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The 163(j) Package – Exempt and excepted businesses and entities

Exempt and excepted businesses and entities

This report provides initial impressions and observations about the 163(j) Package’s rules relating to exempt and excepted businesses and entities.

For a discussion of the general background and applicability dates for the Final Regulations and the 2020 Proposed Regulations, as well as links to other 163(j) Package Focus Reports, read TaxNewsFlash

Exempt small businesses

The Final Regulations provide rules for implementing the small business exception in section 163(j)(3) for certain taxpayers meeting the $25 million gross receipts test of section 448(c), including rules for the application of section 448(c) to individuals in their own capacity and as owners of interests in flow-through entities. Section 448(c)(2) aggregates the gross receipts of multiple taxpayers that are treated as a single employer under sections 52(a) and (b) and 414(m) and (o).

The Final Regulations provide that the exemption for certain small businesses that meet the gross receipts test of section 448(c) does not apply to a tax shelter as defined in section 448(d)(3). Section 448(d)(3) defines a tax shelter by cross-reference to section 461(i)(3), which defines a tax shelter, in relevant part, as a syndicate within the meaning of section 1256(e)(3)(B). Reg. § 1.448-1T(b)(3) provides, in part, that a syndicate is a partnership or other entity (other than a C corporation) if more than 35% of its losses during the tax year are allocated to limited partners or limited entrepreneurs, whereas section 1256(e)(3)(B) refers to losses that are allocable to limited partners or limited entrepreneurs. To clarify and provide consistency, new proposed regulations would require the use of the allocation rule in Prop. Reg. § 1.448-1T(b)(3) in defining the term “syndicate.” 

Excepted trades or businesses and definition of a real property trade or business

Section 163(j) provides elective exceptions for certain real property trades or businesses and for certain farming businesses. The Final Regulations provide applicable rules and mechanics with respect to electing into these exceptions that largely adopt the rules from the 2018 Proposed Regulations, although with a few notable exceptions. 

Exempt small businesses and the election to be an excepted trade or business

The Preamble to the 2018 Proposed Regulations stated the view that a business that qualifies as an exempt small business is not eligible to elect to be an excepted trade or business. In a departure from that view, the Final Regulations permit a real property trade or business or a farming business that meets the requirements of the small business exemption to elect to be an excepted trade or business. This can benefit equity investors in the entity that holds the business by enabling them to allocate their own debt to an excepted trade or business under Reg. § 1.163(j)-10. 

Protective elections

The Preamble to the Final Regulations provides that a real property trade or business as defined under section 469(c)(7)(C) need not rise to the level of a section 162 trade or business, such as the rental of real property under a triple net lease arrangement. The Final Regulations permit such a real property trade or business to protectively elect to be an excepted trade or business.

KPMG observation

A business that does not rise to the level of a section 162 trade or business generates non-trade or business interest expense, which, upon allocation to a C corporation or REIT partner, would be recharacterized as business interest expense for that partner. The ability for such a real property trade or business to nevertheless make an election to be an excepted real property trade or business benefits those REIT and C Corporation partners because the allocated interest expense would be interest from an excepted business (for the REIT, even if it does not make a safe harbor REIT election). Such an election also allows a C corporation partner or REIT partner to allocate its own interest expense to an excepted business.

REIT safe harbor

The Final Regulations retain and favorably modify the REIT safe harbor that was included in the 2018 Proposed Regulations. As proposed, the REIT safe harbor allowed a REIT to make an election to be an electing real property trade or business if the REIT held (1) real property (as defined in section 1.856-10), (2) interests in partnerships holding real property, or (3) shares of other REITs holding real property. The Final Regulations provide that the REIT safe harbor is available to REITs that hold real property directly, or indirectly through partnerships or tiered partnerships, or that hold shares in REITs holding real property either directly or indirectly through partnerships or lower-tier REITs.

In a helpful expansion of the REIT safe harbor, certain REIT-controlled partnerships are also eligible for the REIT safe harbor under the Final Regulations, and thus, are able to elect to be an excepted real property trade or business. The Final Regulations provide that a partnership may apply the REIT safe harbor election at the partnership level if one or more REITs own, directly or indirectly, at least 50% of the partnership’s capital and profits, the partnership meets the REIT gross income and assets tests as if the partnership were a REIT, and otherwise satisfies the requirements of the REIT safe harbor as if the partnership were a REIT. A REIT (or eligible partnership) may choose not to apply the REIT safe harbor and instead elect for one or more of its trades or businesses to be electing real property trades or business, assuming that they qualify, in which case, the taxpayer may not rely on any of the safe harbor provisions.

