A preparer-client decision: Whether to rely on the Sec. 199A proposed or final regulations

By Dan Wise, CPA, Roseland, N.J.

Editor: Valrie Chambers, CPA, Ph.D.

Regulations are Treasury's official interpretation of how a particular Internal Revenue Code section is to be applied. Treasury gets its authority to issue regulations from U.S.C. Title 31. Accordingly, although regulations are not laws, they carry significant authority, as long as they are in furtherance of and consistent with a particular enacted law.

However, regulations that are merely proposed are not binding on the IRS or on taxpayers, and taxpayers cannot rely on them to support a position unless the IRS or the proposed regulations themselves state that they can. Proposed regulations might typically allow for reliance when they are issued to provide needed guidance for a complex new law. This type of proposed regulation is appropriately referred to as a reliance regulation. The need for such reliance regulations arises because, before final regulations can be issued, Treasury must follow specific rule-making procedures to issue them, as outlined in the notice requirements of the Administrative Procedure Act. Following those procedures takes time. Proposals must be publicized in the Federal Register to allow the public to gain insight into how Treasury is interpreting a particular law. The public must be invited with adequate notice to participate in the rule-making process through making comments or participating at hearings. Ultimately, Treasury needs to consider all of these and decide whether to withdraw the proposed regulations or make them final or temporary, with or without modification.

According to Sec. 7805(b), a final, temporary, or proposed regulation can be effective no earlier than the earliest of:

  • Its publication in the Federal Register;
  • The date when a notice that substantially describes the expected contents of the regulations is issued; or
  • Solely in the case of final regulations, the date on which an earlier proposed or temporary regulation to which it relates was published in the Federal Register.

However, there is a specific exception for regulations issued within 18 months of the enactment of the statute to which they relate. There are also other exceptions having a retroactive effect, notably, for regulations issued to prevent abuse (anti-abuse rules), regulations issued to correct a procedural defect, and regulations issued when Congress authorizes a retroactive application.

What happens when proposed regulations are relied on and contradictory final regulations are subsequently issued?

Typically, the proposed regulations would already have specified that a taxpayer may rely on them for a defined period, and, typically, any more restrictive provisions provided under final regulations would be effective only later. The Tax Court has held that final regulations that differ from proposed regulations cannot be enforced against a taxpayer who has already relied on the proposed regulations (Elkins, 81 T.C. 669 (1983)). This needs to be understood: "[Treasury's] discretion to apply . . . regulations retroactively is very broad, but its counterpart is the responsibility to provide taxpayers with adequate guidance as to the extent to which [this] power will be exercised, or at the very least to avoid misleading them" (id. at 681).

Thus, proposed regulations either can be used to support a taxpayer position, if they are reliance regulations, or at the very least represent evidence of the unofficial position of the IRS with respect to the law at the time they were originally issued, in which case they constitute a reasonable view of the law and provide substantial authority for the tax treatment of an item under Regs. Sec. 1.6662(d)(3)(iii).

Where a Code section specifically authorizes Treasury to provide operational rules for Code sections, they are regarded as legislative-type regulations and have the weight of the law itself. Typically, regulations issued pursuant to such authority will detail the statutory authority under which they are issued, and, generally, they constitute a type of regulations not easily subject to challenge.

The explanatory statements that preface the regulations that are issued in the Treasury Decisions, called Treasury Decision preambles, are nearly, if not completely, regarded as part of their regulations. In any case, the IRS is basically bound to what it issues, although taxpayers for their part need to stay aware of any language on the part of Treasury that addresses when proposed regulations cannot be relied on.

Sec. 199A

Sec. 199A, created by the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, conferred general and specific "legislative" regulatory authority to Treasury. Pursuant to the TCJA, Treasury issued Sec. 199A proposed regulations in August 2018 (REG-107892-18) and on Feb. 8, 2019, issued final regulations (T.D. 9847). Consistent with Sec. 7805(b), Treasury made both regulations effective for tax years ending after the date of the issuance of the final regulations, i.e., for tax years ending after Feb. 8, 2019, except for the anti-abuse rules of the regulations, which were made effective retroactive to tax years ending after the date the TCJA became law, i.e., for tax years ending after Dec. 22, 2017. Treasury also provided thattaxpayers may rely either on the August proposed regulations in their entirety or on the final regulations in their entirety,for tax years ending during 2018. As such, taxpayers can choose to be bound by eitherthe proposed regulations or the final regulations for the 2018 tax year or choose not to be bound by either. Again, the anti-abuse rules are effective retroactively, but they are nearly identical in both sets of rules.

