Proposed Regulations Section 199A, Qualified Business Income
The IRS has published seven proposed regulations addressing the qualified trade or business deduction under §199A, enacted under the Tax Cuts and Jobs Act. The §199A deduction will be available to individuals, trusts, and estates who have Qualified Business Income (QBI) from a sole proprietorship or Relevant Pass-Through Entity (RPE), such as a partnership or S Corporation. Such non-corporate taxpayers (herein collectively referred to as Individuals) will be able to deduct up to 20% of their QBI, subject to limitations later discussed. The qualified trade or business deduction is available for tax years beginning after 2017 and before 2026.
Taxpayers should pay close attention to income threshold rules and whether their trade or business qualifies as a Specified Service Trade or Business (SSTB), as both factors will impact the deductible amount, as shown in the following table. For income threshold rules, please continue reading on to Item I. Proposed Regs. §1.199A-1. For a discussion regarding SSTBs, please see Item V. Proposed Regs. §1.199A-5.
*Actual deduction will be limited to 20% of taxable income less net capital gain
Married Filing Jointly
- $315,000 and below
- $315,001 to $415,000
- $415,001 and above
Qualifying Trade or Business
- 20% of QBI
- 20% of QBI less “Reduction Amount”
- W-2 Wage & UBIA Test
- 20% of QBI
- 20% of “Applicable Percentage QBI” less Reduction Amount
- No Deduction
I. Proposed Regs. §1.199A-1: Operational Rules
If an individual has taxable income below $157,500, if filing single or $315,000, if filing joint, then the individual is entitled to a deduction equaling the lower of:
- 20% of the QBI plus 20% of the individual’s combined qualified Real Estate Investment Trust (REIT) dividends and qualified Publically Traded Partnership (PTP) income or
- 20% of the excess of the individual’s taxable income over net capital gain
- i.e. (Taxable income – Capital Gains) x 20%
Example: Aaron, an unmarried individual, operates a landscaping business as a sole proprietor. The business generated $100,000 in net taxable income in 2018. Aaron also has $7,000 in net capital gains in 2018. After non-business allowable deductions, his net taxable income is $74,000. Aaron’s §199A deduction is equal to the lesser of
- 20% of QBI: $100,000 x 20% = $20,000
- 20% of taxable income minus net capital gains: ($74,000 – 7,000) x 20% = $13,400
Therefore, Aaron is allowed a deduction of $13,400.
An individual must calculate the QBI from each of their trades or businesses and then net the amounts. If net QBI is less than zero, the amount will be carried forward as a loss from a qualified trade or business to the next year. This §199A carryforward does not affect the deductibility of losses for other provisions of the Code. For purposes of §199A, qualified REIT Dividends and PTP income amounts are accounted for separately from QBI and do not affect QBI. A separate §199A loss carryforward is required to track losses attributable to REIT dividends and PTP income independent from the QBI loss carryforward. This carryforward is used only to offset against future REIT dividends and PTP income, for purposes of §199A.
An individual with taxable income above the threshold amounts will be subject to additional limitations to determine their deduction. The individual must first calculate the “QBI Component” and add that to 20% of the sum of qualified REIT dividends and qualified PTP income. The result is compared to 20% of their taxable income fewer capital gains. The deduction will be the lesser of the two. For individuals over the threshold amount, QBI from SSTB’s is not included in this calculation.
