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Section 199A Mechanics: A Comprehensive Guide to the Application of the Qualified Business Income Deduction. Hawaii Association of Public Accountants Stephan King CPA/PFS SK Education Services LLC August 2, 2019. Stephan King CPA/PFS.
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Section 199A Mechanics: A Comprehensive Guide to the Application of the Qualified Business Income Deduction Hawaii Association of Public Accountants Stephan King CPA/PFS SK Education Services LLC August 2, 2019
Stephan King CPA/PFS Stephan King CPA/PFS is a partner with Stephan King PC based in Scottsdale, Arizona. He spent 15 years with Moss Adams LLP before retiring in 2012. As a partner with Moss, he held a number of leadership roles including Phoenix Office Tax Leader. Stephan has chaired the Arizona Society of CPAs Tax Steering Committee and Oregon-Springfield Tax Association. He is a frequent speaker on tax related topics. Stephan is a graduate of the University of Hawaii and completed the University of Illinois National Tax Education Program. He began his career in Honolulu and worked for an Oregon regional firm before joining Moss Adams.
Agenda • Background/Overview • Terminology • Basic Calculation • Step 1 - Identifying Qualified Trade or Business (QTB) • Step 2 - Computing Qualified Business Income (QBI) • Step 3 - Computing QBI Limitations • Step 4 - Aggregation • Step 5 - Additional QBI REIT and PTP Income • Step 6 - Overall Taxable Income Limitation
Agenda • Fiduciary Taxation • Reasonable compensation as it applies to Section 199A • Interaction with other IRC sections • State considerations • Reporting issues for flow-through entities including fiduciaries • New developments
Background/Overview • On December 20, 2017, Congress passed the TCJA. The act was signed into law on December 22, 2017. The 2017 TCJA reduced the corporate income tax rate from a series of marginal rates between 15% and 35% to a flat rate of 21%.
Background/Overview • Congress noted that the reduction in the corporate tax rate did not mitigate the high rates of tax imposed on individuals who conduct business in noncorporate passthrough entities or through Schedule Cs.
Background/Overview • To lower these rates, Congress introduced new Section 199A, which provides an income tax benefit to investors in non-corporate businesses. Individuals and fiduciaries may be eligible to claim a deduction of up to 20% of the “Qualified Business Income” or “QBI” earned by such non-corporate business.
Background/Overview • In addition to the qualified business income deduction, §199A allows a deduction with respect to three other types of income: (i) qualified publicly traded partnership income, (ii) qualified REIT dividends, and (iii) income of, or received from, certain agricultural and horticultural cooperatives.
Background/Overview • The benefits provided by the statute are temporary, as §199A applies only to taxable years beginning after December 31, 2017, and on or before December 31, 2025.
Background/Overview • The conference report to the 2017 tax act is the main source of legislative history and providing guidance regarding how to interpret the statute. • In addition, the Joint Committee on Taxation (”JCT”) published its “bluebook” on December 20, 2018.
Background/Overview • On August 8, 2018, the IRS issued proposed regulations and a Notice providing guidance on §199A. On January 18, 2019, the IRS issued final regulations, a Revenue Procedure, and a Notice providing additional guidance. The final regulations generally apply to taxable years ending after February 8, 2019.
Background/Overview • However, taxpayers may rely on either the proposed regulations in their entirety or the final regulations in their entirety for taxable years ending in 2018.
Background/Overview • Section 199A borrows significantly from two other provisions of the Internal Revenue Code, each of which, like §199A, provides a benefit to certain favored types of businesses. • Section 199 • Section 1202
Background/Overview • Section 199 Former §199 was repealed by the Act. §199 provided an incentive for engaging in certain domestic manufacturing activities by allowing a taxpayer to deduct 9% of its “qualified production activities income.” “Qualified production activities income” was defined as the taxpayer's “domestic production gross receipts” less certain deductions. The definition of “domestic production gross receipts” included gross receipts derived from:
Background/Overview 1. The lease, rental, license, sale, exchange, or other disposition of (i) tangible personal property, software, and sound recordings produced in the United States, (ii) films for which at least 50% of the total production-related compensation is for services performed in the United States, or (iii) electricity, natural gas, or potable water produced in the United States. 2. Construction of real property performed in the United States by a taxpayer in the construction trade or business.