Accordingly, practitioners need to recognize that there are three possible strategies to pursue with respect to Sec. 199A for tax year 2018: follow the proposed rules, follow the final rules, or something else. A practitioner needs to be aware of the differences between the two Sec. 199A rules sets and to assist clients accordingly, consistent with the AICPA Code of Professional Conduct and regulatory practice rules, e.g., Section 10.35 of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10).

However, regardless of whether a taxpayer chooses the proposed or the final Sec. 199A rules, he or she needs to be aware that each set is a package deal. Where the two sets of rules are at odds with each other, the taxpayer may not use a rule from one set and other rules from the other set. However, if the taxpayer uses the proposed rules and those rules do not address a matter but the final rules do, using the final rules for that matter would not violate the reliance rule. This is because, where a matter is not addressed by authority, a position taken with respect to that matter needs to be reasonable. Using a final rule is not unreasonable, absent guidance in the proposed rules. However, taxpayers should consider disclosing this position because the level of authority is just reasonable basis. This entails attaching Form 8275, Disclosure Statement, to the return.

Procedurally, filing Form 8275 could simplify matters for clients wanting to rely on the proposed rules, because many of the final Sec. 199A rules are (arguably) mere clarifications of the proposed rules or statute, and so reliance on any subset of the final rules could be disclosed on a Form 8275.

A best practice would be to inform the client of this choice between the two sets of rules (or something else) and of the potential cost involved to make the choice comprehensively and properly, and to have the client decide among the alternatives. Even where an engagement letter has already been executed for 2018, an addendum to that letter would be ideal. For example, if the client does decline a comprehensive analysis and wishes to rely wholly on the final regulations, that would be documented in the addendum.

Some differences between the proposed and final Sec. 199A regulations

Below are some of the areas of Sec. 199A that needed guidance and how the final and proposed regulations compare.

Definition of trade or businessSince Sec. 199A provides for a 20% deduction from "trade or business" income, this definition is crucial. Like the Code, neither set of regulations defines "trade or business," other than stating the phrase has the same meaning as under Sec. 162 (where it is also undefined) but excluding the performance of services as an employee. However, the preamble to the final regulations and certain examples in the regulations themselves provide more clarification that presumably would be equally applicable to the proposed rules as well.

Rental real estate activities as a trade or business: Notice 2019-07, issued simultaneously with the final regulations, described a "proposed revenue procedure" that provides a safe harbor under which a rental real estate "enterprise" will be treated as a trade or business. A rental real estate "enterprise" is defined as either one rental property or a combined group of "similar" rental properties — at the taxpayer's option. "Similar" means that commercial property may not be grouped with residential property. To qualify for the safe harbor, a rental real estate "enterprise" must meet the following criteria:

  • Separate books and records are maintained for each enterprise;
  • 250 hours or more of rental services, as defined in the proposed revenue procedure, are performed per year for the enterprise; and
  • For tax years beginning on or after Jan. 1, 2019, contemporaneous records are maintained of the number of hours, dates, and descriptions of the services performed and the names of persons performing the services.

Although the notice was issued at the time the final regulations were issued, they are not part of the final regulations. As such, taxpayers relying on the proposed regulations may also be able to rely on the notice's safe harbor (see, e.g., Section 4 of the notice).

If an enterprise does not meet the safe-harbor requirements, it may still be treated as a trade or business for purposes of Sec. 199A if it otherwise meets the definition of trade or business in Regs. Sec. 1.199A-1(b)(14).

Triple net leases as a trade or business: Triple net leases are ineligible for the safe harbor under Notice 2019-07, and so under both sets of rules, whether triple net leases are a qualifying trade or business would depend on the facts and circumstances, even where the "business" is leasing many properties under triple net leases.

Self-rentals as a trade or business: Both the proposed and final regulations treatan activity of renting to a "commonly controlled" trade or business as a "self-rental" Sec. 162 trade or business. However, in determining common control — defined as owning at least 50% of both the property and business — the final regulations look to the attribution rules of Secs. 707 and 267, but the proposed regulations do not. The final regulations limit this special rule to situations where the related party is an individual or relevant passthrough entity.

