and budgeting for repairs and improvements It must be clear to the IRS that the taxpayer is operating a business. Consider guidance from IRC 469 (qualifying as a real estate professional) and its exception to treating real estate as passive income. 12

13 199A Deduction Qualified business income does not include: Payments of reasonable compensation by an S corporation to its shareholder Guaranteed payments to partners for services rendered with respect to the business or for the use of capital Independent contractors of business in which they were formerly employed are subject to the presumption that they are employees A specified service trade or business (SSTB) have limited 199A benefits Health, law, accounting, actuaries, performing arts, athletics, financial services, brokerage services, investing, investment management, trading or dealing in financial instruments, or any business where the principal asset is the reputation or skill of one or more employees; except to the extent the owner is below the income threshold Engineering and architecture are NOT specified service businesses and can qualify for QBI 13

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15 199A Deduction Computation General rule deduction equal to lesser of: 20% of qualified business income, or The greater of: 50% of W-2 wages, or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property The 20% deduction creates effective rate of 29.6% against the 37% top individual rate 28% against the 35% rate * IRC 199A(b)(2)(A) and IRC 199A(b)(2)(B)(i) and (ii) 15

16 199A Deduction Computation If a taxpayer's income is below the thresholds below, then the taxpayer does not have to apply the wage and asset test to the QBI Also a taxpayer can take the 199A deduction for income from a SSTB if they meet the below thresholds * IRC 199A(e)(2)(A) IRC 199A(e)(2)(B)(ii)(2) 16

17 199A Deduction Computation QBI from multiple trades and businesses is calculated separately for each trade or business and then netted when used to determine the pass-through deduction Proposed regulations segregate the calculation of QBI form the calculation of REIT dividends and PTP income or loss. If PTP losses exceed REIT and PTP income then this loss is carried forward to future years to offset REIT and PTP Income QBI resulting in a loss is carried forward to future years 17

18 199A Deduction Computation Wage and Asset Test Wage Test The 199A deduction is limited by 50% of the owner's allocable share of W-2 wages paid by the business Wages are generally W-2 wages IRS issued a proposed Revenue Procedure (Notice ) that provides three methods for calculating W-2 wages Proposed regulations also address businesses that use payroll organizations An entity paying the wages could have their employees be considered employees of another trade or business for this purpose i.e. common law employer takes credit for the wages to calculate 199A limitation, however, the wages cannot be double counted If an employee serves more than one trade or business, must allocate their wages using a reasonable method on all facts and circumstances 18

19 199A Deduction Computation Wage and Asset Test Asset Test The 199A deduction is limited to 25% of those W-2 wages plus 2.5% of the owner's allocable share of the unadjusted basis of qualified property. Qualified Property includes all depreciable tangible property used to generate QBI for which the depreciable period is not finished BUT applying a minimum depreciable period of 10 years or more. Unadjusted basis determined the day the property is placed in service Excludes basis adjustments from certain credits and bonus depreciation Improvements added to the basis are included Sections 734 and 743 are not treated as qualified property for the wage and asset test. Anti-Abuse rule excludes property acquired within 60 days of the end of the tax year and disposed with 120 days if the property was used in a trade of business for less than 45 days 19

20 199A Deduction Computation Example 1 Taxpayer with QBI of $1,000,000 and W-2 wages of $400,000. Deduction is limited to the lesser of: QBI of $1,000,000 x 20%= $200,000 W-2 wages of $400,000 x 50% = $200,000 QBI of $1,000,000 - $200,000 deduction $800,000 is taxable 20

21 199A Deduction Computation Example 2 Taxpayer with Qualified Business Income (QBI) of $1,000,000, no W-2 wages, and $10,000,000 in building costs (less land and improvements). QBI of $1,000,000 x 20%= $200,000 [W2 wages of $0 x 50% = $0] W-2 wages of $0 x 25% = $0 Unadjusted Depreciable Basis (UDB) of $10,000,000 x 2.5% = $250,000 QBI of $1,000,000 - $200,000 deduction (lesser of 20% QBI and W-2 wages + UDB) $800,000 is taxable 21

22 199A Deduction Computation Example 3 Taxpayer with Qualified Business Income (QBI) of $1,000,000, W-2 wages of $300,000, and $5,000,000 in building costs land + improvements. QBI of $1,000,000 X 20%= $200,000 [W-2 wages of $300,000 X 50% = $150,000] W-2 wages of $300,000 x 25% ($75,000) + UDB property of $5,000,000 x 2.5% ($125,000) = $200,000 QBI of $1,000,000 - $200,000 deduction (lesser of 20% QBI and W-2 wages + UDP) $800,000 is taxable 22

23 199A Deduction Computation Aggregating Activities for the Wage and Asset Test Certain trades and business may be aggregated for the wage and asset test Rules are not as permissive as the grouping rules under Sections 469 for passive activities Aggregation allowed if the following four requirements are satisfied: Businesses must have the same taxable year Majority ownership must exist for the majority of the year Each aggregated trade or business itself rises to the level of a trade or business Same group of persons own owns a majority interest in each of the businesses None of the aggregated businesses are SSTBs The aggregated businesses meet two of the following three factors: Same or similar products share facilities or business element (like back office functions) operated in coordination with the reliance on the other businesses 23

24 199A Deduction Computation Aggregating Activities for the Wage and Asset Test Aggregation done at individual level Once election is made to aggregate activities a taxpayer cannot change unless a change in circumstances like acquisition of a new business 24

25 199A Deduction Computation Anti-Abuse and deminimis rules for SSTBs No explicit guidance on when a single entity that has separate trades or businesses, some of which may be SSTBs A trade of business with 25 million or less in gross receipts can have up to 10% of its gross receipts from an SSTB activity before its considered an SSTB A trade of business with 25 million or greater in gross receipts can have up to 5% of its gross receipts from an SSTB activity before its considered an SSTB A business is considered an SSTB if it is has 50% common ownership with an SSTB and provides 80% or more of its services to an SSTB or it shares expenses such as wages and overhead and if its gross receipts are no more than 5% of the combined gross receipts. i.e. if an entity with gross receipts of over 25 million has a little as 6% of its gross receipts from an SSTB, then the entire business is an SSTB 25

26 199A Deduction Special Considerations Section 199A reduces taxable income, but not gross income or AGI Will not affect AGI based phase-ins and phase-outs Not expected to be deductible for state tax in states basing their income tax on Federal measures of AGI Section 199A does not itself modify any of the self-employment tax rules or net investment income rules There is no distinction between passive and active owners Reporting Requirements to Investors Those preparing information to investors will have to provide QBI to their shareholders In addition will have to provided the information for the Wage and Asset test 26

27 199A Deduction Planning Considerations Carve out ancillary activities from SSTBs as separate trades or businesses Must have outside revenue to survive anti-abuse tests Carve SSTB into pieces to make the 5% income test easier for related activities Consider S corp wages for QBI and W-2 test Must pay reasonable comp Consider REITs because they don t have to comply with any QBI rules 27