As 2019 comes to an end, most taxpayers have filed their first tax return since the enactment of 2017’s major tax legislation, the Tax Cuts and Jobs Act (TCJA). Now’s the time to reflect on what we’ve learned through application of new Internal Revenue Code (IRC) Section 199A—the qualified business income (QBI) deduction.
The QBI deduction offers noncorporate taxpayers a deduction of up to 20 percent of domestic QBI. From the viewpoint of many taxpayers, this deduction helped bridge the gap between the new corporate tax rate of 21 percent and the highest individual tax rate of 37 percent. However, after initial application, it became apparent taxpayers shouldn’t assume an automatic 20 percent deduction—and in many cases a sophisticated analysis of facts and circumstances was required to correctly determine the deduction amount. Let’s walk through other provisions of the IRC that helped us shape our understanding of IRC §199A, including IRC §1411 on net investment income tax (NIIT), the material participation rules of IRC §469 and the trade or business definition in IRC §162.
NIIT & Material Participation Rules
After the issuance of proposed regulations in IRC §199A, commenters immediately looked for parallels between NIIT and QBI. These parallels quickly faded away as the tax community dug into the details of the QBI deduction. NIIT was enacted to impose a Medicare surcharge on passive income. Specific provisions regarding self-charged rent and self-charged interest followed the intent of the law, assessing additional tax on only truly passive income. Where NIIT sought—from the view of the owner—to provide an additional tax or revenue raiser, the QBI deduction sought—from the view of the business—to provide additional relief, leaving the two provisions at odds with each other.
In determining if a rental activity is eligible for the QBI deduction, many commentators recommended linking the QBI income deduction to material participation. The preamble to the final IRC §199A regulations highlight that the U.S. Department of the Treasury (Treasury) intentionally did not link IRC §199A to a requirement for material participation. By way of explanation, it was highlighted that the material participation regulations were enacted to limit losses incurred in a business in which a taxpayer did not participate in the generation of the losses. Since the QBI deduction’s intent was to provide a reduction in taxes attributable to income generated from a trade or business, linking the deduction to material participation did not align with the intent of the deduction.
In addition—but not new under the TCJA—material participation has implications throughout the flow-through owner’s tax return, including NIIT and limitations on passive activity losses. Thus, the importance of contemporaneous support for which of the seven material participation tests are met on an annual basis was important prior to the TCJA’s enactment. Keep in mind that material participation after retirement or divorce can still be attributable to a former material participant under the fifth test of material participation for five years after the triggering event.
Trade or Business Definition of IRC §162
In the preamble to the final IRC §199A regulations, the IRS and Treasury clarified the elusive definition of “trade or business,” as it will be applicable to the QBI deduction. The preamble specifically declined to reference multiple previously enacted regulations to define a trade or a business. Instead, Treasury highlighted that deeming an operation to be a trade or a business is a facts-and-circumstances analysis that relies on profit motive and a certain scope of regular and continuous activity supported by case law in Higgins v. Commissioner, 312 U.S. 212 (1941) and Commissioner v. Groetzinger, 480 U.S. 23 (1987). The spotlight on the definition of a trade or business reminded the tax community of the widespread implications of that terminology. For example, meeting or not meeting the definition of a trade or business under IRC §162 affects the accurate use of the reclassification of the character of the gain or loss on disposal of property, as well as the classification of expenses as ordinary versus passive. Taxpayers also were reminded that the filing of Form 1099 for vendors further supports their position that the activity of the issuer should be classified as a trade or a business, and thus eligible for the 20 percent deduction. The consistent presentation of an activity as a trade or business will build the support for the taxpayer’s eligibility for the QBI deduction.
Through the TCJA, corporations received a relatively simple means to the call for a tax reduction that could put American businesses on a level playing field with their international competitors—a 21 percent corporate income tax rate. Flow-through entities, in theory, received an equivalent offset, allowing for a 20 percent qualified small business deduction. In reality, the flow-through entity deduction is layered with complexities that don’t allow for the universal applicability that’s available through a tax rate reduction. IRC §199A highlights a renewed focus on ownership, material participation and designation of a trade or business, prompting taxpayers to ensure all the pieces of their tax puzzle are working together. This is the time to work with your trusted advisor at BKD to help you look forward with the correct spotlight on your eligibility for the IRC §199A deduction.
Please reach out to your BKD trusted advisor or complete the Contact Us form below for an analysis or more information.