The enactment of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, created pressure on taxpayers to distinguish what qualifies as a trade or business for tax purposes. The addition of Sec. 163(j), the new limitation on the deduction for business interest, and Sec. 199A, the qualified business income (QBI) deduction, requires taxpayers to distinguish separate and specific types of trades or businesses in order to take advantage of certain tax benefits.
For taxpayers to determine if they have a qualifying trade or business, they must understand what constitutes a trade or business and the requirements to identify a taxpayer's separate trades or businesses. In recent months, the IRS has released proposed regulations for Sec. 163(j) (REG-106089-18) and has issued final regulations for Sec. 199A along with additional guidance advising taxpayers to follow the definition for a trade or business found in Sec. 162(a). Sec. 162(a) generally relies on case law and administrative rulings and does not provide enough clarity for taxpayers to navigate these tax issues effectively. The ambiguity in the definition of a trade or business will likely cause a great deal of controversy.
Sec. 163(j) and real property trades or businesses
The TCJA modified Sec. 163(j), generally placing a limitation on the deduction of business interest for trades or businesses. However, certain trades or businesses are exempt from the limitation, creating a need for a clear definition of trade or business. Prior law allowed a business interest deduction in the year in which interest was paid or accrued, with certain limitations for corporations. Generally, Sec. 163(j) now limits a taxpayer's deduction for business interest to 30% of adjusted taxable income (including business interest income and floor plan financing) and extends the limitation to all business types. Certain trades or businesses are exempt from the limitation under Sec. 163(j)(7), including electing real property trades or businesses. This exemption highlights a murky area where the IRS and Treasury have attempted to provide some clarity in recent months.
Sec. 163(j)(7)(B) defines an electing real property trade or business by reference to Sec. 469(c)(7)(C), which states, "'real property trade or business' means any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business." The proposed regulations clarify that real property includes "land, buildings, and other inherently permanent structures that are permanently affixed to land" and excludes from the definition items such as machines and equipment that serve an active function, even if they are permanently affixed to real property (Prop. Regs. Sec. 1.469-9(b)).
While the proposed regulations provide a clearer definition of real property, they do not include guidance on the overall definition of a trade or business or how to identify separate trades or businesses. This distinction is important, as taxpayers may find it advantageous to segregate their real property trade or business to take advantage of the exemption from the business interest limitation. Where a taxpayer has multiple trades or businesses that are eligible for the exemption, each electing trade or business must include an election statement with the return that describes the exempt trade or business.
Sec. 199A, aggregation, and exclusion of trades or businesses
The distinction between trades or businesses and, more broadly, the definition of a trade or business activity is key for determining whether a passthrough entity's activity qualifies for the deduction under Sec. 199A. The TCJA reduced the corporate tax rate to 21% beginning in 2018. Sec. 199A provides for up to a 20% deduction on income from partnerships, sole proprietorships, and other passthrough businesses. The size of the deduction varies based on the facts and circumstances, such as the type of business activity and the type and amount of income of the owner. One of the goals of Sec. 199A is to level the playing field between passthrough entities and C corporations, as the Sec. 199A deduction reduces the effective tax rate for owners of passthroughs, mirroring the reduction to the C corporation rates.
A qualified trade or business, as defined by Sec. 199A(d), does not include a specified service trade or business (SSTB) or the trade or business of performing services as an employee. The qualified trade or business deduction, for taxpayers with taxable income over a threshold amount, is limited to the greater of: (1) 50% of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis of all qualified property.
Under Regs. Sec. 1.199A-3(b), QBI is defined as the net amount of qualified income, gain, deduction, and loss with respect to any trade or business. However, there is no statutory text or legislative history for Sec. 199A that provides a definition of a trade or business. The regulations cite Sec. 162(a) and case law for the definition of a trade or business for purposes of Sec. 199A without further elaboration. The lack of specific guidance for Sec. 199A purposes regarding whether a taxpayer has more than one trade or business remains a concern.
Generally, when two activities qualify as one trade or business, it is beneficial to the taxpayer because the QBI and limitations are determined on an aggregate basis, allowing excess wages or unadjusted basis of qualified property of one activity to offset the QBI of the other activity. The final regulations permit the aggregation of trades or businesses in certain circumstances. However, the ability to distinguish between one or multiple trades or businesses is potentially a key factor in determining whether a taxpayer is engaged in a qualified trade or business.
What is a trade or business?
