This article is based on my response to a question raised on an online forum. The person asking the question recognized the issue, but because I’ve encountered some advisers who have come to believe the safe harbor is “the” test for rentals I wanted to clarify matters a bit. Hopefully this helps.
Facts: An LLC operates a shopping center with many tenants. While the leases are all triple net leases, the manager spends over 250 hours a year dealing with items related to the center, including collecting rents, paying the bills, finding new tenants, dealing with vendors and keeping the records of the operation. The operation doesn’t qualify for the safe harbor of Notice 2017-07 due to being a set of triple net leases. Does that mean it cannot be a trade or business for Section 199A purposes?
First, let’s start with the important note that the safe harbor of Notice 2019-07 is just that--a safe harbor. So being unable to use the safe harbor or failing to meet the tests in the safe harbor does not mean you don't have a trade or business. It just means you have to look elsewhere to make this determination.
Triple net leases are a bit of a problem, but if you look at the cases the ones that have held a triple net lease situation is not a trade or business are rather distinct from what we are looking at as the owners normally had one lease and for the time in question just were collecting rent.. And, in a closely related determination under ERISA, the Seventh Circuit in Central States Pension Fund v. Personnel, Inc., 974 F.2d 789 (7th Cir. 1992) found a trade or business when the other activities related to the triple-net leases were significant (the court specifically used the IRC Section 162 test for what was a trade or business).
The issue is to test under Commissioner v. Groetzinger, 480 U.S. 23 (1987) which is the key U.S. Supreme Court case on whether an undertaking rises to a trade or business. Under Groetzinger the test to see if you have a §162 trade or business is if the LLC can show:
Its involvement (including that of its agents and members) is continuous and regular and
The primary purpose of running the center is income or profit
While a single triple net lease would have problems rising to that level (the involvement would generally not be continuous), this is far more than a single triple net lease--this is operation of a shopping center that requires a significant level of engagement by a manager to run the business.
Note that the test has to be whether the partnership (which the LLC is pretending to be under the IRC based on its check the box decision) meets the Groetzinger standard since RPE (relevant passthrough entities) are the level at which trade or business status is determined for any undertaking held directly by an RPE. If it does, it’s a trade or business for all three partners. If it doesn’t, it’s not a trade or business with respect to any. This isn't like the passive activity rules--they all sink or swim together on this one.
I certainly think we have a very strong case this is a trade or business and, in fact, if it somehow showed a loss I think the IRS would have a strong case to force the members to recognize negative QBI (this can cut both ways, something often lost in the rental discussions I’ve seen to date).
I would certainly suggest that an adviser explain the justification, likely in a Form 8275, to stop an agent from going far down that rabbit hole in an exam. As well, the client needs to be briefed on the fact that it is possible an IRS agent might come to different conclusion, especially in cases that move closer to the single triple net lease situations.
That is, there simply is no “bright line” test for what is a trade or business. The U.S. Supreme Court rejected the suggestion that such a bright light should exist in this area. The matter always depends on the facts and circumstances of the situation, which means advisers have to exercise their professional judgment in applying the general Groetzinger rules to their specific facts.
The proposed safe harbor in Notice 2019-07 needs to viewed as just one tool that can, but does not have to, be used in determining if there is a trade or business. The Notice added a tool, but it did not remove any tools that we were able to make use of before the final regulations.