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The Legal Landmines and Rewards of Section 199A’s QBI Deduction

Posted on Nov. 5, 2018
[Editor's Note:

This article originally appeared in the November 5, 2018, issue of Tax Notes.

]
Joel Busch
Joel Busch

Joel Busch is an assistant professor in the Lucas College and Graduate School of Business at San Jose State University. He also serves on the California Society of Certified Public Accountants’ Committee on Taxation.

In this report, Busch discusses how to maximize the qualified business income deduction under section 199A, including critical but often overlooked compliance requirements and deduction maximization strategies.

The Tax Cuts and Jobs Act (P.L. 115-97) enacted new section 199A, which is intended to level the playing field primarily for partnerships, S corporations, limited liability companies, and sole proprietorships in light of the significant federal income tax rate reduction for C corporations, from typically 35 percent to 21 percent. This intended leveling is accomplished with a new deduction for owners of these non-C corporation entities. Not all owners of these passthrough entities qualify for section 199A’s qualified business income (QBI) deduction. Given the complex set of rules that determine whether the business owners can potentially claim the QBI deduction, this report explores the section 199A rules — including the recently issued proposed regulations — to provide a detailed analysis of the fundamental requirements of this special tax incentive and the nuances of the law that can substantially enhance the amount of the tax benefit and prevent malpractice claims.

I. Overview of the QBI Deduction

Before discussing the advanced applications and overlooked provisions of the QBI deduction, it is imperative that practitioners understand how the deduction works. Section 199A has extensive rules to determine its applicability and reach for any given year. The cornerstone requirements of the deduction, as it relates to owners of operating businesses,1 include the following:

  • To be a “qualified business,” it must be treated for federal tax purposes as a sole proprietorship, partnership, or S corporation (that is, not a C corporation).2 Any entity that elects to be treated for federal tax purposes as a C corporation under the check-the-box regulations does not qualify for the deduction for its owners.

  • Only business income effectively connected within the United States counts toward the deduction.3 With some limitations, this includes qualified income generated in Puerto Rico.4 While this report focuses on application of the detailed legal guidance surrounding trade or businesses activities conducted within the United States, for those legal entities with income generated both in and outside the United States, an allocation of income and applicable QBI limitation factors will generally need to take place in accordance with section 865(c) and the regulations thereunder.5

  • Eligibility for the deduction is based both on the type of activity the business undertakes and on the amount and type of taxable income of the individual owners of the business.

  • Up to 20 percent of the qualified income derived from the eligible business can be claimed as a deduction by the business owner if the owner is an individual, estate, or trust. This deduction, while a below-the-adjusted-gross-income-line personal income tax deduction, can be taken regardless of whether the owner takes a standard or itemized deduction for the year.6

  • The QBI deduction for the year cannot be greater than 20 percent of the taxpayer’s taxable income (less any net long-term capital gains and qualified dividends) before any QBI deduction that may apply for the year.7 The rest of this report refers to this amount as “applicable taxable income.” Neither net short-term capital gains nor ordinary dividends reduces the applicable taxable income before the 20 percent deduction ceiling.8

  • QBI is generally the net U.S.-based taxable income of the qualified business (or an owner’s share thereof) before applying any of the following types of primarily investment activities of the business: capital gains and losses (both short- and long-term);9 dividends;10 interest income (unless properly allocable to the trade or business);11 gains from the sales of most commodities and foreign currency exchange contracts;12 most notional principal contracts;13 any amounts received from an annuity that is not received in connection with the trade or business;14 and any deductions relating to these items (such as investment interest used to acquire stock that generates taxable dividends).15

  • When a qualified business has a net taxable loss for the year, there will be no QBI deduction for the year for its owner attributable to that particular business, and 20 percent of the loss will be carried over into the following tax year as a reduction of the amount of income that could be used in the QBI deduction in that year.16

  • When an eligible taxpayer has ownership interests in more than one eligible business, the QBI is determined on a stand-alone basis for each business, and the per-business amounts are combined to arrive at the taxpayer’s “combined” QBI amount for the year. This is then compared with the owner’s applicable taxable income to determine the QBI deduction for the year, as well as for any potential net negative combined QBI amounts that will carry over into the following year.17

