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A Primer on Qualified Business Income under IRC Section 199A

By:
Dean L. Surkin, JD, LLM
Published Date:
Mar 1, 2020

The 2017 Tax Cuts and Jobs Act (TCJA) allows owners of pass-through entities and sole proprietors to deduct a portion of their qualified business income (QBI), codified in IRC section 199A. In general, the deduction is the lesser of 20% of qualified business income or the greater of 50% of W-2 wages or the sum of 25% of W–2 wages with respect to the qualified trade or business and 2.5% of the unadjusted basis immediately after acquisition of all qualified property. The deduction is not above the line, so it doesn’t affect adjusted gross income (AGI), but it’s not an itemized deduction, either. (Therefore, it has no effect on New York State income taxes, because New York taxable income is calculated with reference to federal AGI and federal itemized deductions, with modifications.)

Background

The QBI deduction has its genesis in the reduction in federal corporate income tax from brackets peaking at 35% to a flat 21% (the top individual bracket was also reduced, from 39.6% to 37%). The rationale is to preserve the tax advantage that accrues to unincorporated businesses when compared to corporations.

Example, part 1: the tax impact on an individual shareholder receiving a dividend from a corporation was 48% in 2017 compared to 36.8% in 2018.

  • 2017 calculation: corporate income minus 35% tax equals the available dividend (i.e., income × 65%), on which the shareholder pays 20% tax [i.e., (income × 65%) × 80% = 52% of income], so effective tax rate is 48%.
  • 2018 calculation: corporate income minus 21% tax equals the available dividend (i.e., income × 79%), on which the shareholder pays 20% tax [i.e., (income × 65%) × 80% = 63.2% of income], so effective tax rate is 36.8%.

Example, part 2: The tax impact (assuming top tax bracket) on an individual receiving business income in 2017 was 39.6%. Comparing this with the tax effect on a dividend from a corporation (48%) shows that the tax advantage compared to corporation is 48% − 39.6% = 8.4%.

  • 2018 calculation without QBI: The tax rate on an individual is 37%, and the tax disadvantage compared with a corporate dividend is 36.8% − 37% = −0.2%. The swing from 8.4% advantage to 0.2% disadvantage is 8.6%.
  • 2018 calculation with QBI: The tax on an individual with the maximal QBI deduction is Income – (Income × .20) × .37, for an effective tax rate of 29.6%. The tax advantage compared with a corporate dividend is 36.8% − 29.6% = 7.2%. Although this is not as great an advantage as existed before the TCJA, it does restore part of the advantage.

IRC section199A is effective for tax years beginning after 2017. The deduction applies to any taxpayer “other than a corporation.” For a grantor trust, which is a disregarded entity, the QBI is calculated by the grantor [Treasury Regulations section 1.199A-6(d)(2)]. For non-grantor trusts and estates, the QBI is calculated at the entity level and allocated among beneficiaries according to distributable net income [Treasury Regulations section 1.199A-6(d)(3)]. The deduction does not apply to taxable years beginning after Dec. 31, 2025.

Mechanics of the Deduction

The calculation differs depending whether an individual’s taxable income exceeds the threshold amount and what the Treasury Regulations call the phase-in range. The threshold amount is adjusted for inflation for taxable years beginning after 2018, using 2017 as the base year for the chained consumer price index (CPI) adjustment. In 2018, the threshold for married taxpayers filing jointly was $315,000 and for all other taxpayers was $157,500. The phase-in range is $100,000 for married taxpayers filing jointly and $50,000 for all other taxpayers. It is not adjusted for inflation.

2018

Threshold

End of phase-in

Married filing jointly

$315,000

$415,000

All other taxpayers

$157,500

$207,500

2019

 

 

Married filing jointly

$321,400

$421,400

Married filing separately

$160,725

$210,725

Single, head of household, trusts

$160,700

$210,700

2020

 

 

Married filing jointly

$326,600

$426,600

Married filing separately

$163,300

$213,300

Single, head of household, trusts

$163,300

$213,300

It is important to note that there are special rules for trusts. The trust threshold is determined before taking into account any distribution deduction, under Treasury Regulations section 1.199A-6(d)(3)(iv). The Regulations contain anti-abuse rules to prevent taxpayers from creating trusts and splitting income among them to avoid the threshold amount. Furthermore, trusts that have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, established for the principal purpose of avoiding federal income tax, will be aggregated and treated as a single trust (effective for years ending after Aug. 16, 2018).

