FinCEN has issued proposed regulations extending the due date for new entities created during 2024 to 90 days after creation. After 2024, the 30-day deadline will apply.
Tax tips and developments relating to real estate
Many high income and high net worth taxpayers will be relieved to learn that Biden's major revenue proposals are NOT included in the agreement.
Effective for transfers after February 15, 2021, the exemption from reassessment only applies to the excess of the fair market value of a primary residence (qualifying for the homeowner's real estate tax exemption) over the transferor's assessed value up to $1 million.
President Trump changed his mind and signed The Consolidated Appropriations Act, 2021 on December 27, 2020. The Act is more than 5,000 pages. There were not very many tax law changes in the Consolidated Appropriations Act compared to the CARES Act enacted during March 2020. Here are a few highlights
Here are some of the most significant changes, with suggested year-end tax planning moves for 2020, assuming the proposals are enacted.
The Joint Committee on Taxation has issued a description of the tax provisions in the CARES Act.
Here is a URL to download the report. https://www.jct.gov/publications.html?func=startdown&id=5256
Congress passed and President Trump signed the Coronavirus Aid, Relief and Economic Security (CARES) Act (P.L. 116-136) on March 27, 2020.
Here is a URL to see the text of the Act. https://www.congress.gov/116/bills/hr748/BILLS-116hr748enr.pdf
Here is a URL to the Franchise Tax Board’s FAQs relating to COVID-19 issues. https://www.ftb.ca.gov/about-ftb/newsroom/covid-19/help-with-covid-19.html
Here are some highlights of tax provisions of the Act.
Advance tax rebates
The provision that has received the most publicity is advance tax rebates of $1,200 for single persons and $2,400 for married couples who file joint income tax returns. In addition to these amounts, $500 will be included in the advance tax rebate for each dependent child claimed by the taxpayer(s) who qualifies for the child tax credit under Internal Revenue Code Section 24.
The rebates will be mailed or electronically deposited as soon as possible by the IRS to provide relief to Americans who are suffering from the shutdown of our society to fight the coronavirus pandemic.
Not everyone will qualify. The rebates are reduced to not below zero by 5% of the taxpayer’s adjusted gross income above $150,000 for married couples filing joint returns, $112,500 for heads of households, and $75,000 for other taxpayers.
Nonresident aliens, anyone who is claimed as a dependent, estates and trusts don’t qualify for the rebate.
The IRS will make a preliminary determination based on the last income tax return filed for 2018 or 2019, or for seniors who do not file an income tax return, their social security record.
Since the IRS doesn’t have spouse and dependent information for social security recipients who don’t file a tax return, they might want to file income tax returns for 2018 or 2019 if it increase their rebate.
When the taxpayer prepares his or her 2020 federal individual income tax return, the rebate will be recomputed based on the current year facts. Any additional rebate will be allowed as a credit on the income tax return. The taxpayer gets to keep any excess of the amount received over the computed amount.
The rebate reduces the federal income tax and any amount already received by the taxpayer and is treated as an refund received in amount. The rebate isn’t taxable income. The rebate can be more than the tax before the rebate and is refundable.
Waived early withdrawal penalty for certain retirement plan distributions
Taxpayers who receive a distribution from a qualified retirement plan or an IRA before they reach age 59 1/2 are normally subject to a 10% federal early distribution penalty.
The penalty will be waived for up to $100,000 of distributions during 2020 to an individual (1) who is diagnosed with coronavirus, (2) whose spouse or dependent is diagnosed with coronavirus, or (3) who experiences financial consequences as a result of being quarantined, being furloughed or laid off or having work hours reduced due to the coronavirus crisis, being unable to work due to lack of child care due to the virus, closing or reducing hours of a business owned or operated by the individual due to the virus, or other factors as determined by the IRS.
Unless the taxpayer elects out, the income from a coronavirus-related distribution will be spread ratably over a 3-taxable year period, beginning with with the distribution year (2020.)
Although these distributions won’t be eligible under the usual rules for rollovers or trustee-to-trustee transfers, corona virus-related distributions from a qualified plan or an IRA may be repaid to the qualified plan or an IRA within 3 years beginning the day after the date the distribution was received. The amount repaid will be treated as a direct trustee-to-trustee transfer within 60 days of the distribution.
Since these distributions aren’t considered to be rollovers, you can have as many distributions as you want during 2020 treated as trustee-to-trustee transfers or have them taxed over three years, provided they qualify as coronavirus-related.
Roth conversions can also be taxed over three years under the rule, provided the distribution was coronavirus related, such as if the account owner was diagnosed with a mild case of the virus.
It appears claiming the recharacterization of the distribution for any repayments will be reported on the 2020 income tax return, and the return will be amended if the distribution isn’t restored in time.
Distributions from inherited IRAs with a nonspouse beneficiary don’t qualify for rollover treatment. (IRC § 402(c)(4), (9), § 408(d)(3)(C).) (Once a distribution is received by a nonspouse beneficiary from an inherited IRA, it can’t be redeposited.)
The waiver of penalty and extended rollover provisions apply to distributions on or after January 1 and before December 31, 2020. (Evidently, distributions ON December 31, 2020 won’t qualify.)
Required minimum distributions aren’t required for 2020
The required minimum distributions that apply to defined contribution qualified retirement plans (401(k)s and profit sharing plans) and IRAs after a participant reaches age 72 (age 70 1/2 before the SECURE Act was enacted) is waived for 2020.
If an employee reached age 70 1/2 during 2019, so the employee has a required beginning date on April 1, 2020, the penalty is also waived for that payment.
For years after 2020, the required minimum distributions will be computed by the regular procedure (beginning balance divided by life expectancy) without regard to the 2020 required minimum distribution and the required beginning date will be unchanged for other income tax determination purposes.
