Passthrough Deduction Clarifications Tackle W-2 Calculation, Aggregation
Despite the 35-day government shutdown, the IRS was able to finalize regulations issued last Summer on the Sec. 199A passthrough deduction for qualified business income (QBI). Along with the final rules, the IRS released new proposed regulations on REIT dividends, procedures to calculate W-2 wages, and a safe harbor for rental real estate activities (See related article.) In all, the over 300 pages of guidance go a long way toward helping taxpayers and their advisers accurately compute and report the new deduction.
The IRS also has released a draft of Form 8995, Qualified Business Income Deduction Simplified Computation. Taxpayers will use this form to show the IRS how they calculated the QBI deduction. This form must be attached to the taxpayer’s return beginning in the tax year 2019.
Calculating W-2 Wages: A Critical Computation
The qualified business income deduction is limited based on W-2 wages and depreciable property holdings if a taxpayer’s income is above certain threshold levels. For non-professional firms, the deduction is the lesser of 20% of qualified business income or 50% of the W-2 wages paid by the entity. For capital-intensive businesses, the taxpayer’s deduction is the lesser of 20% of QBI or the higher of (1) 50% of the W-2 wages paid by the business; or (2) 25% of wages paid plus 2.5% of the cost of depreciable property held by the business.
W-2 wages are defined as remuneration paid by an employer to an employee for services, including deferred compensation. W-2 wages do not include any amount not reported on a return filed with the Social Security Administration (SSA).
These limits are computed on a business-by-business basis, so you cannot use W-2 wages from one business to compute the deduction for a different business. The revenue procedure provides three methods for calculating W-2 wages:
- the unmodified Box method
- the modified Box 1 method
- the tracking wages method
The simplest method, the unmodified Box method, involves taking the lesser of: (1) the total entries in Box 1 (wages, tips, and other compensation) of all W-2 forms filed by the taxpayer with the SSA; or (2) the total entries in Box 5 (Medicare wages and tips) of all W-2 forms filed with the SSA.
The modified Box 1 method involves making modifications to the total entries in Box 1 of all W-2 forms by subtracting amounts that are not wages for federal income tax withholding purposes (such as supplemental unemployment compensation benefits) and adding the total amounts of elective retirement plan deferrals reported in Box 12.
Under the tracking wages method, the taxpayer tracks total wages subject to federal income tax withholding and elective deferrals reported in Box 12 of W-2 forms.
The IRS says method one is simpler, but methods two and three are more accurate. Note that wages paid to “Statutory Employees”, such as drivers, insurance agents, and salespersons, and reported in Box 13 should not be included in the calculation.
Remember, accurate calculation and reporting of W-2 wages is key to qualifying for a higher QBI deduction, so taxpayers should put in place the tools to do these special computations now.
Final Regulations
The IRS finalized the earlier proposed regulations on the QBI deduction issued last August, after receiving 336 public comments. The final rules cover many subjects, including the treatment of suspended losses, aggregation of business interests, and sharing the basis of qualified property. Here’s a rundown of some of the major issues covered in the final regulations.
Net Capital Gain: The basic QBI deduction is calculated as the lesser of:
- the “combined qualified business income” of the taxpayer, or
- 20% of taxable income over net capital gain.
The final regulations define “net capital gain” as the excess of net long-term capital gain for the tax year over the net short-term capital loss for that year plus qualified dividend income.
Disregarded entities: The final rules clarify that trades or businesses conducted by a disregarded entity are treated as conducted directly by the owner of the entity.
Aggregation by Relevant Passthrough Entities: A relevant pass-through entity (RPE) has the option of aggregating its businesses. The resulting aggregation must be reported by all owners. The regulations define a “relevant passthrough entity” as a partnership or an S corporation that is owned, directly or indirectly, by at least one individual, estate, or trust. Other passthrough entities, including common trust funds and religious organizations, can be treated as relevant passthrough entities if the entity files a partnership return and is owned, directly or indirectly, by at least one individual, estate, or trust.
Basis Adjustments for Qualified Property: The final regulations specify how to compute each partner’s share of the unadjusted basis of qualified property used in the QBI computation.
Suspended Losses: Previously disallowed losses or deductions can be taken into account for purposes of computing QBI, and the final rules require that taxpayers apply the losses in the order from the oldest to the most recent on a first-in-first-out (FIFO) basis.
Employees v. Independent Contractor: Because independent contractors can get the QBI deduction but employees cannot, the IRS is concerned that workers will change to independent contractor status just to qualify for the deduction. The final regulations include a presumption that a worker who was previously treated as an employee and whose status is changed to an independent contractor will be presumed to be an employee and will not qualify for the QBI deduction. This presumption only applies if the worker is providing substantially the same services as an independent contractor that the worker performed as an employee. Importantly, in response to comments, the IRS will only look back at the workers status and duties for three years.
The final regulations allow an individual to rebut the employee presumption by showing records, such as contracts or partnership agreements, that shows the individual’s status as a non-employee for the past three years.
Small Business Trusts: The S portion and non-S portion of an electing small business trust (ESBT) are treated as a single trust for purposes of determining the threshold amounts for the deduction. An ESBT is a trust that holds stock in an S Corporation.
Not long after issuing the final rules, the IRS had to release corrections to the basic adjustments for partners and to the description of disregarded entities.
Proposed Regulations
The proposed regulations fill in gaps left by the final regulations relating to previously suspended losses, regulated investment company dividends, and certain trusts. Some previously disallowed losses relating to a trade or business that is no longer in existence will be treated as a loss from a separate trade or business. If losses relate to a publicly traded partnership, they must be treated as losses from a separate PTP.
RICs and REIT Dividends
The IRS also explained how regulated investment company (RIC) dividends can qualify as REIT dividends eligible for the QBI. A regulated investment company that receives qualified REIT dividends may pay qualified Section 199A dividends. Non-corporate shareholders receiving Section 199A dividends would treat them as qualified REIT dividends if the shareholder meets the holding period requirements for its shares in the RIC.
The proposed rules also include provisions that prevent split-interest trusts and charitable remainder trusts from dividing assets among multiple trusts to avoid the limitations imposed by the taxable income thresholds in the QBI deduction rules.
The IRS has indicated that future guidance will address publicly traded partnerships and dividends distributed by RICs in more detail.
The passthrough deduction, even with the new guidance, remains very complex and technical. This is a critical year to consult with your tax advisor to determine how the rules may affect your qualified business income deduction.