Editor: Kevin D. Anderson, CPA, J.D.
On Feb. 8, 2019, final regulations were published in the Federal Register, providing guidance on Sec. 199A to taxpayers and tax professionals on how to implement the new qualified business income (QBI) deduction (T.D. 9847). Among the areas the final regulations provide guidance on, one of the most challenging is determining when taxpayers can aggregate multiple trades or businesses. Aggregation effectively results in trades or businesses that would otherwise be treated as separate and distinct being combined into one trade or business for purposes of calculating the QBI deduction.
For taxpayers who qualify, aggregation allows the wages and capital limitation of Sec. 199A to be calculated for the combined trade or business rather than for each trade or business individually. Depending on the facts, aggregation may allow a taxpayer to claim a greater QBI deduction than if the wages and capital limitation was applied separately.
Example 1: A taxpayer who is over the applicable taxable income threshold has QBI of $100 each from two trades or businesses A and B. A has $50 of W-2 wages, and B has $20 of W-2 wages. Neither A nor B owns any qualified property. If the QBI deduction is computed separately for A and B, A would generate a QBI deduction of $20, since 50% of W-2 wages, $25, exceeds 20% of QBI, $20. B would receive a QBI deduction of $10, since 50% of W-2 wages, $10, is less than 20% of QBI, $20. In this separate scenario the total QBI deduction for both A and B is $30 ($20 for A + $10 for B). If A and B were aggregated, the total QBI of the combined trade or business would be $200, and the total W-2 wages would be $70. The QBI deduction for the aggregated group would be $35, since 50% of the W-2 wages, $35, is lower than 20% of the QBI of the combined group, $40. Note that the aggregation of A and B results in a net increase to the QBI deduction of $5 over not aggregating the businesses. As illustrated in a later example, aggregation is not always beneficial.
Regs. Sec. 1.199A-4 provides the relevant rules for when taxpayers are allowed to aggregate and how to report aggregations to the IRS. While the preamble to the final regulations acknowledges that what is commonly thought of as a single trade or business may actually operate across multiple tax entities, the final regulations do not necessarily allow all businesses operated by a taxpayer to be aggregated. In fact, the criteria for aggregation are relatively restrictive and must be thoroughly analyzed to ensure eligibility. Before even assessing the aggregation criteria, taxpayers must first determine if the activities rise to the level of a trade or business.
Trade or business for Sec. 199A
Underlying all the criteria (listed below under the heading "The Aggregation Criteria") is that each trade or business to be aggregated must meet the definition of a trade or business under Regs. Sec. 1.199A-1(b)(14). Those regulations provide that for Sec. 199A purposes, "trade or business" generally has the same meaning as under Sec. 162, other than the trade or business of performing services as an employee. The Sec. 199A regulations do expand the definition of trade or business for Sec. 199A purposes in one instance.
If the rental or licensing of tangible or intangible property (rental activity) does not rise to the level of a Sec. 162 trade or business, it may nevertheless be a trade or business for Sec. 199A purposes if the property is rented or licensed to a trade or business conducted by an individual or relevant passthrough entity (RPE) that is commonly controlled, as defined under Regs. Sec. 1.199A-4(b)(1)(i). Put another way, if there is a self-rental activity between an individual or RPE and a commonly controlled trade or business, the self-rental activity will be considered a trade or business for Sec. 199A purposes even if it does not meet the Sec. 162 definition of trade or business.
Due to the requirement that the commonly controlled business be conducted by an individual or RPE, self-rental to a commonly controlled C corporation will not meet this exception and would thus need to meet the Sec. 162 definition of a trade or business.
A comprehensive discussion of the definition of a trade or business for Sec. 162 purposes is outside the scope of this item, but the determination is highly dependent on the facts and circumstances and can be a challenging analysis. Treasury, recognizing this difficulty as it relates to rental activities, attempted to provide certain rental real estate enterprises with a safe harbor.
Notice 2019-07 provides a safe harbor under which a rental real estate enterprise that meets its qualification and procedural requirements will be considered a trade or business for Sec. 199A purposes. A comprehensive discussion of the notice is outside the scope of this discussion, but it is worth noting that not all rental activities will qualify for the safe harbor, and myriad conditions need to be met to benefit from the safe harbor. Once a taxpayer determines which activities rise to the level of a trade or business, he or she will need to determine if the trades or businesses meet the criteria for aggregation.
