IRS has issued final Code Sec. 199A regs for determining the amount of the 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 Code Sec. 199A deduction). This article discusses the changes in the final regs from the previously issued proposed regs on computing qualified business income (QBI).
Background. Generally for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, Code Sec. 199A, as added by the the Tax Cuts and Jobs Act (TCJA; P.L. 115-97, 12/22/2017) allows a deduction to a non-corporate taxpayer, including a trust or estate, who has qualified business income (QBI) from a partnership, S corporation, or sole proprietorship. The deduction 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 net capital gains 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); 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.
In August 2018, IRS issued proposed regs on the Code Sec. 199A deduction.
Final regs. The final regs adopt many of the rules described in the proposed regs, with certain revisions in response to comments. Clarifying language and additional examples have been added throughout the final regs.
The proposed regs provide that previously disallowed losses or deductions —including under Code Sec. 465 (dealing with the at-risk rules), Code Sec. 469 (dealing with passive activity losses), Code Sec. 704(d) (limiting a partner’s distributive share of partnership loss to the extent of the adjusted basis of such partner’s interest), and Code Sec. 1366(d) (special rules for S corporation losses and deduction) — allowed in the tax year are taken into account for purposes of computing QBI so long as the losses were incurred in a tax year beginning after Jan. 1, 2018. IRS agrees that taxpayers with previously disallowed losses for tax years beginning both before and after Jan. 1, 2018, require an ordering rule to determine which portion of a previously disallowed loss can be taken into account for purposes of Code Sec. 199A. Consistent with regs under former Sec. 199 (the domestic production activities deduction), the final regs provide that any losses disallowed, suspended, or limited under the provisions of Code Sec. 465, Code Sec. 469, Code Sec. 704(d), and Code Sec. 1366(d), or any other similar provisions, are used, for purposes of Code Sec. 199A and the regs, in order from the oldest to the most recent on a first-in first-out (FIFO) basis.
Reg § 1.199A-3(b)(1)(v) retains and clarifies the rule that while a deduction under Code Sec. 172 for a net operating loss is generally not considered to be with respect to a trade or business (and thus not taken into account in determining QBI), an excess business loss under Code Sec. 461(l) is treated as a net operating loss carryover to the following tax year and is taken into account for purposes of computing QBI in the subsequent tax year in which it is deducted. Excess business losses are not allowed for the tax year but are instead carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent tax years; an excess business loss for the tax year is the excess of aggregate deductions of the taxpayer attributable to the taxpayer’s trades and businesses, over the sum of aggregate gross income or gain of the taxpayer plus a threshold amount. The threshold amount for a tax year is $500,000 for married individuals filing jointly, and $250,000 for other individuals, with both amounts indexed for inflation.
All deductions attributable to a trade or business should be taken into account for purposes of computing QBI except to the extent provided by Code Sec. 199A and the regs. Accordingly, Reg § 1.199A-3(b)(1)(vi) provides that, in general, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of Code Sec. 199A and Reg § 1.199A-3 are otherwise satisfied. Thus, for purposes of Code Sec. 199A, deductions such as the deductible portion of the tax on self-employment income under Code Sec. 164(f), the self-employed health insurance deduction under Code Sec. 162(l), and the deduction for contributions to qualified retirement plans under Code Sec. 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis. IRS declined to address whether deductions for unreimbursed partnership expenses, the interest expense to acquire partnership and S corporation interests, and state and local taxes are attributable to a trade or business as such guidance is beyond the scope of these regs.
Although Code Sec. 199A is silent with respect to partnership guaranteed payments for the use of capital, Code Sec. 199A does limit the deduction under Code Sec. 199A to income from qualified trades or businesses. IRS believes that guaranteed payments for the use of capital are not attributable to the trade or business of the partnership because they are determined without regard to the partnership’s income. Consequently, such payments should not generally be considered part of the recipient’s QBI. Rather, for purposes of Code Sec. 199A, guaranteed payments for the use of capital should be treated in a manner similar to interest income. Interest income other than interest income which is properly allocated to trade or business is specifically excluded from qualified items of income, gain, deduction or loss under Code Sec. 199A(c)(3)(B)(iii). One commenter noted that if guaranteed payments are treated like interest income for purposes of Code Sec. 199A, and if such payments are properly allocated to a qualified trade or business of the recipient, they should constitute QBI to that recipient in respect of such qualified trade or business. Although, this is an unlikely fact pattern to occur, IRS agrees with this comment and the final regs adopt this comment.
Prop Reg 1.199A-3(b)(2) of the proposed regs addresses items that were not taken into account as qualified items of income, gain, deduction, or loss, and includes all of the items listed in both Code Sec. 199A(c)(3) (exceptions from qualified items of income, gain, deduction, and loss) and Code Sec. 199A(c)(4) (treatment of reasonable compensation and guaranteed payments). The final regs clarify that amounts received by an S corporation shareholder as reasonable compensation or by a partner as a payment for services under Code Sec. 707(a) or Code Sec. 707(c) are not taken into account as qualified items of income, gain, deduction, or loss, and thus are excluded from QBI.
The proposed regs provide that any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss—including any item treated as one of such items, such as gains or losses under Code Sec. 1231 (dealing with certain property used in a trade or business), that are treated as capital gains or losses—are not taken into account as a qualified item of income, gain, deduction, or loss in computing QBI. To avoid any unintended inferences, the final regs remove the specific reference to Code Sec. 1231 and provide that any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss, including any item treated as one of such items under any other provision of the Code, is not taken into account as a qualified item of income, gain, deduction, or loss. To the extent an item is not treated as an item of capital gain or capital loss under any other provision of the Code, it is taken into account as a qualified item of income, gain, deduction, or loss unless otherwise excluded by Code Sec. 199A or these regs.
The proposed regs provide that if an individual or a relevant passthrough entity (RPE) directly conducts multiple trades or businesses, and has items of QBI which are properly attributable to more than one trade or business, the individual or RPE must allocate those items among the several trades or businesses to which they are attributable using a reasonable method based on all the facts and circumstances; the chosen reasonable method for each item must be consistently applied from one tax year to another and must clearly reflect the income and expenses of each trade or business. The final regs retain the rule in the proposed regs. They provide that once a method is chosen for an item, it must be applied consistently with respect to that item.
Effective date. The final regs are effective when published in the Federal Register. However, taxpayers may rely on the rules set out in Reg § 1.199A-1 through Reg § 1.199A-6, in their entirety, or on Prop Reg § 1.199A-1 through Prop Reg § 1.199A-6 issued on Aug. 16, 2018, in their entirety, for tax years ending in calendar year 2018. To prevent abuse of Code Sec. 199A and its regs, the anti-abuse rules in Reg § 1.199A2(c)(1)(iv), Reg § 1.199A-3(c)(2)(ii), Reg § 1.199A-5(c)(2), Reg § 1.199A-5(d)(3), and Reg § 1.199A-6(d)(3)(vii) apply to tax years ending after Dec. 22, 2017, TCJA’s date of enactment. The provisions of Reg § 1.643-1, which prevent abuse of the Code generally through the use of trusts, apply to tax years ending after Aug. 16, 2018