In “Claiming the QBI deduction for trusts,” author Dana McCartney writes that since Treasury Regulations section 1.643(f)-1 uses the test of primary beneficiaries, taxpayers could possibly take a trust with multiple beneficiaries and create a separate subtrust for each beneficiary; this would result in lower taxable income for each subtrust, perhaps below the threshold amount.

Rules Relating to QBI

QBI must be income that is recognized for tax purposes and is associated with the conduct of business within the United States. It does not include portfolio income, such as capital gain/loss (including IRC section 1231 gains), dividends, or interest; reasonable compensation paid to taxpayer by taxpayer’s business; and guaranteed payments paid to partners.

Qualified businesses are all trades or business as defined for purposes of IRC section 162, plus the rental or licensing of tangible or intangible property to a related, commonly controlled trade or business. Rental real estate operations may or may not be a trade or business (for example, a triple-net lease is usually not considered to be one).

Rental real estate

Rental real estate may qualify as a trade or business and Revenue Procedure 2019-38 provides a safe harbor test; the safe harbor is not exclusive. Taxpayers may treat each property as a separate enterprise or aggregate similar properties into one enterprise. There are two categories of properties: residential and commercial. Mixed-use property may be treated as one enterprise or separated into two. Taxpayers must keep separate books and records for each.

The enterprise must provide a minimum number of hours of rental services. If it has been in existence less than four years, it must provide 250 hours or more each year. If it has been in existence four years or more, it must provide 250 hours in any three of five consecutive years, ending with the tax year. Taxpayers must maintain contemporaneous time reports, logs, or similar documents.

Rental services may be performed by owners, employees, agents, or independent contractors. This is different than material participation under the passive activity rules, which require services be performed directly by the taxpayer. Rental services include—

  • advertising to rent or lease the real estate;
  • negotiating and executing leases;
  • verifying information contained in prospective tenant applications;
  • collection of rent;
  • daily operation, maintenance, and repair of the property, including the purchase of materials and supplies;
  • management of the real estate; and
  • supervision of employees and independent contractors.

Rental services do not include financial activities, such as arranging financing, acquiring property, improving property, or time spent traveling to and from property

Specifically excluded from the safe harbor are a taxpayer’s residence (owned directly or through an entity), a triple-net lease, real estate rented to a commonly controlled trade or business, or an activity treated as a specified service trade or business.

Taxpayers must attach statement to timely filed original return claiming the safe harbor. The statement may be included with an amended return for 2018, since the Revenue Procedure was issued after the due date of the 2018 return.

It’s important to note that if an activity produces a loss, it’s better to exclude it from QBI.

Income excluded from QBI

Certain income is excluded from QBI, such as performing services as an employee. Former employees are deemed to still be employees, to prevent individuals from recasting themselves from employee to independent contractor. Specified service trade or businesses (SSTB) are subject to limitations described below.

Also excluded is real estate investment trust (REIT) income (except for capital gain dividends or qualified dividends) and publicly traded partnership (PTP) income. QBI does, however, include ordinary income, if any, recognized by taxpayer upon disposition of his interest in the PTP. Partnership income includes IRC section 751 ordinary income but does not include guaranteed payments for the use of capital.

Suspended losses from years ending before Jan. 1, 2018, do not reduce QBI.

Relevant passthrough entities (RPE) have reporting requirements. They must specify whether any of its trades or businesses are SSTBs; determine the QBI for each trade or business; determine W-2 wages and unadjusted basis income immediately after acquisition (UBIA) for each trade or business; and determine qualified REIT dividends and PTP income, whether directly or through another RPE

Be aware that any unreported items are assumed to be no greater than zero.