  • The QBI deduction is applicable for tax years beginning after 2017 but before 2026.18

II. Specified Service Trades and Businesses

Section 199A substantially limits the applicability and extent of the QBI deduction for businesses engaged in specified services.19 The statutory list that defines what is a specified service business (SSB) is generally based on the specified types of businesses that are not eligible for the small business stock classification under section 1202(e)(3)(A), including those in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or (to be discussed later) any trade or business in which the principal asset of such trade or business is the reputation or skill of one or more of its employees. Note that engineering and architectural firms, while included in the section 1202(e)(3)(A) lines of business, are excluded from the SSB classification for purposes of section 199A.20 Also, businesses that involve the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities are also considered SSBs under section 199A(d)(2)(B).

III. Applying Section 199A Rules in Practice

Before examining the specifics of the overlooked and nuanced tax planning opportunities of the QBI deduction, we must review when the deduction applies as well as how the deduction is calculated under various scenarios for both the qualifying business and the business owner who will ultimately claim the deduction.

A. Scenario 1: Non-High-Income Taxpayer

When an individual business owner has applicable taxable income of $157,500 or less (or $315,000 if married filing a joint tax return)21 and the qualifying business in which they are an owner is not an SSB, the QBI deduction is calculated using a two-step formula.

The QBI deduction is the lesser of:

1. 20 percent of the QBI (as detailed above);22 or

2. 20 percent of the owner’s applicable taxable income.23

Example 1: Susie operates Sports R Us, a retail sporting goods store, as a sole proprietorship. The business generates $130,000 of QBI for 2018. Susie’s applicable taxable income is $116,000. Thus, her QBI deduction for the year is the lesser of:

1. 20 percent of the $130,000 QBI ($26,000); or

2. 20 percent of her $116,000 applicable taxable income ($23,200).

Susie claims a $23,200 QBI deduction on her 2018 personal income tax return.

Example 2: Aiko is a 25 percent partner in the ABC Partnership. The partnership operates a home building construction company. ABC generates $200,000 of QBI for 2018. Aiko’s applicable share of the partnership’s QBI is $50,000. Aiko’s applicable taxable income is $94,500. Thus, her QBI deduction for the year is the lesser of:

1. 20 percent of her $50,000 share of the partnership’s QBI ($10,000); or

2. 20 percent of her $94,500 applicable taxable income ($18,900).

Because her QBI deduction is not limited based on her applicable taxable income (unlike the preceding example), Aiko claims a $10,000 QBI deduction (20 percent of the QBI) on her 2018 personal income tax return.

B. Scenario 2: High-Income Taxpayer

When the business owner has applicable taxable income exceeding $157,500 ($315,000 if married and filing a joint return), an additional (and in-depth) step in the QBI deduction calculation comes into play (except for qualified income from a publicly traded partnership). While the prior two QBI limitations still apply, this third step potentially limits the QBI deduction to the greater of:

1. 50 percent of the applicable wages paid by the business (Step 2A in the examples below); or

2. 25 percent of the applicable wages paid by the business, plus 2.5 percent of the unadjusted basis for most of the depreciable property of the business immediately after its acquisition (Step 2B in the examples below).24

Before detailing the determinations of the applicable QBI deduction for the year under this scenario, we must review additional guidance on the wages limit (item No. 1 above) or wages-plus-property limit (item No. 2). First, the wages or wages plus unadjusted basis of depreciable property limitations fully apply only when the taxpayer’s applicable taxable income is $207,500 or more ($415,000 for married filing a joint return) in 2018.25 For those taxpayers whose pre-QBI taxable income is between $157,500 and $207,500 ($315,000 and $415,000 for joint filers), these QBI limitations are phased in proportionately based on the amount of the taxpayer’s applicable taxable income that falls into the phase-in dollar ranges (that is, $50,000 for all taxpayers except for joint filers, in which case the phase-in range is $100,000).26

Second, the amount of wages is, by statute, normally determined by adding the total amount of wages (including any elective deferrals) paid by the business to its employees for services attributable to the QBI generated for the year.27

Finally, the depreciable property of the business consists of the tangible assets (both real and personal property) that are subject to depreciation (which would, of course, not include land) that are used at any time in the business to produce qualified business income and that either (1) have not been fully depreciated before the end of the tax year or (2) were first placed into service no more than 10 years ago (to account, for example, for when assets were fully depreciated under section 179 or first-year additional depreciation).28

The following is an illustration of how these complex guidelines work for high-income individuals.