Charitable contributions limits for individuals increased
Individuals who don’t itemize deductions on their federal income tax returns will be able to deduct on their 2020 federal income tax returns up to $300 of charitable contributions that would otherwise qualify, except for donations to a donor advised fund or a private foundation.
The limitation for itemized deductions of cash charitable contributions to public charities by individuals, normally 60% of adjusted gross income, is eliminated for 2020.
Charitable contributions limit for corporations increased
The limit for charitable contributions for C corporations is increased for charitable contributions paid in cash during calendar year 2020 to public charities from 10% of modified taxable income to 25% of modified taxable income.
Charitable contributions limit for food inventory
For noncorporate taxpayers, the limit for charitable contributions of food inventory is increased from 15% to 25% of the taxpayer’s aggregate net income for 2020 from all trades or businesses from which such contributions were made.
For C corporations, the limit for charitable contributions of food inventory is increased from 15% to 25% of modified taxable income.
Exclusion for employer payments on student loans
Effective for payments made after March 28, 2020 and before January 1, 2021, payments by an employer, whether paid to the employee or to a lender, of principal or interest on any qualified education loan incurred by the employee for education of the employee are excluded from the employee’s taxable income. The employee won’t be eligible to claim an interest deduction for the excluded amount.
Payroll tax credit for certain employers
Employers who have their business operations fully or partially suspended during a calendar quarter due to orders from a government authority due to the coronavirus during the period beginning with the first calendar quarter beginning after December 31, 2019 for which gross receipts are less than 50% of gross receipts for the same calendar quarter in the prior year and ending with the calendar quarter for which gross receipts are greater than 80% of the gross receipts for the prior year and all tax-exempt organization during 2020 are eligible for an employee retention tax credit of 50% of qualified wages of up to $10,000 for each employee for all calendar quarters.
Note that employers who receive a small business interruption loan aren’t eligible for this credit. (The loan may be eligible for forgiveness, and that would be double-dipping.) If the employer claims the credit and receives a loan in a subsequent quarter, the credit will be recaptured.
The credit is effective for wages paid after March 12, 2020 and before January 1, 2021.
The credit is limited to the 6.2% employer share of social security taxes for all employees during the calendar quarter, but any credit in excess of that amount is treated as an overpayment and is refundable to the employer. (Note that medicare taxes and federal unemployment taxes aren’t eligible to be offset by the credit.)
The credit is reduced for credits allowed for employment of qualified veterans, research expenditures of qualified small businesses, and payroll tax credits for paid sick and paid family and medical leave provided in the Families First Coronavirus Response Act.
For employers having an average of more than 100 full-time employees during 2019, qualified wages means wages paid with respect to which an employee is not providing services due to a government-ordered suspension or a period of significant decline in gross receipts, but not in excess of the amount the employee would have been paid for working an equivalent duration during the 30 days immediately preceding the period.
For employers with an average of 100 or fewer full-time employees in 2019, qualified wages means wages paid with respect to an employee during any period of a government-ordered suspension or during a quarter that is within a period of significant decline in gross receipts.
Qualified wages don’t include any amounts taken in account for payroll tax credits provided in the Families First Coronavirus Response Act.
Qualified wages includes the employer’s qualified health plan expenses properly allocable to the wages that are excluded from the gross income of employees.
Wages of employees for which a work opportunity credit is claimed aren’t eligible for the credit.
Governmental employers aren’t eligible for the credit.
Here is a URL for IRS FAQs on the Employee Retention Credit. https://www.irs.gov/newsroom/faqs-employee-retention-credit-under-the-cares-act
Deferred payment of employer payroll taxes
Deposits of the employer portion of payroll taxes due from March 28, 2020 through December 31, 2020 are deferred and payable 50% on December 31, 2021 and the balance on December 31, 2022.
Payments for one half of self-employment tax (the “employer” portion) for 2020 are also deferred and payable 50% on December 31, 2021 and the balance on December 31, 2022.
Employers that have a loan forgiven under Section 1106 of the CARES Act for a loan under Section 7(a)(36) of the Small Business Act aren’t eligible for deferring payment of employer payroll taxes.
Net operating loss deduction and carrybacks
The 80% of taxable income limitation for deducting net operating losses has retroactively been suspended for taxable years beginning after December 31, 2017 and before January 1, 2021. For taxable years beginning after December 31, 2020, the 80% of taxable income limitation for deducting net operating losses will be restored.
For losses arising in a taxable year beginning after December 31, 2017 and before January 1, 2021, net operating losses may be carried back 5 taxable years. Previously, net operating loss carrybacks weren’t allowed for these years.
Taxpayers may elect to waive the carryback. There is also a special election available to exclude carrybacks to one or more years that have income exclusion of offshore income under Internal Revenue Code Section 965.
Taxpayers may revoke a previous election to waive a net operating loss carryback by July 25, 2020.
Note many taxpayers should consider filing amended returns to claim net operating loss carrybacks from 2017, 2018. and 2019.
Excess business loss limitations suspended
The limitations on deductions for business losses in excess of business income have been suspended for taxable years beginning after December 31, 2017 and before January 1, 2021.
Since these losses will now be allowed, taxpayers who are entitled to them should file amended income tax returns to claim them.
Tax credit for prior year minimum tax liability of C corporations
The alternative minimum tax was repealed for C corporations by the Tax Cuts and Jobs Act of 2017. Unused minimum tax credits were scheduled to be refundable with an annual 50% limitation for taxable years beginning in 2018, 2019, and 2020 until a 100% limitation would be applied for taxable years beginning in 2021.
Under the CARES Act, taxpayers may elect to claim a refundable credit for 100% of the balance for taxable years beginning in 2018 or 2019.
