Navigating through under-the-radar IRS guidance on 199A qualified business income
On April 11, four days before the filing deadline, the IRS quietly added 21 questions to its website page of frequently asked questions about issues related to Section 199A, the new 20 percent deduction for pass-through businesses.
While technically not binding on the IRS or taxpayers, the page does give insight into the IRS’s views on certain matters that many CPAs viewed as unclear regarding Section 199A issues to be reported on 2018 and later tax returns.
Prior to the April 11 additions to the page, it contained only 12 questions and answers related to the qualified business income deductions under Section 199A. The added questions deal with a number of issues, particularly ones that affect partnerships and S corporation interest holders.
The final question contains guidance that many have found surprising regarding the proper treatment of the self-employed health insurance deduction for an S corporation shareholder. The answer provides that the amount allowed as a deduction on the individual return will “generally” be considered a deduction in arriving at qualified business income (QBI), then goes on to note that such treatment “may result in QBI being reduced at both the entity and the shareholder level.”
This could lead to issues for some taxpayers. For example, let’s say Mary owns 100 percent of ABC Inc., an S corporation. She receives a $40,000 salary for services performed for the corporation. In addition, the corporation pays $5,000 for employer-provided health insurance for Mary. ABC, Inc. claims a deduction in computing QBI for the health insurance payment, resulting in QBI and line 1 ordinary income shown on Mary’s K-1 of $20,000. The $5,000 is added to Mary’s taxable wages on her W-2 for the year, and Mary is allowed a $5,000 deduction as an adjustment to income for the self-employed health insurance.
Answer 33 implies that Mary must reduce the $20,000 QBI by $5,000 to $15,000 on her individual return, using that to calculate her qualified business income deduction for the year. That is true even though the $5,000 had already been used in reducing the QBI computed by the S corporation at the entity level.
Many tax software programs had not been adjusting the QBI reported by flow-through entities for items of QBI from the pass-through that are subject to modification or disallowance at the individual equity holder level. Thus, if a partnership passed out negative QBI for 2018 due to incurring a loss, then that QBI loss was used without adjustment. Even some or all of that loss was not deductible on Form 1040 due to basis limitations, at-risk rules or passive loss deduction restrictions.
Question 28 makes clear that the QBI from the flow-through entity must be adjusted for these and other modifications to flow-through income that can only be determined at the partner or shareholder level. In addition, question 31 notes that the same rules apply to QBI flowing out from a publicly traded partnership.
Another example: James receives a K-1 from XYZ Ltd. Partnership that reports a $10,000 ordinary loss and QBI of ($10,000). James does not materially participate in XYZ’s single activity and has no other passive income. Under the passive activity loss rules of §469, James does not report any of the loss in computing taxable income, with the loss suspended and carried forward.
Per answer 28, the $10,000 QBI loss is also removed from the calculation of the Section 199A deduction for the year on James’ return, with that QBI loss carried forward until the related passive loss is finally allowed in computing taxable income in a future tax year.
The FAQ also clarified the IRS’s view on the use of the proposed regulations for 2018 tax returns in lieu of using the guidance in the final regulations published in January. The final regulations provide that, for 2018 only, a taxpayer can use the proposed regulations. However, the choice is an all or nothing choice—if the taxpayer elects to use the proposed regulations, then all of the terms in the proposed regulations must be used.
One item that first appeared in the final regulations was a statement that taxpayers have to reduce their QBI by the above-the-line deductions for self-employed health insurance, self-employment taxes, and SEP/Keogh contributions on behalf of self-employed individuals. Both sets of regulations stated that QBI had to be reduced by deductions effectively connected with the trade or business. Some advisors believed the lack of specific commentary on this issue in the proposed regulations meant that electing to use the proposed regulations eliminated the requirement to reduce QBI by these items.
Question 32 of the FAQ holds that electing the proposed regulations does not allow the taxpayer to avoid reducing QBI by those deductions. The IRS instead takes the position that the final regulations merely clarify that these items were always considered deductions effectively connected with a trade or business.
Example: Lee has $100,000 of net income reported on Schedule C. Per Question 32, Lee cannot simply treat $100,000 as his QBI from the business but must reduce the QBI by the amount of his self-employment tax deduction, any self-employed health insurance deduction, and any SEP/Keogh deduction claimed to the extent those items relate to the Schedule C income.
Since most of the questions were added late in tax season, a number of returns were already prepared and filed before they were issued, and many may have taken positions contrary to what is found in the FAQ. While the FAQ is not binding authority, tax advisors may wish to advise clients if a position was taken on the taxpayer’s return that is contrary to what the IRS indicated was their view of the proper treatment in the FAQ. The pros and cons of filing an amended return should be discussed at that time.
Many advisors likely were not aware that the FAQ had been issued prior to completing returns and extensions by April 15 due to the late date of issuance. Advisors who have not looked at this page should take the time to review the guidance found here.