Editor: Marcy Lantz, CPA
The qualified business income (QBI) deduction of Sec. 199A can result in significant savings for individuals, estates, and trusts. To maximize the deduction, it is important for tax practitioners to understand the interaction between various Code provisions so that items of income and deduction are included in QBI in the same period as the income and deductions are included in calculating regular taxable income. This discussion focuses on how Sec. 1231 and various loss disallowance provisions affect the QBI deduction, which was created by the law known as the Tax Cuts and Jobs Act, P.L. 115-97.
If a taxpayer has one qualified business, the calculation of the QBI deduction is fairly straightforward. If, however, a taxpayer has multiple qualified businesses, the calculation becomes more challenging. This is especially true when the taxpayer is not actively participating in all the businesses. When a business disposes of assets used in a qualified trade or business, Sec. 1231 comes into play to determine the nature of the realized gain or loss from the disposition.
As a refresher, QBI must be calculated for each trade or business activity separately (Sec. 199A(b)). To be included in QBI, the activity must be included or allowed in determining taxable income for the tax year (Sec. 199A(c)(3)(A)(ii)). Various Code provisions suspend recognition of gains and losses in a tax year, including installment sale rules (Sec. 453); basis rules (Secs. 704(d) and 1366(d)); at-risk rules (Sec. 465); passive loss rules (Sec. 469); and excess business loss rules (Sec. 461(l)). In addition, the calculation of QBI includes only qualified income, gain, deduction, or loss (Sec. 199A(c)(3)). One item that is expressly excluded from the calculation of QBI is capital gain or loss, and therefore, on the disposition of business use assets, a determination must be made whether the nature of the gain or loss is ordinary or capital.
QBI and Sec. 1231
Under Sec. 1231, a netting process must be used to determine the nature of the income or loss. Gains and losses from all activities, including publicly traded partnerships (PTPs), must be netted to determine if there is a net Sec. 1231 gain or a net Sec. 1231 loss. The preamble to the Sec. 199A regulations makes clear that:
- Net unrecaptured Sec. 1231 gain is characterized as long-term capital gain and is excluded from QBI;
- Net Sec. 1231 loss is characterized as ordinary loss and is included in QBI; and
- The character then tracks back to the trade or business that disposed of the assets (T.D. 9847).
If the net Sec. 1231 loss stems from multiple activities, then the loss would need to be allocated pro rata to each activity to determine the QBI for each activity.
How is Sec. 1231(c) recapture handled? Sec. 1231(c) recapture occurs when ordinary losses have been claimed in the five prior years and there is Sec. 1231 gain in the current year. The gain is converted from capital gain to ordinary gain to the extent of unrecaptured losses. Ordinary gain or loss under Sec. 1231 is included in QBI. The preamble to the Sec. 199A regulations states that applying Sec. 1231(c) recapture rules and allocating gain to multiple activities is beyond the scope of those regulations and that taxpayers should apply the Sec. 1231(c) recapture rules in the same manner as they would otherwise (T.D. 9847).
A reasonable position would be to treat these losses like the regulations treat carryover losses from years prior to 2018, which is to apply them on a first-in, first-out (FIFO) basis. Therefore, to the extent the recaptured income is from years prior to 2018, the income would be excluded from QBI. Because this income must be used to determine the QBI of specific activities, then the unrecaptured Sec. 1231(c) amounts should be allocated pro rata and tracked by year and by activity. Another, more taxpayer-friendly position is to include the current-year ordinary gain in current-year QBI since the gain originated in the current year, unlike suspended losses that originated in pre-2018 years. Sec. 1231(c) simply changes the character of the gain; it does not work to allow a previously unrecognized item from a prior year to be recognized in the current year.
QBI and loss disallowance provisions
Since the inclusion of losses in QBI reduces the deduction, it is extremely important to understand these provisions so that QBI is not reduced before the losses are allowed in calculating taxable income. Disallowed losses are carried forward and reduce Sec. 199A QBI when allowed in computing taxable income in a subsequent year. These provisions are determined before making the QBI calculation, so these carryforwards should not be confused with the overall net QBI amount of a taxpayer that is less than zero, which is treated as a loss from a qualified trade or business in the succeeding tax year (Sec. 199A(c)(2)).