KPMG observation

In our experience, most publicly traded UpREITs borrow at their operating partnership level rather than at the REIT level. Thus, the REIT safe harbor, as expanded in the Final Regulations, will be helpful in allowing UpREITs in typical commercial structures to benefit from the electing real property trade or business exception.

Modification to REIT safe harbor allocation rule

The Final Regulations require, as did the 2018 Proposed Regulations, that in applying the REIT safe harbor, a REIT must determine the extent to which the value of its assets are allocable to “real property financing assets.”  Under this rule, a REIT treats all of its assets as assets of an electing real property trade or business if 10% or less of the value of a REIT’s assets consist of “real property financing assets” at the close of the applicable tax year, but is required to allocate interest expense, interest income, and other items of expense and gross income between the electing real property trade or business and non-excepted trades or businesses if its financing assets at the close of the tax year exceed 10% its assets.

The Final Regulations permit a REIT shareholder of a lower-tier REIT to determine the extent of the lower-tier’s real property financing assets based upon an applicable financial statement (within the meaning of section 451(b)(3)) of the lower-tier REIT. Otherwise, the shareholder REIT may rely only upon information provided directly from the lower-tier REIT to make the determination of the percentage of real property financing assets. 

The anti-abuse rule

The Final Regulations retain the anti-abuse rule proposed in the 2018 Proposed Regulations that prevents a real property trade or business from being eligible for the election to be treated as an excepted trade or business if at least 80% of its real property is leased to a trade or business under common control (treating businesses as under common control if 50% of their direct and indirect ownership is held by persons that are related within the meaning of section 267 and section 707(b)). The Final Regulations clarify that the 80% determination is made by reference to the fair market rental value of the property used in the business. For this purpose, the fair market rental value is the amount of rent that a prospective lessee that is unrelated to the lessor would be willing to pay for a rental interest in real property, taking into account the geographic location, size, and type of the real property.

New exceptions to the anti-abuse rule

The 2018 Proposed Regulations contained an exception to the anti-abuse rule for REITs leasing qualified lodging facilities and qualified healthcare properties and requested comments on whether this exception should be expanded to capture certain “PropCo/OpCo” structures. In response to comments, the Final Regulations provide two new additional exceptions to the anti-abuse rule. The first new exception, the “de minimis exception,” permits an election to be a real property trade or business by a lessor that leases at least 90% of the fair market rental value of lessor’s rental property to one or more of: (1) a party not under common control with the lessor or the lessee, (2) a party under common control that has made an election to be an electing real property trade or business or electing farming business (but only to the extent that the lessor’s real property is used as part of the excepted trade or business); or (3) a party under common control that is an excepted regulated utility trade or business (but only to the extent that the lessor’s real property is used as part of the excepted trade or business).

If the de minimis exception does not apply because the lessor does not meet the 90% standard for that exception, then a second new exception, the “look-through exception,” may apply. This provision allows the lessor to make a real property trade or business election to the extent that the lessor leases the real property to the parties described above in the de minimis exception and to the extent that the lessee, if under common control with the lessor, ultimately subleases the real property either to a commonly controlled party that is a trade or business that has made an election to be an electing real property trade or business or electing farming business, or to an excepted regulated utility business to the extent the real property is used as part of such business, or to a party not under common control with the lessor or the lessee.

If only a portion of the real property satisfies the requirements of the look-through exception, then the business must allocate the basis of the assets between excepted and non-excepted businesses under the allocation rules of Reg. § 1.163(j)-10. Accordingly, the Final Regulations also modify the allocation rules of Reg. § 1.163(j)-10 to require allocation of the basis of real property leased under the look-through rule between the excepted and non-excepted portions of the real property trade or business based on their respective relative fair market rental values.

KPMG observation

It is important to note that in order for a lessor to avail itself of the de minimis exception or the look-through exception where lessor leases to a party under common control that is a real property trade or business or farming trade or business (or where the lessee subleases to such a trade or business), the lessee (or sublessee) real property trade or business or farming business, as the case may be, must actually make an irrevocable election to be an excepted business and consequently must adopt the alternative depreciation system (“ADS”).

Expansion of the anti-abuse rule exception for REITs leasing qualified lodging facilities and qualified health care properties; proposed revenue procedure safe harbor

In addition to adding the two exceptions to the anti-abuse rule explained above, the Final Regulations expand the availability of this exception to partnerships making a real property trade or business election that lease qualified lodging facilities and qualified health care properties (as each is defined for purposes of the REIT rules).