The aggregation criteria
The final regulations provide that trades or businesses may only be aggregated together if they meet the following five criteria:
- The same person or group of persons, directly or by attribution under Sec. 267(b) or 707(b), owns 50% or more of each trade or business to be aggregated. Under Regs. Sec. 1.199A-4(b)(1)(i), 50% or more of each trade or business means, in the case of such trades or businesses owned by an S corporation, 50% or more of the issued and outstanding shares of the corporation, or, in the case of such trades or businesses owned by a partnership, 50% or more of the capital or profits in the partnership;
- The ownership described above exists for a majority of the tax year, including the last day of the tax year, in which the items attributable to each trade or business to be aggregated are included in income;
- All of the items attributable to each trade or business to be aggregated are reported on returns with the same tax year, not taking into account short tax years;
- None of the trades or businesses to be aggregated is a specified service trade or business (SSTB); and
- The trades or businesses to be aggregated satisfy at least two of the following factors (based on all of the facts and circumstances):
- 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;
- 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).
The first criterion, which requires that the same person or group of persons owns 50% or more of each trade or business, was modified slightly from the proposed regulations to clarify that the 50%-or-more common ownership includes attribution through Secs. 267(b) and 707(b). Additionally, the preamble to the final regulations explicitly provides that a C corporation can constitute part of the ownership group for purposes of this requirement. This rule potentially provides significant flexibility for taxpayers with ownership interests that vary across entities.
Example 2: A, B, and C have 50%, 49%, and 1% interests, respectively, in Partnership X profits; and B, C, and D have 1%, 49%, and 50% interests, respectively, in Partnership Y profits. None of the ownership by A in Partnership X or by D in Partnership Y is attributable to B or C under either Sec. 267(b) or 707(b). Even though B and C do not appear to have a majority of profit interests in either partnership, their common ownership between the two entities is at least 50% and, consequently, they meet the 50%-or-more common ownership test.
Note that the partnership criterion is capital or profits and that there is no minimum required ownership percentage to be included as part of the common group, as long as the common group of owners owns interests totaling 50% or more in each of the trades or businesses.
The second criterion, that the ownership test from the first criterion is met for a majority of the tax year, was also modified from the proposed regulations. Under the final regulations, the second criterion can be satisfied only if the ownership includes the last day of the tax year. So aggregation will not be available in any year of acquisition involving a new 50% owner, or group of owners, if the acquisition occurs after the midpoint of the tax year. In addition, dispositions of interests or shares that result in failure to meet the common ownership requirement as of the last day of the tax year will also prevent aggregation, even if the criterion was met for all the other days of the year.
The third criterion, that all the items attributable to the trades or businesses to be aggregated are reported on returns with the same tax year, not taking into account short tax years, remains unmodified from the proposed regulations. So with the exception of short tax years, all trades or businesses to be aggregated must have the same tax year. This rule effectively precludes aggregation of trades or businesses reporting on a calendar-year basis with trades or businesses reporting on a fiscal-year basis.
The fourth criterion, that none of the trades or business to be aggregated can be an SSTB, is also unmodified from the proposed regulations. While a full discussion of SSTB status is outside the scope of this item, taxpayers and tax professionals should give careful consideration to Regs. Sec. 1.199A-5, which provides the relevant guidance on when a trade or business is considered to be an SSTB. For those who believe they operate a trade or business that is not an SSTB, it is important to also apply the special rules of Regs. Sec. 1.199A-5(c), which may create a trap for the unwary if some of the gross receipts are treated as from an SSTB or where property or services are provided to a related SSTB.
The fifth criterion is also the most subjective, requiring that all the trades or businesses to be aggregated share at least two of the three factors.
The first factor, that the trades or businesses provide products, property, or services that are the same or customarily offered together, is a slight modification from the proposed regulations, which did not name property specifically. The final regulations also provide examples clarifying when a rental real estate trade or business can be grouped with nonrental trades or businesses (see Regs. Sec. 1.199A-4(d), Examples 8 and 9). Examples of when multiple rental real estate trades or businesses can or cannot be grouped together are also provided (see Regs. Sec. 1.199A-4(d), Examples 16, 17, and 18).
The second factor in the two-out-of-three criterion is that the trades or businesses to be aggregated share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology. Neither the proposed nor the final regulations define what "significant" means in this context. The preamble to the final regulations only offers that the meaning "is dependent on the facts and circumstances of each combination of trades or businesses." While this does not offer a bright-line test, obviously, the more centralized business elements the trades or businesses have in common, the more robust will be the argument that this factor is satisfied.
The final factor in the two-out-of-three criteria is that 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). Similar to the second factor, this determination is based on the facts and circumstances, and no bright-line test is provided. While the examples in Regs. Sec. 1.199A-4(d) do occasionally touch on this factor, they do not appear to add any clarification on exactly when this factor will be deemed to have been met.
Who can aggregate?
The most significant change from the proposed regulations to the final regulations was the expansion of the Regs. Sec. 1.199A-4(b)(2) aggregation operating rules to include RPEs in addition to individuals. Under the final regulations, individuals can aggregate any trades or businesses in which they have an interest, whether conducted directly or through an RPE, so long as they satisfy the aggregation criteria listed above. Similarly, RPEs may aggregate trades or businesses they conduct directly or through interests in lower-tier RPEs, so long as the same criteria are satisfied.