The election to claim the 100% limit for 2018 can be made using an application of tentative refund form (Form 1139.) The form should be filed by December 31, 2020. The IRS should issue the refund within 90 days after receiving the form.
Increased limit on deduction for business interest
Certain taxpayers that have more than $25 million of business income or are “tax shelters” are subject to a limitation for deducting business interest expenses.
Under the Tax Cuts and Jobs Act of 2017, the limit is the sum of (1) business interest income of the taxpayer for the tax year; (2) 30% of the taxpayer’s adjusted taxable income for the year; and (3) floor plan financing interest of the taxpayer for tax year.
Under the CARES Act, the limitation of item (2) is increased to 50% for taxable years beginning in 2019 and 2020.
Technical correction for Qualified Improvement Property
Qualified improvement property is an improvement to an interior portion of a building that is nonresidential real property provided the improvement is placed in service after the date the building was first placed in service. Improvements relating to the enlargement of a building, an elevator or escalator, or the internal structural framework of the building aren’t qualified improvement property.
This is the expanded definition of qualified improvement property adopted in the Tax Cuts and Jobs Act of 2017.
A drafting error in the Tax Cuts and Jobs Act of 2017 made the property subject to a 39 year depreciable life and not eligible for 100% bonus depreciation.
The CARES Act includes a technical correction defining qualified improvement property as 15 year property, qualifying for bonus depreciation. This correction is retroactive to the date of enactment of the Tax Cuts and Jobs Act of 2017, which was December 20, 2017.
Even with this technical correction, some taxpayers won’t qualify for bonus depreciation for this property. Taxpayers that are otherwise subject to the limitation for business interest deductions under Internal Revenue Code Section 163(j) (generally they have average annual gross receipts for the three prior years of $26 million for tax years beginning in 2020) and make elections to be excluded from the limitations, notably electing real property trade or businesses, electing farming businesses, and certain infrastructure trades or businesses, must used the alternative depreciation system instead of the modified accelerated depreciation system. For these businesses, depreciable real estate has a useful life of 39 years, so they don’t qualify for bonus depreciation on qualified improvement property.
Taxpayers with commercial buildings that had qualified improvement property placed in service after 2017 should amend their 2017, 2018 and 2019 income tax returns to claim bonus depreciation for the year the property was placed in service.
Government loan guarantees for small businesses
In addition to the tax provisions discussed above and many other matters, the legislation includes a “Paycheck Protection Program.” The Federal government will 100% guarantee SBA administered loans to businesses with not more than 500 employees. Sole proprietors, independent contractors and other self-employed individuals are eligible for loans. The covered loan period begins February 15, 2020 and ends on June 30, 2020.
There is an issue about whether self-employment compensation for partners in partnerships and members of LLC taxed as partnerships can be included in wages for Paycheck Protection Program loans. They aren’t specifically listed.
Act Section 1102(a)(1)(viii)(I)(bb) includes income of a sole proprietor or independent contractor that is a wage, commission,income, net earnings from self-employment, or similar compensation and that is an amount that is not more than $100,000 in 1 year, as prorated for the covered person…”
The SBA “Interim Final Rules” II. 3. f. says payroll costs include “… for an independent contractor or sole proprietor, wage, commissions, income, or net earnings from self-employment or similar compensation.”
Based on these definitions, it seems that it was intended that compensation of self-employed persons, including LLC members, should be covered by the Paycheck Protection Program. In a recent CalCPA webinar, CPAs from Armanino suggested that guaranteed payments in lieu of wages should be included in payroll for the loan application. Since the definition in the Act is “self-employment income”, it seems to me that all self employment income should be included. Guaranteed payments in lieu of wages should be increased or decreased for the partner’s or member’s share of self-employment income or losses from the partnership or LLC.
When you include this item in wages, you should probably explain what you are doing and why.
This legislation was drafted in a hurry, and whoever wrote it wasn’t thinking about partnerships and LLCs.
The maximum loan amount is $10 million through December 31, 2020. The loan amount is based on payroll costs incurred by the business.
Uses of the loan include payroll support, such as employee salaries (subject to a $100,000 limitation for an employee’s wages), paid sick or medical leave, insurance premiums and mortgage interest, rent, and utility payments.
Only compensation of persons whose principal place of residence is in the United States are covered.
Federal employment taxes imposed or withheld between February 15, 2020 and June 30, 2020, including the employee’s and employer’s share of FICA and Railroad Retirement Act taxes and income taxes required to be withheld from employees, are excluded.
Qualified sick and family leave wages for which a credit allowed under the Families First Coronavirus Response Act (Public Law 116-126) are also excluded. (No double dipping!)
Eligibility is based on whether a business was operational on February 15, 2020 and had employees for whom it paid salaries and payroll taxes, or a paid independent contractor.
The Act waives borrower and lender fees for particpating in the Paycheck Protection Program, and waives collateral and personal guarantee requirements under the program.
The maximum interest rate for these loans is four percent.
No loan payments will be required for at least six months and not more than a year, and requires the SBA to issue guidance about the deferment process by April 27, 2020.
Although the stated maturity of the loans is 10 years, the principal amount of the loan is forgiven up to the amount of (1) payroll costs; (2) payments of interest on a covered mortgage obligation; (3) payments on any covered rent obligation; and (4) covered utility payments. No more than 25% of the forgiven amount can be for non-payroll costs.
The debt cancellation is tax free. (Act § 1106(i).)
Caution! I have heard that some businesses, such as registered investment advisors, may be subject to restrictions on having debt. Check with your compliance officer or attorney before going ahead with an application for an SBA loan.