Taxpayers with taxable income not exceeding threshold amount

For individuals, trusts, and estates whose income does not exceed the threshold amount, the QBI deduction equals the lesser of taxpayer’s combines qualified business income or 20% of the excess of taxpayer’s taxable income over his, her, or its net capital gain. [IRC section 199A(a)]

The qualified business income amount equals the aggregate of 20% of a taxpayer’s with respect to each qualified trade or business, plus 20% of the aggregate of qualified REIT dividends and qualified PTP income. Net losses from qualified businesses offset income of other qualified businesses, pro rata. An overall qualified business loss is carried forward and treated as being incurred in the following year.

Example: James Gatz has qualified business income of $40,000 and his net capital gain is $122,000. His taxable income = $40,000 + $122,000 − standard deduction $12,000 = $150,000.

  • 20% of total QBI = 20% × $40,000 = $8,000
  • Excess of taxable income over net capital gain = $150,000 − $122,000 = $28,000
  • 20% × $28,000 = $5,600

His QBI deduction is the lesser of $8,000 or $5,600 = $5,600.

Taxpayers with taxable income exceeding threshold amount

For individuals, trusts, and estates whose income exceeds the threshold amount, the qualified business income is subject to an additional limit. It is the lesser of 20% of qualified business income or the greater of 50% of W-2 wages or the sum of 25% of W–2 wages with respect to the qualified trade or business and 2.5% of the unadjusted basis immediately after acquisition of all qualified property.

The limit based on wages and basis is phased in, as described below. The phase-in calculation differs for SSTBs. Partners and S corporation shareholders take into account their allocable share of W-2 wages and unadjusted basis of property

Phase-in of limit

If taxpayer’s taxable income exceeds the threshold amount plus the phase-in limit, the limit based on wages and basis fully applies. If taxpayer’s taxable income is over the threshold amount but within the phase-in limit, the IRC applies a formula to determine the QBI deduction.

If 20% of qualified business income is less than the greater of 50% of W-2 wages or the sum of 25% of W–2 wages with respect to the qualified trade or business and 2.5% of the unadjusted basis immediately after acquisition of all qualified property, then the QBI equals 20% of qualified business income. If not, then the QBI equals 20% of qualified business income reduced by the reduction amount under IRC section 199A(b)(3)(B)(i): Reduction Amount = Excess Amount × (Taxable Income − Threshold Amount) ÷ ($100,000 married filing jointly or $50,000 for others).

The “excess amount” is the excess of 20% of QBI over the greater of 50% of W-2 wages or the sum of 25% of W–2 wages with respect to the qualified trade or business and 2.5% of the unadjusted basis immediately after acquisition of all qualified property

Rules Relating to Wages

“W-2 wages” means the amount shown as wages in employment returns filed by the business. To prevent late manipulation of wage amounts, the wages must be reported to Social Security Administration within 60 days after due date (with extensions) for such returns.

Under proposed regulations, “wages” includes third-party payor wages (e.g., a PEO) or allocated wages paid by related parties. Wages paid to an S corporation shareholder are included, but wages received by a taxpayer are not included. Guaranteed payments to a partner are not included.

Rules Relating to Qualified Property

Qualified property means tangible property subject to depreciation:

  • Used in production of qualified business income.
  • Held by the company at the end of the year or “available for use in the qualified trade or business.”
  • Acquired within the past 10 years, or if the property’s regular recovery period (even if using ADS) has not ended by end of year.
  • There are special rules for replacement property in like-kind exchanges and involuntary conversions, and property contributed to an S corporation or to a partnership.

The Congressional Conference Committee Report that accompanied the 2017 Tax Act states that leased property can be qualified property, and that forthcoming Treasury Regulations will offer guidance on this.

UBIA is the basis without regard to depreciation. A partnership or S corporate allocates the UBIA among its members. A partnership allocates UBIA to each partner in accordance with how it allocates depreciation, and an S corporation allocates UBIA to each shareholder in accordance with number of shares held at the end of the year.

A partnership that made IRC section 754 election allocates the excess IRC section 743(b) basis adjustment to its members (the basis adjustment generally arises from the transfer of a partnership interest). The basis adjustment is calculated as if the adjusted basis of all the partnership’s property equals the UBIA of such property. The Regulations do not mention a basis step-up (resulting from gain recognized to a partner on a distribution of property), so it is not allowed.

