Section 199a Regulations

<p> Yes. While the safe harbor generally does apply to residential rental real estate, taxpayers are not entitled to rely upon the safe harbor if the taxpayer uses the property as a residence during the tax year. This exclusion applies to vacation properties that the taxpayer rents when not using the property for personal reasons. Notably, if the real estate is rented or leased under a triple net lease, the safe harbor remains unavailable under the final rule. </p><p> When satisfying the "hours of rental real estate services" criteria, only certain activities are counted toward the 250-hour threshold that must be met in order to qualify to use the safe harbor rule. Activities such as rent collection, advertising the rental, property maintenance, negotiating leases and managing the real property generally count toward the threshold. However, financing activities and the construction of capital improvements to the property, as well as hours spent traveling to and from the real property, are excluded (in other words, the taxpayer's activities as an "investor" are not counted). </p><p> If any property within the rental real estate enterprise is classified as a specified service trade or business, the safe harbor is unavailable for the entire business. Further, if the taxpayer rents the real property to a trade or business that is operated either by the taxpayer or an entity under common control, the safe harbor is unavailable.<a href="#_ftn1">¹</a></p><p><hr align="left" size="1" width="33%"></p><p><a href="#_ftnref1">1</a>. Rev. Proc. 2019-38. </p>

<p> Only pass-through entities that qualify as a "trade or business" are entitled to claim the new 20 percent deduction for qualified business income under Section 199A. Many business owners engaged in rental real estate activities had questioned whether their businesses would qualify for the deduction. In response, the IRS released proposed Revenue Procedure 2019-07, finalized by Revenue Procedure 2019-38, which provides a safe harbor so that rental real estate businesses will qualify as "trades or businesses" and can claim the 199A deduction if they satisfy certain criteria. For purposes of the safe harbor, "rental real estate enterprise" is defined to include any interest in real property held to generate rental or lease income, and can be comprised of an interest in a single property or multiple properties. </p><p> To qualify under the safe harbor, the following requirements must be met: <br><blockquote> (1)&nbsp; Separate books and records for each rental enterprise must be maintained, </p><p> (2)&nbsp; If the rental real estate enterprise has been in existence for less than four years, 250 or more hours of rental real estate services must be performed each year, </p><p> (3)&nbsp; If the rental real estate enterprise has been in existence for more than four years, at least 250 hours of rental real estate services must have been performed in at least three of the past five years (these services can be performed by employees or independent contractors of the business), and </p><p> (4)&nbsp; The taxpayer must maintain contemporaneous records regarding the rental real estate services that are performed each year, including time reports, logs or similar documents, with respect to (a) description of all services performed, (b) dates on which the services were performed and (c) who performed the <br> services, </p><p> (5)&nbsp; The taxpayer must attach a statement to the relevant tax return indicating that the safe harbor is being relied upon. </blockquote><br> To qualify under the safe harbor, the interest in real property must also be held directly by the taxpayer or through an entity disregarded as an entity separate from the owner (i.e., a single-member LLC).<a href="#_ftn1">¹</a></p><p><hr align="left" size="1" width="33%"></p><p><a href="#_ftnref1">1</a>. Rev. Proc. 2019-38. </p>

<p> The 2017 tax reform legislation now allows pass-through entities (such as partnerships, S corporations and sole proprietorships) to deduct 20 percent of "qualified business income" (QBI) (in 2018-2025). However, service businesses (including attorneys, accountants, doctors and financial advisors) are not entitled to the full benefit of the 20 percent deduction if the business owner's taxable income exceeds certain threshold amounts. For these taxpayers, taking steps to reduce taxable income in order to take advantage of the full 20 percent deduction can lead to significant tax savings. </p><p> The first (and likely most simple) step that small business owners can take to minimize taxable income is to ensure that they are maximizing contributions to retirement accounts. Small business owners can contribute up to $70,000 in 2025 to a 401(k) (including both the employer and employee portion of the contribution). If the individual is age 50 or above, he or she can contribute an additional $7,500 in catch-up contributions to the account. </p><p> For business owners who need to reduce taxable income by a more substantial amount, a cash balance plan may be a more viable solution. A cash balance plan is essentially a cross between a traditional defined benefit pension plan and a defined contribution plan (e.g., a 401(k)). Generally, employers will contribute a set portion of a participant's salary to the plan each year (a "pay credit"; usually equal to between 5 and 8 percent annually), and the participant's account will also be credited with an interest credit each year. Cash balance plans are technically defined benefit plans, so the annual $70,000 total contribution limit for 401(k) plans (in 2025) does not apply. Instead, the contribution limit for cash balance plans is based on the amount that a participant may receive at retirement (in 2024, a 55-year old could be able to contribute as much as $275,000 to a cash balance plan). An actuary can be used to calculate backward from the benefit amount in order to determine each individual participant's contribution level. </p><p> The business owner is permitted to operate both a 401(k) plan and a cash balance plan at the same time, so that very high income taxpayers can maximize contributions to both types of account. The cash balance plan contribution will lower the taxable income of the business as a whole (rather than at the individual owner's level, so that the benefit is split among the business owners). However, the business owner will be required to contribute to the accounts of non-highly compensated employees, as well, on an annual basis (meaning that the business owner should ensure that the business has sufficient profits to sustain the cash balance plan over a period of time). </p><p> In addition to retirement account planning strategies, small business owners who are charitably inclined should note that the 50 percent AGI limitation on cash contributions to public charities and certain private foundations increased to 60 percent for 2018-2025 (the AGI limit on contributions of capital gains property (such as securities) remained at 30 percent). For 2020 and 2021, the AGI limit was removed entirely under the CARES Act and CAA 2021. This change increases the amount of the contribution that the taxpayer will be able to deduct in order to further reduce taxable income. </p>

