August 17, 2018

The Trade or Business Requirement for the Sec. 199A Deduction

Houston Tax Attorney Blog

Houston Tax Attorney

0

The new Sec. 199A deduction that provides a 20 percent benefit for flow through entities has been in the news as of late.  The Yaryan v. Commissioner, T.C. Memo. 2018-129, case provides an opportunity to consider one aspect of this new Sec. 199A deduction.  Specifically, the Treasury released regulations that adopt a “trade or business” standard that can limit the Sec. 199A deduction for those whose activities are found to be mere investments that do not rise to the level of a “trade or business.”  This issue will be critical for real estate investors and less active business owners.

The Facts & Procedural History

The taxpayers entered into a joint venture agreement with a company that developed homes for sale to customers.  The agreement was memorialized in a jv agreement.  The jv agreement described the business purpose as follows:

[T]he Joint Venture is formed to invest in real estate vacant lots and construct single family residences upon the Joint Venture residential lots for the purpose of resale to the general public.

The jv agreement provided that the developer company would purchase residential lots in its name.  When the taxpayers made contributions to the jv, the taxpayers would be granted a secured interest in the lot that was purchased.  Thus, the taxpayers were providing funds to the jv so the jv could purchase lots.  The developer company would fund construction on the lots.

The taxpayers were to be paid 15 percent of his investment in a lot when the lots were sold.

The developer company was to be paid for his services.

The taxpayers then helped to select the lots, etc. and the developer company performed the day-to-day activities of constructing homes on the joint venture lots.

In the initial years, the taxpayers reported the gains as “other income” on line 21 of their tax returns.  They did not report it on Schedule C as a business would.  In the later years, the taxpayers reported losses from the jv.

The IRS disallowed the losses and tax court litigation ensued.

What is a Trade or Business?

To be able to deduct business bad debts, the bad debts have to have been associated with a “trade or business.”  This is not a term that is defined in the Code.  It is a term of art.

The courts have said that the taxpayer must participate in the activity with continuity and regularity and the primary purpose for engaging in the activity must be for income or profit for the activity to rise to the level of being a “trade or business.”

This activity is more substantial than the activity of managing an investment to earn a profit from the investment.

A Trade or Business of Selling Vacant Lots?

The taxpayers in Yaryan argued that they were “in the trade or business of investing in vacant lots, constructing single-family residences, and selling residences to the public.”  The court didn’t go for it.

The court considered the terms of the jv agreement, which provides that:

Petitioner’s responsibility under the JVA was to provide funds to Prime for the purchase of the lots. The JVA provided that Prime was “solely and exclusively responsible for all aspects of development, design, construction, marketing, and sale” of the properties. Prime was required to incur the risk associated with building and marketing the constructed residences by financing construction with its own funds or loans held solely in its name.

In addition, the court noted that the taxpayers did not have to provide services (although they did) and they were to be paid as a return on their investment and not a share of the profits.

Given these facts in the jv agreement, the court concluded that the jv was not a trade or business of selling lots for the taxpayers.

Real Property Trade or Business?

The taxpayers also argued that they were in a real property trade or business.  There have been a number of court cases and rulings that address whether owning real estate rises to the level of being a trade or business.

As noted by the court in Yaryan, a:

real property is held by the taxpayer in a trade or business: (1) the purpose for which the property was acquired, (2) the activities of the taxpayer and those acting on his or her behalf, (3) the continuity of sales and their frequency, and (4) any other fact relevant to the determination of whether a sale was a transaction of a trade or business.

In considering these factors, the court noted that the taxpayers didn’t own the real property.  The jv did.  The jv agreement also provided that the jv was to hold the real property for sale to customers.  The rules are more nuanced than this, but suffice it to say that the court concluded that the taxpayers did not have a real property trade or business.

The Sec. 199A Trade or Business Requirement

This brings us to the Sec. 199A deduction.  The result in the Yaryan case was that the taxpayers’ business bad debt deduction was not allowed.  But as noted above, this same analysis applies to the new Sec. 199A deduction.

The Sec. 199A deduction is a 20 percent benefit afforded to sole proprietorships, partnerships, S corporations, and some trusts.  It is intended to put these entities on a somewhat equal footing with C corporations–which were allowed a lower flat 21 percent tax rate.  Congress could not grant this low tax rate to C corporations without coming up with some way to reduce the taxes for these flow through entities, or else everyone would have a strong incentive to switch existing flow through entities to C corporations.  The mass exodus would have been a monumental shift in terms of business structures and would have had a ripple effect in terms of compliance and other complications that come from business restructurings.

Unlike C corporations that have the benefit of certainty for the low 21 percent rate, flow through entities were not afforded the same luxury.  The new Sec. 199A deduction is somewhat complex and nuanced for what it is intended to do.  The trade or business requirement is one such nuance.  The IRS issued regulations last week that adopted this line of case law for defining what counts as a “trade or business” for purposes of Sec. 199A.

This issue will be one that taxpayers have to grapple with in determining whether they qualify for the new Sec. 199A deduction.  It is one that nearly all real estate professionals will have to address.

No doubt we see an uptick in court cases in this area as more taxpayers assert that, based on their facts, they are engaged in a trade or business and not merely profiting from the gain from investments, such that they are entitled to Sec. 199A deductions.  This is one area that it may be advisable to get written tax advice before taking positions on tax returns.

Comments are closed.