Background/Overview 3. Engineering or architectural services performed in the United States with respect to the construction of real property performed in the United States. The deduction was limited to 9% of adjusted gross income (for individual, trust, and estate taxpayers) or 9% of taxable income (for C corporation taxpayers). The deduction was also limited to 50% of the wages paid by the taxpayer.
Background/Overview • Section 1202 — Section 1202 allows a noncorporate taxpayer to exclude 50% of the gain recognized from the sale of “qualified small business stock.” “Qualified trades or businesses” are defined by exclusion in §1202(e)(3).
Terminology See Glossary of Terms • § 199A deduction testing taxable income– taxable income exclusive of the § 199A deduction and net capital gain, which is used for calculating an overall 20% limitation of the § 199A deduction. • Aggregated trade or business (Reg. §1.199A-1(b)(1)) – two or more trades or businesses that have been aggregated pursuant to Reg. §1.199A-4.
Terminology • Applicable percentage (§199A(d)(3)(B); Reg. §1.199A-1(b)(2)) – for purposes of §199A(d)(3)(A), with respect to any taxable year, 100 percent reduced (not below zero) by the percentage equal to the ratio that the taxable income of the individual for the taxable year in excess of the threshold amount, bears to $50,000 (or $100,000 in the case of a joint return).
Terminology • Combined qualified business income amount (§199A(b)(1)) – with respect to any taxable year, an amount equal to (i) 20% of QBI for each QTB carried on by the taxpayer (subject to the wage-basis limit), plus (ii) 20 percent of the aggregate amount of the qualified REIT dividends and qualified publicly traded partnership income of the taxpayer for the taxable year. • Depreciable period (§199A(b)(6)(B); Reg. §1.199A-2(c)(2)) – with respect to qualified property of a taxpayer, the period beginning on the date the property was first placed in service by the taxpayer and ending on the later of (i) the date that is 10 years after such date, or (ii) the last day of the last full year in the applicable recovery period that would apply to the property under §168 (determined without regard to §168(g)).
Terminology • Domestic production gross receipts (§199A(g)(3)(D)) – the gross receipts of the taxpayer which are derived from any lease, rental, license, sale, exchange, or other disposition of any agricultural or horticultural product which was manufactured, produced, grown, or extracted by the taxpayer (determined after the application of §199A(g)(4)(B)) in whole or significant part within the United States. The term does not include gross receipts of the taxpayer which are derived from the lease, rental, license, sale, exchange, or other disposition of land.
Terminology • Eligible taxpayer (§199A(g)(2)(D)) – for purposes of §199A(g), (i) a taxpayer other than a corporation, or (ii) a specified agricultural or horticultural cooperative. • Excess amount (§199A(b)(3)(B)(iii)) – for purposes of §199A(b)(3)(B)(ii), the excess of (i) 20% of the taxpayer's QBI with respect to the QTB over (ii) the wage-basis limit. • Expanded affiliated group (§199A(g)(5)(A)(iii)) – for purposes of §199A(g), an affiliated group as defined in §1504(a), determined (i) by substituting “more than 50 percent” for “at least 80 percent” each place it appears, and (ii) without regard to §1504(b)(2) and §1504(b)(4).
Terminology • Individual (Reg. §1.199A-1(a)(2), §1.199A-6(d)(1)) – includes individuals as well as a trust (other than a grantor trust), and an estate to the extent that such trust or estate retains QBI and other items and claims a §199A deduction itself. • Oil related qualified production activities income (§199A(G)(5)(E)(ii)) – for purposes of §199A(g), for any taxable year the qualified production activities income which is attributable to the production, refining, processing, transportation, or distribution of oil, gas, or any primary product thereof (within the meaning of §927(a)(2)(C), as in effect before its repeal) during such taxable year.