When a taxpayer incurs a net business loss, the Code provisions that determine if that loss is allowable in the current year must be applied in a certain order. If the income and losses that result in this net loss come from multiple entities and have multiple activities, then the allowable losses and carryforward amounts must be allocated.
The first loss limitation that must be considered is that of basis. For a taxpayer to claim a deduction for a loss from a relevant passthrough entity, the taxpayer must have basis in the entity. Losses in excess of basis are not allowed in the current year for regular tax purposes (Secs. 1366(d)(1) and 704(d)(1)). Likewise, they are not allowed for QBI. These losses will be allowed for regular tax and QBI purposes in subsequent years when basis is restored (Secs. 1366(d)(2) and 704(d)(2)). Since the basis rule applies to each entity separately and the losses are suspended, no allocations of these loss limitations with other entities are required. If the entity has multiple activities and only part of the losses is allowed, the losses will need to be allocated between the entity's different activities.
Once it is determined the losses are allowed because the taxpayer has basis, the second loss limitation rule must be applied, which is to determine whether the taxpayer is at risk for those losses. With a few exceptions noted in Prop. Regs. Secs. 1.465-42 and -44 and Temp. Regs. Sec. 1.465-1T, as with the basis rules, the at-risk rules of Sec. 465 apply to each entity and activity of the entity separately, so allocations of limited losses with other entities are not required. If the taxpayer is not at risk for the losses, then the losses will not be included in either taxable income or QBI.
The third set of loss limitation rules that must be applied are the passive loss rules of Sec. 469. Complications come into play when a taxpayer has multiple activities requiring separate tracking. In addition, special rules apply for PTPs.
Losses from a PTP business activity cannot be used to offset gains from other activities or portfolio income from its own activities (Sec. 469(k)). If the PTP reports only business losses, those losses will not be allowed for regular tax purposes and will not be allowed as qualified PTP income (Regs. Sec. 1.199A-3(c)(3)(ii)). If the PTP reports Sec. 1231 gain, then the other business losses will be allowed if they are less than or equal to the Sec. 1231 gain, and they will likewise be included in qualified PTP income. If a taxpayer disposes of a PTP, a portion of the gain is taxed as ordinary income (Sec. 751(a)). This ordinary income will be included as part of qualified PTP income, which is a separate component of QBI (Sec. 199A(e)(4)(B)).
For non-PTP activities, passive losses can offset passive gains regardless of the activity generating the gains or losses. When the losses exceed the gains, pro rata allocations must be made between the losses to determine how much of the loss from each entity and activity is allowed (Sec. 469(j)(4)). If qualified business activities mirror passive activities, these same allocations apply for QBI. If qualified business activities are different from passive activities, then additional computations and allocations will be required to make sure only the losses allowed for regular taxable income are allowed for QBI. The disallowed amounts must be carried forward and tracked by year and will be allowed in subsequent years when passive income exceeds passive losses or when there is a complete disposition of the passive activity.
Tracking suspended losses
The tracking of suspended passive losses is straightforward: They are to be tracked by entity, by activity, and by nature of income. A taxpayer must track allocated losses within activities if the type of income would result in an income tax liability that would be different if the items were not separately stated. The types of income that must be accounted for separately are active participation rental real estate activities, non—active participation rental real estate activities, capital losses limited under Sec. 1211, and Sec. 1231 losses related to property used in a trade or business and involuntary conversions (Temp. Regs. Sec. 1.469-1T(f)(2)(iii)). These items must be tracked for both regular and alternative minimum tax (AMT) purposes. Fortunately, for AMT purposes, the Sec. 199A deduction is the same as for regular tax purposes, so no adjustments are required (Regs. Sec. 1.199A-1(e)(5)).