The QBI Component is the lesser of:
- 20% of the QBI for the trade or business, or
- The greater of:
- 50% of W-2 wages with respect to that trade or business, or
- The sum of 25% of W-2 wages plus 2.5% of the Unadjusted Basis Immediately after Acquisition (UBIA) of Qualified Property concerning that trade or business
Individuals in the “phase-in range” must do further analysis to determine if the Reduction Amount applies. The lower limit of this range is the threshold amount, and the upper limit is the threshold amount plus $50,000 or $100,000 if filing jointly. For example, the phase-in range for a married filing joint taxpayer will be between $315,001 and $415,000. To determine if the reduction amount applies, the individual must compare the results of the QBI Component calculation. If 20% of QBI (step i) is less than the wage limit (step ii), then no Reduction Amount is required. However, if 20% of QBI is greater than the wage limit, the Reduction Amount must be calculated. The Reduction Amount is the difference between the amounts from test i and test ii above, multiplied by the ratio by which taxable income exceeds the phase-in range’s lower limit. The Reduction Amount is then subtracted from the result of step i to determine QBI. If the trade or business is an SSTB, an “Applicable Percentage” must be utilized to calculate the deduction, as referenced in the table above. The Applicable Percentage is calculated by subtracting the ratio by which taxable income exceeds the phase-in range’s lower limit from 100%. The SSTB’s QBI, wages, and UBIA are multiplied by the Applicable Percentage before applying the Reduction Amount described above. For further discussion, please see Proposed Regs. §1.199A-1(d).
- 199A deductions do not affect a partnership interest nor the basis of shareholder’s stock in an S Corp or the Accumulated Adjustment Account (AAA).
- Such deductions do not reduce net earnings from self-employment (under §1402) or net investment income (under §1411)
II. Proposed Regs. §1.199A-2 Determination of W-2 Wages and UBIA of Qualified Property
199A(b)(4) requires that wages must be properly allocable to QBI; that is, the associated wage expense used to compute QBI. Taxpayers who utilize a third party payor to pay and report wages to their employees may include those amounts when calculating the W-2 Wage limitation. For additional detail in calculating W-2 wages for §199A, please see IRS Notice 2018-64.
Qualified Property refers to tangible, depreciable property that is held by a trade or business at the close of the tax year, is used in the production of QBI, and for which the depreciable period has not ended before the tax year-end. The depreciable period is defined as beginning on the date the property is placed in service and ending on the later of 10 years after that date or the last day of the last full year in the recovery period under §168(c). Note that additional first-year depreciation does not affect such recovery period. Additionally, Proposed Reg. §1.199A-2(c)(1)(iii) clarifies that partnership special basis adjustments, such as under §§734 or 743, are not treated as Qualified Property.
Qualified Property acquired in a like-kind exchange, or involuntary conversion is treated as replacement Modified Accelerated Cost Recovery System (MACRS) property. For purposes of determining the UBIA depreciable period, the Placed in Service (PIS) date for the exchanged basis is carried over from the relinquished property. The PIS date of any excess basis in the replacement property is the date in which the replacement property is placed in service by the individual or RPE.
The UBIA of Qualified Property will generally be its cost as of the date the property is placed in service. UBIA should also reflect a reduction in basis for any non-business use percentage. The IRS explains the UBIA for property inherited from a decedent and immediately placed in service will be its Fair Market Value at the time of death.
If the Qualified Property is held by an RPE, the partner’s or shareholder’s share of UBIA is determined in the same way as the partner’s share of depreciation. That is, a partner or shareholder’s share of UBIA is the same proportion as the partner’s share of tax depreciation to the entity’s total tax depreciation for the year. The UBIA of Qualified Property not currently producing tax depreciation should be allocated in the same manner gain would be allocated in a hypothetical sale of the property, pursuant to §§704(b) and 704(c).
Note that property transfers made for the principal purpose of increasing the §199A deduction would be considered an abuse of the section. Therefore, property is not regarded as Qualified Property if it is acquired within 60 days of the tax year end and disposed of within 120 days without being used in a trade or business for at least 45 days prior to disposition, unless the taxpayer can demonstrate that the primary purpose was a reason other than increasing the §199A deduction.
III. Proposed Regs. §1.199A-3 QBI, Qualified REIT Dividends, and Qualified PTP Income
QBI equals the net amount of trade or business income, gain, deduction, and loss to the extent such items are conducted within the United States and included or allowed in determining taxable income. A qualified trade or business is a §162 trade or business other than the trade of performing services as an employee. Investment income including, but not limited to, short and long-term capital gains and losses, dividends, non-business interest, and income from annuities is not included in QBI. Specifically, if gain or loss is treated as capital under §1231, it is not QBI. Per further IRS explanation, a §1231 gain or loss that is ordinary in nature must be included in QBI. QBI also does not include reasonable compensation received by the taxpayer for services rendered or any guaranteed payment described in §707(c).