Example 1: Kaylee, who files as single, operates a concrete manufacturing business as a single-member LLC. The business generates $400,000 of QBI for 2018. The business has $50,000 of applicable wages and $1 million of unadjusted basis in depreciable property. Kaylee’s applicable taxable income is $386,000. Because that amount is above the $207,500 ceiling at which the wage-based (or wage-plus-property-based) QBI limitations fully kick in, her QBI deduction for the year is calculated based on the lowest figure from the following three steps:

  • Step 1: 20 percent of the $400,000 QBI ($80,000); or

  • Step 2A: 50 percent of the $50,000 of wages ($25,000); or (if greater)

  • Step 2B: 25 percent of the $50,000 of wages ($12,500) plus 2.5 percent of the unadjusted depreciable property ($25,000), or $37,500 in total.

Because the Step 2B (wages plus property) figure is greater than Step 2A (wages only), the $37,500 wages plus property limitation will be used as the Step 2 limitation.

  • Step 3: 20 percent of Kaylee’s applicable taxable income of $386,000 (or $77,200).

Because the Step 2 figure of $37,500 is the lowest of the three calculated steps, Kaylee’s QBI deduction for 2018 will be $37,500.

Example 2: Noriko, who files as single, is a 30 percent shareholder in an S corporation that operates a restaurant. The business generates $690,000 of QBI for 2018, which includes $200,000 of wages, and has $3 million of unadjusted basis in depreciable property. Noriko’s applicable taxable income is $205,000. Because Noriko’s applicable taxable income is above the $157,500 threshold of when the wage (or wages plus unadjusted property) QBI deduction limitation kicks in, but below the $207,500 ceiling above which the limitation fully applies, her QBI deduction for the year is determined based on the lowest of the following four steps:

  • Step 1: 20 percent of her 30 percent share of the corporation’s $690,000 of QBI ($207,000 x 20 percent = $41,400); or

  • Step 2A: 50 percent of her 30 percent share of the corporation’s $200,000 of wages ($60,000 of wages x 50 percent = $30,000); or (if greater)

  • Step 2B: 25 percent of her allocated $60,000 share of wages ($15,000) plus 2.5 percent of her 30 percent share of the unadjusted depreciable property ($3 million x 30 percent = $900,000 x 2.5 percent = $22,500), or $37,500 in total.

Because the Step 2B (wages plus property) figure is greater than Step 2A (wages only), the $37,500 wages plus property limitation will be used as the Step 2 limitation:

  • Step 3: Because Noriko’s pre-QBI taxable income was $205,000 (or 95 percent) into the $50,000 phase-in range of the imposition of the Step 2 (in this case the wage-only) potential QBI deduction limitation, we take 95 percent of the difference between the Step 1 ($41,400) and Step 2 ($37,500) deduction limitations, or $3,900 x 95 percent = $3,705. This $3,705 figure is then subtracted from the Step 1 amount of $41,400 to arrive a potential QBI of $37,695.

  • Step 4: 20 percent of Noriko’s applicable taxable income of $205,000 (or $41,000).

Because the Step 3 figure of $37,695 is the lowest of the four-step figures, Noriko’s QBI deduction for 2018 will be $37,695.

Example 3: Adam, who files a joint return with his spouse, is a 40 percent member in an LLC that operates a clothing store. The other members are unrelated to Adam. The business generates $475,000 of QBI for 2018, which includes $100,000 of wages, and it has $50,000 of unadjusted basis in depreciable property. Adam’s applicable taxable income is $370,000. Because that is above the $315,000 threshold of when the wage (or wages-plus-unadjusted-property) QBI deduction begins to apply, but below the $415,000 ceiling, his QBI deduction is determined using the lowest figure from the following four steps:

  • Step 1: 20 percent of his 40 percent share of the LLC’s $475,000 of QBI ($190,000 x 20 percent = $38,000); or

  • Step 2A: 50 percent of his 40 percent share of the corporation’s $100,000 of wages ($40,000 of wages x 50 percent = $20,000); or (if greater)

  • Step 2B: 25 percent of his 40 percent share of the LLC’s wages (25 percent x $40,000 = $10,000) plus 2.5 percent of his 40 percent share of the LLC’s unadjusted depreciable property (40 percent x $50,000 = $20,000 x 2.5 percent = $500), or $10,500 in total.