Further, Notice 2020-59, which includes a proposed revenue procedure, was issued concurrently with the Final Regulations. The proposed revenue procedure would provide a safe harbor for a trade or business that manages or operates a qualified residential living facility to be treated as a real property trade or business solely for purposes of qualifying to make the real property trade or business election under section 163(j)(7). The safe harbor is intended to mitigate uncertainty as to whether a lessee residential facility that provides supplemental assistive, nursing, or routine medical services can qualify as electing real property trades or businesses. The revenue procedure defines a qualified residential living facility and supplemental assistive nursing or other routine medical services. The proposed revenue procedure makes clear that satisfying the requirements of the safe harbor allows a taxpayer to treat the business as a real property trade or business solely for purposes of making an election to be an excepted business and is not a determination that the business is a trade or business under section 469. The proposed revenue procedure is proposed to apply to tax years beginning after December 31, 2017 and taxpayers can rely on the proposed safe harbor in the proposed revenue procedure until the proposed revenue procedure is published as a revenue procedure in the Internal Revenue Bulletin.

KPMG observation

The new exceptions provided in the Final Regulations offer new opportunities for trades or businesses to elect to qualify for the electing real property trade or business exception, some of which also require an entity under common control to make an election to be an electing real property trade or business or electing farming business. As noted in the Preamble to the Final Regulations, Revenue Procedure 2020-22 provides procedures for making late elections to become an electing real property trade or business or an electing farming business, which would require a partnership to either file an amended return under Revenue Procedure 2020-23, or alternatively to file an administrative adjustment request. Alternatively, partnerships could simply make the election going forward for future tax years. In any event, businesses may wish to model the effects of making such an election to fit within the new exceptions.


The Preamble to the Final Regulations notes that the definitions of real property trades or businesses and farming businesses have been amended in the Final Regulations to reflect that future guidance may be needed to determine whether a particular trade or business can make an election, and thus those definitions now include a new provision noting that the Secretary may issue guidance on whether a trade or business can be an electing real property trade or business or electing farming business.

Corporate partner cannot make real property trade or business election for partnership

The Preamble to the Final Regulations confirms that a corporate partner in a partnership that conducts a real property trade or business cannot make an election to be an excepted real property trade or business for the partnership. A corporate partner can treat its share of the partnership’s real property trade or business as an electing real property trade or business only if the partnership itself makes the election. By way of explanation, the Preamble to the Final Regulations notes that the election has consequences, including the requirement that the business’s property be depreciated using ADS. 

KPMG observation

However, given the ability of an exempt small business and a non-section 162 real property trade or business to make an election to be an excepted real property trade or business, the inability for a corporate partner to elect on behalf of a real property trade or business partnership is mitigated in some circumstances. 

Definition of real property trade or business

The Final Regulations adopt, with a few changes, proposed amendments to Reg. § 1.469-9(b) from the 2018 Proposed Regulations that provided rules relating to the definition of a real property trade or business under section 469(c)(7)(C). Like the 2018 Proposed Regulations, the Final Regulations define “real property” to include land, buildings, and other inherently permanent structures that are permanently affixed to land. The definition further provides that property manufactured or produced for sale that is not real property in the hands of the manufacturer or producer, but that may be incorporated into real property through installation or any similar process or technique by any person after its manufacture or production (for example, bricks, nails, paint, and windowpanes), is not real property in the hands of any person prior to the completed incorporation or installation of such property into the real property.

Although the definition of a real property trade or business under section 469(c)(7)(C) contains a list of many categories of qualifying trades or businesses, the 2018 Proposed Regulations defined only two of these terms: “real property operation” and “real property management,” but reserved on the other categories. Notably, the Preamble to the 2018 Proposed Regulations, though not the 2018 Proposed Regulations, themselves, indicated that those undefined categories of real property trades or businesses under section 469(c)(7)(C) would require a nexus to the creation, acquisition, or management of rental real estate. Although the Preamble to the Final Regulations acknowledges that the other categories (real property construction, reconstruction, development, redevelopment, conversion, acquisition, or brokerage businesses) should not necessarily be required to have a direct nexus or relationship to rental real estate in order to be treated as real property trades or businesses, it goes on to assert that “the expectation nevertheless remains that the end products or final objectives of such businesses should at least have the potential to be used as rental real estate or as integral components in rental real estate activities.” The Preamble to the Final Regulations does not point to any statutory authority for this conclusion or provide any illustration of a meaningful distinction that it is intended to draw.