Example: Excess IRC section 743(b) basis adjustment [Treasury Regulations section 199A-2(a)(3)(iv)(D)(1)]:

Curly sells his one-third interest in Three Stooges LLC to Shemp for $350,000. The fair market value of the LLC is $350,000 × 3 = $1,050,000. At that time, the adjusted basis for all partnership property is $750,000. Shemp’s IRC section 743(b) basis adjustment is one-third of FMV minus basis, which is ($1,050,000 − $750,000) ÷ 3 = $100,000.

The UBIA is $900,000. The Excess IRC section 743(b) Basis Adjustment uses UBIA instead of adjusted basis, and it is ($1,050,000 − $900,000) ÷ 3 = $50,000.

Shemp’s UBIA is one-third of UBIA plus his Excess IRC section 743(b) Basis Adjustment, which is ($900,000) ÷ 3) + $50,000 = $350,000.

Aggregation of Trades and Businesses

Treasury Regulations section 1.199A-4 allows taxpayers to aggregate trades or business to combine QBI, W-2 wages and UBIA. This would benefit taxpayers with businesses that on their own do not have sufficient W-2 wages and/or UBIA to allow for the maximum deduction.

In order to qualify for aggregation, all of the following requirements must be met:

  • The same person or group of persons, directly or indirectly, owns 50% or more of each trade or business to be aggregated, meaning in the case of trades or businesses owned by an S corporation, 50% or more of the issued and outstanding shares of the corporation, or, in the case of trades or businesses owned by a partnership, 50% or more of the capital or profits in the partnership;
  • The ownership described above exists for a majority of the tax year in which the items attributable to each trade or business to be aggregated are included in income;
  • All of the items attributable to each trade or business to be aggregated are reported on returns with the same tax year, not taking into account short tax years; and
  • None of the trades or businesses to be aggregated is an SSTB.

In addition, two out of the following three requirements must be met:

  • The trades or businesses provide products and services that are the same or customarily offered together (e.g., a restaurant and a catering service).
  • The trades or businesses share facilities or 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 (e.g., rental properties and managing agent).

Aggregation is elective and is made by each individual owner of a pass-through entity. For purposes of the common ownership rules, the partners/shareholders do not have to be related to each other, but the following attribution rules apply: an individual would be considered to own the interest in each trade or business owned, directly or indirectly, by or for the individual's spouse (other than a spouse who is legally separated from the individual under a decree of divorce or separate maintenance), and the individual's children, grandchildren, and parents. Aggregation may not be elected on an amended return (except for a 2018 amended return, since that’s the first year the Regulation was promulgated.)

Once elected, aggregation applies to subsequent years. Taxpayers may add a newly acquired trade or business to a previous aggregation (whether acquired in a taxable or nontaxable transaction). A significant change in facts and circumstances that causes an aggregation to no longer qualify terminates the aggregation, and taxpayers must reapply the rules to determine whether aggregation applies.

Taxpayers must make an annual disclosure on the tax return, including the following:

  • A description of each trade or business.
  • The name and EIN of each entity in which a trade or business is operated.
  • Information identifying any trade or business that was formed, ceased operations, was acquired, or was disposed of during the taxable year.
  • Information identifying any aggregated trade or business of an RPE in which the individual holds an ownership interest.
  • Such other information as the IRS may require in forms, instructions, or other published guidance.

Take caution: the IRS may disregard aggregation if the taxpayer fails to properly report.

Example: Aggregation [Treasury Regulations section 1.199A-1(d)(4)(ix)]

Part 1. George Smiley owns three businesses: Tinker, Tailor, and Soldier. George does not elect aggregation. George’s income exceeds the threshold amount.

 

QBI

Wages

UBIA

Tinker

$1,000,000

$500,000

$0

Tailor

$1,000,000

$0

$0

Soldier

($600,000)

$500,000

$0

George must allocate the loss from Soldier proportionately to the other two businesses. Since they produce the same QBI, the Soldier loss is allocated equally.