Terminology • Net capital gain (Reg. §1.199A-1(b)(3)) – means net capital gain as defined in section 1222(11) plus any qualified dividend income (as defined in section 1(h)(11)(B)) for the taxable year. • Phase-in amount – $50,000 ($100,000 for joint filers) above the threshold amount. For 2018, the amount is $207,500 ($415,000 for joint filers). • Phase-in percentage – the quotient of (i) threshold testing taxable income less the threshold amount over (ii) $50,000 ($100,000 for joint filers).
Terminology • Phase-in range (Reg. §1.199A-1(b)(4)) – means a range of taxable income between the threshold amount and the threshold amount plus $50,000 (or $100,000 in the case of a joint return). • QBI component (Reg. §1.199A-1(b)(6), §1.199A-1(d)(2)) – the lesser of 20% of QBI or the wage-basis limit with respect to a QTB. • Qualified business income (§199A(c); Reg. §1.199A-1(b)(5)) – means the net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business (or aggregated trade or business) as determined under the rules of §1.199A-3(b).
Terminology • Qualified items of income, gain, deduction, and loss (§199A(c)(3)) – items of income, gain, deduction, and loss to the extent such items are (i) effectively connected with the conduct of a trade or business within the United States (within the meaning of §864(c), determined by substituting “Qualified Trade or Business (QTB) (within the meaning of §199A)” for “nonresident alien individual or a foreign corporation” or for “a foreign corporation” each place it appears), and (ii) included or allowed in determining taxable income for the taxable year.
Terminology • Qualified payment (§199A(g)(2)(E)) – for purposes of §199A, with respect to any eligible taxpayer, any amount which (i) is described in §1385(a)(1) or §1385(a)(3), (ii) is received by such taxpayer from a specified agricultural or horticultural cooperative, and iii) is attributable to qualified production activities income with respect to which a deduction is allowed to such cooperative under §199A(g)(1). • Qualified production activities income (§199A(g)(3)) – for any taxable year means an amount equal to the excess (if any) of (i) the taxpayer's domestic production gross receipts for such taxable year, over (ii) the sum of (I) the cost of goods sold that are allocable to such receipts, and (II) other expenses, losses, or deductions (other than the §199A(g) deduction), which are properly allocable to such receipts.
Terminology • Qualified property (§199A(b)(6)(A)) – with respect to any QTB for a taxable year, tangible property of a character subject to the allowance for depreciation under §167 (i) which is held by, and available for use in, the QTB at the close of the taxable year, (ii) which is used at any point during the taxable year in the production of QBI, and (iii) the depreciable period for which has not ended before the close of the taxable year. • Qualified publicly traded partnership income (§199A(e)(4); Reg. §1.199A-1(b)(7), §1.199A-3(c)(3)) – with respect to any QTB a taxpayer, the sum of (i) the net amount of such taxpayer's allocable share of each qualified item from a PTP which is not treated as a corporation under §7704(c), plus (ii) any gain or loss attributable to assets of the PTP giving rise to ordinary income under section 751(a) or (b) that is considered attributable to the trades or businesses conducted by the partnership.
Terminology • Qualified REIT dividends (§199A(e)(3); Reg. §1.199A-1(b)(8), §1.199A-3(c)(2)) – any dividend from a real estate investment trust received during the taxable year which (i) is not a capital gain dividend, as defined in §857(b)(3), and (ii) is not qualified dividend income, as defined in §1(h)(11). • Qualified Trade or Business (QTB) (§199A(d)) – any trade or business other than (i) an SSTB or (ii) the trade or business of performing services as an employee. • Reduction amount (§199A(b)(3)(B)(ii); Reg. §1.199A-1(b)(9)) – the excess amount multiplied by the ratio that the taxable income of the individual for the taxable year in excess of the threshold amount, bears to $50,000 (or $100,000 in the case of a joint return). For purposes of this paragraph (b)(9), the excess amount is the amount by which 20 percent of QBI exceeds the greater of 50 percent of W-2 wages or the sum of 25 percent of W-2 wages plus 2.5 percent of the UBIA of qualified property.
