Sec. 199A update: Tax planning and issues to consider

By Brian R. Koleszar, CPA, Robinson, Grimes & Company PC, Columbus, Ga.

Editor: Marcy Lantz, CPA

The qualified business income (QBI) deduction under Sec. 199A brought issues to the 2018 tax year that ranged from learning and understanding the new Code section to simply making sure the tax software was calculating the deduction correctly. Having made it through the 2019 tax preparation season, practitioners must now consider tax planning and issues for the 2020 season. This discussion does not review the basics of the QBI deduction but focuses instead on a few (but not all) of the specific issues to consider for tax year 2019.

New forms and new thresholds

New forms will be introduced to calculate the QBI deduction. As of this writing, these forms are available only in draft form, but it would be best practice to review them and understand their mechanics. The forms and instructions are available on the IRS website. They include:

  • Form 8995, Qualified Business Income Deduction Simplified Computation;
  • Form 8995-A, Qualified Business Income Deduction;
  • Schedule A (Form 8995-A), Specified Service Trades or Businesses;
  • Schedule B (Form 8995-A), Aggregation of Business Operations;
  • Schedule C (Form 8995-A), Loss Netting and Carryforward; and
  • Schedule D (Form 8995-A), Special Rules for Patrons of Agricultural or Horticultural Cooperatives.

Taxable income thresholds that potentially affect the phaseout of the deduction have been adjusted for tax year 2019 as well (see Rev. Proc. 2018-57): married filing jointly, $321,400; single or head of household, $160,700; and married filing separately, $160,725.

Passive activity losses and Sec. 199A

Passive activity losses (PALs) are not taken into account for the QBI deduction if they are disallowed. In addition, any losses disallowed before Jan. 1, 2018, are never taken into account for the QBI deduction. Consider the following scenario:

Example 1: Taxpayer A has disallowed PALs of $30,000 and $50,000 for 2018 and 2017, respectively, and has passive income of $35,000 in 2019. All income and losses are from qualified trades or businesses. What is QBI?

Fortunately, the final regulations provide an answer. Losses disallowed in tax years ending after 2017 and allowed in the current tax year are taken into account for purposes of computing QBI. Regs. Sec. 1.199A-3(b)(1)(iv) states that for purposes of Sec. 199A, those losses are used in order from the oldest to the most recent, on a first-in, first-out (FIFO) basis. In Example 1, QBI would equal the full $35,000 in 2019. The 2017 PAL is the older previously disallowed PAL and is otherwise allowed against passive income in the current tax year. However, because it is carried over from a pre-2018 tax year, it is disregarded for purposes of determining QBI. When doing tax planning for 2019, it is important to make sure QBI is not inadvertently lowered by used disallowed losses from before 2018 and to review calculations made by the software to ensure they are correct. Note that Regs. Sec. 1.199A-3(b)(1)(iv) also applies to previously disallowed losses under Secs. 465, 704(d), and 1366(d).

Phaseout for a specified service trade or business

When taxable income exceeds the QBI threshold by $50,000 ($100,000 for married filing jointly), the income and losses from any specified service trade or business (SSTB) are no longer taken into account (Regs. Sec. 1.199A-1(d)(2)(i)). Consider the following example, which assumes a filing status of married filing jointly and does not consider other deductions:

Example 2: Taxpayer B has taxable income of $750,000, which includes SSTB income of $200,000; a nonpassive, non-SSTB loss of $50,000; and long-term capital gain of $600,000.

The QBI deduction is zero, since taxable income exceeds the phaseout ceiling. But the $50,000 loss is now carried forward to the next year because the SSTB income is no longer qualified and the loss cannot be offset against it. So, in year 2, Taxpayer B has the situation shown in Example 3.

Example 3: Taxpayer B has taxable income of $160,000, which includes SSTB income of $200,000; a nonpassive, non-SSTB loss of $50,000; and long-term capital gain of $10,000.

QBI in year 2 is $100,000 ($200,000, less $50,000 non-SSTB loss and less $50,000 loss carryforward). Taxable income is less than the threshold, so there is no phaseout.

Sec. 1231 effect on QBI deduction

Another consideration for the 2019 tax season is Sec. 1231 transactions. If a taxpayer has a Sec. 1231 net loss at the individual level, it is treated as ordinary loss and included in QBI. Sec. 1231 gain is treated as capital gain and is excluded from QBI (Regs. Sec. 1.199A-3(b)(2)). But, if a taxpayer has a Sec. 1231 loss in a year and then has a Sec. 1231 gain sometime in the next five years, that gain is treated as ordinary, not capital. The final regulations do not comment on the treatment of Sec. 1231 gain recognized as ordinary income. Based on the preamble of the final regulations, Sec. 1231(c) rules should be applied for deferring a taxpayer's QBI, and, therefore, any Sec. 1231 ordinary loss that reduced QBI in a prior year should be included in QBI in the recapture year.