<p> No. The regulations added a new provision that requires aggregation of two or more trusts if the trusts have substantially the same grantor or grantors, and substantially the same beneficiary or beneficiaries, if the principal purpose of forming the trust or contributing additional assets to the trust is the avoidance of income tax. A principal purpose of avoiding tax is presumed if significant tax benefits are created, unless a significant non-tax benefit can be shown.<a href="#_ftn1">¹</a></p><blockquote><em>Example</em>: Amy owns and operates a pizzeria and several gas stations. Amy's annual income from these businesses and other sources exceeds the Section&nbsp;199A threshold amount, and the W-2 wages properly allocable to these businesses are not sufficient for her to maximize the QBI deduction. Amy reads an article that suggests that taxpayers can avoid the W-2 wage limitation of Section&nbsp;199A by contributing portions of their family businesses to multiple identical trusts established for family members. Based on this advice, in 2018, Amy establishes three irrevocable, non-grantor trusts:&nbsp;Trust 1 for the benefit of Amy's sister, Betty, and Amy's brothers, Chuck and Dan;&nbsp;Trust 2 for the benefit of Amy's second sister, Emily, and for Chuck and Dan; and&nbsp;Trust 3 for the benefit of Emily. Under each trust instrument, the trustee is given discretion to pay any current or accumulated income to any one or more of the beneficiaries.&nbsp;The trust agreements otherwise have nearly identical terms. But for the enactment of Section&nbsp;199A and Amy's desire to avoid the W-2 wage limitation of that provision, Amy would not have created or funded such trusts. Amy names her oldest son, Fred, as the trustee for each trust. </p><p> Amy forms a family limited partnership, and contributes the ownership interests in the pizzeria and gas stations to the partnership in exchange for a 50-percent general partner interest and a 50-percent limited partner interest. Amy later contributes to each trust a 15&nbsp;percent limited partner interest. Under the partnership agreement, the trustee does not have any power or discretion to manage the partnership or any of its businesses on behalf of the trusts, or to dispose of the limited partnership interests without the approval of the general partner. Each of the trusts claims the Section&nbsp;199A deduction on its Form&nbsp;1041 in full based on the amount of QBI allocable to that trust from the limited partnership, as if such trust was not subject to the wage limitation in Section&nbsp;199A(b)(2)(B). Under these facts, for Federal income tax purposes under this section,&nbsp;Trust 1,&nbsp;Trust 2, and&nbsp;Trust 3 would be aggregated and treated as a single trust.<a href="#_ftn2">²</a></blockquote></p><p><hr></p><p><strong>Planning Point:</strong> Significant non-tax reasons often include aggregation of ownership within the family, centralized asset management, avoidance of repetitive asset transfers within the family, asset protection or to relieve a transferring family member of asset management burdens. </p><p><hr></p><p><hr align="left" size="1" width="33%"></p><p><a href="#_ftnref1">1</a>. Treas. Reg. § 1.643(f)-1. </p><p><a href="#_ftnref2">2</a>. Treas. Reg. § 1.643(f)-1(c), Example 1. </p>