Terminology • Relevant passthrough entity (Reg. §1.199A-1(b)(10)) – a partnership (other than a PTP) or an S corporation that is owned, directly or indirectly, by at least one individual, estate, or trust. Other passthrough entities including common trust funds as described in §1.6032-1T and religious or apostolic organizations described in section 501(d) are also treated as RPEs if the entity files a Form 1065, U.S. Return of Partnership Income, and is owned, directly or indirectly, by at least one individual, estate, or trust. A trust or estate is treated as an RPE to the extent it passes through QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, or qualified PTP income.
Terminology • Specified agricultural or horticultural cooperative (§199A(g)(4)(A)) – for purposes of §199A(g), an organization to which part I of subchapter T applies which is engaged (i) in the manufacturing, production, growth, or extraction in whole or significant part of any agricultural or horticultural product, or (ii) in the marketing of agricultural or horticultural products.
Terminology • Specified service trade or business (“SSTB”) (§199A(d)(2)(A); Reg. §1.199A-1(b)(11), §1.199A-5(b)) – any trade or business (i) which is described in §1202(e)(3)(A) (applied without regard to the words “engineering, architecture,”) or which would be so described if the term “employees or owners” were substituted for “employees” therein, or (ii) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in §475(c)(2)), partnership interests, or commodities (as defined in §475(e)(2)).
Terminology • Threshold amount (§199A(e)(2); Reg. §1.199A-1(b)(12)) – for any taxable year beginning before 2019, $157,500 (or $315,000 in the case of a taxpayer filing a joint return). In the case of any taxable year beginning after 2018, the threshold amount is the dollar amount in the preceding sentence increased by an amount equal to such dollar amount, multiplied by the cost-of-living adjustment determined under section 1(f)(3) of the Code for the calendar year in which the taxable year begins, determined by substituting “calendar year 2017” for “calendar year 2016” in section 1(f)(3)(A)(ii). The amount of any increase under the preceding sentence is rounded as provided in section 1(f)(7) of the Code. • Threshold testing taxable income – taxable income exclusive of the § 199A deduction but inclusive of net capital gain, which is used for comparison to the threshold amount and phase-in amount.
Terminology • Total QBI amount (Reg. §1.199A-1(b)(13)) – the net total QBI from all QTBs, including the taxpayer's share of QBI from QTBs conducted by RPEs. • Trade or business (Reg. §1.199A-1(b)(14)) – a trade or business that is a trade or business under section 162 (a section 162 trade or business) other than the trade or business of performing services as an employee. In addition, rental or licensing of tangible or intangible property (rental activity) that does not rise to the level of a section 162 trade or business is nevertheless treated as a trade or business for purposes of section 199A, if the property is rented or licensed to a trade or business conducted by the individual or an RPE which is commonly controlled under §1.199A-4(b)(1)(i) (regardless of whether the rental activity and the trade or business are otherwise eligible to be aggregated under §1.199A-4(b)(1)).
Terminology • Unadjusted basis immediately after acquisition (Reg. §1.199A-1(b)(14), §1.199A-2(c)) – the basis of qualified property on the placed in service date of the property. • W-2 wages (§199A(b)(4); Reg. §1.199A-1(b)(16)) – trade or business (or aggregated trade or business) properly allocable to QBI as determined under §1.199A-2(b). With respect to any person for any taxable year of such person, the amounts described in section 6051(a)(3) and (8) paid by such person with respect to employment of employees by such person during the calendar year ending during such taxable year. Thus, the term W-2 wages includes the total amount of wages as defined in section 3401(a) plus the total amount of elective deferrals (within the meaning of section 402(g)(3)), the compensation deferred under section 457, and the amount of designated Roth contributions (as defined in section 402A).