Aggregation rules under Sec. 199A

Aggregation allows a taxpayer or relevant passthrough entity (RPE) to add together the QBI, W-2 wages, and unadjusted basis immediately after acquisition of qualified property from all the businesses in an aggregated group (Regs. Sec. 1.199A-4(a)). The requirements to aggregate are as follows: The same person or group of persons, directly or by attribution rules, must own 50% or more of each trade or business for the majority of the year, including the last day of the year. The items attributed to the trades or businesses to be aggregated must also be reported on returns with the same tax year. Note that none of the trades or businesses can be SSTBs. In addition, the trades or businesses must satisfy two of the following criteria in Regs. Sec. 1.199A-4(b)(1)(v):

  • They provide products, property, or services that are the same or customarily offered together;
  • They share facilities or significant centralized business elements; or
  • They operate in coordination with, or reliance upon, one or more of the businesses in the aggregated group (horizontal and vertical integration).

Regarding the ownership requirement, it is not the taxpayer who is trying to aggregate who must have 50% common ownership, it is the ownership structure of the trades or businesses. Consider the next example:

Example 4: Partnership 1 is owned by Partner B (75%), Partner C (24%), and Partner D (1%). Partnership 2 is owned by Partner B (50%), Partner C (49%), and Partner D (1%).

Partner D would be able to aggregate the QBI components from Partnerships 1 and 2,even though Partner D's ownership is only 1% of each partnership, since there is common ownership of more than 50%. Since aggregating businesses can create a larger QBI deduction, it is necessary to understand the ownership structures of RPEs.

Another tax planning consideration would be to change the tax year of a trade or business to take advantage of aggregation to get a bigger deduction. However, a careful cost/benefit analysis needs to be done to see whether, in the long term, changing the tax year makes sense, because the QBI deduction expires in 2026 and could possibly be gone even sooner through a change in law.

Once a taxpayer has aggregated two or more trades or businesses, the aggregation is binding, and the trades or businesses must be aggregated in subsequent years; however, newly created or acquired businesses may be added to the aggregate group in subsequent years. In a subsequent year, if there is a significant change in facts and circumstances such that an individual's prior aggregation of trades or businesses no longer qualifies, then the trades or businesses are no longer treated as aggregated. In addition, the IRS may disaggregate a taxpayer's trades or businesses if the taxpayer fails to disclose certain required information.

An initial aggregation of trades or businesses cannot be made on an amended return because this would allow aggregation decisions to be made with the benefit of hindsight. The final regulations, however, provide one exception. For the 2018 tax year only, Regs. Sec. 1.199A-4(c)(1) states that an initial aggregation can be made on an amended tax return.

Another thing to be aware of for the 2019 tax year is superseding tax returns. A superseding return is a return filed subsequent to the originally filed return within the filing period, which includes extensions. If, for instance, in 2019, a tax return was extended and filed on June 1 without an aggregation election, but research later shows aggregation would have greatly benefited the taxpayer, a superseding return can be filed and replace the originally filed return, as long as it is done on or before the extension deadline. This can be a nifty workaround for the inability to amend returns for aggregation, but the decision to do so needs to be timely.

Each tax year, individuals (and RPEs) must attach Schedule B for Form 8995-A or, previously, the worksheet to their returns, with the following information:

  • Identification of each trade or business aggregated;
  • A description of each trade or business and an explanation of the factors met that allow aggregation;
  • The name and employer identification number of each entity;
  • Information identifying any trade or business formed, ceased, acquired, or disposed of during the tax year;
  • Information identifying any aggregated trade or business of an RPE that the individual/RPE holds an ownership interest in; and
  • Any other information the IRS may require in forms, instructions, or other published guidance.

It is important to disclose all the required information, as a failure to do so may result in the disaggregation of businesses and an inability to aggregate them for three tax years (Regs. Sec. 1.199A-4(c)(2)). Aggregation disclosures and documentation should be reviewed carefully in 2019 tax returns to avoid this potentially costly result.

Entity with multiple trades or businesses under Sec. 199A

The de minimis rule under Sec. 199A states that a trade or business is an SSTB if 10% or more of its gross receipts are from an SSTB-type service. If the trade or business has more than $25 million of gross receipts, the threshold drops to 5% (Regs. Sec. 1.199A-5(c)). This means a very small percentage of SSTB gross receipts can taint the entire business. Luckily, though, the final regulations offer an example of an entity with multiple trades or businesses, one of which is an SSTB (Regs. Sec. 1.199A-5(c)(1)(iii)(B)). In the example, the SSTB activity does not taint the entire trade or business.

The key factors described in the example to separate trades or businesses are that each business has separate books and records, separate invoices, and separate employees. Along with the previous factors, it might also be beneficial to create a separate entity to split the SSTB activity from the non-SSTB activity. In tax planning and preparation of 2019 returns, taxpayers and their advisers should carefully review the trades or businesses for SSTB-type revenue streams. If the SSTB gross receipts exceed the threshold, check to see if the business separates invoices and books and records and has separate employees. This can result in a bigger deduction for the taxpayer.

Start preparing now

Sec. 199A contains complex rules. It is best practice to be proactive and to prepare for those complexities. This will not only ensure that tax returns filed will be accurate and in compliance but also will provide clients with effective service.

EditorNotes

Marcy Lantz, CPA, CSEP, is a partner with Aldrich Group in Lake Oswego, Ore.

For additional information about these items, contact Ms. Lantz at 503-620-4489 or mlantz@aldrichadvisors.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica Inc.

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