Secs. 163(j) and 199A both rely on the definition of a trade or business under Sec. 162(a), which grants deductions to a taxpayer for all ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. The term "trade or business" is one of the most widely used terms in the Code, yet it has never been thoroughly defined. Sec. 62(a)(1) provides that a trade or business deduction is "attributable to a trade or business carried on by the taxpayer, if such trade or business does not consist of the performance of services by the taxpayer as an employee."
The lack of definitional guidance of trade or business has led to litigation on several occasions. In a concurring opinion by Justice Felix Frankfurter in Deputy v. Du Pont, 308 U.S. 488, 499 (1940), he stated that in order to be carrying on a trade or business, an individual must hold himself out as selling goods or services to others. A year later, the Court in Higgins, 312 U.S. 212 (1941), failed to adopt Frankfurter's definition but instituted a facts-and-circumstances analysis to determine whether a taxpayer is conducting a trade or business. The Court analyzed the taxpayer's hiring of employees to manage his portfolio holdings, the holdings themselves (which were all personal to the taxpayer), continuity of the activity, and whether the taxpayer held himself out in service to others. The court did not come up with an exhaustive list to examine whether taxpayers are conducting a trade or business, but it did state that "no matter how . . . continuous or extended the work required may be [for managing extensive holdings in real estate, stocks, and bonds], such facts are not sufficient as a matter of law to permit the courts to" determine his activities were a business (312 U.S. at 218). In this case, the court emphasized that while repeatedly engaging in an activity is required for a trade or business, the repetition alone does not make any activity a trade or business.
In Gentile, 65 T.C. 1 (1975), the Tax Court held a gambler was not in the activity of a trade or business because something more than the production of income was necessary. The Supreme Court's holding in Groetzinger, 480 U.S. 23 (1987), which is mentioned in the preamble for the Sec. 199A final regulations, contradicted Gentile by holding that legal gambling activities by an individual were activities in a trade or business because the activity was conducted with continuity and regularity for the primary purpose of earning income or making a profit. Case law related to Sec. 162(a) thus does not provide a uniform analysis for a trade or business but instead requires evaluation of the facts and circumstances in each case. By relying on the definition in Sec. 162(a), the IRS should anticipate increased controversy with taxpayers seeking beneficial treatment when applying Secs. 163(j) and 199A.
Separate trade or business rules
In addition to having to navigate the patchwork of court cases defining a trade or business, taxpayers have received little additional IRS guidance on the requirements to identify and maintain separate trades or businesses. The courts distinguish separate trades or businesses based on facts and circumstances. Treasury provides some guidance in Regs. Sec. 1.446-1(d) under rules for using different accounting methods for each trade or business. At the most basic level, a taxpayer must keep complete and separable books and records for each trade or business. However, this factor alone is not always enough to distinguish between trades or businesses and is not dispositive of the existence of only one trade or business.
While maintaining separate books and records is a positive indicator for establishing separate trades or businesses, the courts frequently examine additional factors. One of the most influential factors is the similarity between the business activities. For example, in Marlin Grocery Co.,15 B.T.A. 1080 (1929), the court determined that the operation of a grocery store and cattle ranch were sufficiently different business activities to be distinct trades or businesses. However, it is important that one of the activities is not merely incidental to the other. In W.W. Enterprise, Inc.,T.C. Memo. 1985-313, the court determined that providing loans to employees and shareholders was not a distinct trade or business from the petitioner's operation of a laundry facility, where the loans were made infrequently and not to customers.
Another significant factor is the nexus between the two activities. In Nielsen, 61 T.C. 311 (1973), the taxpayer operated two hospitals in California. The court determined that the taxpayer operated the hospitals as separate businesses despite their sharing key members of management. The court reached this conclusion because the hospitals' employees were otherwise different, the hospitals were in different geographic locations, and they had different patients. Generally, the IRS and courts have favored the distinction of separate trades or businesses where the separate activities employed individuals with duties to only one of the trades or businesses, with minimal or no crossover with the other activity. The IRS determined in Letter Ruling 8144005 that a taxpayer with a farming operation and cotton gin operated a single trade or business because there were no separate offices, the activities shared accounting personnel, and the activities shared certain assets. These factors were evidence of a single trade or business even though the taxpayer maintained separate books and records.