Here is a URL for the application form for a Paycheck Protection Program loan. https://home.treasury.gov/system/files/136/Paycheck-Protection-Program-Application-3-30-2020-v3.pdf?j=268557&sfmc_sub=124882304&l=3151_HTML&u=8813281&mid=7306387&jb=592&utm_medium=email&SubscriberID=124882304&utm_source=NewsUp_A20Mar225&Site=aicpa&LinkID=8813281&utm_campaign=Newsupdate&cid=email:NewsUp_A20Mar225:Newsupdate:Share+the+application:aicpa&SendID=268557&utm_content=Special
Here is a URL for a borrower’s guide for Paycheck Protection Program loan. https://home.treasury.gov/system/files/136/PPP%20Borrower%20Information%20Fact%20Sheet.pdf?j=268557&sfmc_sub=124882304&l=3151_HTML&u=8813282&mid=7306387&jb=592&utm_medium=email&SubscriberID=124882304&utm_source=NewsUp_A20Mar225&Site=aicpa&LinkID=8813282&utm_campaign=Newsupdate&cid=email:NewsUp_A20Mar225:Newsupdate:accompanying+borrower+guide:aicpa&SendID=268557&utm_content=Special
Here is a URL for the Small Business Administration’s interim final rule for Paycheck Protection Program loans. https://www.sba.gov/sites/default/files/2020-04/PPP–IFRN%20FINAL_0.pdf
Disaster loss election available
Since President Trump invoked the Robert T. Stafford Disaster Relief and Emergency Assistance Act when he declared the coronavirus outbreak to be a national emergency, disaster losses are eligible to be carried back one year under Internal Revenue Code Section 165(i) . Taxpayers should consider which tax year the losses they incur relating to the COVID-19 crisis will have the best tax benefit.
The Act includes a temporary Pandemic Unemployment Assistance program through December 31, 2020 to provide payments to people who traditionally aren’t eligible for unemployment benefits, including self-employed persons, independent contractors and those with a limited work history, who are unable to work as a direct result of the coronavirus public health emergency.
Unemployment compensation benefits are increased an additional $600 per week to each recipient of unemployment insurance or Pandemic Unemployment Assistance for up to four months.
Unemployment benefits are extended an additional 13 weeks through December 31, 2020 when state unemployment benefits are no longer available.
Railroad unemployment benefits are also increased like other unemployment benefits explained above, and the 7-day waiting period for railroad unemployment insurance benefits is temporarily eliminated through December 31, 2020.
For details about how these changes affect your situation, consult with your tax advisor or write to me at firstname.lastname@example.org.
The IRS issued the final regulations for Qualified Opportunity Zones, TD 9889, on December 20, 2019 and they were published in the Federal Register on January 13, 2020. The final regulations are generally effective for taxable years beginning after March 13, 2020, but taxpayers may elect to apply them for taxable years beginning after December 31, 2017 (for most taxpayers, 2018 and 2019.) If taxpayers decide to rely on proposed regulations previously issued by the IRS, they must totally follow the proposed regulations — no cherry picking! Alternatively, if the final regulations are selected for 2018 and 2019, the taxpayer must solely rely on those.
Here’s a link to the regulations in the Federal Register: https://www.federalregister.gov/documents/2020/01/13/2019-27846/investing-in-qualified-opportunity-funds
The final regulations are generally more taxpayer-friendly than the proposed regulations, but there are some rules in the proposed regulations that are more favorable for some taxpayers.
My printout of the final regulations with the preamble is 543 pages. I won’t explain them in detail here, but hit a few highlights. If you are thinking of investing or have invested in a Qualified Opportunity Zone, I highly recommend that you work with a tax professional who has studied the rules.
When investing in a Qualified Opportunity Zone investment, due diligence is essential. This is the type of investment that will attract fraudsters as organizers. You won’t get the tax and investment benefits if the organizer steals your money.
Very briefly and over-simplified, the benefits of Qualified Opportunity Zone investments are: (1) Defer the taxation of capital gains until the earlier of an inclusion event (such as selling the investment) or December 31, 2026; (2) If the investment is held at least five years no later than December 31, 2026, 10% of the original gain becomes tax free; (3) If the investment is held at least seven years no later than December 31, 2026, 5% of the original gain becomes tax free; (4) If the investment is held more than 10 years, the appreciation of the investment becomes tax free. Note that (1) in order to get ALL of the tax benefits, the investment must have been made by December 31, 2019, (2) the tax on at least 85% of the deferred capital gain must be paid for the tax year that includes December 31, 2026.
Remember that states might not conform to the Qualified Opportunity Zone rules. For example, California hasn’t conformed at this time.
The Opportunity Zones are designated by the states. You can likely locate them by searching online for “Qualified Opportunity Zones” and the state. These investments are becoming available through investment advisors. Alternatively, married couples can set up their own Qualified Opportunity Zone fund, or taxpayers otherwise can join together to make these investments. (This is NOT a do-it-yourself project! Only do it with professional help!)
Here are a few comparisons of the proposed and final regulations.
Under the proposed regulations, the taxpayer had to sell the investment (corporation, LLC or partnership interest) in order to get the 100% exclusion of appreciation within the fund after holding the investment (called a Qualified Opportunity Fund or QOF) for more than 10 years. Under the final regulations, the exclusion can be claimed when the QOF sells a Qualified Opportunity Zone asset (for example, a building.)
Under the proposed regulations, a property that was abandoned or otherwise left vacant for 5 years or longer could be treated as “originally used” for the purposed of the Original Use Test. Under the final regulations, the period is reduced to 3 years or longer, or only 1 year if the property was vacant before the designation of its location as a Qualified Opportunity Zone.
In order to defer the taxation of capital gains, the gain the taxpayer wishes to defer must be invested in the QOF within 180 days after the sale.