The Final Regulations favorably modify the definitions of the two previously defined categories of real property operation and real property management by removing what was a subjective and difficult–to-apply standard of distinguishing a real property trade or business from the provision of services by looking to the third-party lessee’s subjective reasons for leasing the property.  In addition, the Preamble to the Final Regulations explains that a revision to the last sentence of each of these definitions is intended to clarify that incidental services, even if significant, do not disqualify a business as a real property trade or business.

The 2020 Proposed Regulations define two additional categories of real property trades or businesses: development and redevelopment trades or businesses. These definitions include timber trades or businesses. As explained in the Preamble to the 2020 Proposed Regulations, because Congress “most likely intended” that these businesses would be excepted from section 163(j), but they are specifically excluded from the definition of farming, Treasury determined that they should be included in the definitions of real property development and real property redevelopment. 

Allocating interest expense, interest income, and other items of expense and gross income to excepted and non-excepted trades or businesses

The amount of a taxpayer’s business interest expense that is properly allocable to excepted trades or businesses is not subject to limitation under section 163(j) and the amount of a taxpayer’s other items of income, gain, deduction, or loss (including interest income) that is properly allocable to excepted trades or businesses is excluded from the calculation of the taxpayer’s section 163(j) limitation. Reg. § 1.163(j)-10 provides rules for allocating these items among excepted and non-excepted trades or businesses. Like the 2018 Proposed Regulations, the Final Regulations reiterate that a taxpayer must determine whether interest expense or interest income is properly allocable to a trade or business prior to determining whether these items are properly allocable to an excepted or non-excepted trade or business. A non-C corporation taxpayer will generally make this initial determination by applying Reg. § 1.163-8T, as well as 2020 Prop. Reg. §§ 1.163-14 and 15 for partnerships and S corporations to the extent applicable. The Final Regulations generally retain the asset basis approach and entity look-through rules to determining whether business interest expense is properly allocable to an excepted or non-excepted trade or business.

Asset basis testing periods

The 2018 Proposed Regulations would have required a quarterly determination of the taxpayer’s adjusted basis in excepted and non-excepted trade or business assets to determine the average relative amount of asset basis for its excepted and non-excepted trades or businesses for a tax year. To alleviate the administrative burdens associated with this approach, the Final Regulations permit a taxpayer to average beginning and end of year asset basis so long as the percentage of the taxpayer’s basis attributable to excepted trade or business assets at the beginning and end of the year does not differ by more than 20%.

De minimis rules

The Final Regulations retain the mandatory application of the various “90% or more” de minimis rules for determining the percentage of a taxpayer’s asset basis for excepted and non-excepted businesses. 

Look-through rules

The Final Regulations generally retain the ability for a taxpayer to look-through a partnership, S corporation, non-consolidated C corporation or CFC for purposes of allocating the taxpayer’s basis in a partnership interest or stock to excepted or non-excepted trades or businesses and to characterize non-investment dividend income as excepted or non-excepted trade or business income.

  • The 80% vote and value ownership threshold is retained for a shareholder to be required to look through a domestic non-consolidated C corporation or CFC. However, under the Final Regulations, if a shareholder owns at least 80% of the value, but less than 80% of the vote, of a domestic non-consolidated C corporation or CFC, the shareholder may elect to look-through the entity.
  • The Final Regulations apply the constructive ownership rules under section 318(a) for purposes of determining eligibility for the corporate look-through rules, but only direct ownership is taken into account for purposes of the dividend look-through rule.
  • The Final Regulations provide that a partner’s basis in its partnership interest (which does not include the partner’s allocable share of debt for this purpose) is to be adjusted to take into account the modified adjusted basis rules that apply to direct ownership of property, but only if the partner applies the look-through rules to such partnership interest. The modified adjusted basis rules include the use of unadjusted basis for land and inherently permanent structures and the use of adjusted basis under the alternative depreciation system for depreciable property other than inherently permanent structures.

KPMG observation

The addition of an adjustment to a partner’s basis in a partnership interest to account for the modified adjusted basis of the assets held by the partnership is a helpful change that will substantially reduce distortions. For example, if a taxpayer directly owns an inherently permanent structure in an excepted trade or business, the taxpayer would use the taxpayer’s original cost basis in the structure for purposes of determining how much of the taxpayer’s basis is attributable to an excepted or non-excepted trade or business. Under the 2018 Proposed Regulations, if the taxpayer owned the same inherently permanent structure indirectly through a partnership, the taxpayer’s basis in the partnership interest would not have been increased to account for depreciation taken on the structure that reduced the taxpayer’s basis in the partnership interest, even if the taxpayer applied the asset basis look-through rules. The absence of an adjustment to the taxpayer’s basis in the partnership interest would potentially reduce the amount of the taxpayer’s business interest expense allocable to the excepted trade or business held by the partnership. Under the Final Regulations, the taxpayer’s basis in the partnership interest is increased to account for the depreciation of the structure to more closely align the taxpayer’s business interest allocation to a situation where the taxpayer owns the inherently permanent structure directly.