Terminology • Wage-basis limit – the greater of (i) the amount determined under the wages test or (ii) the amount determined under the wages plus basis test. • Wages plus basis test – sum of (i) 25% of W-2 wages with respect to the QTB plus (ii) 2.5% of UBIA of qualified property. • Wages test – 50% of W-2 wages with respect to the QTB.
199A Basic Calculation • Section 199A provides a deduction equal to the lesser of: • The taxpayer's “combined qualified business income amount” and • 20% of the taxpayer's taxable income, calculated without regard to net capital gain and to the §199A deduction.
199A Basic Calculation • “Combined qualified business income amount” equals the sum of: • 20% of the taxpayer's “qualified business income” (“QBI”) from each “Qualified Trade or Business (QTB) (“QTB”) (as limited by the “wage-basis limit,” defined later), and • 20% of the taxpayer's aggregate amount of “qualified REIT dividends” and “qualified publicly traded partnership income.”
199A Basic Calculation • Losses • QTB or a publicly traded partnership (PTP) losses reduce the combined qualified business income amount. • The regulations provide separate loss netting rules • For the QBI element of the deduction and • For the qualified REIT dividend and qualified PTP income element of the deduction.
Qualified Trade or Business (QTB) • The calculation of QBI and therefore, the benefits of section 199A, are limited to taxpayers with income from a trade or business. Section 199A and its legislative history, however, do not define the phrase “trade or business.”
Qualified Trade or Business (QTB) • The regulations define trade or business by reference to section 162. Section 162(a) permits a deduction for all the ordinary and necessary expenses paid or incurred in carrying on a trade or business. • For purposes of section 199A and the regulations thereunder, §1.199A-1(b)(14) defines trade or business as a trade or business under section 162 (section 162 trade or business) other than the trade or business of performing services as an employee.
Qualified Trade or Business (QTB) • Treasury stated in the preamble of the final regulations: “it is inherently a factual question and specific guidance under section 162 is beyond the scope of these regulations.” • Accordingly, Treasury concluded that the factual setting of various trades or businesses varies so widely that a single rule or list of factors would be difficult to provide in a timely and manageable manner and would be difficult for taxpayers to apply.
Qualified Trade or Business (QTB) • How do we define trade or business? • In Higgins v. Commissioner, 312 U.S. 212 (1941), the Supreme Court noted that determining whether a trade or business exists is a factual determination. • Specifically, the Court stated that the determination of “whether the activities of a taxpayer are ‘carrying on a business’ requires an examination of the facts in each case.”
Qualified Trade or Business (QTB) • How do we define trade or business? • In Commissioner v. Groetzinger, 480 U.S. 23 (1987), the Supreme Court required a profit motive. They reasoned taxpayer must enter into and carry on the activity with a good faith intention to make a profit or with the belief that a profit can be made from the activity. Secondly, they required the scope of the activities must be considerable, regular, and continuous.
Qualified Trade or Business (QTB) • How do we define trade or business? • In Groetzinger, the Supreme Court stated, “[w]e do not overrule or cut back on the Court's holding in Higgins when we conclude that if one's gambling activity is pursued full time, in good faith, and with regularity, to the production of income for a livelihood, and is not a mere hobby, it is a trade or business within the statutes with which we are here concerned.”
Qualified Trade or Business (QTB) • Profit Motive • The reasonableness of the taxpayer's belief that the activity will generate a profit is not relevant. • A mere hope that an activity will generate profits, in the absence of any specific plans to achieve a profit, is inconsistent with an allegation that the purpose or belief is in good faith. • A trade or business can exist even if there are no profits in the initial years, provided that there is profit potential.