Definition of "employee" in a trade-or-business context: Employee wages are not trade or business income. The proposed regulations provide that an individual who was previously treated as an employee and is subsequently treated as an independent contractor while performing substantially the same services to the same person, or a related person, will be presumed to be in the trade or business of performing services as an employee. The final regulations relax the presumption rule somewhat by providing a finite lookback period of three years for purposes of this presumption and by clarifying that nothing to support a rebuttal of this presumption needs to be attached to the return. Rather, upon notice from the IRS, an individual would rebut the presumption by showing records, such as contracts or partnership agreements, that are sufficient to corroborate the individual's status as a nonemployee for three years from the date a person ceases to treat the individual as an employee for federal employment taxes.

Third-party payers of wages: The final regulations clarify that the provision allowing taxpayers to treat W-2 wages paid by a third party with respect to common law employees or officers of the common law employer is not limited to professional employer organizations certified under Sec. 7705, statutory employers under Sec. 3401(d)(1), and agents under Sec. 3504 (Regs. Sec. 1.199A-2(b)(2)(ii)).

Carryover of unadjusted basis of fixed assets immediately after acquisition (UBIA): UBIA would typically, under general tax principles, look to the basis of property on the date that the property is placed in service. The final regulationsmake favorable taxpayer exceptions in determining UBIA, to instead consider this a carryover attribute in the case of the common types of transfers enumerated in Sec. 168(i)(7)(B), such as a Sec. 351 contribution when forming a corporation; a like-kind exchange under Sec. 1031; or an involuntary conversion under Sec. 1033 (Regs. Sec. 1.199A-2(c)(3)). So, for example, a fully depreciated $1 million property contributed to an S corporation would carry over the $1 million as UBIA. The proposed regulations do not contain this rule.

Partners' Sec. 743 step-up to UBIA: Only the final regulations provide for a Sec. 743 step-up under Sec. 754 to UBIA of property (Regs. Sec. 1.199A-2(a)(3)(iv)). The actual amount of UBIA stepped up is limited to the excess of the new partner's purchase price over the old partner's UBIA.

Allocation of a partnership's UBIA: The proposed regulations provide that the partnership's allocation of UBIA to its partners is based on a partner's share of tax depreciation or, where the property is not yielding tax depreciation, based on how gains would be allocated under Sec. 704(c) (and Sec. 704(b)), presuming the property was sold for fair market value. The final regulations prescribe that a partnership's allocation of UBIA to its partners is determined in accordance with how depreciation would be allocated for Sec. 704(b) book purposes under Regs. Sec. 1.704-1(b)(2)(iv)(g) on the last day of the tax year (Regs. Sec. 1.199A-2(a)(3)(ii)).

Aggregation of activities for the wage-and-asset test: A criterion in aggregating activities is that the activities must be commonly controlled. Under the final regulations, unlike the proposed regulations, the attribution rules of Secs. 267 and 707 apply.The final regulations clarify that within the common control group, each group member is not required to have a degree of interest in each entity of the aggregated group.

Aggregation can be made at the passthrough level: The final regulations amend the proposed regulations to permit an aggregation to be done at the entity level, as opposed to the ultimate-owner level. The owners are bound to that aggregation, but they can add to it when the criteria are met.

Aggregation cannot be changed: An aggregation cannot be changed unless there is an acquisition of a business or other material change in circumstances. The final regulations clarify this rule by providing that a failure to aggregate does not constitute an aggregation, so that aggregation would still be available in a later tax year.

Aggregation flexibility for 2018: Only the final regulations permit an initial aggregation to be made on an amended 2018 return. However, since not all aggregable activities must be aggregated, some aggregations produce better results than others. A practitioner should discuss with a client that is using the final rules the best strategy in determining the optimal outcome. If analyzing various permutations will take some time, such as beyond an extended due date, practitioners should discuss with the client an option of not aggregating on the 2018 return and afterward to go back and amend, once the optimal result is computed.

Aggregation of rental activities: One criterion for an aggregation is that the businesses demonstrate that they are part of a larger, integrated trade or business. To do that, they must satisfy two out of three listed factors, one of which is, under the proposed rules, that the businesses provide the same products and services (for example, a restaurant and a food truck) or that what they provide are customarily offered together. Under the proposed regulations, it was at best unclear whether rental activities could ever meet this factor. The final regulations change the first factor from "products and services" to "products, property, or services" (Regs. Sec. 1.199A-4(b)(1)(v)(A)) and add examples clarifying when a real estate trade or business, not just rentals, satisfies the aggregation rules. However, the final regulations restrict the aggregation of rental activities to those of like type, defining a commercial rental as not being like-kind with a residential rental (Regs. Sec. 1.199A-4(d)(17)).

