Impact of Sec. 199A in computing substantial-understatement penalties

Editors: Heidi Ridgeway, CPA, and Roby B. Sawyers, CPA, Ph.D.

The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, created a deduction under Sec. 199A for an individual, estate, or trust of up to 20% of qualified business income (QBI), subject to certain significant limitations. QBI is income from a domestic trade or business operated as a sole proprietorship or through a partnership, S corporation, trust, or estate. The calculation of QBI and of the deduction is complex, with a variety of issues for return preparers to consider. The deduction is available for tax years beginning after Dec. 31, 2017, and is set to expire for tax years beginning after Dec. 31, 2025.

Under Sec. 199A, an individual, estate, or trust taxpayer generally may deduct 20% of the taxpayer’s QBI earned in a “qualifying trade or business.” The deduction is limited to the sum of:

1. An amount for each trade or business, equal to the lesser of:
   • 20% of the taxpayer’s QBI from the qualified trade or business, or
   • The greater of the following limitations: (1) 50% of the W-2 wages from the trade or business, or (2) the sum of 25% of the W-2 wages from the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of qualified property; and
2. 20% of aggregate qualified real estate investment trust dividends and qualified publicly traded partnership income.

In addition, the Sec. 199A deduction is limited to 20% of the amount by which taxable income exceeds net capital gain (the “overall limitation”).

Return preparers should address these issues when determining the QBI or the qualifying trade or business, which would then affect the potential deduction. Additionally, there are nuances to determining the proper W-2 wages, the application of the 2.5% basis limitation, and whether trades or businesses can be aggregated when calculating the deduction (see Nitti, “Understanding the New Sec. 199A Business Income Deduction,” The Tax Adviser 224 (April 2018).

It is critical to get these issues correct when determining the calculation, because claiming a Sec. 199A deduction lowers the threshold for assessing a substantial-underpayment penalty. In general, Sec. 6662(a) provides a penalty for an underpayment of tax required to be shown on a return. Under Sec. 6662(b), the penalty applies to the portion of any underpayment that is attributable to a substantial underpayment of income tax. Sec. 6662(d)(1) goes on to define a substantial understatement of income tax, which is generally an understatement that exceeds the greater of 10% of the tax required to be shown on the return or $5,000. Sec. 6662(d)(1)(C) provides a special rule in the case of any taxpayer that claims the Sec. 199A deduction for the tax year, which requires that Sec. 6662(d)(1)(A) be applied by substituting “5 percent” for “10 percent.” Thus, a taxpayer claiming the Sec. 199A deduction has a lower bar to overcome before being assessed a penalty for a substantial underpayment of income tax. Given this potential increased exposure for a penalty, it is important to carefully consider all the limitations and rules when calculating the deduction under Sec. 199A.