IRS Issues Final Section 199A Regulations and Defines QBI

If you operate a pass-through business such as a proprietorship, partnership, or S corporation, new tax code Section 199A offers you a possible 20 percent tax deduction gift on your business income.  The gift applies only for tax years 2018 through 2025.

For sure, you obtain this business income gift if your 2018 taxable income is equal to or less than $315,000 (married, filing jointly) or $157,000 (filing as single or head of household).

When you are under the thresholds above, you find your deduction by applying the 20 percent to the lesser of your:

  • defined qualified business income (QBI), or
  • taxable income less defined capital gains.

Example. If you have defined QBI of $100,000 and taxable income of $120,000 with no capital gains, your Section 199A gift is a deduction of $20,000 (20 percent of $100,000).

If you can qualify, you have to love this tax-deduction gift. After all, what’s not to love? So, let’s get started and see what makes up your QBI.

QBI Big Picture

The tax code says QBI includes the net dollar amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.  

A qualified trade or business is a pass-through business such as a proprietorship, partnership, or S corporation that conducts business within the United States.  A pass-through business includes trusts and estates that pass through business income to beneficiaries, and it can include rental properties.

Sole Proprietorship QBI

The QBI for the sole proprietor begins with your net business profit as shown on your Schedule C. You then adjust that profit as follows:

  • Subtract the deduction for self-employed health insurance.
  • Subtract the deduction for one-half of the self-employment tax.
  • Subtract qualified retirement plan deductions.
  • Subtract net Section 1231 losses (ignore gains).

Example. Rick has $120,000 of net income on Schedule C. He also deducted $10,000 for self-employed health insurance, $8,478 for one-half of his self-employment taxes, and $10,000 for a SEP-IRA contribution. His QBI is $91,522 ($120,000 – $10,000 – $8,478 – $10,000).

Rental Property QBI

If you own rental property as an individual or through a single-member LLC for which you did not elect corporate taxation, you report your rental activity on Schedule E of your Form 1040. If you can claim the property is a trade or business, your QBI begins with the net income from your Schedule E.

For 2018 tax returns, you ignore previously suspended passive losses, and for subsequent years, you consider only suspended losses incurred after December 31, 2017.

If the rental creates Section 1231 net losses, you subtract those losses from QBI.

Partner’s QBI from the Partnership

A partner may obtain income from the partnership in two ways: (1) as a payout of profits and/or (2) as a Section 707 payment (generally referred to as a guaranteed payment). The profits qualify as QBI, and the partnership profits are adjusted for the same items as for the sole proprietorship.

The Section 707 payments reduce the net income of the partnership. They do not count as QBI.

S Corporation Shareholder QBI

The more than 2 percent shareholder in an S corporation ends with QBI calculated in the same manner as for the sole proprietor. For example, the S corporation treats the health insurance as wages to the shareholder which reduces the profits of the S corporation and that reduces the shareholder’s QBI.

Wages paid to the shareholder-employee reduce the net income of the S corporation but do not count as QBI.

S corporation capital gains and losses, dividends, and interest earned at the S corporation level are not QBI. The shareholder K-1 will likely show the adjustments for these items.

Trusts and Estates

The rules above apply to trusts and estates. The tricky part is where to apply the rules—to the trust, to the estate, or to the beneficiary.

Losses

Good news. For 2018 tax returns, you don’t have to consider suspended tax losses under Sections 465 (at-risk rules), 469 (passive activity rules), 704(d) (basis in partnership), and 1366(d) (basis in S corporation) if such losses were in place before January 1, 2018.

For 2019, you will examine the losses using a first-in, first-out approach and reduce QBI for post-2017 losses that are released during 2019.  You follow the first-in, first-out procedure in years 2019 through 2025.

Takeaways

Clarity is worth a lot, and the IRS final regulations give you clarity on what makes up QBI. Remember, if your 2018 taxable income is equal to or less than $315,000 (married, filing jointly) or $157,000 (filing as single or head of household), your Section 199A 20 percent deduction is equal to the lesser of your

  • defined QBI as discussed in this article or
  • taxable income less net capital gains.

If your qualifying trade or business income comes from a proprietorship, your 2018 QBI is the net profit from Schedule C adjusted by

  • subtracting the deduction for self-employed health insurance (line 29 of Schedule 1 to your Form 1040);
  • subtracting the deductible portion of your self-employment tax (line 27 of Schedule 1 to your Form 1040);
  • subtracting your self-employed SEP, SIMPLE, and qualified retirement plan contributions (line 28 of Schedule 1 to your Form 1040); and
  • subtracting net Section 1231 losses (ignore gains).

If you operate your business as a partnership or S corporation, you make the same basic adjustments in a variety of ways, only some of which come from the Form 1040, Schedule 1. But the concept is identical. What you see when you factor in the adjustments is that your QBI is business income less both business deductions and deductions triggered by the business, such as the self-employed health insurance deduction.

Thus, the income and deductions that flow to your Form 1040 from an S corporation, partnership, or trust undergo the QBI adjustments in one way or another before you calculate the Section 199A tax deduction.  As always – chat with us on our homepage if you’re ready for less stress.  Less tax.  And more profit.