The 20% of qualified domestic business income (QDBI or called QBI in the regulations) deduction under Internal Revenue Code Section 199A is one of the most complex provisions of the Tax Cuts and Jobs Act, enacted on December 22, 2017.
Even professional tax return preparers will be challenged when computing the deduction for higher-income taxpayers. Any taxpayer who owns an unincorporated business or an S corporation should get professional help for preparing their 2018 income tax returns.
The IRS issued final regulations on January 18, 2019, and a corrected version of the final regulations on February 1, 2019. The final regulations were published in the Federal Register on February 8, 2019, after a delay because of the federal shutdown. The IRS incorporated many of the suggestions that they received in response to proposed regulations that were issued on August 8, 2018, so the final regulations are “new and improved.”
The deduction is effective for taxable years beginning after December 31, 2017. For 2018, taxpayers may elect to use the final regulations in their entirety, the proposed regulations in their entirety, or to only follow the Internal Revenue Code. No cherry-picking! In most cases, taxpayers should follow the final regulations, so they can use benefits like aggregation of businesses.
My printed copy of the final regulations, including the preamble, is 249 pages. I can only cover some highlights here. Professional tax return preparers should study the final regulations and attend the continuing education updates that are widely available.
The computation of the deduction is much simpler and more favorable for taxpayers below the income thresholds. The deduction is computed for individuals and for the undistributed income of trusts and estates.
The basics. The basic computation is 20% of qualified domestic business income. The total deduction under Section 199A is 20% of qualified domestic business income + 20% of qualified REIT dividends + 20% of qualified income from a publicly traded partnership + 9% of qualified production activity income from an agricultural cooperative. The total deduction is limited to 20% of taxable income in excess of net capital gain (including qualified dividends.)
If a taxpayer’s taxable income exceeds a threshold amount, things become more complicated.
The threshold amounts for 2018 are $315,000 for married, filing joint returns and $157,500 for other taxpayers. The threshold limitations are phased in from $315,000 to $415,000 for married, filing joint returns and $157,500 to $207,500 for other taxpayers. The threshold amounts will be indexed for inflation after 2018.
Once the thresholds are reached, the income of specified service trade and businesses (SSTBs) will be phased out and eliminated for the computation of the deduction.
In addition for taxpayers over the thresholds, for income other than from qualified REIT dividends, publicly-traded partnerships or agricultural cooperatives, the deduction will be limited to the greater of (1) 50% of W-2 wages paid, or (2) 25% of W-2 wages + 2.5% of unadjusted basis immediately after acquisition (UBIA.) The limitation is applied for each trade or business or aggregated trades or businesses.
The 20% deduction for QDBI is the same amount for the alternative minimum tax as for the regular tax.
Qualified domestic business income (QDBI, or called QBI in the regulations). Qualified domestic business income means the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business (or aggregated trade or business) as determined under the rules for Internal Revenue Code Section 199A. Only income for business conducted in the United States (including Puerto Rico) qualifies for the deduction. The trade or business must be conducted as a passthrough entity, including sole proprietorships, partnerships, S corporations, and LLCs taxed as sole proprietorships, partnerships or S corporations.
The income of S corporations must be reduced by reasonable compensation paid to shareholders. If an S corporation doesn’t pay reasonable compensation, the IRS can reclassify part of the income as wages. This rule doesn’t apply to partnerships or LLCs taxed as partnerships, because partnerships don’t have a reasonable compensation requirement as corporations do.
Any income taxed as capital gains, including some net gains from the sale of business assets called net Section 1231 gains, are excluded from QDBI. Other investment income such as most interest income and qualified dividends income are also excluded from QDBI.
Interest income that is business income, such as the income of banks from making loans or late charges for accounts receivable, is included in QDBI.
Ordinary income or losses relating to the sale of business assets, including depreciation recapture and net Section 1231 losses, are included in QDBI.
Income from the trade or business of being an employee is excluded from QDBI.
Guaranteed payments to partners are also excluded from QDBI because they are considered similar to wage and interest income.
QDBI is reduced for deductions relating to the income, including the deduction for self-employment taxes, self-employed retirement contributions and the self-employed medical insurance deductions for adjusted gross income.
A controversial matter is whether net rental income from a real estate operation qualifies as a trade or business. The IRS has separately issued Notice 2019-07, a proposed revenue procedure for a safe harbor for real estate operations to qualify as trades or businesses qualifying for the deduction. I have written a separate blog post about Notice 2019-07. http://www.michaelgraycpa.com/posts/irs-issues-safe-harbor-for-rental-real-estate-qualification-for-20-qualified-business-income-deduction/
Loss considerations. The final regulations make it clear that loss limitation rules, such as the passive activity loss rules, at-risk rules and losses limited by basis, are applied before the rules to compute the 20% QDBI deduction. Any loss carryovers from taxable years beginning before January 1, 2018 are disregarded when making the 20% QDBI computations. According to other proposed regulations, REG-134652-18, any future carryovers of those losses are treated as coming from a separate trade or business and are not aggregated with the current-year income of the entity that generated the loss.
Grouping under the passive activity loss rules and the election to be a real estate professional are disregarded for the 20% of QDBI deduction computations.
The negative qualified business income of any entity is allocated and applied to the positive qualified business income of any other entities. Any losses in excess of the total positive business income of the other entities is disregarded and carried forward to the next taxable year. The total loss carryforward will be considered to come from a separate entity in the subsequent taxable year.
The loss limitation is applied separately for publicly traded partnerships and any excess loss is carried forward separately as a loss from a publicly traded partnership.
Passthrough entities (RPEs). The income from a relevant passthrough entity (RPE) (partnership, S corporation, estate or trust) with a taxable year ending in 2018 will be used to compute the 20% of QDBI deduction computations for 2018. These entities might have already issued Schedule K-1s omitting the necessary information. They should consider amending their income tax returns and issuing amended Schedule K-1s including the required information. (The final regulations provide that amended returns can be filed for this purpose.) Otherwise, the W-2 wages and QBIA for the entity will be considered to be zero!
W-2 wages. W-2 wages will generally be determined based on W-2s issued by the entity during the calendar year ending within the taxable year of the entity. A taxpayer may include W-2 wages paid by an employee leasing company on its behalf. In that case, the employee leasing company can’t include those wages for its computation of the 20% of QDBI deduction. (No double counting!) Payments to common law employees who report their income as self-employed aren’t included in W-2 wages. W-2 wages do not include any amount that is not properly included in a return filed with the Social Security Administration on or before the 60th day after the due date (including extensions) for W-2s. File Forms W-2 for your employees on time!
A taxpayer must allocate W-2 wages to the trades or businesses that they relate to. Wages paid for nondeductible items like household workers are disregarded.
The IRS has issued Revenue Procedure 2019-11 with methods for computing W-2 wages.
Unadjusted basis when initially acquired (UBIA). Unadjusted basis when initially acquired (UBIA) is the tax basis of depreciable property before applying accumulated depreciation, including bonus depreciation and the Section 179 expense election. The property must be held by and available for use in the trade or business at the close of the taxable year and must have been used at any point during the taxable year in the trade or business’s production of QDBI.
The depreciable period for the property must have not ended before the close of the individual’s or reporting passthrough entity’s taxable year for it to be included in UBIA. The depreciable period is the lesser of (1) 10 years after the property was placed in service, or (2) the last day of the depreciable life of the property. This means the depreciable period for most personal property is 10 years, the depreciable period for most residential real estate is 27.5 years and the depreciable period for most commercial real estate is 39 years.
There is an anti-abuse provision that property acquired within 60 days of the end of the taxable year and disposed of within 120 days of acquisition without having been used in a trade or business for at least 45 days prior to disposition will be excluded from UBIA.
Basis information for property aquired in tax years ending before 2018 will have to be determined relating to property contributed in a tax-free transaction by a partner or shareholder with a partnership (including most LLCs) or an S corporation. Carryover information also applies for qualified property received in a Section 1031 exchange or a Section 1033 involuntary conversion. Additional amounts invested in property received in a Section 1031 exchange or a Section 1033 involuntary conversion will be treated as the acquisition of another piece of property with an acquisition date when placed in service and its own depreciable period.
The UBIA of inherited property will generally be the fair market value on the date of death. The acquisition date for inherited property will generally be the date of death.
The final regulations allow a Section 743(b) adjustment relating to a transfer of a partner’s interest of depreciable property to be included in UBIA. A Section 734(b) adjustment relating to the liquidation of a partner’s interest is not included in UBIA.
Aggregation. A significant change in the final regulations is allowing aggregation by a relevant passthrough entity. Under the proposed regulations, only the individual taxpayer, estate or trust that claimed the 20% of QDBI deduction could make the aggregation election. This is a simplification measure that will make reporting on Schedule K-1 easier for some passthrough entities. The election by the passthrough entity should be done thoughtfully, because it is irrevocable and may negatively affect some partners who might have chosen different aggregation.
Aggregation, or combining two or more trade or business operations, can be helpful to make limitation amounts for W-2 wages and UBIA from one operation available for income in another operation.
These are the requirements for aggregation:
- The same person or group of persons must own 50% or more of each trade or business to be aggregated;
- The common ownership must be in place for the majority of the taxable year, including the last day of the taxable year (change from the proposed regulations), in which the items attributable to each trade or business to be aggregated are included in income;
- All of the trades or businesses must report on returns with the same taxable year (watch fiscal year passthrough entities!);
- A specified service trade or business isn’t eligible to be aggregated;
- The trades or businesses to be aggregated must satisfy at least two of the following factors:
- The trades or businesses provide products, property or services that are the same or customarily offered together.
- The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources or information technology resources.
- The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain interdependencies.)
A rental of equipment or real estate to a commonly-controlled trade or business should qualify for aggregation. They share significant centralized business elements (B) and rely upon one another (C).
According to the final regulations, the rental or licensing of tangible or intangible property that does not rise to the level of a Section 162 trade or business is nevertheless treated as a trade or business for purposes of Section 199A, if the property is rented or licensed to a trade or business conducted by the individual or an RPE which is commonly controlled.
Once a taxpayer chooses to aggregate two or more businesses, the same aggregation must be followed in all subsequent taxable years, unless there is a change in facts such as the liquidation of a business.
The taxpayer (including RPEs) must make certain disclosures or the IRS can disallow the aggregation.
Specified service trade or business (SSTB). Once a taxpayer exceeds the thresholds, the 20% deduction for QDBI relating to a specified service trade or business (SSTB) is phased out and eliminated.
The listed SSTBs are health, law, accounting, actuarial science, performing arts, consulting (excluding architecture and engineering), athletics, financial services, brokerage services, investing and investment management, trading, dealing in securities, partnership interests or commodities, and 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 final regulations generally are the same as the proposed regulations relating to the SSTBs, with some clarification and additional examples.
Health includes medical services provided by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals. Services by health spas that provide physical exercise or conditioning, payment processing, or the research, testing and manufacture and/or sales of pharmaceuticals or medical devices are not considered healthcare services.
Legal services include services provided by attorneys, paralegals, legal arbitrator, mediators and similar professionals. Services to law firms by printers, delivery services or stenography services are not legal services.
Accounting services are not determined by certification. Accountants, enrolled agents, tax return preparers, financial auditors and professionals providing similar services are considered to be providing accounting services.
Services in the performing arts includes individuals who participate in the creation of performing arts, including actors, singers, musicians, entertainers, directors, and similar professionals. The maintenance and operation of equipment or facilities for use in the performing arts and broadcasting services are excluded.
