Editor: Mark G. Cook, CPA, CGMA
On June 24, 2020, the IRS issued additional final regulations (T.D. 9899) concerning the qualified business income (QBI) deduction under Sec. 199A. These final regulations clarify what is considered QBI and how to calculate it in certain situations. More particularly, the new rules provide guidance on:
- The treatment of previously suspended losses included in QBI, and
- The Sec. 199A deduction for taxpayers that hold interests in regulated investment companies (RICs), split-interest trusts, and charitable remainder trusts.
Sec. 199A provides individual taxpayers (and some trusts and estates) a deduction of up to 20% of QBI from a U.S. trade or business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate. Taxpayers can also take a deduction of up to 20% of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income (Secs. 199A(a) and (b)(1)(B)).
Generally, the QBI deduction is limited by the amount of W-2 wages paid with respect to the trade or business and/or the unadjusted basis immediately after acquisition (UBIA) of qualified property held for use in the trade or business (Sec. 199A(b)(2)). However, qualified REIT dividends and qualified PTP income are not so limited.
In February 2019, the IRS published final regulations (T.D. 9847) (February 2019 final regulations) on Sec. 199A as well as proposed regulations (February 2019 proposed regulations). The new final regulations that are the subject of this article (June 2020 final regulations) amend two substantive sections of the February 2019 final regulations: Regs. Secs. 1.199A-3 and 1.199A-6.
The June 2020 final regulations went into effect for tax years beginning after Aug. 24, 2020. However, taxpayers can rely on these rules (or the February 2019 proposed regulations) in preparing returns for earlier years, if the rules are applied consistently for each year.
Treatment of previously suspended losses in QBI
One topic addressed by the June 2020 final regulations is how to treat previously suspended losses in QBI. Generally, previously disallowed losses or deductions are included in the computation of QBI in the tax year in which they are allowed, except to the extent that they were disallowed, suspended, limited, or carried over from tax years ending before Jan. 1, 2018 (Regs. Sec. 1.199A-3(b)(1)(iv)). Such losses must be used in order from the oldest to the most recent on a first-in, first-out (FIFO) basis.
This QBI rule was originally limited to certain losses and deductions (including those arising under Secs. 465, 469, 704(d), and 1366(d)). However, the June 2020 final regulations not only expand the rule to include losses disallowed under Sec. 461(l) but also provide that this list is not exhaustive (Regs. Sec. 1.199A-3(b)(1)(iv)(A)). Sec. 461(l), as recently amended by the Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, disallows an excess business loss for taxpayers other than C corporations for tax years beginning after Dec. 31, 2020, and before Jan. 1, 2026. Any disallowed excess business loss is treated as a net operating loss (NOL) carryover under Sec. 172(b).
The June 2020 final regulations also clarify that previously disallowed losses or deductions are treated as losses from a separate trade or business (as opposed to the trade or business that generated the loss) for purposes of computing QBI in the year the loss is considered in determining taxable income (Regs. Sec. 1.199A-3(b)(1)(iv)(A)). Further, whether a disallowed loss or deduction is attributable to a trade or business is determined in the year the loss is incurred (Regs. Sec. 1.199A-3(b)(1)(iv)(C)).
Deduction available to shareholders of RICs
The June 2020 final regulations also provide guidance on a QBI issue involving REITs. As stated above, Sec. 199A permits taxpayers other than C corporations a deduction of up to 20% of their combined qualified REIT dividends and qualified PTP income. However, many REITs are held by RICs, which are taxed as C corporations. As a result, REIT dividends paid by RICs were generally ineligible for the Sec. 199A deduction. This resulted in incongruent treatment of REIT dividends: Shareholders that invested in REITs directly could qualify for the deduction, whereas shareholders that invested indirectly through a RIC could not.
The February 2019 final regulations did not address the treatment of REIT dividends received by RICs, but the June 2020 final regulations do. Under these new final regulations, if the Sec. 852(b) RIC taxation rules apply to a RIC for a tax year, then the RIC can pay Sec. 199A dividends (Regs. Sec. 1.199A-3(d)(1)). Thus, the June 2020 final regulations provide that a RIC that receives qualified REIT dividends can pass them through to its shareholder.
The June 2020 final regulations do this by adopting rules in the February 2019 proposed regulations that provide “conduit treatment” for qualified REIT dividends earned by a RIC. This means that if a RIC has certain items of income or gain, then a shareholder may treat dividends received from the RIC in the same (or similar) manner as the shareholder would treat the underlying item of income or gain if the shareholder realized it directly.
The IRS estimates that this change will result in aggregate potential deductions of up to $1.1 billion and will affect up to 2,500 RICs and up to 4.8 million individual tax units. However, the June 2020 final regulations do not provide conduit treatment for qualified PTP income (or other income) earned by a RIC.
Special rules for trusts and estates
The June 2020 final regulations also address certain QBI issues relating to trusts and estates. For one thing, the regulations clarify the “separate share rule” to provide that a trust or estate described in Sec. 663(c) (with substantially separate and independent shares for multiple beneficiaries) is treated as a single trust or estate for purposes of Sec. 199A. The allocation of these items to the separate shares of a trust or estate is governed by the rules under Regs. Secs. 1.663(c)-1 through 1.663(c)-5 (Regs. Sec. 1.199A-6(d)(3)(iii)).
Generally, a charitable remainder trust (CRT) does not itself qualify to claim a Sec. 199A deduction. However, the June 2020 final regulations adopted rules in the February 2019 proposed regulations under which the taxable recipient of a unitrust or annuity amount from a CRT can consider QBI, qualified REIT dividends, or qualified PTP income in determining its Sec. 199A deduction for the tax year to the extent that the distribution consists of such Sec. 199A items under Regs. Sec. 1.664-1(d) (Regs. Sec. 1.199A-6(d)(3)(v)).
In summary, the June 2020 final regulations clarify what is considered QBI, especially in cases involving RICs, trusts, and estates. These new rules mostly adopt the February 2019 proposed regulations but still leave some unanswered questions, such as whether the PTP income of a RIC ever qualifies for the Sec. 199A deduction.
Mark G. Cook, CPA, CGMA, MBA, is the lead tax partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or [email protected].
All contributors are members of SingerLewak LLP.
Original to ‘The Tax Adviser’, 11/1/2020: