On February 1, 2019, the IRS published a corrected version of their final regulations for Section 199A (available here).
The corrections include a handful of minor editorial tweaks. All helpfully flagged in the published document using revision marks. But one particular tweak makes sense to point out and discuss for many, many small businesses.
Do You Have Multiple Trades or Businesses?
That tweak? Well, as you may know if you’re reading this, you need to calculate the Section 199A deduction for each separate trade or business.
You can’t just add up the business profit from all your trades or businesses and multiply that sum by 20 percent even in the simplest case. Rather, you determine the profit of each trade or business, multiply just that trade or business’s profit by 20 percent, and then add up the individual trades’ or businesses’ deductions.
That requirement begs an obvious follow-up question: How do you or I determine whether one or more than one business exists?
The first version of final regulations published in mid-January suggested you needed to look at each situation carefully and apply a variety of tests.
But one important test? Do the activities keep separate books?
The Language Change: No Longer a Separate Requirement
But that “separate books” requirement dropped out of the corrected version which appeared in February.
Here’s the edit to that first language:
Section 1.446-1(d)(2) provides that no trade or business will be considered separate and distinct unless a complete and
separateseparable set of books and records is kept for such trade or business.
The revision added the underlined words and deleted the crossed-out word.
That’s interesting to me. And significant, I think, for three reasons.
No Requirement for Separate Books
The first obvious significance? You or your client don’t need separate books. You need separable books.
For example, to put this in terms of QuickBooks, the most popular small business accounting software program, you don’t need separate QuickBooks data files or separate QuickBooks Online subscriptions for each business.
Rather, you need to be able to set up your QuickBooks accounting records such that you can separate different trades or businesses.
My suggestion? I think you use your chart of accounts to allow for the required separation.
You would want different asset, liability and equity accounts for each trade or business. You would also want different income and expense accounts. (The different accounts should allow for “separable”-ness.)
An example? You would want separate bank accounts.
Another tip for QuickBooks users? I think you would want to use different invoice templates for each trade or business (probably showing different trade or business names).
A landscaper doing both maintenance and then design and wanting to treat these activities as separate and distinct trades or businesses might have one set of accounts for the maintenance business and another set of accounts for the design business.
Remember the Edit
Another significant thing, I suggest, you want to remember about all this?
I think you keep copies of the first draft and then the revised draft of the final regulations to document the editorial change.
If you ever find yourself in a discussion with an IRS auditor about whether you can within one QuickBooks file handle multiple trades or businesses? Hey, you want to point to this editorial change. You want to be able to back up the regulations require not “separate” books… but “separable” books.
No, I know. You can call me a scared-y cat on this. Because I am.
Separable Not Enough
One final thing to say here–though you probably already know this. You don’t create or prove separate trades or businesses merely by making the financial data separable.
The “separable” thing is necessary. It is not sufficient.
The IRS and Treasury set forth a number of other requirements.
For example, and here I quote, they “believe that multiple trades or businesses will generally not exist within an entity unless different methods of accounting could be used for each trade or business under §1.446-1(d).” You and I want to consider that.
Another thing to consider? While multiple trades or businesses can be conducted within one entity, a trade or business “cannot generally be conducted across multiple entities for tax purposes.”
And then this remark: In a discussion in Regulation 1.199A-5(c)(1)(iii), the IRS talks about a landscaping business that can’t treat its maintenance activities and design consulting activities as “separate” and then about a veterinarian who can treat the veterinary medicine practice as separate from a dog food business.
There, the IRS and Treasury say this about the dog food business,
Animal Care LLC also has separate employees who are unaffiliated with the veterinary clinic and who only work on the formulation, marketing, sales, and distribution of the organic dog food products. Animal Care LLC treats its veterinary practice and the dog food development and sales as separate trades or businesses for purposes of section 162 and 199A.
The way I read this? If you want to separate out activities into their own trades or businesses, you want things like “separate employees” and for the activities to be treated in the real world as “separate trades or businesses.”
Final Remarks
I’ve got to get back to preparing tax returns. But two final quick comments.
First, if you are going to break-up the typical small business amalgam of activities into separate trades or businesses, I think you want to make sure the business owners have good accounting skills and systems. Many small businesses find a decent balance sheet hard to produce. I would imagine many more would find a “separable” requirement too difficult to achieve.
Second, if you do try this, I suggest you re-read (or read?) the final regulations’ discussions about how to account for and allocate income, expenses and assets between multiple trades or businesses. That information should help you channel the logic and thinking of the IRS and Treasury.