Under the proposed regulations, gains from the sale of Section 1231 assets (business assets) had to be netted for the taxable year and only Section 1231 gains in excess of losses could be deferred and invested in QOF. Because the net gain couldn’t be determined until the end of the year, the time for the 180 day reinvestment started as of the end of the year of the sale. Under the final regulations, gains from the sale of Section 1231 assets, without regard to Section 1231 losses, can be deferred and invested in a QOF. The time for the 180 day reinvestment starts on the date of the sale. When the gain becomes taxable, it will retain its status as a Section 1231 gain.
(Note that the proposed regulations and final regulations both provide that capital gains, not reduced by capital losses, are eligible for tax deferral by reinvesting them in a QOF. The measuring date for 180 day reinvestment of capital gains is the date of the sale.)
For investors in a partnership or S corporation and for beneficiaries of estates and non-grantor trusts, called pass-through entities, the proposed regulations provided the ratable share of the capital gain from the passthrough entity could be reinvested in a QOF (1) within 180 days of the actual date of a sale or exchange by the passthrough entity, or (2) within 180 days after December 31 of the taxable year in with the gain was incurred. Since it may be some time before the information is determined after the end of the taxable year, the final regulations add a third option, (3) within 180 days after the due date, WITHOUT EXTENSIONS, of the pass-through entity’s tax return for the taxable year in which the sale or exchange took place (generally, either March 15 or April 15 of the following year.)
The final regulations provide that taxpayers may elect to have the 180-day period begin on either the date an installment sale payment is received or on the last day of the taxable year in which the taxpayer would have recognized the gain under the installment method. If the payment date is selected, the taxpayer must continue to follow that method in future years. Also, installment sale gains from sales in years before January 1, 2018 are eligible for reinvestment in a QOF and tax deferral.
The final regulations clarify that nonresident aliens may defer the tax on capital gains that would otherwise be subject to U.S. tax by investing the gains in a QOF.
Under the proposed regulations, there was an inclusion event requiring the taxation of deferred gains for all of the shareholders if a QOF organized as an S corporation had a change of ownership exceeding 25% before the holding period requirements were met. Under the final regulations, this requirement has been eliminated. Only the shareholders who transfer their shares will have an inclusion event.
You can see from these changes that taxpayers will need to determine based on their own facts which set of regulations to choose. As I write this, there is still time to defer federal income taxes by investing in a QOF for sales made late in 2019.
There are many additional provisions, including operating rules for Qualified Opportunity Zone investments, that I haven’t discussed here. Once more, see your tax advisor for details.
A great tax benefit enacted as part of the Tax Cuts and Jobs Act of 2017 is the Qualified Opportunity Fund (QOF).
Taxpayers who reinvest capital gains into one of these funds can defer federal income taxes on the reinvested capital gains, including Section 1231 gains from selling business assets that are taxable as capital gains, for up to eight years until the earlier of the date on which the qualified investment is sold or exchanged or December 31, 2026. In addition, the additional gain relating to the appreciation of the Qualified Opportunity Fund may be tax free, provided an election is made and the investment is held for more than 10 years.
If the QOF is held at least 5 years, 10% of the reinvested deferred gain will be tax free. If the QOF is held at least 7 years, an additional 5% of the reinvested deferred gain will be tax free. These adjustments are accounted for as tax basis adjustments — adding the tax free amounts to the taxpayer’s cost of the investment in the QOF.
The IRS issued proposed regulations for these funds during October, 2018. Now they have issued additional proposed regulations (REG-120186-18 to be published shortly in the Federal Register) and are asking for more feedback from the tax return preparation and consulting community. Another public hearing is scheduled for July 9, 2019 at 10 a.m.
The new proposed regulations provide answers to many questions relating to Qualified Opportunity Funds, and are mostly favorable to taxpayers. I can only cover a few highlights. My printout of the regulations and preamble is about 168 pages. Here are a few key points.
- The ownership and operation (including leasing) of real estate is the active conduct of a trade or business. A triple-net lease is not the active conduct of a trade or business. This broad acceptance of real estate leases as a trade or business only applies for applying the rules for Qualified Opportunity Funds.
2. Only net capital gains and net Section 1231 gains (from sales of business assets) that are taxed as capital gains qualify for deferral by reinvestment. Since net Section 1231 losses are taxed as ordinary losses, the 180-day reinvestment period for net Section 1231 gains begins at the end of the taxable year when the sale of Section 1231 property was closed.
3. If there is an “inclusion event”, any remaining reinvested deferred capital gains and Section 1231 gains will become taxable if the investment hasn’t already been held until December 31. 2026.
4. If an S corporation that invests in a QOF has aggregate change of ownership of capital interests of more than 25%, there is an inclusion event.
5. A conversion of an S corporation to a partnership or disregarded entity or a C corporation is an inclusion event.
6. A taxpayer’s transfer of a qualifying investment by gift, whether outright or in trust, is an inclusion event.
7. A taxpayer’s transfer of a qualifying investment to a revocable living trust (grantor trust) is not an inclusion event, because the trust is disregarded for income tax reporting and the taxpayer is considered to continue to own the investment. The trust becoming irrevocable can be an inclusion event, but see item 8.
8. The transfer of a qualifying investment to a beneficiary of an estate or trust as an inheritance is not an inclusion event. Remaining reinvested deferred income is potentially income with respect of a decedent. The beneficiary steps into the shoes of the decedent relating to when the income will be taxable.
9. A corporate subsidiary that is a QOF is not eligible to be included in a consolidated income tax return.
10. A corporate parent that is a QOF is eligible to be included in a consolidate income tax return.
11. A taxpayer may invest amounts exceeding capital gains and Section 1231 gains that are eligible for deferral in a QOF. The excess investment will be separately accounted for as a separate interest that is not eligible for QOF tax benefits. (Any gain relating to that share will be taxable.)
