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Proposed reliance regs explain operation & calculation of Sec. 199A pass-through/QBI deduction

August 10, 2018

IRS has issued proposed reliance regs that explain the operation and calculation of the Code Sec. 199A pass-through, or “qualified business income” (QBI), deduction. This article provides definitions and computational rules regarding the Code Sec. 199A deduction.

For coverage of the proposed regs’ guidance on the limitations on the deduction for taxpayers with income exceeding the threshold amounts, see “Proposed reliance regs & Notice explain Sec. 199A W-2 wage and basis limitations.” For an explanation of the proposed regs’ guidance on specified service trades or businesses, “Proposed reliance regs explain specified service trade or business and trade or business of an employee.”

Background. For tax years beginning after 2017 and before 2026, Code Sec. 199A, which was enacted in the Tax Cuts and Jobs Act(TCJA, P.L. 115-97, 12/22/2017), and amended by the Consolidated Appropriations Act, 2018 (P.L. 115-141, 3/23/2018), allows individuals and some estates and trusts (but not corporations) a deduction of up to 20% of income from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate.

A taxpayer is allowed to deduct:

  1. the lesser of: (a) the “combined qualified business income amount” of the taxpayer, or (b) 20% of the excess, if any, of the taxable income of the taxpayer for the tax year over the sum of net capital gain and the aggregate amount of the qualified cooperative dividends of the taxpayer for the tax year; plus
  2. the lesser of: (i) 20% of the aggregate amount of the qualified cooperative dividends of the taxpayer for the tax year, or (ii) taxable income (reduced by the net capital gain) of the taxpayer for the tax year. (Code Sec. 199A(a))

The “combined qualified business income amount” means, for any tax year, an amount equal to: (i) the deductible amount for each qualified trade or business of the taxpayer (defined as 20% of the taxpayer’s QBI subject to the W-2 wage limit; see below); plus (ii) 20% of the aggregate amount of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income of the taxpayer for the tax year. (Code Sec. 199A(b))

QBI is generally defined as the net amount of “qualified items of income, gain, deduction, and loss” relating to any qualified trade or business of the taxpayer. (Code Sec. 199A(c)(1)) For this purpose, qualified items of income, gain, deduction, and loss are items of income, gain, deduction, and loss to the extent these items are effectively connected with the conduct of a trade or business within the U.S. under Code Sec. 864(c) and included or allowed in determining taxable income for the year. If the net amount of qualified income, gain, deduction, and loss relating to qualified trade or businesses of the taxpayer for any tax year is less than zero, the amount is treated as a loss from a qualified trade or business in the succeeding tax year. (Code Sec. 199A(c)(2)) QBI does not include: certain investment items; reasonable compensation paid to the taxpayer by any qualified trade or business for services rendered with respect to the trade or business; any guaranteed payment to a partner for services to the business under Code Sec. 707(c); or a payment under Code Sec. 707(a) to a partner for services rendered with respect to the trade or business.

The 20% deduction is not allowed in computing adjusted gross income (AGI), but rather is allowed as a deduction reducing taxable income. (Code Sec. 62(a))

Limitations. Except as provided below, the deduction cannot exceed the greater of:

  1. 50% of the W-2 wages with respect to the qualified trade or business (W-2 wage limit), or
  2. the sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” Qualified property is defined in Code Sec. 199A(b)(6) as meaning tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year, which is used at any point during the tax year in the production of qualified business income, and the depreciable period for which has not ended before the close of the tax year.

The above limit does not apply for taxpayers with taxable income below the “threshold amount” ($315,000 for married individuals filing jointly, $157,500 for other individuals, indexed for inflation after 2018). The application of the limit is phased in for individuals with taxable income exceeding the threshold amount, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals). (Code Sec. 199A(b)(3)) Thus, for 2018, the limit fully applies to married taxpayers with taxable income over $415,000 and other individuals with taxable income over $207,500.

