New IRS §199A Proposed Regulations Provide Guidance On "Qualified Business Income": What Income is "In" and What Income is "Out" in Determining the Amount of the Deduction

The IRS has issued Proposed Regulations now under the new Section 199A 20% profit deduction for pass-through entities. The Proposed Regulations provide important guidance on the definition of "Qualified Business Income" - which is the starting point for determining the amount of the deduction.

New Section 199A, adopted by Congress under the Tax Cuts and Jobs Act (TCJA) and effective January 1, 2018, provides a 20% deduction for pass-through businesses - i.e. businesses that are not corporations. With the corporate tax rate under the TCJA being reduced to a flat 21%, the 20% deduction for other forms of businesses was designed to give a reduction to these businesses approximating the lower corporate tax rate.

If applicable, the 20% deduction can be claimed by owners of S corporations, partnerships, sole proprietorships, and even the beneficiaries of trusts. These are business entities that do not pay income tax at the business entity level (such as corporations), but where the profits and other income of the business go to or "pass-through" to the owners (or to the beneficiaries in the case of a trust).

The 20% pass-through deduction is not applicable generally to businesses that provide services, such as doctors, lawyers, accountants, athletes, stock brokers, and others (but architects and engineers can take it), except where the service provider has taxable income of less than $315,000 (married) or $157,500 (individual). The benefit to these service providers is phased out over these income thresholds (another $100,000 for married filers and $50,000 for individuals), so that where a married filer has over $415,000 in taxable income or an individual filer has over $217,500 in taxable income, the 20% deduction is lost. Thus, there is no benefit here to higher-paid service providers.

For most pass-through business owners, the deduction is the lesser of (1) the "combined qualified business income" of the taxpayer, or (2) 20% of the excess of taxable income over the sum of any net capital gain. The term "combined qualified business income" is then defined as the lesser of (1) 20% of the business owner's "qualified business income" (QBI) or (2) the greater of (A) 50% of the W-2 wages of the business allocable to the owner or (B) 25% of the W-2 wages of the business plus 2.5% of the unadjusted tax basis in property of the business allocable to the business owner.

The new Proposed Regulations issued by the IRS under Section 199A provide guidance on what income is included and not included in QBI, and thus what can be considered and not be considered for purposes of the 20% deduction. Section 199A provides that QBI means the net amount of qualified items of income, gain, deduction, and loss attributable to any qualified trade or business of a taxpayer. QBI does not include certain REIT dividends or income from certain publicly-traded partnerships. The Proposed Regulations apply definitions of "trade or business income" under Internal Revenue Code Section 162(a) for purposes of QBI under Section 199A, and also extend the definition to include income from the rental or licensing of tangible or intangible property to a related trade or business if the rental or licensing and other trade or business are "commonly-controlled" as further defined in the Proposed Regulations.

The Proposed Regulations provide that QBI does not include the following income:

  • Income which is not "effectively connected with the conduct of a trade or business within the United States" - i.e. most foreign income
  • Capital gains or losses (including related Section 1231 gain or loss)
  • Dividends, income "equivalent to a dividend", or a "payment in lieu of dividends" described in certain provisions
  • Interest income, other than interest income which is "properly allocable to a trade or business" and which can specifically include interest earned on accounts or note receivable for services provided or good sold by the trade or business
  • Income from any "notional principal contract"
  • Annuity income not received in connection with a trade or business
  • Reasonable compensation received by an owner/employees of an S corporation (but where the amount so paid can be deducted by the S corporation and which then reduces QBI of the S corporation)
  • "Guaranteed payments" (and payments under Section 707(a)) received by partners of a partnership for services rendered to the partnership (but where the amount so paid can be deducted by the partnership and which then reduces QBI of the partnership)

Owners of pass-through businesses must now pay careful attention to the definition of QBI in the new Section 199A Proposed Regulations, and so as to maximize the amount of QBI and therefore potentially the amount of their potential 20% profit deduction.

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