Health/medical-field SSTB:The proposed regulations limited the performance of services in the field of health to medical services provided directly to a patient. Arguably, that could have entitled certain radiologists and medical technicians who operate medical equipment or test samples to take the deduction. The final regulations do not limit the performance of services in the field of health to medical services provided directly to a patient. However, the final regulations include new examples that illustrate that skilled nursing, assisted-living (and similar) facilities, and outpatient surgical centers are not per se providing medically related services and could possibly qualify for the deduction. Another new example in the final regulations illustrates that the sale of pharmaceuticals and medical devices by a retail pharmacy (as opposed to pharmacist activities) is not the performance of services in the field of health.

Architects, engineers, and staffing agencies as SSTBs: The final regulations explicitly provide that architects, engineers, and pure staffing agencies that are compensated when an applicant accepts a position are not performing consulting services that would disqualify them for the deduction. This position may not be supported under the proposed rules.

Banks as SSTBs: The final regulations clarify that originating and selling loans, making loans, taking deposits, and entering into financing contracts are not the provision of financial services that would disqualify a bank from taking the deduction.

SSTB taint of otherwise qualified activity: The preamble to the final regulations clarifies that an activity generally could be its own separate activity where it has its own separate books and records and has its own employees or follows any other fact pattern showing that the activity is a separate business. Hence, an SSTB activity that is not considered its own separate activity can taint an entire otherwise qualified activity unless it meets the de minimis rule — i.e., the SSTB's gross receipts constitute less than 5% of the gross receipts of the trade or business activity when the trade or business activity's gross receipts exceed $25 million, 10% otherwise. Note that it is ambiguous whether the proposed regulations intended to entirely disqualify an otherwise qualified activity.

SSTB abuse rules: Under the proposed regulations, a trade or business that provides 80% or more of its property or services to an SSTB is treated as an SSTB if there is 50% or more common ownership of the trades or businesses. In cases in which a trade or business provides less than 80% of its property or services to a commonly owned SSTB, the portion of the trade or business providing property to the commonly owned SSTB is treated as part of the SSTB with respect to the related parties. In contrast, the final regulations modified this rule, stating that if a trade or business provides property or services to an SSTB and there is 50% or more common ownership of the trade or business, the portion of the trade or business providing property or services to the 50% or more commonly owned SSTB will be treated as a separate SSTB.

In addition, under the proposed regulations, if a trade or business (that would not otherwise be treated as an SSTB) has both 50% or more common ownership with an SSTB and shared expenses with the SSTB, then the trade or business is treated as incidental to and, therefore, part of the SSTB, if the gross receipts of the trade or business represent no more than 5% of the total combined gross receipts of the trade or business and the SSTB in a tax year. This rule was eliminated entirely in the final regulations.

Franchisors as SSTBs: In order to provide certainty and further economic growth, the final regulations include an example that clarifies that a franchisor will not be considered to be an SSTB based solely on the selling of a franchise that is an SSTB.

A final Sec. 199A conundrum

"Supplemental" proposed regulations were issued Feb. 8, 2019, (the date the final regulations were issued) to "amend" certain Sec. 199A regulations in order to deal with issues such as the treatment of previously suspended losses that constitute qualified business income and the determination of the Sec. 199A deduction for taxpayers that hold interests in regulated investment companies, charitable remainder trusts, and split-interest trusts. These, too, are reliance regulations if applied in their entirety. However, by relying on these regulations, a taxpayer may run afoul of the taxpayer's adoption of the August proposed rules or, alternatively, the final rules where these supplemental proposed regulations contradict something in those regulations.

 

Contributors

Valrie Chambers, CPA, Ph.D., is an associate professor of accounting at Stetson University in Celebration, Fla. Dan Wise, CPA, is a National Tax director and Head of Tax Risk for CohnReznick LLP. Mr. Wise is a member of the AICPA Tax Practice & Procedures Committee. For more information on this article, contact thetaxadviser@aicpa.org.

 

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