IRC 199A: Qualifying as a Separate Trade or Business Part II

Take-Away: The proposed Regulations for IRC 199A confirm that real estate or equipment leasing activities can qualify for the 20% federal income tax deduction under IRC 199A as a separate trade or business. The Regulations apply the IRC 162 definition of a trade or business for non-commonly controlled rental activities. Following IRC 162 definitions can, however,  pose a problem for passive landlords, lessors of non-real estate personal items like equipment, and licensors of intellectual property rights if the rental or licensing business is  not active enough to meet the separate trade or business definition of IRC 162, or more accurately how the federal courts have come to define what constitutes an active trade or business.

Planning Strategy: One of the strategies often suggested to assist businesses to qualify for the IRC 199A 20% income tax deduction is to create a separate line-of-business or separate legal entity that receives income from an operating business, against which the IRC 199A income tax deduction can then apply. A common situation is where an S corporation or partnership owns real estate from which it conducts business; transferring that real estate into a separate business entity might enable the business owner to expose that rental income to the IRC 199A income tax deduction, which would not be the case if the real estate continued to be held as an asset of the operating business. But that separate business must qualify as a separate trade or business as described in IRC 162.

Active vs Passive Business: IRC 162 has been interpreted by courts over the years to require more than the passive receipt of real estate rent or license or royalty income to meet the Tax Code’s definition of an active trade or business. These federal court decisions seem to imply that some degree of activity, or retained legal responsibility,  or economic risk must also be present for the lease or license arrangement to be considered an active trade or business by that asset’s owner. This additional responsibility or risk may come from the retained responsibility for maintenance, active tenant management, or the property owner’s activity to pursue, enter into, or sell positions in leases.

• Triple-Net-Lease Deductible?: The Regulations use an example that provides some guidance for a possible (hopeful?) expansive definition of an active trade or business. That example  is where a property owner manages and leases vacant real property leased to an airport authority; Treasury says in this example that the airport lease qualifies as an active trade or business, which on its face seems awfully passive to me. As such,  it is possible that the Regulations, when they become permanent, might actually allow triple-net-lease landlords with no other activities or risks assumed by the landlord to qualify for the IRC 199A income tax deduction. But until then, it would be best if existing lease or license arrangements are modified to permit the landlord to be more active in the management of the property by imposing some additional duties on the landlord beyond just collecting rent from the tenant, or giving the landlord some ‘skin in the game.’
• Disallowed Deduction?:  But as noted in the earlier summary of the proposed IRC 199A Regulations, if the rental activity by the separate business is within the common control of an excluded profession [e.g. a dentist transfers from his PC his office building to an LLC, which then leases the building back to the PC], the income tax deduction may be disallowed in its entirety, depending upon the owner’s taxable income and ownership of that separate real estate business ( in short, whether the ‘common control’ rules apply.)

What is a Trade or Business? This has been a recurring question in the Tax Court over several decades with no clear answer. More to the point, there appears to be inconsistent conclusions reached by the federal courts as to what constitutes a separate trade or business,  especially when it comes to the classification of a single real estate rental property.  A couple of examples follow:

• Mere Collection of Rent- No: The mere collection of rent without any other activity will not constitute a trade or business. Neill v. Commissioner (Tax Court, 1942). The Court analogized the landlord’s ownership of the real property to the collection of income from individual stocks and bonds that produce income.
• Apartment Buildings- Yes: But if the landlord manages and operates apartment buildings, whether individually or through an agent, that constitutes a trade or business. Schwarcz v. Commissioner 24 T.C. 733 (1955).
• Single Apartment Building- Yes: Even when the ownership and leasing is of a single apartment building, the landlord met the definition of an active trade or business. Lareide v. Commissioner, 23 T.C. 508 (1954).
• Use of Agent Manager- Yes: In Elek v. Commissioner, 30 T.C. 731 (1958) the use of an agent to actively manage and maintain the rental property had no negative effect on the landlord’s trade or business determination by the court.
• Oil and Gas Interests- No:  Where the owner purchased part of an oil lease and then simply collection income from the mineral producing property, that activity did not qualify as a trade or business. Hendrickson v. Commissioner, 54 T.C.M. 1079 (1987).

Conclusion: In light of the need to qualify as a separate active trade or business as contemplated under IRC 162 it makes sense to have other individuals become owners of the real estate or equipment that is leased to the business to avoid the ‘common control’ aggregation approach of the proposed Regulations under IRC 199A. It would also be a good idea to place additional responsibilities on the owners of the real estate or equipment in addition to the use of a simple triple-net-lease, if the goal is to have the separate business become eligible as an active trade or business under IRC 162 to claim the 20% income tax deduction under IRC 199A, such as the landlord/owner assuming some responsibilities, e.g. contracting for janitorial services of the building, or negotiation a percent of tenant sales ‘override’ rent, e.g. 1.0% of sales in excess of $10.0 million of tenant’s sales to formalize the landlord’s economic incentives.