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IRS Releases Final Regulations on the 20 Percent Pass-Through Deduction

February 1, 2019

Just in time for the tax filing season, the IRS has released nearly 250 pages of final regulations regarding the §199A pass-through deduction. The IRS issued previous guidance on the §199A pass-through deduction in August 2018, however, even this final guidance has not answered all questions related to the new deduction. Even so, there are many significant updates in the IRS’s final regulations, which are explained below.

QBI Refresher

The Tax Cuts and Jobs Act (TCJA) added the §199A deduction, which is commonly referred to by several aliases, but typically either the 20 percent pass-through deduction or the qualified business income (QBI) deduction. The deduction is reserved for qualifying business income from pass-through entities (S corporations, LLCs, etc.). However, once the pass-through owner exceeds certain income thresholds, limitations on the deduction may take effect. For instance, where the trade or business is a specified service trade or business (SSTB) the deduction will be denied entirely. SSTBs include physician groups, law firms, accounting firms, and an assortment of additional service businesses. Furthermore, even if the trade or business is not an SSTB, the deduction may be limited depending upon the amount of W-2 wages or property held by the business.

Multiple Trades or Businesses Within a Single Entity

Almost as soon as tax reform passed, tax experts got to work crafting ways to mitigate the harsh tax reality of the SSTB classification. One such strategy is to identify separate trades or businesses within a single entity, those that are SSTB and those that are non-SSTB (think physician [SSTB] that sells skin care products [non-SSTB]). The idea is that a business may be able to get a QBI deduction for the skin care product business even though the physician practice would certainly be ineligible as an SSTB. What did the final regulations have to say on the issue?

The Good News: The IRS explicitly acknowledged that a single entity can conduct more than one trade or business.

The Bad News: The IRS did not explicitly explain how to identify separate trades or businesses, but instead simply referred to a facts-and-circumstances analysis. They did make it clear that at a bare minimum, each business must have a complete and separable set of books and records – otherwise it will be extremely difficult convincing the IRS that there is more than one trade or business in operation. Unfortunately, in the physician example above, it remains unclear whether there is a single trade or business that includes the sale of skin products, or conversely, whether there are two trades or businesses, one of which is eligible for the QBI deduction.

Services or Property Provided to an SSTB

Another suggested strategy was to extract non-SSTB items from an SSTB business. The hallmark example is an SSTB business that removes a building from the operational entity and leases the building back. The idea is that while the SSTB business wouldn’t qualify for the QBI deduction, the building rental just might.

The Bad News: The proposed regulations contained a rule to curtail this strategy: Where a trade or business provides more than 80 percent of its property or services to an SSTB, 100 percent of the income would be treated as an SSTB if there was 50 percent or more common ownership with the SSTB. Below the 80 percent threshold, only the income generated from the SSTB was considered SSTB income.

The Mediocre News: The final regulations ease this result by stating that only the portion provided to the commonly owned SSTB will be treated as an SSTB. Therefore, a rental entity with 90 percent of its rents to a commonly controlled SSTB could still qualify for the QBI deduction on the remaining 10 percent of rents to unrelated parties. Such was not possible under the proposed regulations.

Proposed Real Estate Safe Harbor

Concurrently with the issuance of the final regulations the IRS issued Notice 2019-07, which outlines a proposed safe harbor under which a ‘rental real estate enterprise’ may be treated as a trade or business. As a threshold question, what constitutes a rental real estate enterprise? Answer: an interest in real property held for the production of rents which may consist of an interest in multiple properties; provided the individual or entity (which intends to utilize the safe harbor) holds the interests directly or through a disregarded entity.

The Bad News:

  • Doesn’t apply to triple net leases
  • Requires separate books and records for each enterprise
  • Requires more than 250 hours of rental service with respect to each enterprise on an annual basis
  • For taxable years after Jan. 1, 2019, those 250 hours need to be supported with contemporaneous records
  • Cannot combine commercial and residential activity into a single rental real estate enterprise

The Good News:

  • The 250 hours can be comprised of time spent on a wide range of real estate services
  • Time spent by owners, employees, agents, and independent contractors all count towards the 250 hour requirement

Entity Aggregation

Aggregation allows a taxpayer to combine trades or businesses for purposes of calculating the QBI deduction (provided certain criteria are met). This can be a valuable tool, as combining the W-2 wages and property factors may yield a greater deduction than if the taxpayer were required to calculate the QBI deduction for each separate business alone.

The Good News: Under the proposed regulations, aggregation was only permitted at the owner level. The final regulations permit an entity to aggregate its activities. From a tax compliance standpoint, this is a welcome relief.

The Bad News: An owner will be bound by the entity aggregation.


The final regulations both modify and clarify many provisions of the proposed regulations. Now is the time to engage conversation with your tax advisor to understand the implications for you and your business.

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