<p> Trust or estate beneficiaries take any QBI, W-2 wages or UBIA of qualified property into account in the same manner as though the trust or estate were any other relevant pass-through entity. However, the regulations make clear that trusts formed with a significant purpose of taking advantage of the Section 199A deduction will not be respected.<a href="#_ftn1">¹</a></p><p> The trust or estate is treated as a relevant pass-through entity to the extent it allocates QBI and other items to beneficiaries, and is treated as an individual to the extent it retains QBI and other items.<a href="#_ftn2">²</a> If the trust is a grantor trust, the person owning the trust calculates his or her Section 199A deduction as though he or she directly conducted the relevant activities of the trust.<a href="#_ftn3">³</a></p><p> If the trust is a non-grantor trust, QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends and qualified PTP income must be calculated at the entity level. Those items are then allocated to beneficiaries (and/or to the trust or estate) in proportion to the trust or estate's distributable net income (DNI) for the taxable year that is either distributed to the beneficiaries or retained by the entity. DNI is calculated without regard to Section 199A, but does take into account the separate share rule of IRC Section 663(c). If the trust or estate has no DNI for the year, all items are allocated to the trust or estate.<a href="#_ftn4">⁴</a></p><p><hr></p><p><strong>Planning Point:</strong> The relevant income threshold for Section 199A deduction purposes is $197,300 in 2025 for trusts and estates, $191,950 in 2024, $182,100 in 2023, $170,040 in 2022 and $164,900 in 2021 (i.e., the same income threshold that applies to single filers).<a href="#_ftn5">⁵</a></p><p><hr></p><p> The regulations also clarify that an electing small business trust (ESBT) is entitled to take the Section 199A deduction. The S portion of the ESBT is required to take into account QBI and all other items of any S corporation owned by the ESBT. The grantor portion of the ESBT must take into account QBI and other items from assets treated as owned by the grantor or another person. The non-S portion of the ESBT must take into account any QBI and other items owned by the ESBT.<a href="#_ftn6">⁶</a></p><p><hr align="left" size="1" width="33%"></p><p><a href="#_ftnref1">1</a>. Treas. Reg. § 1.199A-5(d)(3)(v). </p><p><a href="#_ftnref2">2</a>. Treas. Reg. § 1.199A-6(d)(1). </p><p><a href="#_ftnref3">3</a>. Treas. Reg. § 1.199A-6(d)(2). </p><p><a href="#_ftnref4">4</a>. Treas. Reg. § 1.199A-6(d)(3). </p><p><a href="#_ftnref5">5</a>. Rev. Proc. 2020-54, Rev. Proc. 2021-45, Rev. Proc. 2023-34, Rev. Proc. 2024-40. </p><p><a href="#_ftnref6">6</a>. Treas. Reg. § 1.199A-5(d)(3)(iv). </p>

<p> The Section 199A regulations impose certain reporting requirements on entities treated as "relevant pass-through entities" (RPEs). A RPE must identify on Schedule K-1 issued to owners, for any trade or business, the following information: </p><blockquote> Each owner's share of QBI, W-2 wages and UBIA of qualified property attributable to each trade or business, </p><p> Whether any of the trades or businesses is an SSTB, and </p><p> On an attachment to Schedule K-1, the RPE must report each owner's allocated share of any qualified REIT dividends or qualified PTP income or loss received by the RPE. </blockquote><br> The entity must also report on Schedule K-1 any QBI, W-2 wages, UBIA of qualified property, or SSTB determinations that are reported to it by any other pass-through entity in which it owns a direct or indirect interest.<a href="#_ftn1">¹</a></p><p> If the RPE fails to satisfy these reporting requirements, the owner's share of positive QBI, W-2 wages and UBIA of qualified property will be presumed to be zero.<a href="#_ftn2">²</a></p><p><hr align="left" size="1" width="33%"></p><p><a href="#_ftnref1">1</a>. Treas. Reg. § 1.199A-6(b)(3)(ii). </p><p><a href="#_ftnref2">2</a>. Prop. Treas. Reg. § 1.199A-6(b)(3). </p>

