On January 18th, 2019 the IRS released an updated version of section 199A (The Qualified Business Income or QBI) portion of the new tax reform which just took effect.
This updated version serves as a “clarification” of sorts for what is and is not deductible under the new law.
Section 199A provides a deduction of up to 20% for a Qualified Business Income from a qualified trade or business of a noncorporate taxpayer. For this specific purpose the proposed regulations define trade or business by reference to Section 162; which outlines some more specific regulations. Section 162 allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business; while travel from residence to business is typically nondeductible, travel from one business location to another business location is generally deductible under section 162(a).
While the IRS and Treasury have yet to provide specific guidelines to help determine whether an activity rises to the level of section 162 trade or business- they do point to definitional requirements that have emerged from case law on the topic: The taxpayer must enter into and carry on the activity with a good faith intention to make a profit or with the belief a profit can be made from the activity through considerable, regular and continuous activity.
Tax years beginning after December, 31, 2017 and before January, 1, 2026 a taxpayer, other than a corporation is entitled to a deduction equal to 20% of the taxpayers- Qualified Business Income- earned in a qualified trade or business. The deduction is limited for taxpayers with income more than a threshold however, to the greater of
- 50% of the W-2 wages with respect to the qualified business or trade
Or
- The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
The resulting deduction is then subject to a second limitation equal to 20% of the excess of:
- The taxable income for the year, over
- The sum of net capital gain
In short this is available to any taxpayer other than a corporation. This would include:
- Individual owners of sole proprietorships, rental properties, S corporations, or partnerships, and
- An S corporation, partnership, or trust that owns an interest in pass-through entity
Section 199A defines a qualified trade or business by exclusion; every trade or business is a qualified business except
- The trade or business of performing services as an employee and
- A specified service trade or business
A taxpayer must be engaged in a qualified trade or business to qualify for the deduction, the ruling defines a trade or business by exclusion, every trade or business is a qualified business other than:
- The trade or business of performing services as an employee,
- And a specified service trade or business
Notably, the IRS has modified the definition of specified service trade or business such that Engineers and Architects are qualified businesses. So far, these are the only two service businesses allowed the use of the Section 199A deduction.
The first category prevents employees from claiming a 20% deduction against their wage income. The second category serves the same purpose as the first, to prevent classification of personal service income as qualified business income.
Once a taxpayer has established that they are engaged in qualified business, the taxpayer must then determine the qualified business income for each separate qualified trade or business. Qualified business income is defined as: the net amount of qualified items of income, gain, deduction and loss with respect to a qualified trade or business whose operations are conducted within the United States.
Qualified business income however does not include certain investment income including the following:
- Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss;
- Dividend income, income equivalent to a dividend, or payments in lieu of dividends
- Any interest income other than interest income properly allocable to a trade or business;
- Net gain from foreign currency transactions and commodities transactions;
- Income from notional principal contracts;
- Any amount received from an annuity which is not received in connection with the trade or business, and
- Any deduction or loss properly allocable to the items described in the bullets above.
The qualified business income deduction does not include:
- Reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business
- Any guaranteed payments paid to a partner for services rendered with respect to the trade or business
This decision by Congress to exclude wages paid to a shareholder or guaranteed payments to a partner from qualified business income will place those taxpayers at a disadvantage relative to sole proprietors at certain income levels. Contact your tax advisor to discuss specific individual circumstances.
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