 

QBI

Wages

UBIA

Tinker

$700,000

$500,000

$0

Tailor

$700,000

$0

$0

Soldier

$0

$500,000

$0

Computing the QBI deduction:

 

QBI

20% QBI

50% Wages

QBI deduction

Tinker

$700,000

$140,000

$250,000

$140,000

Tailor

$700,000

$140,000

$0

$0

Soldier

$0

$0

$0

$0

Part 2. Assume George aggregates the three business (and calls the aggregation Spy, because what else would he call it).

 

QBI

Wages

UBIA

Tinker

$1,000,000

$500,000

$0

Tailor

$1,000,000

$0

$0

Soldier

($600,000)

$500,000

$0

Spy

$1,400,000

$1,000,000

$0

 

Calculating the QBI deduction:

 

QBI

20% QBI

50% Wages

QBI deduction

Spy

$1,400,000

$280,000

$500,000

$280,000


Special Rules for SSTBs

The special rules for SSTBs only apply if taxpayer’s taxable income exceeds the threshold amount. The Blue Book (the explanation of the TCJA issued by Congress) refers to “some service businesses that generally give rise to income from labor services…and excludes those businesses from the provision.” SSTBs are trades or businesses that provide services in the fields of:

  • Health (includes physicians, veterinarians, psychologists)
  • Law (includes lawyers, paralegals, arbitrators); does not include services that do not requires skills unique to field of law, e.g., stenography
  • Accounting (includes CPAs, enrolled agents, return preparers)
  • Actuarial science
  • Performing arts (includes actors, singers, dancers, but not maintenance and operation of equipment, nor broadcasting)
  • Consulting (including lobbying) – providing advice and counsel to assist clients in achieving goals and solving problems. If ancillary to sale of goods or performance of other services, not an SSTB
  • Athletics (athletes, coaches, team managers). This includes a passive investor in a partnership that owns a sports team; the investor’s share of the partnership income is SSTB income
  • Financial services (managing wealth, advising clients). Does not include banking or money lending services
  • Investing and investment management
  • Trading
  • Dealing in securities and commodities
  • Securities brokers are subject to SSTB definition but not real estate or insurance brokers
  • That portion of a trade or business that provides property or services to an SSTB that has at least 50% common ownership
  • Any trade or business where principal asset is reputation or skill of one or more its employees. Treas. Reg. §1.199A-5(b)(2)(xiv). Examples include an individual who receives income for endorsing products or services, the use of image, name, voice, signature, trademark, or appearing at an event or in the media

Example.  SSTBs [Treasury Regulations section 1.199A-5(b)(3)]

Example (7) Bicycle shop where employees have reputations for the quality of their work is not an SSTB; it’s a sales and repair business.

Example (8) A famous chef owns multiple restaurants and receives endorsement fees for cookware. The restaurant income is not SSTB, but the endorsement fees are.

The Blue Book appears to give a broader definition than the proposed regulations. It says:

“For example, a trade or business in which the taxpayer works as an independent contractor for various unrelated businesses, where the business generally holds minimal tangible and intangible property, is an SSTB if the principal asset is…the reputation or skill of its owner.”

There is a de minimus rule that provides that if less than the applicable percentage of income is attributable to SSTB services, then the business is not an SSTB. The applicable percentage is 10% if gross receipts are not more than $25 million and 5% otherwise.

Example: An owner of a music store sells violin strings with gross receipts of $990,000 and also works at a restaurant, traveling table to table playing solo violin versions of Led Zeppelin’s greatest hits, for which she earns $10,000. Gross receipts from business equals $1,000,000 and the percentage attributable to SSTB services is $10,000 ÷ $1,000,000 = 1%. Therefore, the business is not an SSTB.

Calculation of QBI for SSTB

If an individual’s taxable income does not exceed the threshold amount, the SSTB rules don’t apply. If the taxpayer’s taxable income exceeds the phase-in range, then SSTB income is wholly excluded from QBI. If it exceeds the threshold but is within the phase-in range, then SSTB income is phased out from QBI. In that case, only the applicable percentage of SSTB income is QBI. The applicable percentage equals 100% − [(Taxable Income – Threshold) ÷ ($100,000 married filing jointly or $50,000 for others)].

