The new section 199A of the Internal Revenue Code (IRC) provides a potential tax break for owners of passthrough entities like S corporations, partnerships, and limited liability companies (taxed as partnerships or as disregarded entities). For higher-income taxpayers, the 20% Qualified Business Income (QBI) deduction is generally limited to the greater of 50% of the allocable W-2 wages for the trade or business, or 25% of allocable W-2 wages for the trade or business plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property. This is referred to as the W-2 wage or UBIA limitation. To illustrate, the proposed regulations provide the following examples for taxpayers above the taxable income phase-in range:
Example 1. D, an unmarried individual, owns several parcels of land that D manages and which are leased to several suburban airports for parking lots. The business generated $1,000,000 of QBI in 2018. The business paid no wages and the property was not qualified property because it was not depreciable. After allowable deductions unrelated to the business, D’s total taxable income for 2018 is $980,000. Because D’s taxable income exceeds the applicable threshold amount, D’s section 199A deduction is limited to zero because the business paid no wages and held no qualified property.
Example 2. Assume the facts as in Example 1, except that D developed the land parcels in 2019, expending a total of $10,000,000 to build parking structures on each of the parcels, all of which is depreciable. During 2020, D leased the parking structures and the land to the suburban airports. D reports $4,000,000 of QBI for 2020. After allowable deductions unrelated to the business, D’s total taxable income for 2020 is $3,980,000. Because D’s taxable income is above the threshold amount, the QBI component of D’s section 199A deduction is subject to the W-2 wage and UBIA of qualified property limitations. Because the business has no W-2 wages, the QBI component of D’s section 199A deduction will be limited to the lesser of 20% of the business’s QBI or 2.5% of its UBIA of qualified property. Twenty percent of the $4,000,000 of QBI is $800,000. Two and one-half percent of the $10,000,000 UBIA of qualified property is $250,000. The QBI component of D’s section 199A section is thus limited to $250,000.
As illustrated above, the tax computations are important to determine the allowable section 199A deduction. However, proper tax reporting from the passthrough entity is as essential under the current IRS guidance. Under Prop. Reg. §1.199A-6(b)(2), the relevant passthrough entity is required to: (i) determine whether it is engaged in one or more trades or businesses and identify whether any of those trades or businesses are Specified Service Trade or Businesses (SSTBs) within the meaning of section 199A; (ii) determine the amount of QBI for each business engaged indirectly; (iii) determine the amount of W-2 wages and UBIA of qualified property for each business engaged indirectly, and (iv) determine whether the entity has any qualified REIT dividends or qualified PTP income directly or indirectly. For further explanation of these rules, click here for the 184-page IRS guidance published in the Federal Register.
After determining (i) through (iv) above, the passthrough entity must report on the Schedule K-1 or attachments thereto, the owner’s allocable share of QBI, W-2 wages, UBIA of qualified property, and the SSTB determination attributable to any trade or business activity engaged in directly by the entity. The entity also needs to attach a statement to the Schedule K-1, a summary of the QBI, W-2 wages, UBIA of qualified property, and SSTB determinations reported to it by any other passthrough entity in which the reporting entity owns a direct or indirect interest. The attachment should also include each owner’s allocated share of any qualified REIT dividends or qualified PTP income or loss.
The consequences for failing to report can be dire for owners. If the passthrough entity fails to report the section 199A information on the Schedule K-1 or any attachments thereto, that owner’s share of positive QBI, W-2 wages, and UBIA of qualified property attributable to the trades or businesses engaged in by the entity will be presumed to be zero under the proposed rules. Thus, even though the section 199A deduction is applied at the owner level, the entity has the tax reporting responsibility to provide the relevant section 199A information to its owners so that they can claim the QBI deduction. As always, business owners should take care of this new tax law environment and consult with their advisors to determine the proper tax impact under the new rules.
DISCLAIMER: To ensure compliance with requirements imposed by the U.S. Treasury Regulations, we inform you that any tax advice contained in this blog is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.