Because the Step 2A (wages) figure is greater than Step 2B (wages plus property), the $20,000 wages-only limitation will be used as the Step 2 limitation.

  • Step 3: Because Adam’s applicable taxable income of $370,000 is $55,000 (or 55 percent) into the $100,000 (for joint filers) phase-in range of the imposition of the Step 2 limitation (in this case the wage-only limitation), we take 55 percent the difference between the amount calculated in Step 1 ($38,000) and Step 2 ($20,000), or 55 percent x $18,000 = $9,900. This $9,900 amount is then subtracted from the Step 1 figure of $38,000 to arrive a Step 3 amount of $28,100.

  • Step 4: 20 percent of Adam’s applicable taxable income of $370,000 (or $74,000).

Because the Step 3 figure of $28,100 is the lowest of steps 1, 3, and 4, Adam’s QBI deduction for 2018 will be $28,100.

C. Scenario 3: High-Income Owner of an SSB

For taxpayers with income coming from an SSB, the QBI deduction is eliminated when the taxpayer’s applicable taxable income is at or above $207,500 ($415,000 for joint filers).29 For taxpayers with an applicable taxable income of $157,500 or less ($315,000 for joint filers), the deduction is simply the lesser of 20 percent of QBI or 20 percent of the taxpayer’s applicable taxable income (see scenario 1, example 1 above). However, for SSB owners with applicable taxable income less than $207,500/$415,000, but greater than $157,500/$315,000, the deduction is calculated differently. The QBI deduction is determined as follows:

  • Step A: The applicable 20 percent of QBI figure (Step 1 in the previous examples) is reduced based on the percentage that the taxpayer’s applicable taxable income exceeds the $50,000/$100,000 excess over the $157,500/$315,000 thresholds.

  • Step B: The amount in Step A is compared with the applicable wages (or wages-plus-property) limitation (retaining their Step 2A and 2B monikers in their upcoming examples), but unlike in the non-SSB scenarios, here the wages (or wages plus property) limitation amount is further reduced by the same percentage that the taxpayer’s applicable taxable income falls into the $50,000/$100,000 excess over the $157,500/$315,000 thresholds, and if the Step B figure is less than the amount determined in Step A, the amount of the difference between steps A and B is reduced by the same percentage that the taxpayer’s applicable taxable income falls into the $50,000/$100,000 phase-out range, to arrive at a Step C figure that is subtracted from Step A to arrive at the taxpayer’s QBI deduction for the year (unless it is more than 20 percent of the taxpayer’s applicable taxable income, in which case the 20 percent of applicable taxable income will be the amount of the QBI deduction). However, if the Step B figure is greater than the amount calculated in Step A, the taxpayer’s QBI deduction will simply be the amount calculated under Step A.30 In a nutshell, unlike for non-SSBs, the wages (or wages plus property) limitation cannot potentially get a taxpayer to the full 20 percent of QBI deduction when their pre-QBI taxable income is in the $50,000/$100,000 phase-out range above the $157,500/$315,000 applicable income thresholds.

Because of the increased complexity of the SSB rules, let us decipher their formulaic applications in the following examples.

Example 1: Joanne, who files as single, operates a law firm as a sole proprietorship. Her pre-QBI taxable income is $270,000. Because her business is an SSB and her applicable taxable income is above the $207,500 complete phase-out threshold, she will not receive any QBI deduction for the year — regardless of the amount of wages or property used by the business during the year.