For a partnership or S corporation, each partner or shareholder is treated as having W-2 wages for the tax year in an amount equal to his or her allocable share of the W-2 wages of the entity for the tax year. A partner’s or shareholder’s allocable share of W-2 wages is determined in the same way as the partner’s or shareholder’s allocable share of wage expenses. For an S corporation, an allocable share is the shareholder’s pro rata share of an item.

Service businesses. Except as provided below, the deduction does not apply to specified service businesses (SSTB, i.e., trades or businesses described in Code Sec. 1202(e)(3)(A), but excluding engineering and architecture; and trades or businesses that involve the performance of services that consist of investment-type activities). However, the disallowance of the deduction for specified service trades or businesses of the taxpayer does not apply for taxpayers with taxpayer income below the threshold amount described above. And, the benefit of the deduction for service businesses is phased out over the next $100,000 of taxable income for joint filers ($50,000 for other individuals). (Code Sec. 199A(d)) Thus, for 2018, the limit fully applies to married taxpayers with taxable income over $415,000 and other individuals with taxable income over $207,500.

In addition, the deduction does not apply to the trade or business of being an employee.

Cooperatives. Under Code Sec. 199A(g), specified agricultural or horticultural cooperatives may claim a special entity-level deduction that is substantially similar to the domestic production activities deduction under former Code Sec. 199.

Definitions.  The proposed regs provide the following definitions of terms used throughout the regs:

  • “Individual” means  an individual, trust (other than a grantor trust), estate, or other person eligible to claim the Code Sec. 199A deduction. (Prop Reg § 1.199A-1(a)(2))
  • “Trade or business” for purposes of Code Sec. 199A means a Code Sec. 162 trade or business other than the trade or business of performing services as an employee. In addition, rental or licensing of tangible or intangible property (rental activity) that does not rise to the level of a Code Sec. 162 trade or business is nevertheless treated as a trade or business for purposes of Code Sec. 199A, if the property is rented or licensed to a trade or business which is commonly controlled under Prop Reg § 1.199A-4(b)(1)(i). (Prop Reg § 1.199A-1(b)(13))
  • “Aggregated trade or business” means two or more trades or businesses that have been aggregated pursuant to Prop Reg § 1.199A-4.  (Prop Reg § 1.199A-1(b)(1))
  • “Applicable percentage” means, with respect to any tax year, 100% reduced (not below zero) by the percentage equal to the ratio that the taxable income of the individual for the tax year in excess of the threshold amount, bears to $50,000 (or $100,000 in the case of a joint return).  (Prop Reg § 1.199A-1(b)(2))
  • “Phase-in range” means a range of taxable income, the lower limit of which is the threshold amount, and the upper limit of which is the threshold amount plus $50,000 (or $100,000 in the case of a joint return).  (Prop Reg § 1.199A-1(b)(3))
  • “Qualified business income” (QBI) generally means the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business of the taxpayer, as determined under Prop Reg § 1.199A-3(b).  (Prop Reg § 1.199A-1(b)(4))
  • “QBI component” means  the amount determined under Prop Reg § 1.199A-1(d)(2) (see below).  (Prop Reg § 1.199A-1(b)(5))
  • “Qualified PTP income” means the amount defined in Prop Reg § 1.199A-3(c)(3).  (Prop Reg § 1.199A-1(b)(6))
  • “Qualified REIT dividends” are  defined in Prop Reg § 1.199A-3(c)(2).  (Prop Reg § 1.199A-1(b)(7))
  • “Reduction amount” means, with respect to any tax year, the “excess amount” multiplied by the ratio that the taxable income of the individual for the tax year in excess of the threshold amount, bears to $50,000 (or $100,000 in the case of a joint return). The excess amount is 20% of QBI over the greater of (i) 50% of W-2 wages or (ii) the sum of 25% of W-2 wages plus 2.5% of the UBIA of qualified property.  (Prop Reg § 1.199A-1(b)(8))
  • “Relevant passthrough entity” (RPE) means a passthrough entity that directly operates the trade or business, or that passes through the trade or business’ items of income, gain, loss, or deduction from lower-tier RPEs to the individual. (Prop Reg § 1.199A-1(b)(9))
  • “Specified service trade or business” (SSTB) means a specified service trade or business as defined in Prop Reg § 1.199A-5(b). (Prop Reg § 1.199A-1(b)(10))
  • “Threshold amount” means, for any tax year beginning before 2019, $157,500 (or $315,000 in the case of a taxpayer filing a joint return), indexed for inflation in tax years beginning after 2018. (Prop Reg § 1.199A-1(b)(11))
  • “Total QBI amount” means the net total QBI from all trades or businesses (including the individual’s share of QBI from trades or business conducted by RPEs). (Prop Reg § 1.199A-1(b)(12))
  • “Unadjusted basis immediately after acquisition (UBIA) of qualified property” is defined in Prop Reg § 1.199A-2(c) (see below). (Prop Reg § 1.199A-1(b)(14))
  • “W-2 wages” means a trade or business’s W-2 wages properly allocable to QBI as defined in Prop Reg § 1.199A-2(b) (see below). (Prop Reg § 1.199A-1(b)(15))

