This is the fourth[i] and final in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction/
Earlier posts considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one , the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A, https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ , and the meaning of “qualified business income.” https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-three/. Today, we turn to the calculation of the deduction, the limitations on the amount of the deduction, and some special rules.
Threshold and Phase-In Amounts
Let’s assume for the moment that our taxpayer (“Taxpayer”) is a married individual, files a joint return with their spouse, and owns an equity interest in a qualified trade or business (“QTB”) that is conducted through a pass-through entity (“PTE”), such as a sole proprietorship,[ii] a partnership, or an S corporation.
At this point, Taxpayer must determine their joint taxable income for the taxable year.[iii]
There are three categories of taxpayers for purposes of Section 199A – those whose joint taxable income[iv]:
- does not exceed $315,000 (the “threshold”),
- exceeds $315,000 but does not exceed $415,000 (the “phase-in range”),[v] and
- exceeds $415,000.[vi]
Below the Threshold
If Taxpayer falls within the first category – joint taxable income that does not exceed $315,000 – they determine their Section 199A deduction by first calculating 20% of their QBI with respect to their QTB (Taxpayer’s “combined QBI amount”).[vii] For this first category of taxpayer, their share of income from a specified service trade or business (“SSTB”) qualifies as QBI.
Taxpayer must then compare their
- combined QBI amount (determined above) with
- an amount equal to 20% of the excess of:
- their taxable income for the taxable year, over
- their net capital gain for the year.
The lesser of these two amounts is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain. Taxpayer’s Section 199A deduction is equal to the lesser of these two amounts.
Thus, if Taxpayer’s only source of income was their QTB, Taxpayer would be entitled to claim the full “20% of QBI” deduction, with the result that their QBI would be subject to an effective top federal income tax rate of 29.6%[viii]
Above the Threshold and Phase-In
If Taxpayer falls within the third category – joint taxable income for the taxable year in excess of $415,000 – they face several additional hurdles in determining their Section 199A deduction.[ix] It is with respect to these taxpayers that the application of the Section 199A rules becomes even more challenging, both for the taxpayers and their advisers.
To start, no SSTB in which Taxpayer has an equity interest will qualify as a QTB as to Taxpayer.
Moreover, there are other limitations, in addition to the ones described above, that must be considered in determining the amount of Taxpayer’s Section 199A deduction.
Before turning to these limitations, it is important to note the following:
- the application of the threshold and phase-in amounts is determined at the level of the individual owner of the QTB[x], which may not be where the trade or business is operated; and
- taxpayers with identical interests in, and identical levels of activity with respect to, the same trade or business may be treated differently if one taxpayer has more taxable income from sources outside the trade or business than does the other;
- for example, a senior partner of a law firm, who has had years to develop an income-producing investment portfolio, vs a junior partner at the same firm, whose share of partnership income represents their only source of income.[xi]
The additional limitations referred to above are applied in determining Taxpayer’s “combined QBI amount.”
Specifically, the amount equal to 20% of Taxpayer’s QBI with respect to the QTB must be compared to the greater of:
- 50% of the “W-2 wages” with respect to the QTB, or
- The sum of (i) 25% of the W-2 wages plus (ii) 2.5% of the unadjusted basis (“UB”) of qualified property immediately after the acquisition of all qualified property (“a” and “b” being the “alternative limitations”).
The lesser of Taxpayer’s “20% of QBI” figure and the above “W-2 wages-based” figure may be characterized as Taxpayer’s “tentative” Section 199A deduction; it is subject to being further reduced in accordance with the following caps:
- The Section 199A deduction cannot be greater than 20% of the excess (if any) of:
- Taxpayer’s taxable income for the taxable year, over
- Taxpayer’s net capital gain for the year.
- The resulting amount – i.e., the tentative deduction reduced in accordance with “a” – is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain.
Taxpayer’s Section 199A deduction is equal to the lesser of the two amounts described in “b”, above.
Applied to Each QTB
Under the PR, an individual taxpayer must determine the W-2 wages and the UB of qualified property attributable to each QTB contributing to the individual’s combined QBI. The W-2 wages and the UB of qualified property amounts are compared to QBI in order to determine the individual’s QBI component for each QTB.
After determining the QBI for each QTB, the individual taxpayer must compare 20% of that trade or business’s QBI to the alternative limitations for that trade or business.
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, and the deduction is reduced.
The PR also provide that, if an individual has QBI of less than zero (a loss) 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 limitations based on W-2 wages and UB of qualified property.
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 limitation based on W-2 wages and UB of qualified property, the net 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 UB of qualified property from the trades or businesses which produced negative QBI for the taxable year are not carried over into the subsequent year.