The most significant consequence of aggregating at the RPE level, instead of the individual level, is that any upper-tier RPEs or any individuals with an interest in the RPE cannot disaggregate those trades or businesses that have been aggregated by the lower-tier RPE. Upper-tier RPEs and individuals with an interest in the RPE that made the aggregation election are free to add additional trades or businesses to the aggregated group at their level, provided the normal aggregation criteria are satisfied. Essentially, when aggregation occurs at the RPE level, the owners of that RPE can add to, but not subtract from, the trades or businesses in the aggregated group.
Aggregation at the RPE level also provides a simplification to the reporting requirements. Generally, under Regs. Sec. 1.199A-6(b), RPEs are required to report each owner's share of QBI, W-2 wages, and unadjusted basis immediately after acquisition (UBIA) from each trade or business conducted by the RPEs or through lower-tier RPEs. When RPEs aggregate trades or businesses, they are only required to report out QBI, W-2 wages, and UBIA to the owners for the aggregated trade or business under Regs. Sec. 1.199A-6(b)(2).
Taxpayers should carefully weigh the costs and benefits of aggregation at the RPE level versus the individual level. While the simplification of reporting at the RPE level is a significant incentive, it comes at the cost of eliminating flexibility for upper-tier RPEs and individuals. Factors to consider include whether any owners are likely to want to disaggregate the trades or businesses, whether the wages and capital limitation for the aggregated trades or businesses would result in a higher deduction with or without aggregation, and the likelihood that factors leading to the current decision are likely to persist in the future.
Reporting and consistency requirements
Regs. Sec. 1.199A-4(c) provides the reporting and consistency requirements for aggregation by both individuals and RPEs. Unlike grouping elections under Sec. 469, aggregation under Sec. 199A must be disclosed annually for both individuals and RPEs even if there is no change in the trades or businesses aggregated. Specifically, a statement must be included with the return, in the case of an individual, or with each Schedule K-1, in the case of an RPE, reporting the following information for every trade or business in the aggregated group:
- A description of each trade or business;
- The name and employer identification number of each entity in which a trade or business is operated;
- Information identifying any trade or business that was formed, ceased operations, was acquired, or was disposed of during the tax year;
- Information identifying any aggregated trade or business of an RPE in which either the individual or upper-tier RPE holds an ownership interest; and
- Any other information as the IRS may require in forms, instructions, or other published guidance.
For tax year 2018 the IRS has provided, in Publication 535, Business Expenses, that the proper method for disclosing aggregations is "Schedule B — Aggregation of Business Operations" for that publication's QBI deduction worksheet. In addition to Publication 535, the 2018 instructions for Forms 1065, U.S. Return of Partnership Income, 1120S, U.S. Corporation Income Tax Return, and the related Schedule K-1 instructions also provide guidance on how to properly report aggregations.
Once an aggregation election has been made, it must be followed consistently in all subsequent tax years unless a significant change in facts and circumstances causes the prior aggregation to no longer qualify under the criteria above. Presumably, the disposition of a trade or business would be considered a significant change in facts and circumstances, since it would guarantee violation of the second criterion above, that common ownership exists for the majority of the tax year, including the final day of the tax year (Regs. Sec. 1.199A-4(b)(1)(ii)). The final regulations also provide that when the prior aggregation no longer qualifies due to a significant change in facts and circumstances, the individual or RPE is required to reapply the aggregation rules and determine a new permissible aggregation, if any. Individuals and RPEs are allowed to add newly created or newly acquired trades or businesses to an existing aggregation group, assuming all applicable criteria are met.
Importantly, in contrast with the rules under Sec. 1411, failure to aggregate will not itself be considered an aggregation. So not aggregating in tax year 2018, for example, does not prevent a taxpayer from aggregating in tax year 2019, even if there have been no changes in facts and circumstances. Generally, aggregation cannot be made on an amended tax return; however, for tax year 2018 this general rule does not apply. In the event that an individual or RPE does treat a group of trades or businesses as aggregated, without providing the required disclosure statement, the IRS has discretionary authority to disaggregate those trades or businesses. If the IRS exercises this right, the taxpayer is not permitted to aggregate those trades or businesses for the subsequent three tax years. Since the QBI deduction is currently scheduled to expire on Dec. 31, 2025, that three-year period could significantly limit a taxpayer's ability to benefit from an aggregation.
To aggregate or not to aggregate
Aggregation under Sec. 199A ultimately boils down to two questions: Can the individuals or RPEs aggregate under the applicable rules, and if they can, should they? If they should, the remaining question is whether to do it at the individual or RPE level. Since neither the statute nor the regulations ever force a taxpayer to aggregate for Sec. 199A purposes, taxpayers have a great deal of flexibility.
