The IRS has issued final regulations on determining allowable deductions based on qualified business income (QBI) from pass-through entities. This break is available only through 2025, unless it's extended by future legislation.
The QBI deduction was originally designed to achieve greater tax parity for pass-through business entities and C corporations, which are now subject to a flat 21% federal income tax rate. Income from pass-through entities is reported on the individual owners' personal tax returns, and effective tax rates for individuals only decreased slightly under the Tax Cuts and Jobs Act (TCJA).
Limitations on the QBI Deduction
Above specified income levels, QBI deduction limitations are phased in. These limitations are based on:
The unadjusted basis immediately after acquisition (UBIA) of qualified property, and
Whether the business is classified as a specified service trade or business (SSTB).
The limitation phase-in ranges are indexed annually for inflation. For 2018, the limitations are phased in when the individual has taxable income (calculated before any QBI deduction) above $157,500 or $315,000 for a married couple who files a joint tax return. For 2019, the phase-in threshold is $160,700 or $160,725 for a married person who files a separate return or $321,400 for a married couple who files a joint return.
The limitations are phased in over a taxable income range of $50,000 or $100,000 for a married couple who files a joint tax return. For 2018, phaseout is complete once taxable income for that year exceeds $207,500 or $415,000 for a married couple who files a joint tax return. For 2019, it increases to $210,700 or $210,725 for a married person who file a separate return or $421,400 for a married couple who files a joint return.
In addition, your allowable QBI deduction can't exceed 20% of taxable income calculated before the QBI deduction and before any net capital gain. (This is net long-term capital gains in excess of net short-term capital losses plus qualified dividends.)
The rules in the new final regulations are nearly 250 pages long. They're largely the same as in proposed regulations that the IRS issued in August 2018. However, the final regulations include clarifications and additional examples. Here are highlights of the new final regulations.
Important: The new final regulations don't address when income from rental real estate ventures can qualify for the QBI deduction. However, IRS Notice 2019-7 was issued at the same time as the new final regulations. It provides a helpful safe-harbor regulations for eligible rental real estate enterprises.
Rentals to Controlled Businesses
Under a special rule, the rental or licensing of tangible or intangible property to a related business is treated as a business for QBI deduction purposes. The special rule applies only if the rental or licensing activity and the other business are commonly controlled (50% common ownership).
The final regulations clarify that this special rule is limited to situations in which the rental is to another business owned by the taxpayer or to a pass-through entity that's commonly controlled. For example, if an individual rents property to his or her 100%-owned S corporation, the rental activity would count as a business for QBI deduction purposes. On the other hand, renting property to a controlled C corporation won't count as a business for QBI deduction purposes.
Net Capital Gains
Taxpayers with investment interest expense (typically from brokerage firm margin accounts) can elect to treat net long-term capital gains and qualified dividends as ordinary investment income. This treatment can increase the taxpayer's allowable deduction for investment interest expense.
If this election is made, the final regulations clarify that it does not change the individual's net capital gain amount for purposes of the overall QBI deduction limitation.
Under the final regulations, guaranteed payments to a partner (or LLC member treated as a partner for tax purposes) for the use of capital aren't considered business income. Therefore, these payments aren't counted as income when calculating a recipient partner's (LLC member's) QBI.
In addition, business-related losses or deductions that were suspended, disallowed or limited in earlier tax years (for example by the passive loss rules), but that are allowed in the current year, are generally included when calculating QBI for the current year. These now-allowed losses are taken into account in the current year from the oldest to the most recent (first-in, first-out method). However, losses or deductions that were disallowed, suspended or limited in tax years ending before January 1, 2018, are not taken into account in calculating QBI for later years.
Generally, a net operating loss (NOL) deduction is not considered a business loss or counted when calculating QBI. However, the final regulations clarify that allowable current-year deductions for disallowed excess business losses from earlier years (which are treated as NOLs) are included when calculating QBI for the current year.