The PR provide that, in determining W-2 wages, the common law employer (such as a PTE) may take into account any W-2 wages paid by another person – such as a professional employer organization – and reported by such other person on Forms W-2 with the reporting person as the employer listed on the Forms W-2, provided that the W-2 wages were paid to common law employees of the common law employer for employment by the latter.[xii]
Under this rule, persons who otherwise qualify for the deduction are not limited in applying the deduction merely because they use a third party payor to pay and report wages to their employees.
The W-2 wage limitation applies separately for each trade or business. Accordingly, the PR provides that, in the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined to be in the same proportion to total W-2 wages as the ordinary business deductions associated with those wages are allocated among the particular trades or businesses.
W-2 wages must be properly allocable to QBI (rather than, for example, to activity that produces investment income). W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.
Where the QTB is conducted by a PTE, a partner’s or a shareholder’s allocable share of wages must be determined in the same manner as their share of wage expenses.
Finally, the PR provide that, in the case of an acquisition or disposition of (i) a trade or business, (ii) the major portion of a trade or business, or (iii) the major portion of a separate unit of a trade or business, that causes more than one individual or entity to be an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity.
UB of Qualified Property
The PR provides that “qualified property” means (i) tangible property of a character subject to depreciation that is held by, and available for use in, a trade or business at the close of the taxable year, (ii) which is used in the production of QBI, and (iii) for which the depreciable period has not ended before the close of the taxable year.
“Depreciable period” means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property without regard to whether any bonus depreciation was claimed with respect to the property. Thus, it is possible for a property to be treated as qualified property even where it is no longer being depreciated for tax purposes.
The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased or contributed.
UB is determined without regard to any adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense (for example, under Sec. 179 of the Code). Therefore, for purchased or produced qualified property, UB generally will be its cost as of the date the property is placed in service.
For qualified property contributed to a partnership in a “tax-free” exchange for a partnership interest and immediately placed in service, UB generally will be its basis in the hands of the contributing partner, and will not be changed by subsequent “elective” basis adjustments.
For qualified property contributed to an S corporation in a “tax-free” exchange for stock and immediately placed in service, UB generally will be its basis in the hands of the contributing shareholder.[xiii]
Further, for property inherited from a decedent and immediately placed in service by the heir, the UB generally will be its fair market value at the time of the decedent’s death.
In order to prevent trades or businesses from transferring or acquiring property at the end of the year merely to manipulate the UB of qualified property attributable to the trade or business, the PR provides that property is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the deduction.
For purposes of determining the depreciable period of qualified property, the PR provide that, if a PTE acquires qualified property in a non-recognition exchange, the qualified property’s “placed-in-service” date is determined as follows: (i) for the portion of the transferee-PTE’s UB of the qualified property that does not exceed the transferor’s UB of such property, the date such portion was first placed in service by the transferee-PTE is the date on which the transferor first placed the qualified property in service; (ii) for the portion of the transferee’s UB of the qualified property that exceeds the transferor’s UB of such property, if any, such portion is treated as separate qualified property that the transferee first placed in service on the date of the transfer.
Thus, qualified property acquired in these non-recognition transactions will have two separate placed in service dates under the PR: for purposes of determining the UB of the property, the relevant placed in service date will be the date the acquired property is placed in service by the transferee-PTE (for instance, the date the partnership places in service property received as a capital contribution); for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the transferor first placed the property in service (for instance, the date the partner placed the property in service in their sole proprietorship).
The PR also provide guidance on the treatment of subsequent improvements to qualified property.[xiv]
Finally, in the case of a trade or business conducted by a PTE, the PR provide that, in the case of qualified property held by a PTE, each partner’s or shareholder’s share of the UB of qualified property is an amount that bears the same proportion to the total UB of qualified property as the partner’s or shareholder’s share of tax depreciation bears to the entity’s total tax depreciation attributable to the property for the year.[xv]
Computational Steps for PTEs
The PR also provide additional guidance on the determination of QBI for a QTB conducted by a PTE.
A PTE conducting an SSTB may not know whether the taxable income of any of its equity owners is below the threshold amount. However, the PTE is best positioned to make the determination as to whether its trade or business is an SSTB.
Therefore, reporting rules require each PTE to determine whether it conducts an SSTB, and to disclose that information to its partners, shareholders, or owners.
In addition, notwithstanding that PTEs cannot take the Section 199A deduction at the entity level, each PTE must determine and report the information necessary for its direct and indirect individual owners to determine their own Section 199A deduction.