Example 2: Harry, who files as single, operates a CPA firm as a sole proprietorship. The business generates $210,000 of QBI for 2018, which includes $50,000 of wages and it has $12,500 of unadjusted basis in depreciable property. Harry’s applicable taxable income is $199,000, Because Harry’s applicable taxable income is below the $207,500 ceiling in which the QBI deduction is completely phased-out, but above the $157,500 beginning phase-out threshold, his QBI deduction for the year will be determined as follows:

  • Step A: 20 percent of the firm’s $210,000 QBI ($42,000) multiplied by 17 percent (because his applicable taxable income is $41,500 into the $50,000 phase-out range), or $7,140.

  • Step 2A: 50 percent of the $50,000 of wages ($25,000) multiplied by 17 percent, or $4,250.

  • Step 2B: 25 percent of the $50,000 of wages ($12,500) plus 2.5 percent of the unadjusted depreciable property (2.5 percent x $12,500 = $314) = $12,814 in total. We then multiply this figure by 17 percent to arrive at $2,178 (rounded).

Because the Step 2A (wages only) figure is greater than Step 2B (wages plus property) amount, the $4,250 wages-only limitation will be used as the Step 2 limitation figure in the next calculations.

  • Step B: Here, we must look at the difference between the Step A (QBI-based) figure of $7,140 and the Step 2 (wages-only based) limitation of $4,250, which is $2,800 (which we will call the “excess amount”). We then take 83 percent of the $2,890 excess amount determined directly above (Step B) to arrive at a reduction amount of $2,399 (rounded). This reduction amount of $2,399 is subtracted from the Step A figure of $7,140 to arrive at a tentative QBI deduction of $4,741.

  • Step 3: We take 20 percent of Harry's applicable taxable income of $199,000 (or $38,900).

As the Step B figure of $4,741 is lower than that determined in Step A ($7,140) and in Step C ($39,800), Harry's QBI deduction for 2018 will be $4,741.

IV. Overlooked Compliance Area

Most discussions on the section 199A deduction involve the complexity of how and when wages factor into the QBI deduction calculation. But a vastly overlooked requirement is that when the owner of an eligible business has modified taxable income that is high enough that wages come into play in the deduction determination, those wages must be reported to the Social Security Administration (SSA) by the business within 60 days of the due date (including any extensions).31 That means for both employees of the QBI-eligible company and outside payroll practitioners, missing a Form W-2 reporting deadline could now be a huge problem when it previously may not have been a major issue.

For example, suppose Jennifer, a single individual, hearing about the new QBI deduction, opens a landscaping company at the beginning of 2018 as a sole proprietorship. It generates $500,000 of QBI for the year. Jennifer has pre-QBI taxable income of $463,300. Because she has limited capital available during her first year of business, Jennifer rents all the equipment she needs to operate the business. She has three employees, each of whom is paid $100,000 in wages. While she provides each employee with a W-2 by the due date, Jennifer does not file the three W-2s with the SSA by the January 31, 2019, deadline,32 but files them on April 4, 2019, because she erroneously believes they are due by April 15. Had Jennifer filed the W-2s (and accompanying W-3) with the SSA 63 days late for the prior tax year, she would have faced only $300 in late filing penalties ($100 for each W-2 filed more than 30 days after the due date but before August 1).33 However, because she files the W-2s more than 60 days past the due date in 2019, none of the wages will count toward the QBI deduction.

Because Jennifer’s pre-QBI taxable income is above the $207,500 pre-QBI taxable income threshold for a single individual, whereby the 50 percent of W-2 wages (or 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis of qualifying depreciable property) QBI limitation fully applies, and the business has no qualifying depreciable property, on which to apply 2.5 percent of the qualifying unadjusted basis, Jennifer will not receive any QBI deduction for the year. On the other hand, had Jennifer filed the W-2s on time (or no more than 60 days after the due date), her QBI deduction for the year would have been $92,660, calculated as follows:

The lesser of:

  • Step 1: 20 percent of the business’ QBI ($500,000 x 20 percent) = $100,000; or

  • Step 2A: 50 percent of the reportable W-2 wages (50 percent x $300,000) = $150,000; or (if greater)

  • Step 2B: 25 percent of the reportable W-2 wages (25 percent x $300,000 wages) = $75,000, plus 2.5 percent of the unadjusted basis of qualifying property ($0 since there is no owned, qualifying property).