The final regulations also state that, to the extent that an individual's gross income from a related business is included in calculating QBI, the following expenses are treated as attributable to the business and are therefore subtracted in calculating QBI:
The deductible portion of self-employment tax,
The self-employed health insurance deduction, and
Deductions for contributions to self-employed retirement plans.
With multiple businesses, these amounts are allocated in proportion to gross income from the businesses.
Carryover of Negative QBI Amounts
If an individual's total QBI amount is less than zero, the negative amount is treated as negative QBI from a separate business in the individual's following tax year. This carryover rule doesn't affect the deductibility of losses under any other tax code provisions.
Important: W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of qualified property from a business that produces negative QBI for the current tax year aren't taken into account for purposes of the W-2 wage and UBIA of qualified property limitations. (See "Limitations on the QBI Deduction" at right.) In addition, those W-2 wages and the UBIA of qualified property aren't carried over to the following tax year.
Calculating W-2 Wages
The final regulations confirm that W-2 wages paid to S corporation shareholder-employees count as W-2 wages for purposes of the W-2 wage limitation. However, W-2 wages paid to an S corporation shareholder-employee don't count as QBI.
The IRS issued Revenue Procedure 2019-11 at the same time it released the final QBI deduction regulations. The new guidance explains allowable methods for calculating W-2 wages of a business for purposes of the W-2 wage limitation. It also discusses when employee elective deferral (salary reduction) contributions to retirement plans can be counted as W-2 wages. The guidance applies to tax years beginning after December 31, 2017.
Calculating UBIA of Qualified Property
In calculating the UBIA of qualified property, the final regulations set forth the following rules:
Each partner's share of the UBIA of qualified partnership property follows how depreciation is allocated for book purposes under the partnership tax allocation regulations as of the last day of the partnership's tax year. The same rule applies to members of LLCs treated as partnerships for tax purposes.
Each shareholder's share of the UBIA of qualified S corporation property follows the shareholder's stock ownership percentage as of the last day of the S corporation's tax year.
For qualified property acquired from a decedent and immediately placed in service, the UBIA of the property generally equals its fair market value on the date of the decedent's death.
The UBIA of qualified property received in a Section 1031 like-kind exchange (replacement property) generally equals the UBIA of the property that's relinquished in the exchange. However, if the taxpayer receives money or non-like-kind property (boot) in the exchange or gives up money or non-like-kind exchange property in the exchange, the taxpayer's UBIA in the replacement property must be adjusted accordingly.
When qualified property that's not of like kind to the relinquished property is received in a Section 1031 exchange, the received qualified property is treated as separate qualified property that's placed in service when placed in service by the taxpayer that receives the replacement property.
In addition, a basis adjustment to a partner's (LLC member's) share of partnership (LLC) qualified property when a partnership (LLC) interest is transferred is treated as qualified property to the extent the basis adjustment reflects an increase in the fair market value of the underlying partnership property. The final regulations include a procedure to implement this rule. The basis adjustment is treated as a separate item of qualified property that's placed in service when the transfer of the partnership (LLC) interest occurs.
For tax years ending in 2018, taxpayers can generally choose to rely on the rules in the new final regulations in their entirety or those in the earlier proposed regulations (issued in August of 2018) in their entirety. However, anti-abuse rules in the final regulations apply to tax years ending after December 22, 2017. And rules intended to prevent abuse by trusts apply to tax years ending after August 16, 2018.
Ask a Tax Pro
The QBI deduction can help eligible individuals, estates and trusts save significant taxes. But the rules are complicated. In addition to the final regulations discussed above, the IRS has issued new proposed regulations that cover such topics as 1) the treatment of previously suspended losses, 2) regulated investment companies (mutual funds), 3) charitable remainder trusts, and 4) split interest trusts.
Contact your EHTC Tax Professional if you have questions about IRS guidance on the QBI deduction or want more information. Your advisor can help you make the most of this potentially lucrative new tax break.