Notice 2018-99 and the Qualified Business Income Rules

The Tax Cuts and Jobs Act of 2017 introduced the Qualified Business Income deduction under Internal Revenue Code Section 199A. This deduction offers a benefit for owners of sole proprietorships, partnerships, and S corporations, but it is a temporary provision scheduled to expire for taxable years beginning after December 31, 2025. The complexity of the law created uncertainty regarding its practical application. In response, the Internal Revenue Service issued regulations to provide clarity, helping taxpayers understand the operational mechanics of the deduction and providing foundational rules for determining eligibility and calculating the proper amount.

Defining a Trade or Business for QBI

A requirement for claiming the Qualified Business Income (QBI) deduction is that the income must be derived from a “trade or business.” The regulations clarified that the definition for Section 199A purposes is consistent with the long-standing definition used for business expense deductions under Section 162 of the tax code. Under this standard, an activity qualifies as a trade or business if the taxpayer engages in it with continuity and regularity, and the primary purpose is to generate income or profit. This determination depends on the specific facts and circumstances of each case. This approach means that passive activities or hobbies that do not rise to the level of a Section 162 trade or business are ineligible for the QBI deduction.

The Rental Real Estate Safe Harbor

The IRS provided a safe harbor test in Revenue Procedure 2019-38 to allow a rental enterprise to be treated as a trade or business for the QBI deduction. Meeting the safe harbor provides certainty that the activity qualifies, removing the need to rely on the more subjective Section 162 test. To qualify, the taxpayer must maintain separate books and records to reflect the income and expenses for each rental real estate enterprise.

Second, a specific number of rental service hours must be performed. For a rental enterprise in existence for five or more years, at least 250 hours of rental services must be performed in any three of the five consecutive years. If the enterprise has been in existence for less than five years, 250 hours must be performed annually. These services can be performed by owners, employees, or independent contractors. Qualifying rental services include:

• Advertising the property for rent and negotiating leases
• Verifying information contained in tenant applications
• Collecting rent payments
• Performing daily operations, maintenance, and repairs
• Managing the property and supervising employees or contractors

Time spent arranging financing, acquiring property, reviewing financial statements, or traveling to and from the property does not count toward the total. Finally, the taxpayer must maintain contemporaneous records, including time reports, that detail the hours, description, dates, and performer of all services. The safe harbor is not available for real estate rented under a triple net lease. Failing to meet the safe harbor does not automatically disqualify a rental activity, but it means the taxpayer must prove it meets the general trade or business definition.

Aggregation Rules for Businesses

IRS guidance permits taxpayers to elect to aggregate, or combine, multiple trades or businesses into a single entity for calculating the QBI deduction. The primary benefit is to blend the QBI, W-2 wages, and the unadjusted basis immediately after acquisition (UBIA) of qualified property from all included businesses. This can be advantageous if a profitable business’s deduction is otherwise limited by low W-2 wages or UBIA.

To aggregate, the same person or group must own 50% or more of each business for the majority of the tax year, including the last day. The businesses must also satisfy at least two of three factors showing they are an integrated operation: providing the same or complementary products/services; sharing facilities or centralized business elements; or operating in coordination with each other. A Specified Service Trade or Business (SSTB) cannot be aggregated with any other trade or business.

Guidance on Specified Service Trades or Businesses

The QBI deduction is subject to limitations for higher-income taxpayers who own a Specified Service Trade or Business (SSTB). These fields include health, law, accounting, consulting, and financial services. The guidance provided clarity for businesses with both SSTB and non-SSTB activities by establishing a de minimis rule, which creates a quantitative threshold for when a business is classified as an SSTB.

For a trade or business with gross receipts of $25 million or less, it will not be considered an SSTB if less than 10% of its gross receipts are attributable to a specified field. For a business with gross receipts exceeding $25 million, the threshold is lower, and the business is not an SSTB only if less than 5% of its gross receipts are from a specified service activity. This two-tiered system provides a measurable test for taxpayers with mixed-activity businesses.

Calculating W-2 Wages and UBIA of Qualified Property

For taxpayers with income above certain thresholds, the QBI deduction is limited by either 50% of the W-2 wages paid by the business or 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property. W-2 wages for this purpose are the total wages subject to income tax withholding paid to employees. The UBIA of qualified property is its cost basis on the date it is placed in service.

The property must be tangible and depreciable, and its depreciable period must not have ended before the close of the taxable year. The guidance clarified how to determine UBIA for property acquired in certain nonrecognition transactions. For instance, if property is contributed to a partnership, it generally retains the UBIA it had in the hands of the contributing partner on the date it was first placed in service. Similarly, for property acquired in a like-kind exchange, the UBIA of the new property is generally the same as the UBIA of the property that was relinquished.