Here the greater amount is the 50 percent of wages figure (Step 2A), so we will use $150,000 for Step 2, or:

  • Step 3: 20 percent of Jennifer’s applicable taxable income (20 percent x $463,300) = $92,660.

Given Jennifer’s 2018 marginal tax rate of 35 percent covering the entirety of the lost QBI deduction (because of the late W-2 filing) what was previously a $300 mistake in a late filing by 63 days (had it occurred last year) now results in a substantial $32,731 increase34 in federal taxes and penalties for the 2018 tax year.

V. Owned Versus Rented Property

The QBI deduction does not provide for potential use toward the deduction for any property that is rented or leased, as opposed to being owned by the business. When two unrelated equipment-intensive businesses (such as those in the construction industry) have the same amount of qualified (for the QBI deduction) income at both the business and owner levels, but one construction company owns all of its business assets and the other rents all of their equipment, when the wages plus property limitation is determinative of the QBI deduction, the company with the higher amount of owned equipment will normally obtain a higher QBI deduction for its owner. This result runs counter to tax provisions in other contexts surrounding the use of tangible assets used by businesses. For example, for state income tax purposes, for states that use a property component in their apportionment formula for multistate businesses35 rented and leased property is included in the total property factor in each state by using an eight-times-annual-rent figure. That levels the effect of rented and owned equipment for companies that are otherwise similar in economic performance and operations in determining how much relative property they have in each state to determine (in part) how much taxable income is to be apportioned to each state. Thus, the current QBI deduction formula could give incentives to capital-intensive companies to purchase equipment (even if it requires substantial borrowing) as opposed to continuing to rent the all or most of their equipment to potentially increase or even qualify for the QBI deduction (when the business does not pay any wages but has property).

VI. Capitalizing Versus Expensing Assets

Regarding assets used by a business, another evaluation point comes into play for owners when the unadjusted depreciable assets plus wages base affords a higher QBI deduction than just the 50 percent of wages limitation. In these situations, a business may have an incentive to capitalize some expenditures that could otherwise be immediately expensed to increase the total unadjusted cost basis of depreciable assets. While the detailed rules are beyond the scope of this report, in general, federal tax law affords some businesses the flexibility to elect, under the de minimis safe harbor rules, to expense expenditures for specific assets with a total cost of $2,500 or less.36 An election to expense assets with a cost of $5,000 or less also applies, but this is primarily for businesses that have financial statements that are required to be filed with the SEC, which are almost exclusively C corporations (which are not eligible for the QBI deduction).37

However, non-C corporation entities could be eligible for the $5,000 capitalization threshold election if they have audited financial statements for credit, reporting to owners, or other substantial nontax purposes.38 While many businesses typically prefer to currently deduct expenditures as much as possible, if the unadjusted basis of property formula results in a higher QBI deduction as compared with the wages-only limitation, it might make more sense to capitalize assets that can be capitalized under the general capitalization guidelines39 (exclusive of the aforementioned de minimis safe harbor election) — especially if the collective bases of these assets are material. Of course, given the expanded capabilities of full cost recovery under section 179 and additional first-year depreciation under the TCJA, some cost recovery issues might be mitigated by increasing the scope of expenditures that are capitalized by the business, but compliance costs to track the increased number of depreciable assets (that could otherwise be expensed) must be considered.

VII. Guaranteed Payments to Partners

One of the biggest areas for operational and legal governance changes to maximize the QBI deduction is the rule regarding guaranteed payments for partners (or members in an LLC taxed as a partnership). In a nutshell, like wages paid to shareholder-employees (discussed later), guaranteed payments made to a partner are not eligible for the QBI deduction.40 On the other hand, as noted, a partner’s share of a partnership’s QBI is subject to the QBI deduction. Thus, when the QBI might be in play for some partners in a partnership, they should make a comprehensive evaluation to determine if the level and extent of any preexisting guaranteed payments in the partnership agreement should be changed to increase the overall QBI deduction benefit for the partners. This is a complex analysis, however, given the factors in play for each partner.

