The IRS has released final regulations and additional guidance on the QBI deduction just before the first tax season where taxpayers can claim the deduction. The new guidance provides some clarity on who qualifies for the QBI deduction and how to calculate the deduction amount.
QBI deduction in action
The QBI deduction is up to 20% of QBI received from a PTE, subject to certain limitations. QBI is equal to the net amount of income, gains, deductions and losses, but excludes reasonable compensation, investment items and guaranteed payments to partners.
QBI is determined for each qualified business and the net amounts are aggregated. If the net amount is below zero, it is treated as a loss for the following year, reducing that year’s QBI deduction. The deduction can never be more than 20% of a taxpayer’s taxable income (excluding income subject to capital gains rates).
Other limitations apply if a taxpayer’s taxable income exceeds a threshold amount—$315,000 for joint filers or $157,500 for all other filers. The limits phase in over $100,000 of income for joint filers and $50,000 of income for all others.
First, for certain specified service trades or businesses (SSTBs), an owner does not receive the deduction. SSTBs include, among others, businesses involving law, financial, health, brokerage and consulting services, as well as any business earning endorsement fees or similar income from the “reputation or skill” of an employee or owner.
Second, all businesses are subject to a limit based on wages and depreciable property. Under this limit, the deduction cannot exceed the greater of
- 50% of the business’s W-2 wages; or
- 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified business property (QBP).
The UBIA of qualified property generally is the purchase price of tangible depreciable property held at the end of the tax year. Partnerships and S corporations must determine the amount of the W-2 wages and UBIA allocable for each partner or shareholder for the year.
The QBI deduction applies to taxable income and does not impact adjusted gross income (AGI). It is available to taxpayers who itemize deductions, as well as those who do not itemize and those paying the alternative minimum tax.
See our other alerts about the QBI deduction here: “IRS Proposes Pass-Through Deduction Regulations” and “Combining Businesses and Netting Losses for the Section 199A Pass-Through Deduction”
New Guidance for rental real estate owners
One of the lingering questions related to the QBI deduction was whether owners of rental real estate were operating a “trade or business,” such that the net rental income could qualify for the deduction. A taxpayer must “regularly” and “continuously” engage in an activity before a court will treat it as a trade or business.
There is no exact rule for qualifying under this test, so the IRS provided a safe harbor when it issued Notice 2019-07. Certain real estate enterprises can rely on the safe harbor to qualify as a “business” for purposes of the QBI deduction until a different rule is issued.
The owner can elect the safe harbor if the owner attaches a signed statement to her return that certifies:
- Separate books and records are kept for each rental real estate enterprise;
- For taxable years 2018 through 2022, at least 250 hours of services are performed each year for the enterprise, then the rule is 250 hours in any three of the prior five years; and
- For tax years beginning after 2018, the taxpayer maintains contemporaneous records showing the hours of all services performed, the services performed, the dates they were performed and who performed them.
The 250 hours of services may be performed by owners, employees, contractors and agents. Time spent on maintenance, repairs, rent collection, expense payment, provision of services to tenants and efforts to find tenants all count toward the 250 hours. Investment-related activities, such as arranging financing, procuring property and reviewing financial statements, do not count toward the 250 hours.
Be aware that rental real estate used by a taxpayer as a residence for any part of the year is not eligible for the safe harbor. Also it is not available for property leased under a triple net lease. For these purposes, a triple net lease is one that requires the tenant to pay all or some of the real estate taxes, maintenance, insurance and any building fees.
Aggregation of multiple businesses
It is not unusual for small business owners to operate more than one business. The proposed regulations included rules allowing an individual to aggregate multiple businesses that are owned and operated as part of a larger, integrated business for purposes of the W-2 wages and UBIA of qualified property limitations, thereby maximizing the deduction. The final regulations retain these rules with some modifications.
For example, the proposed rules allowed a taxpayer to aggregate trades or businesses based on a 50% ownership test, which must be maintained for a majority of the taxable year. The final regulations clarify that the majority of the taxable year must include the last day of the taxable year.
Unlike the proposed regulations, the final regulations also allow a PTE to do the aggregation, assuming it meets the ownership test and other tests. When the PTE chooses to aggregate, the owners must follow suit.
A taxpayer who does not choose to aggregate in one year can choose to do so in a future year. On the other hand, once aggregation is chosen, the taxpayer must continue to aggregate in future years unless there is a significant change in circumstances.
The final regulations generally do not allow an initial aggregation of businesses to be done on an amended return, but since this is the first filing season where taxpayers can take the QBI deduction, the IRS will permit taxpayers to make initial aggregations on amended returns for 2018.
UBIA in qualified property
The proposed regulations adjusted UBIA for transactions where no gain or loss is recognized. These non-recognition transactions include contributions, like-kind exchanges and involuntary conversions. Under the final regulations, UBIA of qualified property generally remains unadjusted as a result of non-recognition transactions.
Property contributed to a partnership or S corporation in a non-recognition transaction usually will retain its UBIA on the date it was first placed in service by the contributing partner or shareholder. Partnerships may also benefit from certain special basis adjustments resulting from distributions or sales of partnership interests. These adjustments are made when the partnership has made a 754 election or has a substantial built-in loss.
The UBIA of property received in a like-kind exchange is generally the same as the UBIA of the relinquished property. The same rule applies for property acquired as part of an involuntary conversion.
Many of the comments the IRS received after publishing the proposed regulations sought further guidance on whether specific types of businesses are SSTBs. The IRS, however, declined to provide additional guidance because the determination of whether a particular business is an SSTB often depends on its individual facts and circumstances.
Nonetheless, the IRS did establish rules regarding certain kinds of businesses. For example, it states that veterinarians provide health services. It also retained the rule that real estate and insurance brokers are not SSTBs. They also provide an example of a surgical center that, with the right facts, is not providing “health services” for purposes of this deduction— meaning income from the center is qualified.
The rules preventing the so-called “crack and pack” strategy were also retained. The strategy would have allowed entities to split their non-SSTB components into separate entities that charged the SSTBs fees. When a qualified business provides property or services to a related-party SSTB, a portion of the business (based on gross receipts) is also treated as an SSTB.
The final regulations make changes for businesses with some income that qualifies for the deduction and some that is from an SSTB. The owner or PTE can separate the different activities by keeping separate books to claim the deduction on the eligible income.
For example, insurance brokerage commissions qualify for the deduction, but wealth management and similar advisory services do not. A financial services business could separate the bookkeeping for these functions to permit owners to claim the deduction on the qualifying income.
In addition to the deduction based on qualified business income, the same code section provides a deduction for up to 20% of a taxpayer’s combined qualified real estate investment trust (REIT) dividends and qualified publicly-traded partnership (PTP) income—including dividends and income earned through PTE.
The new guidance clarifies that shareholders of mutual funds with REIT investments can apply the deduction. The IRS is still considering whether PTP investments held via mutual funds qualify.
Proceed with caution
These new provisions can be very valuable, but are also very complex. In addition to providing benefits, the new law lowers the threshold for imposing penalties for taxpayers that incorrectly calculate the deduction. We can help you avoid penalties and answer all of your questions regarding the QBI deduction.