In certain instances, losses and deductions are currently disallowed by several sections of the Code. Proposed Regs. §1.199A-3(b)(1)(iv) states that disallowed losses from tax years before January 1, 2018, are not included in calculating QBI in a later year. Additionally, net operating losses should not be treated as QBI when carried forward in subsequent years; such NOLs should have been included in computing QBI in the year incurred.
A qualified REIT dividend means any dividend from a REIT which is not a capital gain dividend nor qualified dividend income. Further, the REIT stock must be held by the taxpayer for 45 days or more. Qualified PTP income is the sum of the taxpayer’s allocated net income from a PTP plus any gain or loss attributable to the PTP’s assets classified as ordinary income.
IV. Proposed Regs. §1.199A-4 Aggregation
An individual may aggregate the net income or loss from multiple trades or businesses if all of the following requirements are satisfied:
- Each trade or business must itself be a trade or business as defined in the regulations;
- The same person, or group of persons, owns a 50% or greater interest in each business to be aggregated;
- That ownership must exist for the majority of the year;
- Each trade or business must have the same taxable year;
- None of the trades or businesses is an SSTB;
- The businesses have enough commonality to be aggregated, demonstrated by meeting two of the three following tests:
- The businesses provide similar or customarily related products and services
- The businesses share facilities or share significant business elements (e.g., accounting, legal, HR, etc.)
- The businesses are operated in coordination with other businesses in the group
Example: W owns a 75% interest in S1, an S corporation, and a 75% interest in the capital and profits of PRS, a partnership. S1 manufactures clothing and PRS is a retail pet food store. W manages S1 and PRS.
W owns 50% or more of the stock of S1 and 50% or more of the capital and profits of PRS thereby satisfying the second requirement above. Although W manages both S1 and PRS, W is not able to satisfy the sixth requirement above as the two businesses do not provide goods or services that are the same or customarily offered together; there are no significant centralized business elements; and no facts indicate that the businesses are operated in coordination with, or reliance upon, one another. W must treat S1 and PRS as separate trades or businesses and is therefore unable to aggregate the two businesses.
When determining ownership for the above rules, an individual is considered to own the interest in each trade or business owned by the individual’s spouse, children, grandchildren, and parents.
For purposes of §199A, the rental of tangible or intangible property to a related trade or business is treated as a trade or business if the rental and the other business are commonly controlled. This rule comes into effect in instances where taxpayers segregate rental activity from operating businesses. The rule allows taxpayers to aggregate their rental and operational trades or businesses provided all above requirements are otherwise satisfied.
If an individual aggregates multiple businesses, the individual must combine the QBI, W-2 Wages, and UBIA for all aggregated businesses when applying the wage & UBIA limitations described in Proposed Regs. §1.199A-1(d).
Individuals must consistently report the aggregated group in later tax years unless there is a change in facts and circumstances. Every year, individuals must attach a statement to their returns detailing the trades or businesses being aggregated. This statement should include:
- A description of each trade or business;
- The name and EIN of each entity; and
- Information identifying any trade or business that was formed, ceased operations, was acquired or was disposed of during the taxable year.
The Treasury Department and IRS are still considering permitting aggregation by an RPE in a tiered structure. One possible approach would be allowing only the operating entity to aggregate the trades or businesses. Another approach would be permitting each tier to add the aggregated trade or business from a lower-tier, provided the aggregation requirements are otherwise satisfied had the businesses all been owned by the lower-tier entity. The Treasury and IRS are requesting comments on proposed approaches to tiered structures while maintaining the reporting requirements regarding QBI, W-2 wages, and UBIA.
V. Proposed Regs. §1.199A-5 SSTBs and the Trade or Business of Performing Services as an Employee
The definition of an SSTB for §199A is any trade or business providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.
