Unit Two - The Basics

Learning Objectives

After completing this Unit, you will be able to: › Gain an understanding of the basic concepts in determining the §199A deduction. › Define and understand the relevance of the components of the §199A deduction formula including: The “QBI Component” “Combined Qualified Business Income Amount” “Qualified Items” “Qualified REIT dividends” and Qualified Publicly Traded Partnership income › You will also learn what constitutes a “Qualified Trade or Business”

I. Overview

A. The § 199A deduction is allowed to individuals and some trusts and estates (but not corporations). B. The calculation of the § 199A deduction begins with a determination of the taxpayer’s “combined qualified business income”. C. The deduction is limited to 20% of that income but may also limited by the taxpayer’s share of the W-2 wages paid by that business, and the level of qualified property owned by that business. D. Finally, there is an overall limitation based on 20% of the taxpayer’s taxable income in excess of the net capital gain of the taxpayer. E. The §199A deduction is not allowed in calculating adjusted gross income (“AGI”), which means that the deduction will not affect calculations tied to AGI. F. A taxpayer who is subject to the alternative minimum tax (“AMT”) under §55 may take the §199A deduction in computing alternative minimum taxable income. 1. The statute provides that a taxpayer's QBI for AMT purposes equals the taxpayer's QBI for regular tax purposes,

notwithstanding any adjustments otherwise applicable in the computation of alternative minimum taxable income. 2. The regulations expand this rule and provide that a taxpayer's §199A deduction for AMT purposes equals the taxpayer's §199A deduction for regular tax purposes.

II. The Deduction Formula.

The following formula represents the basic calculation of the § 199A

deduction:

The § 199A deduction equal the lesser of: [A] 20 percent of the Qualified Business Income for each of “Qualified Trade or Business” of the Taxpayer plus 20 percent of the sum of Qualified REIT dividends and Qualified Publicly Traded Partnership income for the taxable year; or [B] The greater of: (i) 50 percent of W-2 wages with respect to that trade or business, or (ii) the sum of 25 percent of 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. But not greater than 20% of the excess of the taxable income of the taxpayer over the taxpayer’s net capital gain for the taxable year.

III. “Combined Qualified Business Income Amount”

A. Overview 1. An eligible taxpayer is able to deduct the “combined qualified business income amount” subject to an overall taxable income limitation. 2. The “combined qualified business income amount” is the sum of three separate amounts: - 20% of the taxpayer's “qualified business income” (QBI) from each “qualified trade or business (QTB) (as limited by the “wage-basis limit,” defined below), - 20% of the taxpayer's aggregate “qualified REIT dividends,” and

- 20% of the taxpayer's aggregate “qualified publicly traded partnership income.” 3. In order to better understand the term “combined qualified business income” we have to define the following terms: a. “Qualified business income”, b. “Qualified Items” c. “Qualified trade or business” d. “Qualified REIT dividend” e. “Qualified publicly traded partnership” B. “Qualified Business Income” 1. Definition. a. The definition of the term “qualified business income” (“QBI”) is for any taxable year, the net amount of “qualified items” of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. b. QBI does not include any qualified REIT dividends or qualified publicly traded partnership income. 2. Carryover of Losses — If the net amount of qualified income, gain, deduction, and loss with respect to qualified trades or businesses of the taxpayer for any taxable year is less than zero, such amount shall be treated as a loss from a qualified trade or business in the succeeding taxable year. C. A “Qualified Trade or Business”. 1. Definition. Under the Regulations a “qualified trade or business” is defined as any trade or business other than (i) a “specified service trade or business” or “SSTB”, or (ii) the trade or business of performing services as an employee. 2. SSTB. For detailed discussion of the effect of being a “specified service trade or business”, and a definition of the term see Unit Five, below. 3. Trade or Business of Performing Services as an Employee. a. The trade or business of performing services as an employee is not a trade or business for purposes of § 199A.

