The new Section 199A deduction gets complicated. And one nearly hidden complexity? The qualified business income adjustments, or QBI adjustments, taxpayers need to make in order calculate the deduction.
This short blog post, therefore, describes how these qualified business income adjustments work.
I’ll also summarize the explicit adjustments the final regulations require. And then I’ll point out some of the other adjustments which people probably need to consider by applying the final regulations’ instructions.
Qualified Business Income Adjustments (aka “QBI Adjustments”)
The first thing to know: You may need to adjust the qualified business income number that appears on a K-1 from an S corporation or partnership, on a Schedule C, or on a Schedule E.
In other words, you can’t look only at the bottomline number. You start with that number. But you don’t necessarily end with that number.
Rather, you need to deduct from the number shown someplace like a Schedule C form any additional deductions connected or “attributable” to the trade or business.
The final regulations, for example, say this,
All deductions attributable to a trade or business should be taken into account for purposes of computing QBI except to the extent provided by section 199A and these regulations.
Helpfully the final regulations also provide some examples, pointing out,
for purposes of section 199A, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis.
Example Qualified Business Income Adjustments
Applying the explicit examples from the final regulations is pretty easy.
Say, for example, that you have a sole proprietorship that generates $108,000 of bottomline profit and that you take an $8,000 self-employment tax deduction, a $10,000 self-employment health insurance deductions, and a $10,000 SEP-IRA contribution deduction.
In this case, you adjust your $108,000 of sole proprietorship profits by subtracting the $28,000 of deductions. The actual qualified business income number that plugs into the Section 199A equals $80,000.
The Complicated QBI Adjustments
By the way? After the final regulations came out on January 18, 2019, everybody agreed that you make adjustments those like described above. But once you move beyond the explicit examples from the regulations, the accounting gets more cloudy.
The reason the accounting gets cloudy? Let me start the discussion by providing the chunk of regulation that matters here, Section 1.199A-3(b)(vi):
(vi) Other deductions. Generally, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of section 199A and this section are otherwise satisfied. For purposes of section 199A only, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.
The problem concerns the boldfaced italicized words above…
That language rather explicitly says deductions are “attributable” and so “qualified business income adjustments” if the trade or business income is “taken into account in calculating the allowable deduction.”
Pretty clear, right?
So the question becomes, does the trade or business income matter for the deduction. If “yes,” you adjust the qualified business income number for the deduction. If “no,” you don’t.
Elective Deferrals Seem to Count as QBI Adjustments
Here’s the big example of something that does seem to matter: The elective deferral chunk of a 401(k) deduction or Simple-IRA deduction for a sole proprietor or partner. That elective deferral number does take into account the trade or business income.
For example, you need income from your sole proprietorship or partnership interest in order to make the elective deferral. You can’t for example run a sole proprietorship that earns zero income and make a 401(k) plan contribution.
Further the total income from a sole proprietorship or partnership interest matters in terms of the total elective deferral and profit sharing match.
And then this frustrating thought? Surely as we work through the tax returns over the next few weeks, we’ll spot other deductions that take into account the trade or business income.
Stuff that Maybe Doesn’t Adjust Qualified Business Income
One other wrinkle to consider here. Some things you might assume get treated as qualified business income adjustments surely shouldn’t.
For example, while the final regulations specifically call out self-employed health insurance, that deduction shouldn’t count if it’s already been used to reduce the qualified business income on the trade or business’s tax return.
Take the case of the self-employed health insurance paid by an S corporation shareholder-employee. That amount gets deducted as shareholder-employer wages on the S corporation tax return. The deduction therefore reduces qualified business income at that point. You don’t need to deduct again the self-employed health insurance that appears on the taxpayer’s individual tax return.
And then here’s another thing to ponder as you work to identify the appropriate adjustments. If a trade-or-business-y deduction does not take into account the income from a trade or business, the deduction maybe is not a QBI adjustment.
The final regulations hint at a handful of examples of this situation pointing out,
The Treasury Department and the IRS decline to address whether deductions for unreimbursed partnership expenses, the interest expense to acquire partnership and S corporation interests, and state and local taxes are attributable to a trade or business as such guidance is beyond the scope of these regulations.
One way to explain the above lack of guidance? These items don’t necessarily “take into account” the income from the trade or business. And therefore they don’t necessarily adjust qualified business income.
Two final thoughts about all this. First, be careful as you do your Section 199A accounting and make the Section 199A calculations. As many tax accountants have noted since the statute appeared, this thing is complicated!
Second, both tax accountants and taxpayers need to understand errors in deduction calculations are sure to appear later on once we get more guidance. Much of this guidance will come after you file your tax return or your client’s tax returns unfortunately…
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