The Tax Cuts and Jobs Act (TCJA), signed into law in late 2017, created a new section of the tax code—199A. Section 199A provides a 20% deduction for “qualified business income” generated by pass-thru entities such as LLCs, partnerships, and S-corporations. The law went a long way to help small business owners compete, but left a bevy of unanswered questions.
Business owners and tax practitioners had been waiting eight months for the Internal Revenue Service to provide clarity. Their wait concluded in mid-August when the IRS published proposed regulations and a related Notice regarding 199A. Although some questions remain, the regulations provide significant clarity that the legislative language lacks. The following sections highlight some of the most important developments.
What to Account for When Determining Qualified Business Income
The 20% deduction is calculated using “qualified business income” (QBI). What exactly constitutes QBI, other than what is stated in the legislative text, has been open to question.
The regulations specify certain gains and losses that must be accounted for:1
- Sales and exchanges of interest in a partnership
- Guaranteed payments are included as deductions that decrease QBI2
- Adjustments made when changing accounting methods, as per section 481
- The TCJA greatly expanded the use of cash accounting for businesses with gross receipts less than $25 million, so more businesses than usual may change accounting methods in the next few years.
- “Disallowed” losses, such as passive losses, reduce QBI as long as the loss was disallowed in a year beginning after December 31st, 2017.
- Net operating losses (NOLs) are only taken into account if they had been previously disallowed.
The Treatment of Investment Income
A good rule of thumb to use when determining what to include in QBI is that any income already receiving preferential tax treatment (i.e. deduction or preferential rate) probably does not increase one’s QBI and, by extension, their 199A deduction. The IRS’ reasoning being that income already shielded from taxation at the highest applicable rate should not receive a second tax break.
Investment income generally falls within this bucket. In particular, capital gains and losses, any gain or loss treated as a capital gain/loss (such as that described in sec. 1231), dividends, and interest income are explicitly excluded from QBI.3
Compensation for Services
QBI also excludes wage income and equivalent compensation received from a business for services rendered. Thus, S-corps shareholders who receive “reasonable compensation” may not include those earnings when calculating QBI. Similarly, guaranteed payments received by a partner in a partnership do not count toward the individual’s QBI. At the entity level, however, these payments must be deducted from the business’s QBI before it is allocated to shareholders or partners.
Note that the type of payment, not the characteristics of the recipient, determines whether it is included in qualified business income. In other words, a partnership that is a partner in and receives guaranteed payments from another partnership, may not include those guaranteed payments in its QBI.4
The Definition of “Trade or Business” and Rental Income
The proposed regulations define “trade or business” using section 162 of the tax code.5 Fortunately, the statute has existed for decades and thus has a great deal of case law associated with it. Even if rental activity does not meet the burden of sec. 162, however, the regulations state that rental of tangible property can be treated as a trade or business if the property is rented to a “commonly controlled” trade or businesses.6 7
Unfortunately, the use of sec. 162 may preclude other real estate activity from qualifying for 199A. One unanswered question stemming from the proposed regulations is whether income from a triple-net lease property would qualify. This is an area in which further guidance is necessary.
Deduction Disallowed for Income Derived from a “Specified Service Trade or Business”
One of the more contentious provisions of 199A is the language that denies certain businesses–specified service trades or businesses (SSTBs)–any 199A QBI if taxable income exceeds a certain threshold ($415,000 and $207,500 for married couples filing jointly and single filers, respectively).
The law states that QBI does not include income earned with respect to any trade or business activity involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading, or dealing in securities, partnership interests, or commodities–all of which are SSTBs.
But the text also disqualifies income derived from “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.”8 Industry leaders had been understandably concerned that this “catch all” would be interpreted to include home builders, remodelers, and specialty trade contractors.
Fortunately, the IRS narrowly interpreted the provision. The “reputation and skill” clause applies only to a trade or business
- In which a person receives fees, compensation, or other income for endorsing products or services;
- 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 any other symbols associated with the individual’s identity; and/or
- Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.9
Limitations on High-Income Earners
Although the TCJA included limitations to 199A based on a taxpayer’s income, exactly how the provisions would apply was an qualified unknown until the recent release of IRS regulations.
For instance, after taxable income exceeds certain thresholds (assuming the income is not derived from a “specified” trade or business), the amount of the allowable deduction depends on W-2 wages paid by the business, a combination of wages paid and qualified depreciable property held by the business, and taxable income. Prior Eye on Housing posts have explained how to calculate the deduction if taxable income is within the phase-out range and if taxable income exceeds the top of that range.
Business owners using the W-2 wage-based method to calculate their possible deduction may not include reasonable compensation payments made by S-corps or guaranteed payments made by partnerships. However, if a business uses a payroll service, the business’s owners may use their allocable share of W-2 wages paid to employees on its behalf by such a company when calculating their allowable deduction.
The Depreciable Property Test and Like-Kind Exchanges
Another 199A calculation method available to high-income taxpayers uses the “unadjusted basis” of depreciable property. This method allows owners of capital intensive firms paying little or no W-2 wages to get a 199A deduction based on their investment in physical capital.
In this case, the deduction is limited by 25 percent of W-2 wages paid plus 2.5 percent of the taxpayer’s unadjusted basis in qualified property.
Unadjusted basis is generally equal to the original price paid for the property. A taxpayer using this method can calculate their 199A limitation using this unadjusted basis for 10 years or the depreciable life of the asset, whichever is longer. After this period, however, the taxpayer cannot use basis in that property when calculating their allowable deduction.
A common question over the last eight months has been how like-kind exchanges (LKEs) would affect unadjusted basis for these purposes. The proposed regulations answered with the following:
“[A] nonrecognition transaction, such as a…[like-kind] exchange, will reset the unadjusted basis of property to the current adjusted basis of the qualified property (accounting for depreciation taken to date) as of the new placed-in-service date.”10
In other words, if property a taxpayer receives in a LKE has already been fully depreciated, the recipient has zero unadjusted basis in the property and thus may not use its value to increase his or her allowable 199A deduction. This provision was ostensibly included to prevent taxpayers from using LKEs for the sole purpose of increasing their allowable deduction.
1 Proposed Regulation §1.199A-3(b)(1)
2 Guaranteed payments do not count as QBI for the recipient.
3 Interest income that is “properly allocable” to a business would be included in QBI.
4 Proposed regulations §1.199A-3(b)(2)
5 The only departure from sec. 162 is that the business of being an employee is excluded.
6 Proposed regulations §1.199A-4(b)(1)(i)
7 “Commonly controlled trades or businesses” are two or more businesses in which the same person or persons own at least 50 percent of each.
8 I.R.C. §1202(e)(3)(A)
9 Proposed Regulations §1.199A-5(b)(2)(xiv)
10 Proposed Regulations §1.199A-2(c)(4)—example 3.
This article is for informational purposes only. It should not be considered tax advice. Before making any tax decisions, work with a tax professional. For more detail, please see the full disclaimer.