What Qualifies As Business Income?

The AICPA which stands for the America Institute of CPA’s recently made recommendations to the IRS (Internal Revenue Service) about the proposed rules for deductions for qualified business income. This directly affects individuals, partnerships, s-corporations, as well as trust, estates doing domestic business in the United States.

Here are the following specific areas which are the highest priority in which guidance is needed and recommended by the AICPA.

  • Qualification of rental real estate as a trade or business
  • Modification of the rental property recharacterization rule (Prop. Reg. §1.199A-5(c)(2))
  • Clarification of the de minimis rule in the allocation between specified service trade or business (SSTB) and non-SSTB Activities
  • Clarification on the definition of qualified business income (QBI)
  • Treatment of the ordering rule for sections 465, 469, 704(d), and 1366(d)
  • Interaction of section 199A with section 461(l) for purposes of calculating QBI
  • Treatment of relevant passthrough entities (RPEs)
  • Clarification on the aggregation rules
  • Effect of sections 743(b) and 734(b) basis adjustments on unadjusted basis immediately after acquisition (UBIA) of qualified property
  • Effect of sections 351, 721, and 1031 on UBIA of qualified property and the depreciable period

The AICPA also included an appendix of other issues it believes affect QBI that warrant guidance.

The proposed rules on the qualified business income deduction were issued under REG-107892-18, IRS Notice 2018-64 on “Methods for Calculating W-2 Wages for Purposes of Section 199A,” and IRS Frequently Asked Questions (FAQs) on the “Tax Cuts and Jobs Act, Provision 11011 Section 199A – Deduction for Qualified Business Income.”

 

Understanding the new Sec. 199A business income deduction

  • Sec. 199A allows taxpayers other than corporations a deduction of 20% of qualified business income earned in a qualified trade or business, subject to certain limitations.
  • The deduction is limited to the greater of (1) 50% of the W-2 wages with respect to the trade or business, or (2) the sum of 25% of the W-2 wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property (generally, tangible property subject to depreciation under Sec. 167). The deduction also may not exceed (1) taxable income for the year over (2) net capital gain plus aggregate qualified cooperative dividends.
  • Qualified trades and businesses include all trades and businesses except the trade or business of performing services as an employee and “specified service” trades or businesses: those involving the performance of services in law, accounting, financial services, and several other enumerated fields, or where the business’s principal asset is the reputation or skill of one or more owners or employees.
  • Qualified business income is the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business that are effectively connected with the conduct of a business in the United States. However, some types of income, including certain investment-related income, reasonable compensation paid to the taxpayer for services to the trade or business, and guaranteed payments, are excluded from qualified business income.
  • The W-2 wage limitation does not apply to taxpayers with taxable income of less than $157,500 for the year ($315,000 for married filing jointly) and is phased in for taxpayers with taxable income above those thresholds. Income from specified service businesses is not excluded from qualified business income for taxpayers with taxable income under the same threshold amounts.
  • The new law also reduces the threshold at which an understatement of tax is substantial for purposes of the accuracy-related penalty under Sec. 6662 for any return claiming the deduction, from the generally applicable lesser of 10% of tax required to be shown on the return or $5,000 before the new law, to 5% of tax required to be shown on the return or $5,000.
  • The law’s many yet-unclear points include its application to rental property, the netting of qualified business income and loss for taxpayers with multiple qualified trades or businesses, determining the deduction for tiered entities, allocating W-2 wages among businesses, and whether compensation paid to an S corporation shareholder is included in W-2 wages for purposes of that limitation.
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