12. Distributions by QOFs can be inclusion events. For example, if a QOF partnership or S corporation borrows money and distributes funds exceeding their tax basis to its partners (remember most QOF interests will start with a basis of zero, because there is no tax basis for the deferred gains that are reinvested in the fund), the distributions will be an inclusion event. (Distributions of operating income should be handled carefully. Remember you can have positive cash flow when you don’t have taxable income because of noncash deductions, like depreciation.)
13. Special rules are provided for mergers, recapitalizations and reorganizations. They are beyond the scope of this summary. See your tax advisor.
14. Used property leased tangible property that was previously not used for a depreciable purpose for at least five years can be eligible “original use” QEF property.
15. The proposed regulations include fairly liberal “substantially all” definitions for various limitations. They are beyond the scope of this summary. See your tax advisor.
16. Leases shouldn’t include prepayments for more than a year.
17. The proposed regulations include valuation guidelines for tangible property when applying the test requiring 90% of the property of the QOF to be used in the Qualified Opportunity Zone. The QOF may either use the value for a qualified (audited) financial statement or cost and present value of lease payments as of the inception of the lease. The property doesn’t have to be revalued each year.
18. QOFs are required to annually pass a 50% of gross receipts test. A least 50% of the QOF’s gross income must be earned in a Qualified Opportunity Zone. Under the regulations, the gross receipts aren’t tested based on where the customer is located, but on where the work is done to produce the products or services. That means sales from reselling products produced overseas won’t be qualified income. Just having a post office box located in a Qualified Opportunity Zone doesn’t mean the business is considered to be located there.
19. Unimproved land won’t be considered qualifying property unless plans are in place to substantially improve the land within 30 months.
The IRS says they will be issuing more proposed regulations for QOFs soon.
These proposed regulations are critically important for taxpayers to realize the tax benefits that they are counting on when making investments in QOFs.
The 20% of qualified domestic business income (QDBI or called QBI in the regulations) deduction under Internal Revenue Code Section 199A is one of the most complex provisions of the Tax Cuts and Jobs Act, enacted on December 22, 2017.
Even professional tax return preparers will be challenged when computing the deduction for higher-income taxpayers. Any taxpayer who owns an unincorporated business or an S corporation should get professional help for preparing their 2018 income tax returns.
The IRS issued final regulations on January 18, 2019, and a corrected version of the final regulations on February 1, 2019. The final regulations were published in the Federal Register on February 8, 2019, after a delay because of the federal shutdown. The IRS incorporated many of the suggestions that they received in response to proposed regulations that were issued on August 8, 2018, so the final regulations are “new and improved.”
The deduction is effective for taxable years beginning after December 31, 2017. For 2018, taxpayers may elect to use the final regulations in their entirety, the proposed regulations in their entirety, or to only follow the Internal Revenue Code. No cherry-picking! In most cases, taxpayers should follow the final regulations, so they can use benefits like aggregation of businesses.
My printed copy of the final regulations, including the preamble, is 249 pages. I can only cover some highlights here. Professional tax return preparers should study the final regulations and attend the continuing education updates that are widely available.
The computation of the deduction is much simpler and more favorable for taxpayers below the income thresholds. The deduction is computed for individuals and for the undistributed income of trusts and estates.
The basics. The basic computation is 20% of qualified domestic business income. The total deduction under Section 199A is 20% of qualified domestic business income + 20% of qualified REIT dividends + 20% of qualified income from a publicly traded partnership + 9% of qualified production activity income from an agricultural cooperative. The total deduction is limited to 20% of taxable income in excess of net capital gain (including qualified dividends.)
If a taxpayer’s taxable income exceeds a threshold amount, things become more complicated.
The threshold amounts for 2018 are $315,000 for married, filing joint returns and $157,500 for other taxpayers. The threshold limitations are phased in from $315,000 to $415,000 for married, filing joint returns and $157,500 to $207,500 for other taxpayers. The threshold amounts will be indexed for inflation after 2018.
Once the thresholds are reached, the income of specified service trade and businesses (SSTBs) will be phased out and eliminated for the computation of the deduction.
In addition for taxpayers over the thresholds, for income other than from qualified REIT dividends, publicly-traded partnerships or agricultural cooperatives, the deduction will be limited to the greater of (1) 50% of W-2 wages paid, or (2) 25% of W-2 wages + 2.5% of unadjusted basis immediately after acquisition (UBIA.) The limitation is applied for each trade or business or aggregated trades or businesses.
The 20% deduction for QDBI is the same amount for the alternative minimum tax as for the regular tax.
Qualified domestic business income (QDBI, or called QBI in the regulations). Qualified domestic business income means the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business (or aggregated trade or business) as determined under the rules for Internal Revenue Code Section 199A. Only income for business conducted in the United States (including Puerto Rico) qualifies for the deduction. The trade or business must be conducted as a passthrough entity, including sole proprietorships, partnerships, S corporations, and LLCs taxed as sole proprietorships, partnerships or S corporations.
The income of S corporations must be reduced by reasonable compensation paid to shareholders. If an S corporation doesn’t pay reasonable compensation, the IRS can reclassify part of the income as wages. This rule doesn’t apply to partnerships or LLCs taxed as partnerships, because partnerships don’t have a reasonable compensation requirement as corporations do.
Any income taxed as capital gains, including some net gains from the sale of business assets called net Section 1231 gains, are excluded from QDBI. Other investment income such as most interest income and qualified dividends income are also excluded from QDBI.
Interest income that is business income, such as the income of banks from making loans or late charges for accounts receivable, is included in QDBI.
Ordinary income or losses relating to the sale of business assets, including depreciation recapture and net Section 1231 losses, are included in QDBI.
Income from the trade or business of being an employee is excluded from QDBI.
Guaranteed payments to partners are also excluded from QDBI because they are considered similar to wage and interest income.