<p> Generally, no. Qualified business income excludes income that is earned from the trade or business of being an employee. Unlike in the case of SSTBs, no phase-in applies—all income earned from the trade or business of being an employee is excluded from QBI regardless of the taxpayer's income level.<a href="#_ftn1">¹</a> Because of this, many employees would now rather be characterized as independent contractors in order to take advantage of the Section 199A QBI deduction. See Q <a href="javascript:void(0)">8722</a> to Q <a href="javascript:void(0)">8736</a> for a discussion of how the IRS determines whether an individual is an employee or an independent contractor, and the consequences of improper classification, as these factors are relevant in the determinization for the QBI deduction, as well. </p><p> Under the regulations, if an individual was classified as an employee for tax purposes and, while continuing to perform substantially the same services for the same employer (whether directly or indirectly), was re-classified as an independent contractor, the IRS will presume that the individual remains an employee for Section 199A purposes.<a href="#_ftn2">²</a></p><p><hr></p><p><strong>Planning Point:</strong> The individual may be denied independent contractor status under this rule for Section 199A purposes and continue to be an independent contractor for other tax purposes. </p><p><hr></p><p> The presumption contained in the proposed regulations is a rebuttable presumption—if the individual can show that he or she is, in fact, properly classified as an independent contractor under general legal principles applicable to making this determination, Section 199A will be available. </p><p> The final regulations retain this presumption and add a requirement that the presumption applies for three years after the employment classification changes (three year "look-back" requirement), so that the individual must present three years' worth of evidence to rebut the presumption before being re-classified as an independent contractor for 199A purposes.<a href="#_ftn3">³</a></p><p><hr align="left" size="1" width="33%"></p><p><a href="#_ftnref1">1</a>. Prop. Treas. Reg. § 1.199A-5(a)(3). </p><p><a href="#_ftnref2">2</a>. Prop. Treas. Reg. § 1.199A-5(d)(3). </p><p><a href="#_ftnref3">3</a>. Treas. Reg. § 1.199A-5(d)(3). </p>

<p> The rules regarding aggregation under the Section 199A regulations differ from existing rules regarding aggregation under the Section 469 passive activity rules. Before aggregating, if the individual directly owns the entity, the taxpayer must first compute QBI, W-2 wages and UBIA for each business. The individual then combines those figures to apply the W-2 wage and UBIA limitations.<a href="#_ftn1">¹</a></p><p> Under the Section 199A rules, businesses may be aggregated if the following specific requirements are satisfied: <br><ol><br><li>The same person or group of persons owns, directly or indirectly, 50&nbsp;percent or more of each business (family attribution rules apply to aggregate interests owned by spouses, children, grandchildren and parents<a href="#_ftn2">²</a>) for the majority of the tax year;</li><br></ol></p><p><hr></p><p><strong>Planning Point:</strong> The individual who chooses to aggregate does not have to own 50 percent or more of each business, so long as the ownership requirement is met by another person or group of persons. </p><p><hr></p><blockquote><em>Example</em>: Celia owns 60&nbsp;percent of three partnerships, and Larry owns 5&nbsp;percent of each of those three partnerships. Leslie owns 10&nbsp;percent of two of the partnerships.&nbsp;The entities satisfy all of the aggregation requirements listed below. Celia and Larry may aggregate all three partnerships. Leslie may aggregate the two partnerships in which she owns an interest.&nbsp;The partnerships are commonly controlled for purposes of all three individuals—it does not matter that only Celia owns more than a 50&nbsp;percent interest in the entities. </blockquote><br><ol start="2"><br><li>The "control test" is satisfied (i.e., 50&nbsp;percent common ownership test);</li><br><li>The entities share the same tax year so that all items to be aggregated are reported on returns within the same tax year (not taking into account short tax years);</li><br><li>None of the businesses to be aggregated are SSTBs;</li><br><li>Two of the following three requirements are satisfied: (a) the businesses must offer the same products or services (or those typically offered together), (b) the businesses must share facilities or other centralized functions (such as personnel, human resources, accounting, legal, purchasing, etc.), or (c) the businesses are operated in coordination with, or reliance upon, one or more businesses in the group.<a href="#_ftn3">³</a></li><br><li>The business to be aggregated must qualify as a trade or business (i.e., under IRC Section&nbsp;162), rather than a hobby.</li><br></ol><br> Activities are treated as a trade or business if the activity involves renting or licensing property to a commonly controlled entity (see Q <a href="javascript:void(0)"></a>). </p><p> Aggregation must be reported consistently in all subsequent tax years. If the taxpayer acquires a new business that satisfies the above requirements, that new business may be aggregated with the existing group. If the aggregated group ceases to meet the above requirements, the aggregation will no longer apply. Taxpayers will be required to include certain information with their federal income tax returns each year regarding the aggregation requirements.<a href="#_ftn4">⁴</a> Both the proposed and the final regulations provide that the choice as to whether to aggregate certain businesses is elective, but once the taxpayer makes the election, it cannot be revoked. However, newly acquired businesses may be added to an existing aggregation (either at the individual or entity level) if all of the regulations' requirements are satisfied. Similarly, if an existing aggregation stops being permitted because of a change in circumstances, the businesses will no longer be aggregated.<a href="#_ftn5">⁵</a></p><p><hr></p><p><strong>Planning Point:</strong> Aggregation for Section 199A purposes takes place at the owner level under the proposed regulations. This means that one partner may choose to aggregate businesses, while another partner with ownership interests in the same businesses may not choose to aggregate those same businesses.<a href="#_ftn6">⁶</a> Under the final regulations, aggregation is also permitted at the entity level.<a href="#_ftn7">⁷</a></p><p><hr></p><p> The choice as to whether to aggregate certain businesses is elective, but once the taxpayer makes the election, it cannot be revoked. </p><p><hr></p><p><strong>Planning Point:</strong> Aggregation can be useful in the case of business structures where one business may generate substantial income but has low W-2 wages, and the opposite is true for another business under common control. </p><p><hr></p><p> Both the proposed and the final regulations provide that the choice as to whether to aggregate certain businesses is elective, but once the taxpayer makes the election, it cannot be revoked. However, newly acquired businesses may be added to an existing aggregation (either at the individual or entity level) if all of the regulations' requirements are satisfied. Similarly, if an existing aggregation stops being permitted because of a change in circumstances, the businesses will no longer be aggregated.<a href="#_ftn8">⁸</a></p><p><hr align="left" size="1" width="33%"></p><p><a href="#_ftnref1">1</a>. Prop. Treas. Reg. § 1.199A-4(b)(2). </p><p><a href="#_ftnref2">2</a>. Prop. Treas. Reg. § 1.199A-4(b)(3). </p><p><a href="#_ftnref3">3</a>. Prop. Treas. Reg. § 1.199A-4(b)(1), Treas. Reg. § 1.199A-4(b)(1). </p><p><a href="#_ftnref4">4</a>. Prop. Treas. Reg. § 1.199A-4(c). </p><p><a href="#_ftnref5">5</a>. Treas. Reg. § 1.199A-4(b)(2). </p><p><a href="#_ftnref6">6</a>. Prop. Treas. Reg. § 1.199A-4(b)(2). </p><p><a href="#_ftnref7">7</a>. Treas. Reg. § 1.199A-4(a). </p><p><a href="#_ftnref8">8</a>. Treas. Reg. § 1.199A-4(b)(2). </p>

