Unit Three – The Limitations

Learning Objectives

After completing this Unit, you will be able to: › Understand the limitations on the §199A deduction. › Learn how to calculate the W-2 Wage/Basis Limitation › Understand the application of Taxable Income limitation I. Overview – A taxpayer's §199A deduction may be limited by two limitations: A. W-2 Wage/Basis Limitation – The §199A deduction may be limited by the taxpayer’s share of the greater of the “W-2 Wage/Basis Limitation” which is the greater of (i) the amount determined under the “wages test” or (ii) the amount determined under the “wages plus basis test”. B. The Taxable Income Limitation – The §199A deduction of a taxpayer cannot exceed an amount equal to 20 percent of the excess (if any) of the taxable income of the taxpayer for the taxable year, over the net capital gain of the taxpayer for such taxable year.

II. The W-2 Wage/Basis Limitation.

A. Overview. 1. Above certain threshold amounts

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, the § 199A deduction is limited by the “W-2 Wage/Basis Limitation” which is equal to the taxpayer’s share of the greater of: (I) 50 percent of the W-2 wages with respect to that trade or business (the “wages test”), or (II) 25 percent of the W-2 wages with respect to that trade or business plus 2.5 percent of the Unadjusted Basis of Qualified Property with respect to that trade or business (the “W2 Wage/Basis Limitation”). 2. Within the so-called “phase in range”3 the W-2 Wage/Basis Limitation phased in as the level of that taxpayer’s income increases

2The term “threshold amount” means, for any taxable year beginning before 2019, taxable income of $157,500 (or $315,000 in the case of a taxpayer filing a joint return). This figure will be adjusted by a cost-of-living adjustment on an annual basis. 3 The “phase-in range” means a range of taxable income, the lower limit of which is the threshold amount, and the upper limit of which is the threshold amount plus $50,000 (i.e., taxable income of between $157,500 and $207,500)or $100,000 in the case of a joint return(i.e., between taxable income between $315,000 and $415,000). 21

3. Below threshold amounts, the W-2 Wage/Basis Limitation does not apply. B. The W-2 Wage Component 1. Overview – In order to determine the W-2 wage component of the § 199A deduction calculation the taxpayer must determine the W-2 wages that are properly allocable to QBI. The proposed regulations provide the following three-step process for determining this amount: Step One – Determine the total amount of W-2 wages treated as paid by the taxpayer for the taxable year; Step Second - Allocate the W-2 wages between or among one or more trades or businesses; Step Three – Determine the amount of such wages with respect to each trade or business, which are allocable to the QBI of the trade or business (or aggregated trade or business). 2. Step One – Wages Paid a. An individual or RPE must first determine its W-2 wages “paid” for the taxable year.269 For these purposes, “paid” includes amounts of deferred compensation. b. Rev. Proc. 2019-11 provides three alternative methods for computing an individual's or RPE's W-2 wages paid in a taxable year:271 (1) the “unmodified Box method,” (2) the “modified Box 1 method,” and (3) the “tracking wages method.” These are described below: (1) W-2 wages paid under the unmodified Box method equal the lesser of the total of the amounts reported in Box 1 (Wages, tips, and other compensation) and the total of the amounts reported in Box 5 (Medicare wages and tips) with respect to Forms W-2 of that individual's or RPE's employees. (2) W-2 wages paid under the modified Box 1 method equal the total of the amounts reported in Box 1, minus the total of the amounts reported in Box 1 that are “not wages for Federal income tax withholding purposes,"

plus the total of certain elective deferral amounts reported in Box 12. (3) W-2 wages paid under the tracking wages method equal the total of the “amounts of wages subject to Federal income tax withholding that are paid to employees of the taxpayer for employment by the taxpayer and that are reported on Forms W-2 filed with [the Social Security Administration] by the taxpayer for the calendar year” plus the total of certain elective deferral amounts and employee salary reductions under a §408(p) SIMPLE plan reported in Box 12. c. For a partner who is allocated QBI by a partnership or a shareholder who has a share of an S corporation's QBI, the partner's or shareholder's allocable share of W-2 wages is determined in the same manner as the partner's or shareholder's allocable share of W-2 wage expense for the taxable year. 3. Step Two – Allocation of Wages a. After calculating total W-2 wages for a taxable year, each individual or RPE that directly conducts more than one trade or business must allocate those wages among its various trades or businesses. W-2 wages must be allocated to the trade or business that generated those wages. b. In the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined in the same manner as the expenses associated with those wages are allocated among the trades or businesses under §1.199A-3(b)(5). c. Amounts that are treated as W-2 wages for a taxable year under any method cannot be treated as W-2 wages of any other taxable year. Also, an amount cannot be treated as W-2 wages by more than one trade or business (or aggregated trade or business). 4. Step Three – Wages Allocable to QBI a. Once W-2 wages for each trade or business have been determined, each individual or relevant pass through entity must identify the amount of W-2 wages properly allocable to QBI for each trade or business (or aggregated trade or business).