Noticeably absent is a requirement to track these losses by year. For regular tax purposes, there really is not a need for this, as the passive losses may be carried over indefinitely since they do not expire. In addition, the carryover losses are treated as deductions from the activity for the succeeding tax year (Regs. Sec. 1.469-1(f)(4)). At some point, these suspended losses will be included in taxable income, either because the taxpayer has passive income in excess of total passive losses or when there is a complete disposition of the activity. Herein lies the issue: The QBI deduction is allowed only for items arising in tax years beginning after Dec. 22, 2017, and before Dec. 31, 2025. Since losses carried over from years prior to 2018 never reduce QBI (Regs. Sec. 1.199A-3(b)(1)(iv)(A)), it is important to properly trace loss carryforwards by year. So, the separately tracked items must now be tracked by year so that deduction and loss items prior to 2018 do not reduce QBI when they are allowed for regular taxable income purposes.
The IRS in June issued amendments to Regs. Secs. 1.199A-3 and 1.199A-6, which apply to tax years beginning after Aug. 24, 2020. Taxpayers may choose to apply these amendments to tax years beginning on or before Aug. 24, 2020 (T.D. 9899). Regs. Sec. 1.199A-3(b)(1)(iv) was amended and deals specifically with previously disallowed losses, whether from pre-2018 tax years or post-2017 tax years. This discussion incorporates this amended subparagraph. While these rules are discussed in the context of Sec. 469's passive loss rules, the same concepts apply to disallowed, suspended, and limited losses under Secs. 461(l) (excess business loss rules), 465 (at-risk rules), and 704(d) and 1366(d) (basis rules). These provisions add another level of complexity since the allocations for QBI will now be different than for regular tax, requiring another set of carryforwards to be tracked.
So how do you handle these pre-2018 passive loss carryforwards when they can be claimed in the current year? For QBI, the carryforward losses are applied using FIFO — the oldest losses are utilized first (Regs. Sec. 1.199A-3(b)(1)(iv)(A)). Also, the amended regulations state they are treated as losses from a separate trade or business. If the losses relate to a PTP, they must be treated as a loss from a separate PTP (id.). Thus, if there are pre-2018 losses, they are taken into regular taxable income first but do not reduce QBI. Only when pre-2018 losses have been fully utilized do 2018 and subsequent-year losses reduce QBI.
The amended regulations also provide guidance regarding the partial allowance of a current-year loss or deduction. Only the portion allowed that is attributable to QBI will be used in determining QBI in the year the loss or deduction is incurred. The allocation is pro rata based on the portion of the loss that is attributable to QBI incurred in the year divided by the total loss incurred in the year (Regs. Sec. 1.199A-3(b)(1)(iv)(B)).
Attributes of the disallowed loss or deduction are determined in the year the loss is incurred, not the year the loss is allowed (Regs. Sec. 1.199A-3(b)(1)(iv)(C)). So, when preparing the current-year return, one must make these determinations as they relate to the carryover amount to subsequent years because, in the subsequent year, this carryover will be treated as arising from a separate trade or business. The first step is to determine if the disallowed amount is attributable to a trade or business and otherwise meets the requirements of Sec. 199A (Regs. Sec. 1.199A-3(b)(1)(iv)(C)(1)).
The second step is to determine whether the activity is from a specified service trade or business (SSTB) (Regs. Sec. 1.199A-3(b)(1)(iv)(C)(2)). If the activity is an SSTB, then all the SSTB calculations must be made in the current year on the disallowed amounts to determine how much of the disallowed amounts may be carried forward to the subsequent year and treated as a separate trade or business. In the subsequent year(s), these separate trades or businesses will not be subjected to the SSTB rules for the subsequent year(s); rather, the negative QBI from each separate trade or business will be applied proportionately to QBI in the subsequent year(s) when the loss is taken into account in calculating taxable income, regardless of the taxable income amount and application of the SSTB rules in the year the loss is allowed for calculating regular taxable income (Regs. Sec. 1.199A-3(b)(1)(iv)(D), Example (2)).
The SSTB rules provide limitations on the allowable amount for QBI based on threshold amounts. If taxable income is at or below the threshold amount in the year the loss or deduction is incurred (not the year allowed), the entire disallowed amount is carried over. If taxable income is within the phase-in range, then the applicable percentage of the allowed amount is carried over. Finally, if the taxable income exceeds the phase-in range, then none of the disallowed amounts will be carried over.
