BY JAMES M. KEHL, PUBLISHED BY BLOOMBERG TAX
After the proposed regulations concerning the qualified business income (QBI) deduction were published, a CPA, who is a tax specialist and one of the best instructors for continuing professional education tax programs in the U.S., called me to express his disappointment with these proposed regulations. The reason he was disappointed was because this published guidance did not provide him with any assurance that net rental income of a taxpayer reported on Form 8825 was income from a trade or business for purposes of the QBI deduction.
I agreed with his observation that this published guidance did not directly address the issue of defining the circumstances of when a rental activity would be defined either as a trade or business or as an activity engaged in to produce income. We both observed that the preamble to the proposed QBI regulations is not literally correct when it states that the term ‘‘trade or business’’ is ‘‘defined’’ by several other sections of the tax code. Several sections of the tax code contain the words ‘‘trade or business,’’ but do not define that term. What the new QBI proposed regulations probably meant was that the term as used in those sections of the tax code was defined by the case law and other guidance on this subject.
This article will discuss a process for characterizing a rental activity as a trade or business activity. This discussion will begin with a general review of the principles promulgated by case law and other published guidance in this area.
CASE LAW AND ADMINISTRATIVE GUIDANCE ON TRADE OR BUSINESS
Approximately 77 years ago, the U.S. Supreme Court stated in one of the tax cases it decided that the existence of a trade or business was a determination that was to be based on facts and circumstances. In another case decided in 1987, the Supreme Court elaborated on some of the characteristics of a trade or business. The Supreme Court opined that trade or business activities are regular, ongoing, and continuous as opposed to activities that are sporadic. Sporadic activities do not constitute a trade or business. The activities must be substantial, which apparently means considerable in quantity. From the Supreme Court’s litany in this case about the characteristics of a trade or business, one could derive a definition that a trade or business is an activity or group of activities that are conducted on a regular, continuous, and substantial basis. Some U.S. Courts of Appeals decisions required that these regular, continuous, and substantial activities had to be engaged in for making a profit. One federal appeals court decision seemed to imply that the profit motive was the most important aspect of being a trade or business. However, a profit motive in and of itself is not enough to make an activity a trade or business. A single sale of an asset may be executed with a profit-making motive. However, a single sale of an asset is a sporadic activity. An activity that is not considered a hobby under the hobby loss rules because it is engaged in for profit is not necessarily a trade or business. It could be an activity to produce income.
From the above court decisions, a working definition of a trade or business that can be derived from these court decisions and other guidance is that a trade or business is either an activity or group of activities conducted on a regular, continuous, and substantial basis to earn a profit.
The U.S. Tax Court has acknowledged that there have been cases where it has ruled that the rental of a single property was a trade or business. In that case, the Tax Court also stated that, as a matter of law, it cannot rule that the rental of a single piece of property was a trade or business. At the same time, the Tax Court also stated that, as a matter of law, it cannot rule that the rental of a single piece of property was not a trade or business. In this case, the Tax Court held that a person who held a regular job and rented six properties was engaged in a trade or business of leasing properties because of the regular, continuous, and substantial activities of that taxpayer in renting those six properties. One might say that the Tax Court aggregated the six rental properties and found that the aggregation of those rental properties constituted a single trade or business.
PROPOSED SOLUTION TO DILEMMA
My CPA friend and I posited a possible solution to this dilemma of determining whether a rental property is a trade or business by referring to the regulations that define rents for purposes of calculating an S corporation’s passive investment income. Those regulations state that, for purposes of calculating passive investment income, the term ‘‘rents’’ does not include rentals derived from the active business of renting property. The regulations go on to state that rents are derived from an active business of renting property only if, based on all the facts and circumstances, an S corporation incurs significant costs or provides significant services in this rental business. These regulations point out that significant services are not performed, and substantial costs are not incurred with respect to net leases. Some of the facts and circumstances mentioned in these regulations as indications of the performance of significant services and the incurrence of substantial costs include, but are not limited to, the number of persons employed to perform those services and the amount of costs and expenses incurred (other than depreciation). Whether significant services are performed, or substantial costs are incurred will obviously be a matter of judgment and will be different based on facts and circumstances. However, a reference in the QBI regulations to this regulation would be helpful to taxpayers and their advisors in determining whether the rental of property is a trade or business.
When the proposed QBI regulations are finalized, a reference in those final regulations to this S corporation regulation for determining rents from the active conduct of a rental trade or business may be helpful in determining whether a rental activity is a trade or business.
OWNER’S PROPERTY RENTED TO OWNER’S BUSINESS
The definition of ‘‘trade or business’’ that is contained in the proposed QBI regulations indicates that there may be situations where the rental or licensing of property does not rise to the level of a trade or business. Thus, whether a rental activity is a trade or business or an activity to produce income is an issue for purposes of the QBI deduction. However, these proposed QBI regulations did clarify that if property is rented or licensed to a commonly controlled trade or business, that rental or licensing activity will be treated as a trade or business for purposes of the QBI deduction even if that activity does not rise to the level of a trade or business. This is good news for owners of buildings who may lease those buildings to a partnership or S corporation conducting a trade or business that they own and control. This trade or business treatment will apply even if the rental activity and the trade or business do not qualify as trades or businesses that may be aggregated.
Emory Inc. is an S corporation that manufactures air conditioning parts. The stock of Emory Inc. is owned 60 percent by Jack Emory and 40 percent by his daughter Tiffany. Jack Emory owns the building in which this manufacturing business is conducted and leases that building to Emory LLC. For economic and income tax reasons, the building is not owned by the S corporation. The rental of the building by Jack Emory is treated as a trade or business solely for purposes of the QBI deduction.
Under the proposed QBI regulations, the results would be somewhat different if this building was rented to a specified service trade or business (SSTB).
Dr. Edwards is a pediatrician who has taxable income before the QBI deduction for 2018 of $465,000. Dr. Edwards conducts his medical practice through an S corporation in which he owns 100 percent of the stock. Dr. Edwards also owns the office building in which the S corporation’s medical practice is conducted and leases that building to this S corporation. Since 80 percent or more of the leased property is used by an SSTB and there is 50 percent or more common ownership of both trades or businesses, the building is part of the SSTB. As such, any net rental income is not eligible for the QBI deduction. If less than 80 percent of the building is leased to the S corporation, then only the portion of the property leased to the S corporation is treated as part of the SSTB. Whether the portion that is leased to unrelated tenants is a trade or business will have to be separately determined based on the trade or business principles.
The proposed QBI regulations did not define a rental property trade or business. Indeed, the definition of a trade or business contained in those regulations indicated that there are circumstances where the operation of a rental property may not rise to the level of a trade or business. It is possible that two professionals will reach different conclusions as to whether the operation of the same rental property is a trade or business or an activity to produce income. This is the case with many matters of professional judgment.
In making this judgment, tax professionals should bear in mind the definition developed from case law and other guidance that a trade or business involves regular, continuous and substantial activities that have the objective of making a profit. If the operation of a rental property involves significant services and substantial costs, it is likely to be a trade or business.
James M. Kehl is a principal at Weil, Akman, Baylin & Coleman, P.A., James Kehl has over 42 years of experience as a CPA and has focused primarily on taxation. Mr. Kehl also has extensive experience with financial statements, audits, review, and compilations.