b. W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI. c. In the case of a RPE, the wage expense must be allocated and reported to the partners or shareholders of the relevant pass through entity as required by the Code, including subchapters K and S of chapter 1 of subtitle A of the Code. The relevant pass through entity must also identify and report the associated W-2 wages to its partners or shareholders. 5. Partners of Partnerships and Shareholders of S Corporation. For a partner who is allocated QBI by a partnership or a shareholder who has a share of an S corporation's QBI, the partner's or shareholder's allocable share of W-2 wages is determined in the same manner as the partner's or shareholder's allocable share of W-2 wage expense for the taxable year. 6. Trusts and Estates. In the case of trusts and estates that incur W-2 wages, the statute provides that rules similar to those in former §199 will apply for the apportionment of W-2 wages between the trust or estate and its beneficiaries. C. The UBIA of Qualified Property Component 1. Overview – The basis component of the W-2 Wage/Basis Limitation is an amount equal to 2.5% of the “unadjusted basis immediately after acquisition of qualified property”. 2. “Unadjusted basis immediately after acquisition” - The term unadjusted basis immediately after acquisition (UBIA) means the basis on the placed in-service date 3. Definition of “Qualified Property”- The term qualified property means, with respect to any trade or business (or aggregated trade or business) of an individual or RPE for a taxable year, tangible property of a character subject to the allowance for depreciation under section 167(a)-a. Which is held by, and available for use in, the trade or business (or aggregated trade or business) at the close of the taxable year; b. Which is used at any point during the taxable year in the trade or business's (or aggregated trade or business's) production of QBI; and

c. The depreciable period for which has not ended before the close of the individual's or RPE's taxable year. 4. Improvements to Qualified Property. — In the case of any addition to, or improvement of, qualified property that has already been placed in service by the individual or RPE, such addition or improvement is treated as separate qualified property first placed in service on the date such addition or improvement is placed in service.

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5. Adjustments Under Sections 734(b) and 743(b). — Excess section 743(b) basis adjustments as defined in that section are treated as qualified property. That excess is the excess of the transferee partner's proportionate share of the adjusted basis of the partnership property over the basis of his interest in the partnership. Otherwise, basis adjustments under sections 734(b) and 743(b) are not treated as qualified property.5 6. Property Acquired at End of Year. — Property is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days of acquisition without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the § 199A deduction 7. Depreciable Period-- The term “depreciable period” means, with respect to qualified property of a trade or business, the period beginning on the date the property was first placed in service by the individual or RPE and ending on the later of (a) the date that is 10 years after such date; or (b) the last day of the last full year in the applicable recovery period that would apply to the property under section 168(c), regardless of any application of section 168(g)(the “alternative depreciation system” (ADS), which generally causes the recovery period of depreciable property to be longer than it would otherwise be under §168.6

4 A literal reading of the regulations may result in improvements not being qualified property if the underlying property's depreciable period has ended prior to the time when the improvement was placed in service, because the underlying property must be qualified property when the improvement is placed in service 5 Under IRC. Sec. 743 the basis of partnership property is adjusted as the result of a transfer of an interest in a partnership by sale or exchange or on the death of a partner provided an election under section IRC Sec. 754 (relating to optional adjustment to basis of partnership property) is made with respect to the partnership. 6This means that taxpayers that are required to use ADS will not receive any offsetting benefit under §199A by virtue of the extended recovery period of their depreciable property. 25

8. Partners of Partnerships and Shareholders of S Corporation. A partner's allocable share of UBIA is determined in accordance with how the partnership would allocate depreciation for book purposes under Reg. §1.704-1(b)(2)(iv)(g) on the last day of the taxable year. In the case of qualified property held by an S corporation, each shareholder's share of UBIA is equal to its pro rata share of the S corporation's UBIA. 9. Trusts and Estates. In the case of trusts and estates that own qualified property, the statute provides that rules similar to those in former §199 will apply for the apportionment of UBIA of qualified property between the trust or estate and its beneficiaries. However, there are no express rules in former §199 (or the regulations thereunder) regarding the allocation of basis

III. The Taxable Income Limitation.

A. Under §199A(a)(2) the §199A deduction is limited to an amount equal to 20% of the taxpayer's taxable income, calculated without regard to net capital gain or the §199A deduction. B. “Net capital gain” means net capital gain (excess of net longterm capital gain for the taxable year over the net short-term capital loss) plus any qualified dividend income for the taxable year.

Interactive Exercise 5

Which of the following is not a possible limitation to the Sec. 199A Deduction: A. The taxpayer’s taxable income B. The taxpayer’s share of W-2 wages paid by the taxpayer’s trade or business C. The limitation on itemized deductions.

A is Incorrect - Under §199A(a)(2) the §199A deduction is limited to an amount equal to 20% of the taxpayer's taxable income, calculated without regard to net capital gain or the §199A deduction. B is Incorrect - The § 199A deduction is limited by the “W-2 Wage/Basis Limitation” which is equal to the taxpayer’s share of the greater of: (I) 50 percent of the W-2 wages with respect to that trade or business (the “wages test”), or (II) 25 percent of the W-2 wages with respect to that trade or business plus 2.5 percent of the Unadjusted Basis of Qualified Property with respect to that trade or business (the “W-2 Wage/Basis Limitation”). C is Correct – This is not a limitation to the Sec, 199 A Deduction. A taxpayer's §199A deduction may be limited by two limitations: (1) the W-2 Wage/Basis Limitation, and (2) the Taxable Income Limitation –