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February 08, 2019

Section 199A: The New Small Business Tax Break—Part II

Small_business2

As tax attorneys in Columbus, Ohio, Nardone Limited routinely assists individuals and businesses with representation in tax examinations, audits, and civil litigation with the Internal Revenue Service (the “IRS”) and the Ohio Department of Taxation. As part of that representation, our tax attorneys keep individuals and businesses informed about new information and guidance provided by the IRS. This article is the second in a series of articles exploring what some tax professionals describe as the best small business tax break of the last half-century—the Section 199A Qualified Business Income Deduction (the “Deduction”).

Tax Law Update: On January 18, 2019 the IRS released its final versions of the Proposed Regulations to Section 199A, which it released in August of 2018.

Brief Reintroduction

As stated in our first Section 199A article, the owners of “pass-thru entities” have the potential to receive a deduction equal to 20 percent of the qualified business income (“QBI”). QBI is the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business (“QTOB”) of the taxpayer.1 As part of our initial understanding of QBI, it is important that we first consider what constitutes a QTOB.

QTOB, or Not QTOB, That Is the Question

QTOB is broadly defined by Section 199A as any trade or business other than: (i) a specified service trade or business (“SSTB”), or (ii) the trade or business of performing services as an employee.2 Let’s first address what Section 199A defines as a non-QTOB trade or business.

Non-QTOB Trades or Businesses

The definition of QTOB does not include an SSTB, which is defined as any trade or business involving the performance of services in one of the following fields: health; law; accounting; actuarial science; performing arts; consulting; athletics; financial services; brokerage services; investing and investing management; trading; dealing; or a business where the principal asset is the reputation or skill of one or more of its owners or employees.3 The Regulations go on to give examples of what specific trades or businesses within each of these fields are, and are not, considered an SSTB. But, it is important to understand that just because a trade or business is considered an SSTB, it does not necessarily mean that the income related to that trade or business does not qualify for the deduction. Part III of this series will further discuss this matter.

Also, a QTOB does not include the trade or business of performing services as an employee. Meaning, an employee who receives W-2 wages cannot take the Deduction for those wages. To prevent potential circumventions of this rule, the IRS added an anti-abuse measure that bars the Deduction from employees who terminate their employment and then re-establish a relationship with the employer as an independent contractor.4

What is Considered a QTOB Trade or Business

The definition of trade or business under the Regulations is equally as vague as the definition in Section 199A. The Regulations state that a Section 199A trade or business is the same as a Section 162 trade or business.5 Section 162 typically requires case law analysis to determine whether an activity is a trade or business. The Court in Commissioner v. Groetzinger held that a taxpayer engages in a trade or business when they are “involved in the activity with continuity and regularity” for the “primary purpose” of earning “income or profit.”6 Although this holding seems broad and open to interpretation, the IRS doubles down on the idea that the Section 199A analysis of a “trade or business” should be as restrictive as the analysis under Section 469 for passive losses.

Unlike Section 162, the Regulations provide that the renting or licensing of tangible or intangible property to a related trade or business is a trade or business under Section 199A so long as there is common ownership as defined by Reg. § 1.199A-4(b)(1)(i).7 But, as we will discuss in our next Section 199A article, there are additional considerations involved where one of the related trades or businesses is an SSTB.

Proposed Treatment for Rental Real Estate Activity Under Section 199A: The treatment of rental real estate activity as a trade or business is an area of uncertainty in many Code sections. This uncertainty is due to inconsistencies in the case law for determining whether the generally “passive” act of renting real estate satisfies the definition of trade or business. The IRS hopes to eliminate such uncertainty as it relates to Section 199A. To do so, the IRS published Notice 2019-07 contemporaneously with the release of the Section 199A final regulations (the “Notice”). The Notice specifically addresses the treatment of rental real estate activity and describes a proposed revenue procedure that provides safe harbor treatment for certain rental real estate activity as a trade or business under Section 199A. Nardone Limited will publish a separate article that discusses the Notice and highlights the requirements for the safe harbor treatment to apply.

Identifying Items Included in QBI

Remember that QBI includes the net amount of income, gain, deduction, and loss from a taxpayer’s QTOB.8 The Code defines this to include everything from the trade or business’s operating income to the ordinary gains and losses resulting from the disposition of assets used in the trade or business.9 But, QBI does not include short-term and long-term capital gains and losses, interest income other than that allocable to a trade or business, and C corporation dividend income.10 

Calculating the Deduction for a QTOB

As discussed in our first Section 199A article, the Deduction is subject to a “wage/investment” limitation (the “Limitation”) when QBI comes from a QTOB and the taxpayer’s taxable income exceeds $157,500 for single filers and $315,000 for joint filers (the “Threshold”).11


Taxpayers whose taxable income is less than or equal to the Threshold enjoy a full 20 percent deduction. But, the Limitation phases-in once a taxpayer’s taxable income exceeds the Threshold. Regardless of the Limitation, the starting point for the Deduction is always 20 percent of QBI.

Calculating the Limitation

When taxable income exceeds the Threshold, the Limitation is the lesser of: (i) 20 percent of QBI from a QTOB, or (ii) the greater of: (a) 50 percent of W-2 wages from a QTOB, or (b) 25 percent of W-2 wages from a QTOB, plus 2.5 percent of the unadjusted basis in qualified property.

Phase-In of the Limitation

The percentage of phase-in is the difference between a taxpayer’s taxable income and the Threshold, over either $50,000 for single filers or $100,000 for joint filers (the “Phase-In Percentage”). The Phase-In Percentage is used to determine the reduction amount used against the 20 percent of QBI deduction starting point. It is important to note that the Phase-In Percentage is capped at 100 percent.

The Phase-In Percentage is multiplied against the difference between: (i) 20 percent of QBI and (ii) the Limitation. This figure represents the phase-in of the Limitation, or the amount by which the 20 percent of QBI starting point is reduced to determine the Deduction.

Conclusion

If all of that seems confusing, it’s because it is. First, the taxpayer is required to determine whether their trade or business constitutes a QTOB. The taxpayer must then determine the amount of QBI generated from their QTOB, which, in comparison, is relatively easy. After all of that, the taxpayer can then start to calculate their Deduction—which we know can be a mess. Calculating the taxpayer’s Deduction is far from simple and requires one to understand the impact of figures beyond the QBI realm (e.g., wages, the unadjusted basis in qualified property, etc.). This introduces an additional level of complication. Maybe that is why the IRS estimates Section 199A creates an additional 25-million-hour burden annually?12 25 million hours!

Therefore, it is important that taxpayers not only work with their bookkeepers and external accountants, but also with experienced tax law professionals who understand the Code’s implications from a legal perspective. The tax and business attorneys at Nardone Limited have this understanding and are prepared to discuss your Section 199A planning today.

P.S. Keep an eye out next week for Part III where we discuss the Deduction from the perspective of an SSTB owner, and the potential impact the SSTB classification has on otherwise “clean” QBI from a QTOB.


1 I.R.C. § 199A(c)(1).

2 I.R.C. § 199A(d)(1).

3 Reg. § 1.199A-5(b)(1).

4 Reg. § 1.199A-5(d)(3).

5 Reg. § 1.199A-1(b)(14).

6 Commissioner v. Groetzinger, 480 U.S. 23, 35 (1987).

7 I.R.C. § 1.199A-1(b)(14).

8 I.R.C. § 199A(c)(1).

9 Reg. § 1.199A-3(b).

10 I.R.C. § 199A(c)(3)(B).

11 I.R.C. § 199A(b)(3).

12 Preamble to the § 199A Final Regulations release January 18, 2019.

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February 08, 2019

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