Consulting involves providing professional advice and counsel to clients to help achieve clients’ goals and solving problems. Consulting embedded in or ancillary to the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB is not included, provided there is no separate payment for the consulting services.
Athletics service includes the performance of services who participate in athletic competition, such as athletes, coaches, and team managers. The maintenances and operation of equipment or facilities for use in athletic events or broadcasting or distributing video of athletic events are excluded. Schools for teaching amateur sports skills should be excluded.
Sales of commodities relating to property that is stock in trade of a trade or business or that otherwise would be included in the inventory of a trade or business are excluded.
The most favorable provision relates to the last category. A trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owner includes any of the following.
- A trade or business in which a person receives fees, compensation or other income for endorsing products or services,
- A trade or business in which a person licenses or receives fees, compensation, or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or other symbols associated with the individual’s identity,
- Receiving fees, compensation, or other income for appearing at an event or on radio, television or another media format.
Receiving a partnership interest or the receipt of stock of an S corporation is included in fees, compensation or other income.
For a trade or business with gross receipts of $25 million or less for a taxable year, the trade or business is not an SSTB if less than 10% of the gross receipts of the trade or business are attributable to SSTB items. (If 10% or more of the gross receipts are attributable to SSTB items, the entire entity is treated as a SSTB.)
For a trade or business with gross receipts exceeding $25 million, the threshold will be 5% instead of 10%.
Taxpayers that have trades or businesses that include SSTB income and other income should consider splitting them into separate entities, including having separate books and records, to avoid recharacterizing what would otherwise be qualifying income to SSTB income under the above rule. Having a separate S corporation would clearly be a separate trade or business.
If a trade or business provides property or services to an SSTB that has 50% or more common ownership, that trade or business will also be treated as a separate SSTB with respect to the related parties. (For example, rental income from a building leased to a medical S corporation that has the same ownership will be SSTB income.) Common ownership can be direct or indirect through family members or related entities under Internal Revenue Code Sections 267(b) or 707(b).
Trade or business of performing services as an employee. Income from a trade or business of performing services as an employee is not QDBI. Reporting income on Form W-2 does not determine whether an individual is an employee. Whether an individual is an employee is a trade or business is determined by facts and circumstances.
An individual who was properly treated as an employee for Federal employment tax purposes and is later treated as not an employee while providing the same services to the trade or business will be presumed to be an employee for three years after ceasing the be treated as an employee for Federal Employment Services. This is a rebuttable presumption that can be disputed by providing records, such as contracts or partnership agreements, that corroborate the individual’s status as a non-employee.
Disclosure for relevant passthrough entities (RPEs). The final regulations include disclosure rules for RPEs. If an RPE fails to properly report any item, it is considered to be zero.
Estates and trusts. Information relating to income that is taxable to a beneficiary of an estate or trust should be reported on Schedule K-1s issued to the beneficiaries, including QDBI, W-2 wages, and UBIA for each trade or business (or aggregated trades and businesses.)
Income that isn’t distributed or distributable to the beneficiaries will be taxed to the estate or trust and the estate or trust will be eligible to claim the 20% of QDBI deduction relating to that income. This will require allocation of the QDBI, W-2 wages and UBIA between the estate or trust and the beneficiaries of the estate or trust.
Since the trust threshold for 2018 is $157,500, the final regulations include an anti-abuse rule requiring two or more trusts to be aggregated and treated as one trust if the trusts have substantially the same grantor or grantors and substantially the same beneficiary or beneficiaries. Spouses are treated as one person when applying this rule. This anti-abuse rule is effective for taxable years ending after December 22, 2017.
Conclusion. I hope this summary persuades many who are eligible for the 20% of QDBI deduction to get help with structuring their operations to maximize this tax benefit and to properly compute the deduction.
The software providers are scrambling to incorporate the requirements in their tax return preparation software.
You might not be able to correctly compute the deduction using the carryover information in the system. The output should be carefully reviewed to be sure it is complete, especially for desireable elections. If the information isn’t properly reported, the deduction could be lost entirely.