The IRS released Publication 535 on Jan. 30, 2019. Chapter 12 covers the qualified business income (QBI) deduction, including guidance, worksheets and instructions in arriving at the new 20 percent deduction. Under the Tax Cuts and Jobs Act, and beginning in tax year 2018, individuals and some trusts and estates may be eligible to claim a 20 percent deduction on QBI from a trade or business, including from a pass-through entity, plus 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. This article summarizes and explains (including excerpts) some of the important concepts laid out in the publication.
Taxpayers Who May Claim the QBI Deduction
Individuals (including sole proprietorships), estates and trusts are eligible to take the QBI deduction. Partnerships and S corporations don’t take the deduction at the entity level, but instead, the deduction is passed through to partners and shareholders on Schedule K-1 and reported on Form 1040.
Trades or businesses (other than C corporations) as defined by IRC section 162 can qualify for the deduction. The trade or business standard is determined at the entity level and means you must be involved in the activity, with continuity and regularity, and your primary purpose is to earn income or a profit.
IRS Notice 2019-07 establishes a new safe harbor for rental real estate. Individuals and entities can treat their ownership in a rental real estate enterprise as a trade or business for QBI purposes if they meet certain requirements. Owning and renting real property may still qualify as a section 162 trade or business even if the safe harbor requirements are not met.
Specified Service Trades or Businesses (SSTB)
If you’re in one of the specified service trades or businesses (health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing/trading/dealing, and any trade or business where the principal asset is the reputation or skill of one or more of its employees), your deduction could be limited or not allowed depending on the level of taxable income. The publication elaborates on the professions included in each of the specified fields (i.e. law includes lawyers, paralegals, legal arbitrators and mediators) and this gives taxpayers better clarity in planning for the deduction.
If your trade or business is an SSTB, the following rules apply:
- Taxable income < $157,500 ($315,000 if married filing jointly): full deduction allowed.
- Taxable income > $207,500 ($415,000 if married filing jointly): no deduction allowed.
- If your taxable income is in between these taxable income levels, you get a partial deduction and will use Schedule A in the publication to compute the deduction.
If you have a trade or business that provides services or property to an SSTB, and have 50 percent or more common ownership, the portion of the services or property provided to the SSTB needs to be treated as a separate SSTB. However, if you have a blend of income from an SSTB and a non-SSTB, and your gross receipts from the SSTB component are under a certain threshold percentage, a de minimis rule applies and will allow the SSTB to be fully eligible for the QBI deduction.
How to Figure the Deduction
Generally, you’ll use the simplified worksheet in the Form 1040 instructions when taxable income is no more than $157,500 ($315,000 if married filing jointly), whereas the worksheets included in Publication 535 are used when taxable income is over the threshold level.
QBI includes items of income and deductions from trades or businesses conducted within the United States, and does not include investment income, W-2 income, guaranteed payments and reasonable compensation from an S corporation. QBI is reduced by the deductible tax on self-employment income, self-employed health insurance and contributions to qualified retirement plans.
The QBI deduction worksheet is the main worksheet used to arrive at the bottom line QBI deduction and runs through the various computations: W-2 wage, qualified property limitation and taxable income limitation.
- W-2 wages: W-2 wages include amounts paid to employees for the performance of services, plus elective deferrals (i.e. contributions to a 401(k) plan), and excludes amounts paid to statutory employees. If you conduct more than one trade or business, W-2 wages must be allocated to the business that generated the wage.
- Unadjusted basis immediately after acquisition (UBIA): UBIA means the basis in property when the asset is placed in service and includes all tangible property subject to depreciation for which the depreciable period has not yet ended. The depreciable period ends on the latter of 10 years after the property is placed in service or the last day of the full year for the applicable recovery period.
- Key takeaway: The limitations associated with QBI are comprehensive; the worksheet helps you run through these computations to arrive at a bottom line QBI deduction that flows to the tax return.
Aggregation of Business Operations
Individuals and pass-through entities may choose to aggregate multiple trades or businesses into a single trade or business for purposes of applying the QBI limitations. For the aggregated trades or businesses, each of the QBI components (QBI, W-2 wages, UBIA, qualified REIT dividends and qualified PTP income) are combined when computing the deduction. Certain requirements must be met to qualify for aggregation, and your business aggregations must be disclosed and reported on a consistent basis in future years.
- Key takeaway: The aggregation rule may allow you to maximize your deduction depending on how the QBI components (QBI, W-2 wages and UBIA) lay out for the multiple businesses. Be careful making this election because future years will be impacted.
Netting Losses and Carrying Losses Forward
If any of your trades or businesses have a net loss in the current year or a QBI loss from a prior year, you need to offset these losses proportionately against net income from other trades or businesses. If you have an overall net loss for the year, you don’t have a QBI deduction in the current year and the loss is carried forward to next year.
- Net operating losses are computed without taking into account the QBI deduction.
- You’re allowed to take the QBI deduction for alternative minimum tax purposes.
- Net earnings from self-employment are not reduced by the QBI deduction.
The rules and computations associated with the QBI deduction are comprehensive, and hopefully this article and IRS Publication 535 help you to further your understanding. You can rely on your Intuit® ProConnect™ software, including ProConnect Tax Online, Lacerte® and ProSeries®, to automate many of these computations and generate worksheets for you. However, it’s still important for the tax professional to be familiar with the rules in order to collect the right information from clients, apply the proper classifications and provide proactive planning services.