Section 199A Deduction
Qualified Business Income (QBI) Deduction

NOTES:

  • Businesses that are being taxed as a C-Corp do not qualify for this deduction.
  • Qualified trades or businesses include most trades or businesses except: (1) specified service trade or business businesses (defined below) and (2) W-2 employees.
  • The §199A deduction is not claimed on a trade or business tax return, rather it is claimed on line 9 of the owner’s 2018 Form 1040 or line XX of a trust’s Form 1041.
  • Only applies if the trade or business shows a profit for the year and it also meets other qualifications that are discussed below.
  • Unfortunately, while a potential 20% deduction is a significant boon for many taxpayers, §199A is just one small part of the biggest change to the U.S. tax law in three decades. Therefore, the IRS will need to provide guidance and regulations for applying the new and modified tax laws.  It may be months, if not years, before answers are finalized.
  • Until IRS guidance and regulations are available, §199A needs to be approached cautiously in light of the new reduced threshold for the §6662 substantial-understatement of tax penalty that applies when a taxpayer chooses to claim the §199A deduction.
  • Proposed IRS regulations issued on August 8, 2018 have killed hope for a so-called “crack and pack” plan of spinning off non-QBI portions of a business.
  • Form 8995 released in draft form on 2/13/2019


SITUATION 1 (retirement and investment income) do not qualify for a QBI deduction.

Effective tax planning Invest in an LLC that operates a trade or business that will pass-through a QBI deduction.


SITUATION 2 (W-2 employees) does not qualify for a QBI deduction.

Effective tax planning reduce or terminate your employment relationship. Form an S-Corp to provide consulting services to the former employer. Make sure the worker classification tests and 20-factor test are complied with.


SITUATION 3 (most all small businesses, including certain real estate rentals) Business owners with qualified business income below $157,500 (or $315,000 for those filing jointly with a spouse) generally will have a QBI deduction of 20% of their qualified business income (or 20% of their taxable income, if that is lower)

It generally will not make any difference with the structure or what type of business is generating the income (as long as it is not being operated by a business that is taxed as a C-Corp), nor is there any need to analyze W-2 wages paid by the business nor analyze the depreciable assets owned by the business.

Generally, the 199A deduction is equal to the lesser of (1) 20% of the combined QBI amount of all businesses or (2) the overall limitation (20% * taxpayer’s taxable income in excess of any net capital gain).  IRS Regulations or Tax Court will need to clarify if M2M ordinary gains are defined as “net capital gain” for this purpose, and likewise they also will need to clarify if non-M2M capital gains of traders are exempt from the definition of “net capital gain” for this purpose.

Effective tax planning basically every self-employed (Sch. C) business should have QBI below $157,500 (or $315,000 for those filing jointly with a spouse).  Otherwise, form an S-Corp to drive the QBI down.

If the business is an S-Corp – justify a way to legitimately lower the amount of wages paid to the owner.  This increases the QBI deduction and lowers the payroll taxes.


SITUATION 4 (pertaining to specified service trade or business businesses) For business owners with qualified business income over $157,500 (or $315,000 for those filing jointly with a spouse) who have income from a “specialized service activity” (such as: doctors, lawyers, accountants, athletes, musicians and traders) the QBI deduction of 20% is phased out and then completely eliminated once qualified business income goes over $207,500 (or $415,000 for those filing jointly with a spouse)

A specified service trade or business probably means any trade or business activity involving:

  • Doctors
  • Health
  • Lawyers
  • Law
  • Accounting
  • CPAs
  • Financial advisors
  • Financial services
  • Consulting
  • Actuarial science
  • Athletes
  • Athletics
  • Actors
  • Musicians
  • Performing arts
  • Brokerage services
  • Investing
  • Investment management
  • trading in securities, partnership interests, or commodities (but perhaps not any other financial instruments)
  • dealing in securities, partnership interests, or commodities (but perhaps not any other financial instruments)
  • Any other trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners
  • See IRC §199A(d)(2) and IRC §1202(e)(3)(A)
  • Specifically exempt from this definition are the businesses of Engineers and Architects
  • The bolded items above are also listed at IRC §1202(e)(3)(A)
  • also see this article


Effective tax planning here may include forming an S-Corp to separate and spin-off any non-specialized service activity into.


SITUATION 5 (not for specified service trade or business businesses) For a business other than a specialized service activity with qualified business income over $157,500 (or $315,000 for those filing jointly with a spouse) there is also a phase out which can be forestalled by having certain amounts of W-2 wages and depreciable business property by meeting certain test guidelines.  With this situation, the tax law is very complex to plan for.

Generally those test guidelines are the greater of:

  1. Payroll expense * 50%
  2. Payroll expense * 25% + Capital Assets * 2.5%

 

Effective tax planning here may include forming an S-Corp in order to start paying payroll to the owner.
Double bonus: this strategy also may result in paying lower self-employment (payroll) taxes.


ALL SITUATIONS Filing married separate, rather that filing jointly, may result in lower overall federal and state income tax.  Whereas in the past it seldom was more beneficial to file separately. For these situations, the tax law is somewhat more complex to plan for.

ALL SITUATIONS Contribute to a retirement plan to bring taxable income down below the phase out levels.

ALL SITUATIONS Getting married to your partner who is a live-in homemaker effectively doubles the phase out levels, and thereby lowers your annual IRS taxes by as much as, for example $15,120 ($315,000 * 20% * 24%) until year 2025.


