Take a Closer Look at the Final QBI Deduction Regulations (article)
One of the most significant provisions of the tax reform law known as the Tax Cuts and Jobs Act (TCJA) has been Internal Revenue Code Section 199A. This new provision introduced the qualified business income (QBI) deduction, which allows pass-through entity owners to deduct up to 20 percent of their share of business income. The new law initially left pass-through entities and their tax preparers with many questions about how the QBI deduction would work. In August 2018, the IRS released proposed regulations that fleshed Section 199A and gave taxpayers substantial guidance about how it would impact their returns. The final version of these regulations was released on Jan. 18, 2019, and it deviates only slightly from the proposed version – with a few key exceptions.
Taxpayers may aggregate more than one of their businesses when calculating the QBI deduction so that deduction limitations are mitigated by the pooling of certain factors among the aggregated businesses. Aggregation is available as long as those businesses:
- Are under common control,
- Pass certain activity tests, and
- Are not specified service trades or businesses (SSTBs).
Under the proposed regulations, taxpayers would pass the common control test as long as the same person (or group) held majority ownership over all of the businesses 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 year, and that ownership via attribution counts. It also states:
- Businesses are eligible for aggregation even if some of their gross receipts are derived from a SSTB activity, as long as such SSTB receipts are de minimis under a percentage test.
- Taxpayers can begin aggregating their businesses in any future year even though they were not aggregated in an earlier year, and they must maintain that aggregation going forward.
In a major shift from the proposed regulations, the final regulations allow aggregation at the entity level in addition to the individual level. S corporations and partnerships that control lower-tier pass-through entities can therefore aggregate the activities from those lower-tier entities. All owners of all entities must maintain the chosen aggregation, though.
Specified Service Trades or Businesses
The final regulations introduced a few taxpayer-friendly provisions concerning SSTBs. Now, in many situations, SSTBs do not include franchisors, assisted living facilities, personal staffing firms, and pharmacies selling prescriptions and over-the-counter medications. The final regulations also pulled back slightly on the proposed rules that were aimed to combat a perceived potential for abuse involving “crack and pack” strategies.
The proposed regulations aimed to prevent taxpayers from bifurcating a single business involving different activities into two separate businesses – one subject to SSTB limitations, and the other not – as a strategy to claim the deduction for the “cleansed” business. Under the proposed regulations, this rule applied when a business provides more than 80%of its property or services to an SSTB that shares at least 50% of its ownership, in which case the non-SSTB business would be considered an SSTB itself. The final regulations removed this 80% rule. Now, if a business provides property or services to an SSTB with at least 50%shared ownership, only the portion of the property or services provided to the related SSTB is treated as an SSTB.
The QBI deductions of certain taxpayers will be limited if the unadjusted basis immediately after acquisition (UBIA) of business property is insufficient (in addition to certain amounts of W-2 wages). The proposed regulations provided highly unfavorable rules to calculate these values with regard to property involved in like-kind exchanges, involuntary conversions, and asset contributions to successor businesses. The final regulations favorably redefine UBIA in these circumstances, and also provide other UBIA clarifications:
- The UBIA of property is zero if all of the assets are sold in a full disposition of the business.
- In general, the transferor’s UBIA of property in a like-kind exchange, involuntary conversion, or business contribution should carry over to the transferee, decreased by the transferee’s cash received and increased by the transferee’s cash paid.
- Section 743(b) basis adjustments involved with sales or exchanges of partnership interests are treated as additional UBIA, to the extent the adjustment reflects an increase in the fair market value of the underlying property. There is no UBIA “step-up” for partnership redemption transactions under Section 734(b), however.
The final regulations address more than just what is highlighted above. They also clarify that:
- Passive business owners are eligible for the deduction.
- Business owners have a “safe harbor” that can help them determine whether their rental real estate enterprises are eligible for the QBI deduction.
- When calculating QBI, taxpayers should consider previously-disallowed losses on a first-in, first-out basis.
- Both single trusts and multi-trust structures will be disallowed if they were created to help a taxpayer qualify for a larger QBI deduction by duplicating exemption thresholds.
The final regulations incorporated comments that the IRS solicited from the public. Although the final regulations were published in 2019, taxpayers can rely on them (or the proposed regulations) on their 2018 tax return. For questions about your QBI deduction and planning ideas to help maximize the deduction, please reach out to your local tax provider.
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