QDBI is reduced for deductions relating to the income, including the deduction for self-employment taxes, self-employed retirement contributions and the self-employed medical insurance deductions for adjusted gross income.
A controversial matter is whether net rental income from a real estate operation qualifies as a trade or business. The IRS has separately issued Notice 2019-07, a proposed revenue procedure for a safe harbor for real estate operations to qualify as trades or businesses qualifying for the deduction. I have written a separate blog post about Notice 2019-07. http://www.michaelgraycpa.com/posts/irs-issues-safe-harbor-for-rental-real-estate-qualification-for-20-qualified-business-income-deduction/
Loss considerations. The final regulations make it clear that loss limitation rules, such as the passive activity loss rules, at-risk rules and losses limited by basis, are applied before the rules to compute the 20% QDBI deduction. Any loss carryovers from taxable years beginning before January 1, 2018 are disregarded when making the 20% QDBI computations. According to other proposed regulations, REG-134652-18, any future carryovers of those losses are treated as coming from a separate trade or business and are not aggregated with the current-year income of the entity that generated the loss.
Grouping under the passive activity loss rules and the election to be a real estate professional are disregarded for the 20% of QDBI deduction computations.
The negative qualified business income of any entity is allocated and applied to the positive qualified business income of any other entities. Any losses in excess of the total positive business income of the other entities is disregarded and carried forward to the next taxable year. The total loss carryforward will be considered to come from a separate entity in the subsequent taxable year.
The loss limitation is applied separately for publicly traded partnerships and any excess loss is carried forward separately as a loss from a publicly traded partnership.
Passthrough entities (RPEs). The income from a relevant passthrough entity (RPE) (partnership, S corporation, estate or trust) with a taxable year ending in 2018 will be used to compute the 20% of QDBI deduction computations for 2018. These entities might have already issued Schedule K-1s omitting the necessary information. They should consider amending their income tax returns and issuing amended Schedule K-1s including the required information. (The final regulations provide that amended returns can be filed for this purpose.) Otherwise, the W-2 wages and QBIA for the entity will be considered to be zero!
W-2 wages. W-2 wages will generally be determined based on W-2s issued by the entity during the calendar year ending within the taxable year of the entity. A taxpayer may include W-2 wages paid by an employee leasing company on its behalf. In that case, the employee leasing company can’t include those wages for its computation of the 20% of QDBI deduction. (No double counting!) Payments to common law employees who report their income as self-employed aren’t included in W-2 wages. W-2 wages do not include any amount that is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for W-2s. File Forms W-2 for your employees on time!
A taxpayer must allocate W-2 wages to the trades or businesses that they relate to. Wages paid for nondeductible items like household workers are disregarded.
The IRS has issued Revenue Procedure 2019-11 with methods for computing W-2 wages.
Unadjusted basis when initially acquired (UBIA). Unadjusted basis when initially acquired (UBIA) is the tax basis of depreciable property before applying accumulated depreciation, including bonus depreciation and the Section 179 expense election. The property must be held by and available for use in the trade or business at the close of the taxable year and must have been used at any point during the taxable year in the trade or business’s production of QDBI.
The depreciable period for the property must have not ended before the close of the individual’s or reporting passthrough entity’s taxable year for it to be included in UBIA. The depreciable period is the lesser of (1) 10 years after the property was placed in service, or (2) the last day of the depreciable life of the property. This means the depreciable period for most personal property is 10 years, the depreciable period for most residential real estate is 27.5 years and the depreciable period for most commercial real estate is 39 years.
There is an anti-abuse provision that property acquired within 60 days of the end of the taxable year and disposed of within 120 days of acquisition without having been used in a trade or business for at least 45 days prior to disposition will be excluded from UBIA.
Basis information for property aquired in tax years ending before 2018 will have to be determined relating to property contributed in a tax-free transaction by a partner or shareholder with a partnership (including most LLCs) or an S corporation. Carryover information also applies for qualified property received in a Section 1031 exchange or a Section 1033 involuntary conversion. Additional amounts invested in property received in a Section 1031 exchange or a Section 1033 involuntary conversion will be treated as the acquisition of another piece of property with an acquisition date when placed in service and its own depreciable period.
The UBIA of inherited property will generally be the fair market value on the date of death. The acquisition date for inherited property will generally be the date of death.
The final regulations allow a Section 743(b) adjustment relating to a transfer of a partner’s interest of depreciable property to be included in UBIA. A Section 734(b) adjustment relating to the liquidation of a partner’s interest is not included in UBIA.
Aggregation. A significant change in the final regulations is allowing aggregation by a relevant passthrough entity. Under the proposed regulations, only the individual taxpayer, estate or trust that claimed the 20% of QDBI deduction could make the aggregation election. This is a simplification measure that will make reporting on Schedule K-1 easier for some passthrough entities. The election by the passthrough entity should be done thoughtfully, because it is irrevocable and may negatively affect some partners who might have chosen different aggregation.
Aggregation, or combining two or more trade or business operations, can be helpful to make limitation amounts for W-2 wages and UBIA from one operation available for income in another operation.
These are the requirements for aggregation:
- The same person or group of persons must own 50% or more of each trade or business to be aggregated;
- The common ownership must be in place for the majority of the taxable year, including the last day of the taxable year (change from the proposed regulations), in which the items attributable to each trade or business to be aggregated are included in income;
- All of the trades or businesses must report on returns with the same taxable year (watch fiscal year passthrough entities!);
- A specified service trade or business isn’t eligible to be aggregated;
- The trades or businesses to be aggregated must satisfy at least two of the following factors:
- The trades or businesses provide products, property or services that are the same or customarily offered together.
- The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources or information technology resources.
- The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies.)
A rental of equipment or real estate to a commonly-controlled trade or business should qualify for aggregation. They share significant centralized business elements (B) and rely upon one another (C).
