The IRS issued final regulations for the Section 199A deduction – also known as the qualified business income (QBI) deduction – in January 2019. The regulations, applicable for tax years ending after Aug. 16, 2018, resolve some uncertainties S-corporation financial services organizations had harbored about their eligibility for the potentially valuable deduction.
The resolutions largely are favorable for S-corp financial services organizations, but such organizations should take heed of some potential traps. Those that do not risk unwittingly forfeiting a significant deduction.
The question raised for S-corp financial services organizations was whether activities that would qualify as an SSTB on a stand-alone basis (for example, wealth management advisory services) would taint other banking activities that otherwise are eligible for the QBI deduction. Proposed regulations had included a de minimis rule providing that, for a business with gross receipts of greater than $25 million, if 5% or less of the gross receipts are attributable to the performance of SSTB services, that income is ignored and the entire business is not an SSTB. For businesses with gross receipts of $25 million or less, the applicable de minimis threshold is 10% of gross receipts.
Thus, if wealth services represent only 1% of gross receipts, they likely would not be deemed a separate trade or business and would be included in QBI under the de minimis rule. But what if core banking activities generated 94% of gross receipts and SSTB activities generated the remaining 6%? Would the core banking activities be disqualified from the deduction?
The final regulations make clear that a pass-through entity can carve out the income from an SSTB activity, assuming the activity qualifies as a separate trade or business (based on applicable facts and circumstances). The remaining qualified activities then still are eligible for the 20% deduction.
Notwithstanding the de minimis rule, however, a financial services organization that has an SSTB (or multiple SSTBs) that is determined to be separate from core banking activities – rather than ancillary to them – should segregate that activity. Failure to do so potentially can result in all of the organization’s income losing the 20% deduction in a later year (and going forward) if the gross receipts from the SSTB activity in that later year exceed the de minimis threshold.
For example, consider an S-corp bank with more than $25 million in total gross receipts, including 3% from wealth management services. The wealth services contribute that same proportion of gross receipts for three years, and the bank reports only one trade or business (banking), with all of the taxable income from it counting as QBI because the wealth management services income is below the applicable 5% de minimis threshold. In year four, though, the bank acquires another wealth management business, boosting the gross receipts from those services to 8% of total gross receipts.
Because the bank reported only one trade or business in the earlier years, it might not be able to claim the wealth management services are a separate trade or business, which could put all of the bank’s taxable income at risk of not qualifying as QBI in year four and going forward. Of course, the bank would have to consider the specific facts and circumstances, which might support a conclusion that the wealth management services did not rise to the level of a separate trade or business until the year four acquisition.
The final regulations provide that the performance of services to originate a loan is not treated as the purchase of a security from the borrower. This should exempt most S-corp financial services organizations from the dealer in securities status. Thus, unless an organization purchases loans for resale on the secondary market (as opposed to originating loans for resale), its normal lending activities will not result in SSTB treatment.
In conjunction with the final regulations, the IRS issued Notice 2019-07, which provides a safe harbor outlining the specific requirements to be met for rental real estate activities to qualify as a trade or business. Rental real estate activities will be treated as a trade or business for deduction purposes if all of the following apply:
The resolutions largely are favorable for S-corp financial services organizations, but such organizations should take heed of some potential traps. Those that do not risk unwittingly forfeiting a significant deduction.
The impact of specified service trade or business (SSTB) activities
The QBI deduction was created by the Tax Cuts and Jobs Act (TCJA) and generally allows taxpayers to deduct 20% of qualified business income from a pass-through entity, such as an S corporation. However, for certain SSTBs, the deduction begins to phase out above a threshold amount of taxable income. It phases out completely when taxable income exceeds $207,500 for single filers and $415,000 for joint filers.The question raised for S-corp financial services organizations was whether activities that would qualify as an SSTB on a stand-alone basis (for example, wealth management advisory services) would taint other banking activities that otherwise are eligible for the QBI deduction. Proposed regulations had included a de minimis rule providing that, for a business with gross receipts of greater than $25 million, if 5% or less of the gross receipts are attributable to the performance of SSTB services, that income is ignored and the entire business is not an SSTB. For businesses with gross receipts of $25 million or less, the applicable de minimis threshold is 10% of gross receipts.