Other Related Resources
If you’re reading this discussion, you might also find this related blog post useful: Section 199A Trade or Business Concept Deconstructed.
This blog post might be useful too, if you’re still scrambling to make sense of the Section 199A complexity: Section 199A Qualified Business Income Deduction Danger Zones.
Notice 2019-07 proposes RevProc 2019-xxx, and Section 3.06 addresses a statement for application of the RRE (Rental Real Estate) Safe harbor. For 2018, the QBI deduction is just a line entry, and no supporting worksheet is required. (1) What do you suggest for wording? (2) Do you suggest that it just be included in the efiled tax return or that it be signed and attached as a pdf to the efiled return?
Hi Neal, I’m reading the notice to say the statement is required on a return (any return) that relies on the safe harbor. The language I’m looking at from the notice:
I think only the contemporaneous time log requirement kicks in in 2019 but not 2018 based on this language from the notice:
.
Stephen,
Can you please comment at all on Pub 535, page 54, Schedule B – Aggregation of Business Operations, as it relates to rental real estate? Or if there is an article I am missing that clarifies this I’d be glad to read there. I bought your book on the 199A deduction and have downloaded the updates.
The place I get confused on is applying the safe harbor and this aggregation component.
Assume none of these are held in the same company.
An example would say you have:
1. storage unit that is self-rental,
2. a beach condo that has a property manager that manages collecting rent, pays fees, housekeeping and maintenance. Owner pays property taxes, insurance, utilities.
3. Another condo operating similarly to #2 above but managed by someone else
4. Another residential rental that is currently in a long term lease with minimal expenses.
I would read the regulations and Notice 2019-07 as saying that you could use Section 162 to determine individually whether any of the properties you list show a profit motive and enough regularity and continuity to count as a qualified business. And that would be my preferred way to address this.
Note: The storage unit self rental, if rented to another business you own, is automatically and easily a qualified business as per the regulations.
If you did want to use the safe harbor, that might work… note that you’d need two safe harbor uses, right? One for the residential properties and another for the storage unit. Per the notice, you can’t combine residential and commercial properties within same safe harbor grouping as per this language:
Regarding an election to aggregate, I haven’t thought about that as a way to legitimize treating a collection of rental properties as a qualified business. But that approach, which I think might mean you aren’t using the safe harbor, would seem to work.
Again, though, I would think relying on Section 162 rule (“do you have a profit motive and does your rental operation show continuity and regularity?”) probably gets you to where you want to be.
You may have already seen this other blog post but in case not it goes into details of Section 162 rule: Section 199A rental property trade or business definition.
Thanks for this helpful update.
A question: last year was the first year that I operated as a single-member S Corp. I received Schedule C income from 2017 for the same service that the S Corp provides that due to cash accounting will land in 2018, so I will have both Schedule C and K-1 QBI for providing the same (199A eligible) service.
My assumption was that I would calculate the deduction separately for the two pools of QBI (since I will be deducting retirement contributions from both pools and the adjustments for that deduction are calculated differently) and then add the deductions together and include on the 1040.
Seems simple enough but wondering if it is indeed…
Most conventionally, I think, you’d incorporate the Schedule C sole proprietorship, transferring all of its assets and liabilities, including uncollected receivables and open accounts payables to the new corporation. This is called a Section 351 transfer btw…
When you do this, the income earned in 2017 by the sole proprietorship and then collected in 2018 when you’re a corporation becomes the corporation’s income. Ditto for unpaid bills. And in this case, you don’t file a Schedule C in 2018 for the trailing 2017 activity.
You probably want to amend your 1120S return to add these trailing bits of income and expenses to the S corp return… and that’ll have effect of automatically combining the QBI calculations. It will also increase your S corporation savings.
Tip: You would also want to add a Section 351 transfer statement to the 1120S return and your 1040 return.
Ya, decidedly not as simple as I thought.
Thank you for the guidance – wondering if that is really the only way to go about it and if so to clarify whether the ‘incorporation’ you describe is a one-time tax year transfer or if I would be actually rolling the sole proprietorship into the corp, which I wouldn’t want to do.
Thank you!
Your original comment described the sole proprietorship as providing the same service as the new LLC you’re treating as an S corporation.
Seems like that’s probably the same business (same customers? some products? maybe same computer?)… why not do the accounting right and handle the business the first year as Schedule C sole proprietorship and second year on 1120S for LLC?
You maximize your S corp savings by doing the Section 351 transfer correctly. You may also reduce your audit risks. (This last remark is based on my and other CPA’s anecdotal observation that short-year unincorporated businesses and short-year S corps can seem to trigger audits.)