Computational rules.  An individual with income attributable to one or more domestic trades or businesses, other than as a result of owning stock of a C corporation or engaging in the trade or business of being an employee, and with taxable income (before computing the Code Sec. 199A deduction) at or below the threshold amount, is entitled to a Code Sec. 199A deduction equal to the lesser of: (i) 20% of the QBI from the individual’s trades or businesses plus 20% of the individual’s combined qualified REIT dividends and qualified PTP income; or (ii) 20% of the excess (if any) of the individual’s taxable income over the individual’s net capital gain. (Prop Reg § 1.199A-1(c)(1))

Carryover rules.  For purposes of Code Sec. 199A, if the net QBI with respect to qualified trades or businesses of the taxpayer for any tax year is less than zero, such amount is treated as a loss from a qualified trade or business in the succeeding tax year. (Code Sec. 199A(c)(2)Prop Reg § 1.199A-1(c)(2)(i) clarifies that the  Code Sec. 199A carryover rules do not affect the deductibility of the losses for purposes of other provisions of the Code.

If an individual has an overall loss after qualified REIT dividends and qualified PTP income are combined, the portion of the individual’s Code Sec. 199A deduction related to qualified REIT dividends and qualified PTP income is zero for the tax year. This overall loss does not affect the amount of the taxpayer’s QBI but is instead carried forward and used to offset combined qualified REIT dividends and qualified PTP income in the succeeding tax year(s) for purposes of Code Sec. 199A. (Prop Reg § 1.199A-1(c)(2)(ii))

Rules where individual’s income exceeds threshold.  For individuals with income above the threshold amount, the rules relating to the REIT/PTP component of the Code Sec. 199A deduction apply as they do to individuals with taxable income below the threshold amount (Prop Reg § 1.199A-1(d)(1)), but the QBI component is subject to limitations, including the exclusion or reduction of items from an SSTB and limitations based on the W-2 wages of the trade or business (the wage limit) or a combination of the W-2 wages and the UBIA of qualified property (wage/UBIA limit).  (Prop Reg § 1.199A-1(d)(2))

If an individual’s taxable income is above the threshold amount but within the phase-in range, then the individual must calculate an applicable percentage that limits the QBI, W-2 wages, and UBIA of qualified property from an SSTB that are used to calculate the individual’s Code Sec. 199A deduction. If the individual’s taxable income is above the phase-in range, then no amount of QBI, W-2 wages, or UBIA of qualified property from an SSTB can be used by the individual in calculating the individual’s Code Sec. 199A deduction. (Prop Reg § 1.199A-1(d)(2)(i))