Furthermore, a taxpayer cannot rely on the fact that he or she has multiple legal entities to support the assumption of multiple trades or businesses. In Gold-Pak Meat Co., T.C. Memo. 1971-83, the court decided the taxpayer was unable to use different accounting methods under Regs. Sec. 1.446-1(d) for two C corporations filing a consolidated return because of the close interrelationship between the entities. Other court rulings have determined that even when taxpayers file separate returns, a single trade or business may exist. In Morton,98 Fed. Cl. 596 (2011), the court considered whether a taxpayer's interrelated S corporations were part of a "unified business enterprise." Morton highlights that where separate legal entities share a similar profit motive, a single trade or business may exist. On the other hand, the IRS ruled in Chief Counsel Advice 201430013 that disregarded entities for federal tax purposes can still be separate trades or businesses.
Several of the most recent court cases examining the issue of separate trades or businesses come from states with marijuana farms and dispensaries. To preserve deductions and avoid Sec. 280E, which prohibits deducting expenditures in connection with the illegal sale of drugs, taxpayers have asserted their dispensaries include multiple trades or businesses.
The taxpayer in Patients Mutual Assistance Collective Corp.,151 T.C. No. 11 (2018), a California medical-marijuana dispensary, sold several products that did not contain marijuana, including rolling paper, lighters, books, and branded clothing. The taxpayer also provided several no-cost services to its clients. The taxpayer performed all these activities at one location, and several of its employees performed duties related to both its marijuana and nonmarijuana activities. The court, using many of the factors outlined above, found that the taxpayer'sactivities constituted one trade or business, which was trafficking in a controlled substance.
The proposed regulations reiterate the position that a taxpayer can carry on multiple trades or businesses (Prop. Regs. Sec. 1.163(j)-9). The elections for exempted trades or businesses under Sec. 163(j) are made at the trade or business level and not at the taxpayer level. Accordingly, an entity that has multiple activities will need to make appropriate elections for each trade or business to which the taxpayer wishes to apply the election. Prop. Regs. Sec. 1.163(j)-10 provides an additional clarifying detail, stating that an activity will not be considered a separate trade or business if it does not "involve the provision of services or products to a person other than the taxpayer." The regulations use the example of a lawyer providing in-house counsel to a manufacturer; the manufacturer is not treated as also engaged in the trade or business of providing legal services. This prevents many taxpayers from engaging in structuring activities to create tax benefits. For example, under the guidance, accounting firms cannot segregate out from the firm's accounting trade or business administrative activities that provide services only to the firm.
While several court cases noted shared assets across activities as evidence of a single trade or business, the guidance under Prop. Regs. Sec. 1.163(j)-10(c)(3) provides a method for allocating interest expense when assets are used in more than one trade or business. This suggests that sharing assets among business activities does not disqualify them, per se, from being separate trades or businesses. This seems to be at odds with some prior court cases that held the sharing of assets or employees as evidence of a single trade or business.
Consider a common scenario where a passthrough taxpayer holds real property in one disregarded entity while maintaining its business operations in another. The taxpayer may wish to treat these disregarded entities as separate trades or business: one as an electing real property trade or business and the other as an SSTB. If the taxpayer rents a portion of the real property to a third party, is the management of the rental agreement enough to satisfy the rules in Prop. Regs. Sec. 1.163(j)-10, requiring the provision of services to someone other than the taxpayer to establish a separate trade or business? The ability to distinguish a trade or business from another activity quickly creates winners and losers, considering the potentially favorable treatment available under Secs. 163(j) and 199A. Unless the IRS provides more guidance to distinguish separate trades or businesses, taxpayers may find themselves in considerably more controversy with the IRS on what is a trade or business.
After the publication of hundreds of pages of regulations on Secs. 163(j) and 199A, taxpayers have still received little substantive guidance on the definition of a trade or business and the requirements to maintain separate trades or businesses. At the same time, taxpayers have an increased incentive to identify separate trades or businesses to take advantage of taxpayer-favorable provisions. Without more guidance, the definitions of trades or businesses may be left up to the courts, even though the courts themselves have not been consistent in deciding whether activities constitute a trade or business. While Congress has shown little interest in providing a clear definition of a trade or business, one can expect taxpayers to take a very serious look at the issue in coming years. Congress or Treasury should act quickly to address the trade or business issues to avoid an influx of controversy on the topic.
Mo Bell-Jacobs, J.D., is a manager, Washington National Tax for RSM US LLP.
For additional information about these items, contact the authors at Erica.Parra@rsmus.com or Darian.Harnish@rsmus.com.
Contributors are members of or associated with RSM US LLP.