The list of SSTBs provided by the IRS appears clear-cut in some areas and nuanced in others. For example, medical services performed by physicians, pharmacists, and veterinarians would be considered an SSTB, whereas services provided by health clubs or spas would not. The scenario of having the principal asset of a trade or business be the reputation or skill of its employees or owners is an especially broad category. Proposed Regs. §1.199A-5 (b)(2)(xiv) offers additional guidance for the “reputation or skill” component: a trade or business will be considered an SSTB if it receives compensation for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbol associated with their identity. Additionally, income earned from endorsements and appearances is considered to be SSTB income.
Example: H is a well-known chef and the sole owner of multiple restaurants, each of which is owned in a disregarded entity. Due to H’s skill and reputation as a chef, H receives an endorsement fee of $500,000 for the use of H’s name on a line of cooking utensils and cookware. H is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, H is also in the trade or business of receiving endorsement income. H’s trade or business consisting of the receipt of the endorsement fee for H’s skill and/or reputation is an SSTB.
Additionally, there is a proposed de minimis rule for a trade or business that has a small percentage of income from SSTBs. If a business has gross receipts of $25 million or less, and less than 10% of the gross receipts are attributable to the performance of services, the business is not considered an SSTB. For businesses with gross receipts greater than $25 million, the de minimis percentage is 5%.
Some taxpayers have contemplated strategies to separate administrative functions from their SSTBs in order to qualify the separated department for the §199A deduction; however, this strategy would not be consistent with §199A’s purposes. Therefore, this section provides that an SSTB include any trade or business with 50% or more common ownership that provides 80% or more of its property or services to an SSTB. Further, if a trade or business has 50% or more common ownership with an SSTB, even if they fall below the 80% threshold, the portion of the property or services provided to the SSTB will be treated as an SSTB.
Performing services as an employee are not considered a trade or business for purposes of §199A. Therefore, no items of income, gain, loss, or deduction generated from performing services, as an employee constitutes QBI.
VI. Proposed Regs. §1.199A-6 Relevant Passthrough Entities (RPEs), PTPs, Trusts, and Estates
An RPE must determine the items necessary for its owners to calculate the §199A deduction, using the four rules below:
- The RPE must determine if it is engaged in one or more trades or businesses. The RPE must also determine whether any of its trades or businesses is an SSTB.
- The RPE must determine the QBI for each trade or business it is engaged in.
- The RPE must determine the W-2 wages and UBIA of Qualified Property for each trade or business it is engaged in.
- The RPE must determine if it has any qualified REIT dividends and any income or loss from a qualified PTP.
The RPE must separately identify on Schedule K-1, each owner’s allocable share of QBI, W-2 wages, and UBIA of Qualified Property attributable to each trade or business as well as qualified REIT dividends and qualified PTP income or loss. An RPE must also provide on Schedule K-1, any of the details above flowing from a lower-tier RPE. The Schedule K-1 disclosure must indicate if any of the trades or businesses is an SSTB. Similar reporting requirements also apply to PTPs, trusts, and estates.
If the RPE fails to provide the required details, the owner’s share of positive QBI, W-2 wages, and UBIA of Qualified Property will be presumed to be zero.
VII. Proposed Regs. §1.643(f)-1 Treatment of Multiple Trusts
For purposes of §199A, the income threshold amount is determined at the trust level without regard to any distribution deductions. To prevent taxpayers from forming multiple trusts and effectively abusing the given thresholds, Congress has declared that if two or more trusts have the same grantor or primary beneficiary and the establishment of such trusts is primarily income tax avoidance; such trusts will be treated as a single trust for federal purposes.
Taxpayers should be advised that §6662(d)(1)(C) provides for a highly stringent penalty rule for any individual who substantially understates income tax by way of inaccurately claiming the §199A deduction.
It should be noted that the proposed regulations are not yet finalized by the Treasury Department and IRS, but they may be relied upon until such final regulations are published. §199A can be a great benefit over the next seven years, but it is inseparable from the bevy of detailed computations and required disclosures that are discussed in the proposed regulations. Since the potential benefits of §199A begin in the 2018 tax year, taxpayers would be well advised to consult their tax advisor as early as possible.
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 Internal Revenue Code of 1986, as amended