Caveats:

In the above review, I’ve ignored special rules for qualified cooperative dividends.

There are many points that are not clear as of yet, including:

  • what rental properties will qualify
  • netting of qualified business income and loss for taxpayers owning multiple qualified trades or businesses
  • the applicable deductions for tiered entities
  • allocating W-2 wages among businesses
  • whether compensation paid to an S corporation shareholder is included in W-2 wages for purposes of limitations
  • section 1231 gains

 

IRS Guidance:
IRS issues proposed regulations on new 20 percent deduction for passthrough businesses
IRS proposed regulations
IRS Notice 2018-64
IRS FAQs on Section 199A

Trading in financial instruments is a Specified Service Trade or Business (SSTB). See Temporary Regs 1.199A-5(b)(2)(xii)

1.199A-5(b)(2)(xii) [page 164] Meaning of the provision of services in trading. For purposes of section
199A(d)(2) and paragraph (b)(1)(xi) [page 159] of this section only, the performance of services
that consist of trading means a trade or business of trading in securities (as defined in
section 475(c)(2)), commodities (as defined in section 475(e)(2)), or partnership
interests. Whether a person is a trader in securities, commodities, or partnership
interests is determined by taking into account all relevant facts and circumstances,
including the source and type of profit that is associated with engaging in the activity
regardless of whether that person trades for the person’s own account, for the account
of others, or any combination thereof. A taxpayer, such as a manufacturer or a farmer,
who engages in hedging transactions as part of their trade or business of manufacturing
or farming is not considered to be engaged in the trade or business of trading
commodities.

1.199A-5(d) [page 170] Trade or business of performing services as an employee–(1) In general.
The trade or business of performing services as an employee is not a trade or business
for purposes of section 199A and the regulations thereunder. Therefore, no items of
income, gain, loss, and deduction from the trade or business of performing services as
an employee constitute QBI within the meaning of section 199A and §1.199A-3. … ed. further, any tricks or funny business are prohibited [page 171]

 




Rental properties (reported on Schedule E)

The new tax break applies to qualified business income (QBI) from a trade or business. Since many real estate rentals operate at a tax loss (after depreciation) each year, this QBI issue is probably not applicable for those.

But for properties with net taxable income, the final IRS regs. continue to refer to the standard under federal tax code Section 162, the statute that generally governs the deductibility of trade or business expenses. Unfortunately, this standard is somewhat unclear in the context of a rental activity. That’s because it’s based on facts and circumstances specific to each taxpayer. Among the relevant factors: Type of property leased (commercial or residential), extent of day-to-day involvement by the lessor or the lessor’s agents, lease terms, number of properties rented and other ancillary services provided under the lease

A proposed “safe harbor” applies if at least 250 hours are devoted to each real estate rental activity (or as a group if so chosen) by the property owner, employees or independent contractors in a year. Time spent on repairs, collecting rent, negotiating leases and providing tenant services counts. Hours put in for arranging financing, constructing long-term capital improvements, and driving to and from the real estate aren’t included in the 250-hour standard.

If the 250-hour test is met, you can treat the rental as a trade or business for purposes of the 20% pass-through deduction IF separate records and bank accounts must be maintained. And for post-2018 years, contemporaneous records must be kept that detail the hours, dates and description of the services, and who performed them. The safe harbor doesn’t apply to property that is leased under a triple net lease or used as a residence for any part of the year by the lessor or the lessor’s family. Notice 2019-07 has details on the proposed safe harbor, including how to claim it, and a required signed statement that states for the section 199A deduction herein, the requirements in Section 3.0x of Rev. Proc. 2016-xx have been satisfied. The statement must be signed and state: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”

Consider that generally a trade or business must issued Form 1099-MISC by January 31st to each of those people or businesses that were paid for services, such as plumbers, landscapers, lawyers, commissioned brokers, etc.  meeting the safe harbor provisions arguably helps exempt landlords from this requirement.

See the ten page IRS Notice 2019-07 for more details.

See alternative, to be treated as a trade or business in your own right here

IRS Publication 535, page 50
Determining your qualified trades or businesses. Your qualified trades and businesses include your section 162 trades or businesses, other than trades or businesses conducted through a C corporation, W-2 wages earned as an employee, and specified service trades or businesses.

In general, to be engaged in a trade or business, you must be involved in the activity with continuity and regularity and your primary purpose for engaging in the activity must be for income or profit. If you own an interest in a pass-through entity, the trade or business determination is made at that entity’s level.

The ownership and rental of real property may constitute a trade or business. Notice 2019-07 provides a safe harbor under which rental real estate enterprise will be treated as a trade or business for purposes of the QBI deduction. For more information, on the safe harbor see Notice 2019-07. Rental real estate that does not meet the requirements of the safe harbor may still be treated as a trade or business for purposes of the QBI deduction if it is a section 162 trade or business.

In addition, the rental or licensing of property to a commonly controlled trade or business operated by an individual or a pass-through entity is considered a trade or business under section 199A.

To see the development of the IRS’s thoughts on this, see the December 19, 2018 revision DRAFT IRS Publication 535, page 2
The ownership and rental of real property doesn’t, as a matter of law, constitute a trade or business, and the issue is ultimately one of fact
in which the scope of your activities in connection with the property must be so extensive as to give rise to the stature of a trade or business.

However, the rental or licensing of property to a commonly controlled trade or business is considered a trade or business under section 199A.