Thus, the PR direct PTEs to determine what amounts and information to report to their owners and the IRS, including QBI, W-2 wages, and the UB of qualified property for each trade or business directly engaged in.
The PR also require each PTE to report this information on or with the Schedules K-1 issued to the owners. PTEs must report this information regardless of whether a taxpayer is below the threshold amount.
“That’s All Folks!”[xvi]
With the series of posts ending today, we’ve covered most aspects of the new Section 199A rule, as elaborated by the PR, though the following points are also worth mentioning:
- the Section 199A deduction has no effect on the adjusted basis of a partner’s interest in a partnership;
- the deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation or the S corporation’s accumulated adjustments account;
- the deduction does not reduce (i) net earnings from self-employment for purposes of the employment tax (for example, a partner’s share of a partnership’s operating income), or (ii) net investment income for purposes of the surtax on net investment income (for example, a shareholder’s share of an S corporation’s business in which the shareholder does not materially participate); and
- for purposes of determining an individual’s alternative minimum taxable income for a taxable year, the entire deduction is allowed, without adjustment.
Stay tuned. Although taxpayers may rely upon the PR, they are not yet final. A public hearing on the PR is scheduled for October 16; the Republicans recently proposed to make the deduction “permanent” (whatever that means); midterm elections are scheduled for November 6; we have a presidential election in 2020; the deduction is scheduled to disappear after 2025. Oh, bother.
[i] Yes, I know – where has time gone? The fourth already? Seems like just yesterday, I was reading the first. Alternatively: Oh no, not another! It’s like reading . . . the Code? Where are those definitions of SSTB covered? The first or the second installment?
[ii] Including a single-member LLC that is disregarded for tax purposes.
[iii] Of course, we are only considering taxable years beginning after December 31, 2017, the effective date for Section 199A of the Code.
[iv] Regardless of the source or type of the income.
[v] See EN ix, below.
[vi] For our purposes, it is assumed that Taxpayer has no “qualified cooperative dividends,” no “qualified REIT dividends,” and no “qualified publicly traded partnership income.”
[vii] If Taxpayer has more than one QTB, this amount is determined for each such QTB, and these amounts are then added together.
[viii] I.e., 80% of the regular 37% rate.
[ix] Yes, we skipped the second category – taxpayers with taxable income in excess of the threshold amount but within the phase-in range amount.
The exclusion of QBI (for SSTBs), W-2 wages, and UB of qualified property from the computation of the Section 199A deduction is subject to a phase-in for individuals with taxable income within the phase-in range.
[x] Thus, we look at the taxable income of the individual member of the LLC or shareholder of the S corporation – not at the taxable income of the entity.
[xi] Compare to the passive activity loss rules (material participant or not?), and the net investment income surtax rules (modified adjusted gross income in excess of threshold; material participant?).
[xii] In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person.
[xiii] The PR also provide special rules for determining the UB and the depreciable period for property acquired in a “tax-free” exchange.
Specifically, for purposes of determining the depreciable period, the date the exchanged basis in the replacement qualified property is first placed in service by the trade or business is the date on which the relinquished property was first placed in service by the individual or PTE, and the date the excess basis in the replacement qualified property is first placed in service by the individual or PTE is the date on which the replacement qualified property was first placed in service by the individual or PTE. As a result, the depreciable period for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.
Thus, qualified property acquired in a like-kind exchange will have two separate placed in service dates under the PR: for purposes of determining the UBIA of the property, the relevant placed in service date will be the date the acquired property is actually placed in service; for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the relinquished property was first placed in service.
[xiv] Rather than treat them as a separate item of property, the PR provides that, in the case of any addition to, or improvement of, qualified property that is already placed in service by the taxpayer, such addition or improvement is treated as separate qualified property that the taxpayer first placed in service on the date such addition or improvement is placed in service by the taxpayer for purposes of determining the depreciable period of the qualified property. For example, if a taxpayer acquired and placed in service a machine on March 26, 2018, and then incurs additional capital expenditures to improve the machine in May 2020, and places such improvements in service on May 27, 2020, the taxpayer has two qualified properties: The machine acquired and placed in service on March 26, 2018, and the improvements to the machine incurred in May 2020 and placed in service on May 27, 2020.
[xv] In the case of qualified property of a partnership that does not produce tax depreciation during the year (for example, property that has been held for less than 10 years but whose recovery period has ended), each partner’s share of the UB of qualified property is based on how gain would be allocated to the partners if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property. In the case of qualified property of an S corporation that does not produce tax depreciation during the year, each shareholder’s share of the UB of the qualified property is a share of the UB proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.
[xvi] And so ended every episode of Looney Tunes. Thank you Mel Blanc.