 
  • Under the 2018 Proposed Regulations, a taxpayer would not have been able to look-through an entity that is eligible for the small business exemption. The Final Regulations allow a taxpayer to look through an entity that is eligible for the small business exemption, provided the small business entity makes an election for its trade or business to be an excepted trade or business under Reg. § 1.163(j)-9.

KPMG observation

The ability to look through an entity that is eligible for the small business exemption will enable a direct or indirect owner of such exempt entity to allocate business interest expense to an excepted trade or business held directly or indirectly by such exempt entity. It is important to note, however, that the Final Regulations appear to only allow the application of the look-through rule to exempt businesses that make an excepted business election under Reg. §1.163(j)-9. It appears that such an election can only be made by an exempt business to the extent the exempt business directly holds a business that is eligible to be an excepted trade or business. Accordingly, if an upper-tier exempt entity does not directly hold a business that is eligible to be an excepted trade or business, a taxpayer that owns an interest in such exempt entity will not be able to look through such exempt entity in order to allocate the taxpayer’s business interest expense to an excepted trade or business owned indirectly by such exempt entity.

 

Disallowed disqualified interest

The 2018 Proposed Regulations reserved on the allocation of business interest expense, including carryforwards, for which a deduction was disallowed under old section 163(j) in the taxpayer’s last tax year beginning before January 1, 2018, and that was carried forward under old section 163(j) (“Disallowed Disqualified Interest”). The Final Regulations provide that a taxpayer may allocate Disallowed Disqualified Interest between excepted and non-excepted trades or businesses using a “historical approach” or an “effective date approach.” Under a historical approach, the taxpayer would allocate Disallowed Disqualified Interest between excepted and non-excepted trades or businesses by applying the Reg. § 1.163(j)-10 allocation rules in the tax year in which such interest expense was actually paid or accrued. Under an effective date approach, the taxpayer would allocate Disallowed Disqualified Interest between excepted and non-excepted trades or business by applying the Reg. § 1.163(j)-10 allocation rules as if the Disallowed Disqualified Interest was paid or accrued in the taxpayer’s first tax year beginning after December 31, 2017.

KPMG observation

The option to use the either the historical approach or the effective date approach provides a great deal of flexibility in determining the allocation of Disallowed Disqualified Interest between excepted and non-excepted trades or businesses. The treatment of Disallowed Disqualified Interest initially would have been determined on a taxpayer’s 2018 tax return and Reg. § 1.163(j)-10(c)(4) provides that disallowed business interest expense carryforwards are not re-allocated between non-excepted and excepted trades or businesses in a succeeding tax year. Accordingly, it seems that a taxpayer would have to amend its 2018 tax return (or file an administrative adjustment request, if applicable) to change the allocation of Disallowed Disqualified Interest between the taxpayer’s excepted and non-excepted trades or businesses under the historical approach or the effective date approach.

Direct allocations for qualified nonrecourse indebtedness

The Final Regulations continue to require a taxpayer to allocate qualified nonrecourse indebtedness, within the meaning of Reg. § 1.861-10T(b) (with certain modifications), directly to the excepted or non-excepted assets encumbered by such indebtedness. Under the 2018 Proposed Regulations, for purposes of allocating a taxpayer’s business interest expense between excepted and non-excepted trades or businesses, a taxpayer would have been required to reduce the taxpayer’s basis in excepted or non-excepted trade or business assets, as applicable, by the taxpayer’s entire basis in the assets encumbered by such qualified nonrecourse indebtedness. To alleviate the distortions that would have resulted from this rule, the Final Regulations only require a taxpayer to reduce the basis in the taxpayer’s excepted or non-excepted trade or business assets up to the amount of the qualified nonrecourse indebtedness, but not below zero.

Contact us

For more information, contact a tax professional with KPMG's Washington National Tax:

Jon Finkelstein | +1 (202) 533 3724 | jfinkelstein@kpmg.com

Ossie Borosh | +1 (202) 533 5648 | oborosh@kpmg.com