Section 199A, which generally provides a 20 percent deduction to individuals with respect to their qualified business income, has been one of the most talked-about (and commented on) aspects of the 2017 Tax Cuts & Jobs Act.¹ On June 24, 2020, the Department of Treasury (Treasury) and the Internal Revenue Service (IRS) published final regulations (the Final Regulations) that provide welcome guidance on a number of issues, including on how certain income earned by regulated investment companies (RICs), which include mutual funds and other types of investment entities, can generate a deduction for the individual shareholder of the RIC.²

Conduit Treatment for Qualified REIT Dividends Earned by RICs

RICs are corporations subject to the special rules of Part I of Subchapter M (sections 851 through 855). RICs generally can avoid paying most or all corporate-level tax by making distributions to their shareholders who then pay the resultant tax, in some cases preserving the underlying character (Conduit Treatment).³ For example, a RIC shareholder generally can obtain long-term capital gain treatment on his or her own tax return with respect to a distribution from a RIC where the underlying source of the distribution was a long-term capital gain.⁴

Section 199A is silent as to whether the general rule of Conduit Treatment applies to a RIC's qualified business income that would have eligible for the 20 percent deduction had an individual earned it directly. Due to the statutory restrictions on the assets and income of a RIC,⁵ this issue arises primarily with respect to income from real estate investment trusts (REITs) and publicly traded partnership (PTPs). 

The Final Regulations finalized proposed regulations issued on February 8, 2019 (the Proposed Regulations) relating to Conduit Treatment for qualified REIT dividends paid to RICs.⁶ Where an individual earns qualified REIT dividends directly, he or she is generally eligible for the section 199A deduction,⁷ and the Final Regulations provide the same result when a RIC shareholder receives a distribution from a RIC that it is attributable to a qualified REIT dividend.⁸ The Proposed Regulations were relatively uncontroversial – in the preamble to the Final Regulations Treasury and the IRS noted only that they "received one comment requesting that the proposed rules providing this treatment be finalized"⁹ – and the Final Regulations adopted them without significant change.

Qualified PTP Income: A Bridge Too Far? 

More interesting is the treatment of PTP income. Partnerships that are publicly traded are treated as partnerships for federal tax purposes so long as 90 percent or more of their gross income comes from qualifying sources, which include income and gains derived from the exploration, development, mining, production, processing, refining, transportation, or marketing of any mineral or natural resource.¹⁰ These types of income may fall into the definition of "qualified PTP income" in section 199A(e)(4) (generally, income that is qualified business income in the hands of the PTP) which is eligible for the 20 percent deduction. Indeed qualifying PTP income (along with qualified REIT dividends) receive favorable treatment under section 199A in the form of an exclusion from the W-2 wage/unadjusted basis of qualified property limitation, though they are still subject to the specified service trade or business (SSTB) rules.¹¹

The Proposed Regulations expressed skepticism about providing Conduit Treatment to PTP income, notwithstanding that Congress intended qualified PTP income to be eligible for the section 199A deduction when earned directly and that section 199A treats qualified PTP income and qualified REIT dividends similarly. Treasury and the IRS stated that "unlike conduit treatment for qualified REIT dividends received by a RIC, conduit treatment of qualified PTP income presents several novel issues."¹² Treasury and the IRS identified and requested comments on the following issues: 

• Uncertainty about whether RICs have sufficient qualified PTP income that it would be worth it to write rules permitting Conduit Treatment;
• Challenges about differentiating between RIC shareholders who are below the threshold at which the SSTB limitation applies ($315,000 of adjusted gross income for married filing jointly taxpayers) and those who are above it, as PTP income from an SSTB will be qualified business income for the former group but subject to a phase-out for the latter group;¹³
• Challenges relating to the treatment of losses from PTPs, which in general may be required to reduce qualified business income in a subsequent year;
• Concerns about whether allowing for Conduit Treatment for PTP income would conflict with the general treatment of RICs as "blockers" for effectively connected income for non-U.S. RIC shareholders and unrelated business taxable income from tax-exempt RIC shareholders, as by definition qualified PTP income is effectively connected with a U.S. trade or business; and  
• A general concern that implementing Conduit Treatment for PTP income is complex, and potentially in conflict with one of the policy goals behind the RIC regime which is simplicity.¹⁴

Several comment letters took up the challenge, but in the preamble to the Final Regulations Treasury and the IRS punted, and simply stated that they "continue to consider those comments and evaluate whether it is appropriate and practicable to provide conduit treatment for qualified PTP income or other income of a RIC to further the purposes of section 199A(b)(1)(B)."¹⁵ While there's no question that the calculations required would be complex – at least at the RIC level if not at the shareholder level – the preamble to Final Regulations makes no attempt to grapple with the approaches suggested by the comments. 

The Right Result? 