Aggregation is not always beneficial.
Example 3: A owns 100% of the outstanding shares of two S corporations that qualify for aggregation, Operating Inc. (Operating) and Property Inc. (Property). The companies have the amounts of QBI, W-2 wages, and UBIA set forth in the table, "Aggregation of Trades or Businesses in Example 3," below. Assume A is fully subject to the wages and capital limitation, i.e., has taxable income exceeding the threshold amount on his individual return, meaning his QBI deduction for Operating and Property will be limited under Sec. 199A(b)(2)(B) to the greater of 50% of the W-2 wages or 25% of the W-2 wages plus 2.5% of the UBIA from the trades or businesses. Those limitations are calculated in the table in lines 4 and 5.
If A does not aggregate Operating and Property, the QBI deduction will be calculated separately for each business. In the facts in Example 3, this results in a deduction for each business equal to $20,000, so if he does not aggregate, A's total deduction is $40,000. This is because each business has exactly enough W-2 wages or UBIA to qualify for the full 20% deduction on its QBI, after applying the Regs. Sec. 1.199A-1(d)(2)(iv) QBI component calculation rules.
If A instead chose to aggregate Operating and Property, he is required, under Regs. Sec. 1.199A-1(d)(2)(ii), to combine the QBI, W-2 wages, and UBIA for both trades or businesses before applying the QBI component calculation. Since the aggregated group is effectively treated as one trade or business for this calculation, it only gets to take the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of UBIA for the aggregated group. In this case, 50% of W-2 wages is $20,000 and 25% of W-2 wages plus 2.5% of UBIA is $30,000 ($10,000 + $20,000), so even though 20% of QBI for the combined group is $40,000, the deduction is limited to $30,000 by the wages and capital limitation. So under these specific facts, aggregating actually cuts A's QBI deduction by a quarter, which is not a taxpayer-favorable result.
As Example 3 shows, one situation that potentially results in aggregation being unfavorable is when the trades or businesses do not all have the same limitation under the wages and capital limitation, meaning one trade or business would have a greater QBI deduction using the 50% of W-2 wages limitation, and another trade or business would have a greater QBI deduction under the 25% of W-2 wages plus 2.5% of UBIA limitation.
Another situation in which aggregation may be unfavorable is when at least one of the trades or businesses to be aggregated is generating negative QBI. In these situations, the general fact pattern does not guarantee that aggregation will be beneficial or detrimental. It will depend highly on the specific facts, so both taxpayers and tax professionals must do the math before deciding whether to aggregate.
A few general rules of thumb should be helpful when making an aggregation decision. First, if one can confidently predict that all owners will be below the applicable taxable income threshold for tax year 2018, meaning they will not be subject to the wages and capital limitation, there is no harm in forgoing an aggregation. Since the wages and capital limitation is not applicable in this situation, aggregation will not affect the amount of a taxpayer's deduction for 2018. Taxpayers in this situation can forgo aggregation with the comfort of knowing it will not prevent them from making an aggregation in a future year and that, even if a subsequent amended return increased their taxable income above the applicable threshold, the special rule for 2018 would allow aggregation on their amended return, if desired. Obviously, for 2019 and future tax years the amended return option will not be available. Similarly, even taxpayers who are over the applicable taxable income threshold but receive no current benefit from aggregating would be wise to avoid aggregating in 2018 and address the decision in 2019.
For taxpayers over the income threshold, considering aggregation is inherently complex. The first phase would be analyzing whether aggregation is beneficial in the current year. Given the binding nature of the aggregation, it is critical to also consider whether the beneficial facts for the current year are likely to persist going forward. For example, if aggregation is beneficial in 2018 but is not likely to be in 2019, individuals and RPEs will have to decide whether they want to lock themselves into an aggregation that is not guaranteed to be beneficial going forward. Similarly, since aggregation at the RPE level binds all upper-tier RPEs and individuals who receive Schedules K-1 to follow that aggregation, RPEs would be wise to exercise significant caution before actually undertaking an aggregation. Leaving the aggregation decision to the owners alleviates the risk of a disgruntled owner complaining in the future about a detrimental aggregation. At the same time, if there is a significant administrative burden related to providing the required QBI, W-2 wages, and UBIA information by each trade or business, the two competing concerns will need to be balanced delicately.
While the final regulations do provide a substantial amount of guidance on how the aggregation rules work, there remain a wide array of areas where taxpayers and tax professionals will have to carefully sort through the gray areas of facts and circumstances to determine which trades or businesses qualify for aggregation and which eligible ones taxpayers may actually want to aggregate.
Kevin D. Anderson, CPA, J.D., is a partner, National Tax Office, with BDO USA LLP in Washington, D.C.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.