<p> If a pass-through entity received income in a tax year that began before January 1, 2018, but after December 31, 2017 (i.e., a non-calendar year entity), the income is treated as though received or incurred in the year in which the entity's tax year ends.<a href="#_ftn1">¹</a> Therefore, these taxpayers will be entitled to claim the QBI deduction with respect to income received in 2017 if all other requirements for claiming the deduction are satisfied. </p><p><hr align="left" size="1" width="33%"></p><p><a href="#_ftnref1">1</a>. Treas. Reg. § 1.199A-1(f)(2). </p>

<p> The W-2 wage limitation and UBIA limitation only come into play if the taxpayer's income for the year exceeds the relevant threshold levels. Therefore, if the taxpayer's income for the year is $100,000, the QBI deduction is generally 20 percent, or $20,000, depending upon the taxpayer's total taxable income for the year (see Q <a href="javascript:void(0)"></a> to Q <a href="javascript:void(0)"></a>). However, in a more complicated situation, the deduction may be limited or phased out entirely, as discussed in detail in Q <a href="javascript:void(0)"></a> and Q <a href="javascript:void(0)"></a>, which explain how the QBI deduction is calculated if the taxpayer's income either exceeds the threshold levels, or is within the phase-out range. <br><blockquote><em>Example. </em>Ed, a sole proprietor, owns a business that generates $400,000 worth of QBI for the year. Ed pays $100,000 in W-2 wages and has $100,000 of qualified property. Ed's wife earns $200,000 for the year, bringing their total joint income to $600,000. Ed's income is technically below the relevant threshold for complete phase-out for joint returns, but, when combined with his wife's income, their total income exceeds the annual threshold amount.&nbsp;Therefore, the limitations apply, and the 20&nbsp;percent deduction no longer applies. Ed's deduction is limited to the greater of: 50&nbsp;percent of W-2 wages ($50,000) or the sum of 25&nbsp;percent of the W-2 wages of the business plus 2.5&nbsp;percent of the UBIA of all qualified property ($25,000 + $2,500 = $27,500). Ed's QBI deduction is therefore $50,000. </blockquote></p>