Thus, if wealth services represent only 1% of gross receipts, they likely would not be deemed a separate trade or business and would be included in QBI under the de minimis rule. But what if core banking activities generated 94% of gross receipts and SSTB activities generated the remaining 6%? Would the core banking activities be disqualified from the deduction?
The final regulations make clear that a pass-through entity can carve out the income from an SSTB activity, assuming the activity qualifies as a separate trade or business (based on applicable facts and circumstances). The remaining qualified activities then still are eligible for the 20% deduction.
Notwithstanding the de minimis rule, however, a financial services organization that has an SSTB (or multiple SSTBs) that is determined to be separate from core banking activities – rather than ancillary to them – should segregate that activity. Failure to do so potentially can result in all of the organization’s income losing the 20% deduction in a later year (and going forward) if the gross receipts from the SSTB activity in that later year exceed the de minimis threshold.
For example, consider an S-corp bank with more than $25 million in total gross receipts, including 3% from wealth management services. The wealth services contribute that same proportion of gross receipts for three years, and the bank reports only one trade or business (banking), with all of the taxable income from it counting as QBI because the wealth management services income is below the applicable 5% de minimis threshold. In year four, though, the bank acquires another wealth management business, boosting the gross receipts from those services to 8% of total gross receipts.
Because the bank reported only one trade or business in the earlier years, it might not be able to claim the wealth management services are a separate trade or business, which could put all of the bank’s taxable income at risk of not qualifying as QBI in year four and going forward. Of course, the bank would have to consider the specific facts and circumstances, which might support a conclusion that the wealth management services did not rise to the level of a separate trade or business until the year four acquisition.
The “dealer in securities” issue
The original language in the proposed regulations would have caused financial services organizations that engage in loan sales to third parties to be considered dealers in securities, which would have been an SSTB activity under the proposed regulations. This would have wreaked havoc not only with the application of the de minimis rule but also with the potential loss of the 20% deduction with respect to lending activities.The final regulations provide that the performance of services to originate a loan is not treated as the purchase of a security from the borrower. This should exempt most S-corp financial services organizations from the dealer in securities status. Thus, unless an organization purchases loans for resale on the secondary market (as opposed to originating loans for resale), its normal lending activities will not result in SSTB treatment.
Rental real estate activities
The proposed regulation did not clearly address whether the 20% QBI deduction was available for owners of rental real estate – specifically, whether rental real estate activities would qualify as a trade or business or would be considered an investment activity generating the equivalent of portfolio income not eligible for the 20% deduction.In conjunction with the final regulations, the IRS issued Notice 2019-07, which provides a safe harbor outlining the specific requirements to be met for rental real estate activities to qualify as a trade or business. Rental real estate activities will be treated as a trade or business for deduction purposes if all of the following apply:
- Separate books and records are kept to reflect income and expenses for each rental real estate enterprise.
- For taxable years through 2022, at least 250 hours of rental services are performed each year for the enterprise.
- For tax years after 2018, the taxpayer maintains contemporaneous records showing the income and expenses, the hours of all services performed, the services performed, the dates they were performed, and who performed them.
The hours-of-services requirement can be satisfied by work performed by owners, employees, or contractors. Qualifying work includes maintenance, repairs, rent collection, expense payment, lease negotiation and execution, and efforts to rent out property. Investment-related activities – such as arranging financing, procuring property, and reviewing financial statements – do not qualify.
Financial services organizations might lease out excess space at their branches or administrative offices under triple net lease arrangements. The notice specifically excludes triple net lease activities from the safe harbor, but those activities nonetheless could qualify for the 20% deduction if they qualify as a trade or business. A facts and circumstances determination would be necessary.
S-corp financial services organizations should review any rental real estate activities to assess whether they qualify as a separate trade or business under the safe harbor or, if they do not, under a facts and circumstances determination. If deemed to instead be an investment activity, such as a single triple net lease arrangement, the 20% deduction might not be available for the rental real estate activities but remains available for core banking activities.