According to the final regulations, the rental or licensing of tangible or intangible property that does not rise to the level of a Section 162 trade or business is nevertheless treated as a trade or business for purposes of Section 199A, if the property is rented or licensed to a trade or business conducted by the individual or an RPE which is commonly controlled.
Once a taxpayer chooses to aggregate two or more businesses, the same aggregation must be followed in all subsequent taxable years, unless there is a change in facts such as the liquidation of a business.
The taxpayer (including RPEs) must make certain disclosures or the IRS can disallow the aggregation.
Specified service trade or business (SSTB). Once a taxpayer exceeds the thresholds, the 20% deduction for QDBI relating to a specified service trade or business (SSTB) is phased out and eliminated.
The listed SSTBs are health, law, accounting, actuarial science, performing arts, consulting (excluding architecture and engineering), athletics, financial services, brokerage services, investing and investment management, trading, dealing in securities, partnership interests or commodities, and any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. The final regulations generally are the same as the proposed regulations relating to the SSTBs, with some clarification and additional examples.
Health includes medical services provided by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals. Services by health spas that provide physical exercise or conditioning, payment processing, or the research, testing and manufacture and/or sales of pharmaceuticals or medical devices are not considered healthcare services.
Legal services include services provided by attorneys, paralegals, legal arbitrator, mediators and similar professionals. Services to law firms by printers, delivery services or stenography services are not legal services.
Accounting services are not determined by certification. Accountants, enrolled agents, tax return preparers, financial auditors and professionals providing similar services are considered to be providing accounting services.
Services in the performing arts includes individuals who participate in the creation of performing arts, including actors, singers, musicians, entertainers, directors, and similar professionals. The maintenance and operation of equipment or facilities for use in the performing arts and broadcasting services are excluded.
Consulting involves providing professional advice and counsel to clients to help achieve clients’ goals and solving problems. Consulting embedded in or ancillary to the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB is not included, provided there is no separate payment for the consulting services.
Athletics service includes the performance of services who participate in athletic competition, such as athletes, coaches, and team managers. The maintenances and operation of equipment or facilities for use in athletic events or broadcasting or distributing video of athletic events are excluded. Schools for teaching amateur sports skills should be excluded.
Sales of commodities relating to property that is stock in trade of a trade or business or that otherwise would be included in the inventory of a trade or business are excluded.
The most favorable provision relates to the last category. A trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owner includes any of the following.
- A trade or business in which a person receives fees, compensation or other income for endorsing products or services,
- A trade or business in which a person licenses or receives fees, compensation, or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or other symbols associated with the individual’s identity,
- Receiving fees, compensation, or other income for appearing at an event or on radio, television or another media format.
Receiving a partnership interest or the receipt of stock of an S corporation is included in fees, compensation or other income.
For a trade or business with gross receipts of $25 million or less for a taxable year, the trade or business is not an SSTB if less than 10% of the gross receipts of the trade or business are attributable to SSTB items. (If 10% or more of the gross receipts are attributable to SSTB items, the entire entity is treated as a SSTB.)
For a trade or business with gross receipts exceeding $25 million, the threshold will be 5% instead of 10%.
Taxpayers that have trades or businesses that include SSTB income and other income should consider splitting them into separate entities, including having separate books and records, to avoid recharacterizing what would otherwise be qualifying income to SSTB income under the above rule. Having a separate S corporation would clearly be a separate trade or business.
If a trade or business provides property or services to an SSTB that has 50% or more common ownership, that trade or business will also be treated as a separate SSTB with respect to the related parties. (For example, rental income from a building leased to a medical S corporation that has the same ownership will be SSTB income.) Common ownership can be direct or indirect through family members or related entities under Internal Revenue Code Sections 267(b) or 707(b).
Trade or business of performing services as an employee. Income from a trade or business of performing services as an employee is not QDBI. Reporting income on Form W-2 does not determine whether an individual is an employee. Whether an individual is an employee is a trade or business is determined by facts and circumstances.
An individual who was properly treated as an employee for Federal employment tax purposes and is later treated as not an employee while providing the same services to the trade or business will be presumed to be an employee for three years after ceasing the be treated as an employee for Federal Employment Services. This is a rebuttable presumption that can be disputed by providing records, such as contracts or partnership agreements, that corroborate the individual’s status as a non-employee.
Disclosure for relevant passthrough entities (RPEs). The final regulations include disclosure rules for RPEs. If an RPE fails to properly report any item, it is considered to be zero.
Estates and trusts. Information relating to income that is taxable to a beneficiary of an estate or trust should be reported on Schedule K-1s issued to the beneficiaries, including QDBI, W-2 wages, and UBIA for each trade or business (or aggregated trades and businesses.)
Income that isn’t distributed or distributable to the beneficiaries will be taxed to the estate or trust and the estate or trust will be eligible to claim the 20% of QDBI deduction relating to that income. This will require allocation of the QDBI, W-2 wages and UBIA between the estate or trust and the beneficiaries of the estate or trust.
Since the trust threshold for 2018 is $157,500, the final regulations include an anti-abuse rule requiring two or more trusts to be aggregated and treated as one trust if the trusts have substantially the same grantor or grantors and substantially the same beneficiary or beneficiaries. Spouses are treated as one person when applying this rule. This anti-abuse rule is effective for taxable years ending after December 22, 2017.
Conclusion. I hope this summary persuades many who are eligible for the 20% of QDBI deduction to get help with structuring their operations to maximize this tax benefit and to properly compute the deduction.
The software providers are scrambling to incorporate the requirements in their tax return preparation software.
You might not be able to correctly compute the deduction using the carryover information in the system. The output should be carefully reviewed to be sure it is complete, especially for desireable elections. If the information isn’t properly reported, the deduction could be lost entirely.