Once a determination is made that passive losses are allowed, a fourth provision comes into play that may further limit the ability to deduct losses. Sec. 461(l) limits excess business losses for noncorporate taxpayers to the excess of the taxpayer's aggregate trade or business deductions for the tax year over the sum of the taxpayer's aggregate trade or business income or gain plus $250,000. If the loss is limited for regular tax purposes, then the loss is limited for QBI. The Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, made several modifications to Sec. 461(l) including modifying the dates to which the provision applies: The provision no longer applies for losses arising in 2018, 2019, and 2020 but continues to apply for tax years beginning after Dec. 31, 2020, and before Jan. 1, 2026.
Any disallowed excess business loss is treated as a net operating loss (NOL) for the tax year for purposes of determining any NOL carryover under Sec. 172(b) for subsequent tax years (Sec. 461(l)(2)). Generally, an NOL deduction is not considered with respect to a trade or business and therefore is not considered in computing QBI. However, the excess business loss is included for purposes of computing QBI in the subsequent tax year in which it is deducted (Regs. Sec. 1.199A-3(b)(1)(v)).
When an entire interest in a passive activity is disposed of under the installment sale method of Sec. 453, special rules apply related to passive losses that are freed up as the result of a complete disposition. Sec. 469(g)(3) states that suspended losses that exceed the gain on the disposition are recognized over the term of the installment obligation using the same gross profit percentage that is used to recognize the gain on the installment sale. If there is a loss on the disposition, all suspended losses are recognized in the year of disposition, as installment sale reporting only applies to gains, not losses. Any freed-up suspended losses incurred after Dec. 31, 2017, will be included in QBI in the same year they are recognized for regular tax purposes. The election out of the installment sale method would accelerate the recognition of suspended losses, which can be beneficial for reducing regular taxable income. However, it is also detrimental, as it reduces QBI, so an analysis of the overall impact on taxable income over the life of the obligation may be needed to determine if the election out is truly beneficial for a taxpayer.
Also, if a taxpayer disposes of a partnership, a portion of the gain may be taxed as ordinary income (Sec. 751(a)). This ordinary income is attributable to the trades or businesses conducted by the partnership and therefore is part of the QBI computation for that activity (Regs. Sec. 1.199A-3(b)(1)(i)). Ordinary income under Sec. 751 is recapture income if received under the installment method and must be recognized in the year of disposition as if all payments to be received were received in the tax year of disposition (Sec. 453(i)(2)); accordingly, the ordinary income would also be included in QBI in the year of disposition.
Tax planning opportunities
It is only after the tax practitioner has applied all these Code provisions that one can then apply the complicated provisions of Sec. 199A to determine how much of the income and losses from each activity will be allowed in the taxpayer's combined QBI. The taxpayer's combined QBI is then compared to 20% of the excess of the taxpayer's taxable income over the taxpayer's net capital gain. The lesser of these two amounts is the taxpayer's QBI deduction for the tax year (Sec. 199A(a)). If the taxpayer's combined QBI is less than zero, there is no current-year deduction, and the loss is treated as a qualified trade or business loss in the succeeding tax year (Sec. 199A(c)(2)).
The tax law changes and consequences of the TCJA continue to evolve some three years after its passage. While the TCJA was arguably not the promised complete overhaul of the Code, the introduction of the QBI deduction and the interplay between it and other Code sections, both old and new, should have savvy tax practitioners licking their chops in anticipation of the planning opportunities.
Marcy Lantz, CPA, CSEP, is a partner with Aldrich Group in Lake Oswego, Ore. Ms. Lantz would like to thank the following practitioners for their help editing the December Tax Clinic: Michael T. Odom, CPA, CVA, partner at Fouts & Morgan CPAs PC in Memphis, Tenn.; Carolyn Quill, CPA, J.D., LL.M., principal at Thompson Greenspon CPAs & Advisors in Fairfax, Va.; Kristine Boerboom, CPA, CMA, MBA, partner at Wegner CPAs in Madison, Wis.; and Todd Miller, CPA, partner at Maxwell Locke & Ritter in Austin, Texas.
For additional information about these items, contact Ms. Lantz at 503-620-4489 or firstname.lastname@example.org.
Contributors are members of or associated with CPAmerica, Inc.