Before starting the detailed tax benefit analysis of guaranteed payments, it is imperative that the business, its owners, and any outside tax advisers not lose sight of the non-tax-related issues surrounding guaranteed payments. Guaranteed payments ensure that distributions are made to partners that are entitled to receive them because of their services (and less frequently, capital) provided to the partnership, without regard to the profitability of the business. For services provided by a partner, having guaranteed payments generally serves as a baseline amount of income that partners know they will receive even if the business has losses. On the tax front, guaranteed payments are generally treated as earned income, subject not only to income tax but also self-employment tax by the partner,41 if the partnership is deemed to be engaged in a trade or business.42 A partnership claims an ordinary deduction for guaranteed payments made to partners.43

In light of the QBI deduction, partners and partnerships could, after the detailed analysis, amend their partnership agreements to reduce or eliminate guaranteed payments with the hope of obtaining more income derived from the business that could qualify for the QBI deduction. Of course, not every partner may want to take on this change. First, partners who want the economic stability of a regular, guaranteed distribution every month (or at other specified intervals) will probably not want to give up this protection — even with the prospect of a potentially higher QBI deduction. Further, for partners with applicable taxable income levels at which the QBI deduction will be minimal or nonexistent (depending on whether the partnership is classified as an SSB and the amount of wages and qualified depreciable property of the business) it will not make any sense, from their individual perspective, to reduce any pre-existing guaranteed payments that they are currently entitled to receive.

At the macro-statistical level, according to IRS data, out of an estimated $380 billion of ordinary business income from all partnership returns received for the 2015 tax year, about $67 billion of guaranteed payments were made to partners.44 Thus, collectively, there is significant potential for partnerships to reduce the amount of guaranteed payments paid to their partners to potentially increase the applicability of the QBI deduction.

VIII. Reasonable Wages to S Corp Employees

Running parallel to guaranteed payments for partners, reasonable wages paid to S corporation shareholder-employees also are not subject to the QBI deduction.45 The issue is not just a concern for the QBI deduction. Reasonable wages have long been an issue between S corporations and their employee-shareholders because wages are subject to FICA taxes, whereas a shareholder-employee’s share of an S corporation’s earnings is not subject to FICA tax.46 Thus, with the new, incentive for S corporations and their shareholders to minimize the characterization of payments to shareholders as wages by virtue of section 199A, the IRS likely will even more closely scrutinize payments made to shareholders in the form of wages versus distributions to ensure they are reasonable, as required by section 162(a)(1).

IX. IRS Issues Proposed Regulations

On August 8 the IRS released much anticipated proposed regulations that have provided much, but by no means all, of the needed clarification on the large number of unanswered questions about the QBI deduction. Highlights of the proposed regulations are as follows:

1. A new de minimis rule has been established to prevent a business that derives some (but not all) of its business from SSB-classified activities from being classified as an SSB for the entire business. Under this guidance, most businesses will not be classified as an SSB if less than 10 percent of gross income is derived from one or more specified lines of services. For businesses with more than $25 million of gross income, this new SSB exemption applies if less than 5 percent of its gross income is derived from one or more specified lines of services.47 What this means is that if a business exceeds the applicable threshold, the entire business will be classified as an SSB.

2. Much to the relief of most business owners, the IRS has limited what, based on the statute, could have been an almost endless capturing of businesses that could have been classified as SSBs under the “principal asset based on the reputation or skill of one or more of its employees” provision of section 1202(e)(3)(A) via section 199A(d)(2)(A). Under the proposed regulations, this open-ended SSB magnet has been almost entirely removed, except for the following types of activities:

  • 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 any other symbols associated with the individual’s identity, and

  • receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.48

3. Whether net gains or losses from sales of section 1231 assets are to be included in the QBI calculation was a hot topic even before passage of the TCJA. While the section 199A statutory guidance explicitly excludes capital gains and losses from the QBI calculation, section 1231 gains and losses are not technically capital gains and losses — net section 1231 gains are generally treated as long-term capital gains49 (exclusive of any recharacterization under the five-year lookback rule under section 1231(c)), whereas net section 1231 losses are treated as ordinary losses.50 The proposed regulations have addressed this issue — net section 1231 gains are not considered in the computation of QBI. But net section 1231 losses are deducted from other qualifying income to determine QBI, because the regulations explicitly state that “any item treated as one of such items, such as gains or losses under section 1231 which are treated as capital gains or losses” are not to be included in the QBI figure for the company.51