Section 199A says nothing about RICs one way or another, and the legislative history of the provision gives no indication that RIC distributions ought to qualify for section 199A treatment. Significantly, Treasury and the IRS proposed and finalized regulations permitting a RIC that receives qualified REIT dividends to pay section 199A dividend under the general authority granted under section 199A(f)(4) that directs them to prescribe regulations "as are necessary to carry out the purposes of" section 199A. What the "purposes" of section 199A beyond the obvious grant of a noncorporate tax deduction for certain types of income is somewhat of a mystery. Nevertheless it is clear that Congress intended to grant the deduction for both qualified REIT dividends and qualified PTP income where an individual earns those types of income directly. It is also clear that the policy behind the RIC rules is to provide RIC shareholders with the same tax treatment that would arise if they held the RIC's asset directly, i.e., Conduit Treatment.¹⁶ Given these two tenets, it is hard to argue that Congress intended to provide Conduit Treatment to qualified REIT dividends but not to qualified PTP income. Yet, that's where the Final Regulations leave us. 

Looking Ahead 

The practical impact of Treasury and the IRS's demur is that to the extent mutual funds own PTP shares, their shareholders continue to miss out on the benefits of section 199A. Notwithstanding that a RIC's PTP holdings are capped at 25 percent, a significant number of RICs focus on the energy sector with substantial PTP holdings.¹⁷ In order to claim the benefit of section 199A on their individual tax returns, U.S. shareholders of these funds need the funds to pass through the relevant information that would allow them to do so. That guidance wasn't in the Final Regulations, and given that Treasury and the IRS have already passed on this issue in two section 199A guidance packages, one can be forgiven for thinking it's not a priority. 

Treasury and the IRS left the door open to rules allowing Conduit Treatment for qualified PTP income in some future guidance, so there's still hope for RICs and their shareholders. But time is of the essence. The Final Regulations relating to RICs are generally applicable to taxable years beginning after the Federal Register publication date, though taxpayers may choose to apply the rules to previous years so long as they do so consistently for each such year. If Treasury and the IRS adopt Conduit Treatment for qualified PTP income with a similar effective date rule, it would mean that taxpayers could receive Conduit Treatment for most previous years only by filing amended returns and by doing so for each year in which it received qualifying RIC distributions, and then only if every RIC with qualified PTP income in which the taxpayer owned an interest for years in which section 199A applied (generally, 2018 and later) provided the necessary information. Some funds might be willing to go back and provide calculations for some years, but it is likely that many will not. Given that section 199A is scheduled to expire after 2025¹⁸ and the relatively slow pace of enactment for the REIT Conduit Treatment rules (proposed in February 2019, finalized in June 2020), even if Treasury and the IRS issue favorable rules, their impact may be limited. Of course, there is always the possibility that Congress could extend section 199A, which would increase the significance of any rules providing for Conduit Treatment for qualified PTP income. 

For more information, please contact:

Andy Howlett, ahowlett@milchev.com, 202-626-5821

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¹All "section" references are to the Internal Revenue Code of 1986, as amended and currently in effect. 
²T.D. 9899, RIN 1545-BP12 (June 24, 2020). For earlier coverage of section 199A regulations, see Andy Howlett, Final Section 199A Regulations Offer, Clarity, Questions, and Opportunity (Jan. 24, 2019), https://www.millerchevalier.com/publication/final-section-199a-regulations-offer-clarity-questions-and-opportunity. 
³See section 852. 
⁴Section 852(b)(3)(B).
⁵See section 851. 
⁶See 84 Fed. Reg. 3015.
⁷Section 199A(b)(1)(B). A qualified REIT dividend means any dividend from a real estate investment trust received during the taxable year which— (A) is not a capital gain dividend, as defined in section 857(b)(3), and (B) is not qualified dividend income, as defined in section 1(h)(11). Section 199A(e)(3). 
⁸Treas. Reg. § 1.199A-3(d). 
⁹RIN 1545-BP12 at 8.
¹⁰See section 7704(d).
¹¹See section 199A(b)(1)(A). Under section 199A(b)(2) a taxpayer's deduction for qualified business income derived from a qualified trade or business generally is limited to the lesser of (1) 20 percent or (2) the greater of 50 percent of the W-2 wages with respect to he qualified trade or business or 25 percent of such W-2 wages plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property. 
¹²84 Fed. Reg. at 3017. 
¹³Here, Treasury and the IRS asked commentators to consider "Whether SSTB items are sufficiently rare or incidental for PTPs that a conduit regime for PTP dividends should exclude all SSTB items[.]"  84 Fed. Reg. at 3018.  
¹⁴84 Fed. Reg. at 3018. 
¹⁵RIN 1545-BP12 at 10.
¹⁶See, e.g., Staff of the Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the 108th Congress (JCX-5-05) at 247 (May 2005) ("A regulated investment company ('RIC') generally is treated as a conduit for Federal income tax purposes.").
¹⁷See https://www.mlpassociation.org/wp-content/uploads/2019/01/Funds-List.pdf for an illustrative list of funds. Congress may have decided to permit RICs to own PTPs in part because it believed that "publicly traded partnerships may have improved access to capital markets if their interests were permitted investments of mutual funds." H.R. 108-548 Part I, at 152 (Conf. Rep. 2004), commenting on the change in law (section 851(b)(2)(B), (b)(3)(B)(iii) and (h)) that allowed RICs to own publicly traded partnerships. See American Jobs Creation Act of 2004, Pub. L. 108-357, § 331 (Oct. 22, 2004). 
¹⁸Section 199A(i). 

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