An individual must determine the W-2 wages and the UBIA of qualified property attributable to each trade or business contributing to the individual’s combined QBI under the Prop Reg § 1.199A-2, then compare these amounts to QBI in order to determine an individual’s QBI component for each trade or business. After determining the QBI for each trade or business, the individual must compare 20% of that amount to the alternative limitations—i.e., the wage limit, and the wage/UBIA limit—for that trade or business.  (Prop Reg § 1.199A-1(d)(2)(ii), Prop Reg § 1.199A-1(d)(2)(iv))

If 20% of the QBI of the trade or business is greater than the relevant alternative limitation, the QBI component is limited to the amount of the alternative limitation. If (i) an individual’s taxable income is within the phase-in range, and (ii) 20% of QBI is greater than either of the limitation amounts, then the individual’s QBI component for the trade or business is instead equal to 20% of QBI reduced by the reduction amount as described in Prop Reg §1.199A-1(d)(iv)(B). (Prop Reg § 1.199A-1(d)(2)(iv)(B))

If an individual has QBI of less than zero from one trade or business, but has overall QBI greater than zero when all of the individual’s trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the wage and wage/UBIA limits. (Prop Reg § 1.199A-1(d)(2)(iii)(A)) The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the wages/UBIA limit, the net gain or income with respect to each trade or business (as offset by the apportioned losses) is the taxpayer’s QBI with respect to that trade or business. The W-2 wages and UBIA of qualified property from the trades or businesses which produced negative QBI are not taken into account for purposes of Prop Reg §1.199A-1(d), and are not carried over into the subsequent year. (Prop Reg § 1.199A-1(d)(3)(iii)(B))

Special rules.  The proposed regs also provide that:

  • The Code Sec. 199A deduction, which is applied at the partner or shareholder level in the case of a partnership or S corporation under Code Sec. 199A(f)(1), has no effect on either the adjusted basis of the partner’s interest in the partnership or the shareholder’s stock in an S corporation, or the S corporation’s accumulated adjustments account. (Prop Reg § 1.199A-1(e)(1))
  • The Code Sec. 199A deduction does not reduce net earnings from self-employment under Code Sec. 1402 or net investment income under Code Sec. 1411. (Prop Reg § 1.199A-1(e)(2))
  • In the case of a taxpayer with QBI from within Puerto Rico, if such income is taxable under Code Sec. 1 for a tax year, then for purposes of determining QBI of such individual for such tax year, the term “United States” includes Puerto Rico. (Prop Reg § 1.199A-1(e)(3))
  • For purposes of determining alternative minimum taxable income under Code Sec. 55, the deduction allowed under Code Sec. 199A(a) for a tax year equals the Code Sec. 199A(a) deduction allowed in determining taxable income for that tax year (i.e., without regard to any adjustments under Code Sec. 56 through Code Sec. 59(. (Prop Reg § 1.199A-1(e)(4))
  • The substantial underpayment penalty under Code Sec. 6662(d)(1)(C) generally applies when the understatement exceeds 10% of the tax required to be shown on the return or $5,000, but, in the case of a taxpayer who claims the Code Sec. 199A deduction for the tax year, the 10% figure is reduced to 5%. (This rule is cross-referenced in Prop Reg § 1.199A-1(e)(5))
  • In the case of any qualified trade or business of a patron of a specified agricultural or horticultural cooperative, the amount determined under Code Sec. 199A(b)(2) with respect to such trade or business is reduced by the lesser of (A) 9% of so much of the QBI with respect to such trade or business as is properly allocable to qualified payments received from such cooperative, or (B) 50% of so much of the W-2 wages with respect to such trade or business as are so allocable. (Prop Reg § 1.199A-1(e)(6))

Effective date. The proposed regs would generally apply to tax years ending after the date the Treasury decision adopting them as final regs is published in the Federal Register, but taxpayers may rely on the proposed regs pending their finalization. (Prop Reg § 1.199A-1(f))

References:  For the QBI deduction, see FTC 2d/FIN ¶L-4305 et seq; United States Tax Reporter ¶199A4.