X. Conclusion

As shown, the eligibility rules and level of complexity to determine the amount of the QBI deduction in any given year should not be underestimated. Even before the first 2018 tax returns are filed, it is critical that practitioners and qualified business owners fully understand these rules to maximize the QBI deductions that are at play, while properly taking into consideration the nontax aspects of any operational changes in the business. Further, because the QBI deduction depends heavily on the taxable income of the business owner, it is now even more critical for tax planners and their clients to take advantage of tax-reduction opportunities, such as increasing contributions into tax-deferred retirement plans (that is, 401(k), traditional IRAs, etc.); investing in tax-free income-generating assets (such as state and local bonds and the interest income earned thereon); increasing deductions; and following other traditional avenues of minimizing their federal taxable income to maximize the amount of the QBI deduction that Congress intended for owners of non-C corporation businesses.

FOOTNOTES

1 The QBI deduction also applies to real estate investment trust dividends under section 199A(b)(1)(B).

2 Section 199A(a).

3 Section 199A(c)(3)(A)(i).

4 Section 199A(f)(1)(C).

5 Section 199A(c)(3)(A)(i).

6 Section 63(d)(3).

7 Section 199A(a)(2) and (e)(1).

8 Section 199A(a)(2)(B).

9 Section 199A(c)(3)(B)(i).

10 Section 199A(c)(3)(B)(ii).

11 Section 199A(c)(3)(B)(iii).

12 Section 199A(c)(3)(B)(iv).

13 Section 199A(c)(3)(B)(v).

14 Section 199A(c)(3)(B)(vi).

15 Section 199A(c)(3)(B)(vii).

16 Section 199A(c)(2).

17 Section 199A(b).

18 Section 199A(i).

19 Section 199A(d)(1)(A) and (d)(2)(A).

20 Section 199A(d)(1)(A).

21 Section 199A(e)(2)(A). These applicable taxable income figures and thresholds are for the 2018 tax year. For years starting in 2019, these amounts will be adjusted for inflation under section 199A(e)(2)(B).

22 For this and the remaining examples, QBI (and later, applicable wages and property of the business) will refer to either the business (in the case of a sole proprietorship or single-member limited liability company) or a partner/member/shareholder’s applicable share of the partnership, multimember LLC, or S corporation’s QBI, wages, or property.

23 Section 199A(a)(2).

24 Section 199A(b)(1)(B), -(b)(2)(B), -(c)(1), and -(e)(4).

25 Section 199A(b)(3)(B).

26 Id.

27 Section 199A(b)(4).

28 Section 199A(b)(6).

29 Section 199A(d)(3).

30 Id.

31 Section 199A(b)(4)(C).

32 Section 6051(a).

33 Section 6721(b)(2).

34 ($92,660 lost QBI deduction x 35 percent marginal tax rate) plus the $300 W-2 late filing penalty.

35 Under the Uniform Division of Income for Tax Purposes Act, to which many state statutes partially or fully conform.

36 Reg. section 1.263(a)-1(f) and Notice 2015-82, 2015-50 IRB 859.

37 Id.

38 Reg. section 1.263(a)-1(f)(4).

39 Reg. section 1.263(a)-2, -3, and -4.

40 Section 199A(c)(4)(B).

41 Reg. sections 1.707-1(c) and 1.1402(a)-1(b).

42 D.B. Grubb v. Commissioner, T.C. Memo. 1990-425.

43 Sections 162(a)(1) and 707(c) and reg. section 1.707-1(c).

44 IRS Statistics of Income, “2015, Partnership Returns, Line Item Estimates,” at 2 (2015).

45 Section 199A(c)(4)(A).

46 Sections 3101(a), 3111(a), 3121(a), 3306(b), and 3401(a).

47 Prop. reg. section 1.199A-5(c)(1).

48 Prop. reg. section 1.199A-5(b)(iv).

49 Section 1231(a)(1).

50 Section 1231(a)(2).

51 Prop. reg. section 1.199A-3(b)(2)(ii)(A).

END FOOTNOTES

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