The Regulations contain an excellent example of the application of this calculation [Treasury Regulations section 1.199A-1(d)(4), Example (5)]. The example uses the threshold amounts from 2018 (before the 2019 adjustment for inflation).

Miscellaneous Issues

Losses

Pre-2018 losses are not factored into QBI, but post-2017 losses are factored into QBI. QBI is computed after application of loss limitations calculated under the partnership or S corporate basis limit, the at-risk limit, and the limit on passive activity losses.

Ordinary income versus capital gain

IRC section 1231 net gains are capital, so are not part of QBI. On the other hand, net losses are ordinary and reduce QBI. PTP gain due to basis adjustments are characterized as ordinary income, and increases PTP income for QBI purposes

Other deductions

Certain other deductions reduce QBI.

The IRC section 179 deduction reduces QBI to the extent it reduced income from activity.

The instructions to Form 8995 list other deductions that reduce QBI, to the extent they are associated with a qualified trade or business. These include—

  • charitable contributions,
  • unreimbursed partnership expenses,
  • business interest expense,
  • deductible part of self-employment tax,
  • self-employment health insurance deduction, and
  • contributions to qualified retirement plans.

Determining the optimal amount of wages to maximize QBI

Consider this example: Krell Corp. has one shareholder, Dr. Morbius. The corporation has $100,000 income, zero wages, and zero UBIA. The QBI is zero. If Krell Corp. pays $50,000 salary to Dr. Morbius, the corporate income is reduced to $50,000, but he can take the QBI equal to the lesser of 20% of income or 50% of wages. The income limit is 20% income = 20% × $50,000 = $10,000 and the wages limit is 50% wages = 50% × $50,000 = $25,000. The QBI deduction would be $10,000

Assume the taxpayer is above the threshold amount, and UBIA is nominal. Since QBI is limited to 50% of wages, the sole shareholder of an S corporation receives the maximum benefit when 20% of QBI equals 50% of wages. It can be determined from the formula 20% × (income [before the deduction for wages] – wages) = 50% × wages. Applying simple algebra, wages = 2/7 × Income.

Conclusion

The QBI deduction has attracted a great deal of attention from business owners. Clients have asked their advisors for guidance, including questions about whether they should restructure their business operations. In any such situation, a practitioner should prepare a careful projection of the benefits or detriments to any change in business organization and should remind clients that the QBI deduction is currently scheduled to expire after 2025. Any benefit after that date is dependent upon future action by Congress.


Acknowledgements: Special thanks to my Gettry Marcus colleague Robert Thee and Ben Lederman of Cohn Reznick, whose comments and additions to the original presentation that I made were invaluable.


Dean L. Surkin, JD, LLM, is a tax director at Gettry Marcus CPA, P.C. He is a tax attorney with broad-based experience in tax planning and research, has litigated major cases in the fields of taxation, probate, and general commercial matters, and has been peer-reviewed by Martindale-Hubbell. Mr. Surkin received his BA from the University of Pennsylvania in 1973 (double major in mathematics and political science), his JD from New York University School of Law in 1976, and his LLM in taxation from New York University School of Law in 1985. He is admitted to the New York State Bar, the Federal District Courts of the Southern and Eastern Districts of New York, the Second Circuit Court of Appeals, and the U.S. Tax Court. Mr. Surkin holds the faculty appointment of Professor (Adjunct) at Pace University Graduate School of Business where he  teaches taxation of entities. He was recently honored for 35 years of service to Pace. . He formerly served as Adjunct Associate Professor at the NYU School of Continuing and Professional Studies where he was program coordinator of the Estate and Gift Taxation and Planning Certificate Program. He has also served as Adjunct Assistant Professor at Hunter College, CUNY. He has presented seminars to  FAE, the New York State Bar Association, the Association of the Bar of the City of New York, the American Society of Women Accountants, and many private groups. His published articles on tax law have appeared in peer-reviewed journals, practitioners’ journals, and the popular press.