Beginning with the 2018 taxable year, owners of pass-through entities engaged in qualified businesses can claim a U.S. federal income tax deduction up to 20% on their qualified business income (“QBI”). This deduction could possibly bring a taxpayer’s effective tax rate on such income down from 37% (without the deduction) to 29.6% (with the deduction).
Although investment managers generally cannot take advantage of the QBI deduction (described below in section III), investors in funds may claim QBI deductions in certain circumstances. Therefore, sections I and II of this Memorandum discuss how an investor may benefit from QBI earned by a fund. Section III and IV discuss QBI generally and how it is calculated.
I. Can funds pass along QBI to their investors?
QBI means income from a qualified trade or business, and certain income from REITs and publicly-traded partnerships (“PTPs”) may also give rise to QBI.
A private investment fund that invests in REITs and MLPs can generally pass-through to its investors its distributive share of QBI from qualified REIT dividends and qualified PTP income.1 Investment funds that rely on the qualifying income exception from the PTP rules do not generate qualified PTP income because investment and trading activities are a specified services trade or business.
A mutual fund may pass through qualified REIT dividends to its shareholders. The IRS continues to study whether QBI received by a mutual fund from a PTP may be passed through to the mutual fund’s shareholders.
II. Can real estate funds pass QBI to their investors?
Income from real estate will generally qualify for the QBI deduction if the real estate activities qualify as a trade or business. Therefore, the fund must be engaged in a real estate trade or business to pass QBI to investors. As there is no participation requirement, passive investors in real estate funds that are engaged in a trade or business for U.S. federal income tax purposes may be able to claim a QBI deduction.
Whether a real estate enterprise constitutes a trade or business is determined under general income tax principles.2 However, uncertainty exists regarding when rental real estate activities rise to the level of a trade or business. Recognizing this uncertainty, the IRS proposed a safe harbor to allow taxpayers that own rental real estate businesses to claim this deduction (the “Safe Harbor”).3
Generally, the Safe Harbor imposes record keeping requirements on the business and also requires that 250 hours of rental services are performed annually by the business’s employees, owners or agents. The Safe Harbor must be met separately with respect to residential and commercial rental activities. Endnote 3 below describes the Safe Harbor in further detail. If a rental real estate enterprise does not meet the Safe Harbor, the rental real estate activities may still constitute a trade or business under Code section 162.
III. Who else can claim the QBI deduction?
Owners of pass-through entities or sole proprietors that have QBI may claim this deduction, even if they do not actively participate in the business. Recently finalized regulations define pass-through entities as partnerships (other than PTPs) or S-corporations owned, directly or indirectly, by at least one individual, estate or trust. Certain trusts or estates may also be a pass-through entity for this purpose.
The definition of “qualified trade or business” excludes a “specified service trade or business.” Income from such specified services businesses generally are not eligible for the QBI deduction.4 Investment management and investing activities fall under this exclusion, and principals of investment management companies cannot claim this deduction. Other businesses that constitute a specified services trade or business include other financial services businesses, brokerages, medical, accounting and consulting practices, performing arts businesses, athletic businesses (including professional sports clubs) and any trade or business that relies principally on the skill or reputation of its employees.
We note that recently finalized regulations contain an anti-abuse provision preventing the segregation of QBI from non-QBI activities. Where an entity conducts both a specified services trade or business and also other qualified business activities, the entity’s owners generally cannot spin out the QBI activities into a new entity, charge a fee or rent to the original entity and claim a QBI deduction with respect to the QBI from the new entity.
IV. How is QBI calculated?
The determination of QBI is made at the level of the trade or business. As discussed above, an entity or sole proprietor must be engaged in a trade or business (other than a specified services trade or business) to have QBI. QBI is the net income from such trade or business.
The maximum deduction allowed is 20% of QBI. Generally, the amount of QBI from a qualified trade or business eligible for deduction is limited to the lesser of:
- (1) 20% of the taxpayer’s QBI with respect to the qualified trade or business, and
- (2) the greater of:
- (A) 50% of the W-2 wages with respect to the qualified trade or business, and
- (B) the sum of 25% of the W-2 wages with respect to the qualified trade or business plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of all qualified property.
Like QBI, the determination of the W-2 wage and UBIA limitations is also made at the level of the trade or business. A partner’s share of QBI from a partnership or S corporation will be reflected on his Schedule K-1. The deduction for QBI may be further limited at the partner level.
In situations where one or more trades or businesses is operated across multiple entities for legal, economic, or other non-tax reasons, taxpayers may aggregate income, expenses (including wage expenses) and UBIA across entities. Taxpayers may choose to aggregate entities that have QBI where there is common ownership for more than half of the year, the businesses or entities to be aggregated generally relate to each other to be viewed as a single enterprise, and certain other requirements are met. Aggregating QBI across entities may help taxpayers optimize the amount of the QBI deduction.
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For additional information on recent tax changes, please contact please contact Ronald P. Cima (212-574-1471), Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210), or Brett R. Cotler (212-574-1269).
1 20% of Qualified REIT dividends and qualified publicly-traded partnership (“PTP”) income are also deductible. The deduction for 20% of combined qualified REIT dividends and qualified PTP income is not subject to W-2 wage or UBIA limitations described above. Qualified REIT dividends generally include any REIT dividend to the extent it is taxable as ordinary income to the REIT shareholder. Qualified PTP income means a partner’s net share of income, gain, loss and deduction from a qualified trade or business of the PTP (e.g., MLPs).
2 The final 199A regulations define trade or business by reference to Code section 162(a).
3 See Notice 2019-7. The safe harbor treats a rental real estate enterprise as a trade or business if the enterprise:
- Keeps separate books and records to reflect income and expenses for each rental real estate enterprise;
- At least 250 hours of rental services per year are performed by the owners, employees or agents of the real estate enterprise; and
- For taxable years beginning after December 31, 2018, the taxpayer maintains time records, logs or similar documents regarding (a) hours of all services performed, (b) description of all services performed, (c) dates on which services were performed, (d) who performed the services. Such records should be made available for inspection at the request of the IRS.
Triple net leases are excluded from the safe harbor.
4 Taxpayers with taxable income below $157,500 ($315,000 if married) can claim the QBI without regard to the wage or UBIA limitations and with respect to income from a specified service trade or business.