b. Therefore, no items of income, gain, loss, or deduction from the trade or business of performing services as an employee constitute QBI. c. No taxpayer may claim a § 199A deduction for wage income, regardless of the amount of taxable income. d. The Regulations also provide that an individual whose employer formerly characterized the individual as an employee for Federal employment tax purposes is presumed, for three years after the employer ceases to treat the individual as an employee for Federal employment tax purposes, to be in the trade or business of performing services as an employee with respect to the provision of substantially the same services directly or indirectly to the employer or a related person Note: A taxpayer can have a “combined qualified business income amount” even if the taxpayer has no QBI. This is because the combined qualified business income amount includes not only 20% of QBI, but also 20% of qualified REIT dividends and 20% of qualified publicly traded partnership income 5. Notice 2019-07 - Rental Real Estate Safe Harbor. a. Overview - Notice 2019-07, released concurrently with the regulations, provides notice of a revenue procedure which, if issued, would create a safe harbor under which a “rental real estate enterprise” may be treated as a trade or business solely for purposes of §199A. An enterprise that fails the safe harbor may still be treated as a trade or business for purposes of §199A if the enterprise rises to the level of a trade or business under §162. b. Definition. (1) The proposed revenue procedure defines rental real estate enterprise as “an interest in real property [or multiple properties] held for the production of rents.” (2) An individual or RPE relying on the proposed revenue procedure must hold the interest in real property directly or through a disregarded entity. (3) Although the proposed revenue procedure generally permits taxpayers to treat each rental property as either a separate enterprise or as part of a single

enterprise, commercial and residential properties may not be part of the same enterprise. (4) Therefore, there is no safe harbor for mixeduse buildings. (5) Additionally, taxpayers may not change the treatment of a property (i.e., as a separate enterprise or part of a single larger enterprise) unless there has been a significant change in facts and circumstances. c. Requirements for Eligibility. To be eligible for the safe harbor, the following requirements must be satisfied during the taxable year with respect to the rental real estate enterprise: (1) Books and Records. Separate books and records must be maintained for each rental real estate enterprise reflecting income and expenses of the enterprise. (2) Hours of “Rental Services. For taxable years beginning prior to January 1, 2023, at least 250 hours of “rental services” must be performed each year with respect to the enterprise. For taxable years beginning after December 31, 2022, at least 250 hours of rental services must be performed with respect to the enterprise in three of five consecutive taxable years that end with the taxable year.

(a) For purposes of the proposed revenue procedure, rental services may be performed by owners, employees, agents, independent contractors and include the following activities: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collecting rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors. (b) However, rental services do not include financial or investment management activities, such as arranging financing; procuring property; studying

and reviewing financial statements or reports on operations; planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate. (3) Contemporaneous Records. Taxpayers must keep contemporaneous records (i.e., time reports, logs, or similar documents) regarding the number of hours of all services performed for the enterprise, as well as a description of such services, including who the service was performed by and on what date such service was performed. The records must be made available for inspection at the request of the IRS. (4) Attached Statement. Taxpayers must include a statement attached to the return on which they claim the §199A deduction that the requirements in (a) – (c) have been satisfied. An RPE must include such statement on the return on which they pass through the §199A deduction. (5) Real Estate Not Eligible. Certain rental real estate arrangements are not eligible for the safe harbor, including: (a) real estate that is used by a taxpayer (or an owner or beneficiary of an RPE) as a residence for any part of the year under §280A; and (b) real estate rented under a triple net lease (i.e., a lease agreement that requires the tenant or lessee to pay all or a portion of taxes, fees, and insurance, and to be responsible for maintenance activities for all or a portion of property in addition to rent and utilities). D. “Qualified Items” 1. In General — The term “qualified items of income, gain, deduction, and loss” means items of income, gain, deduction, and loss to the extent such items are: (1) effectively connected with the conduct of a trade or business within the United States; and (2) included or allowed in determining taxable income for the taxable year. 2. Exclusions - The following items shall not be taken into account as a qualified item of income, gain, deduction, or loss: a. Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss.

b. Any dividend, income equivalent to a dividend, or payment in lieu of dividends. Any amount described in section 1385(a)(1) shall not be treated as described in this clause. c. Any interest income other than interest income which is properly allocable to a trade or business. d. Any item of gain or loss described in subparagraph (C) or (D) of section 954(c)(1) (applied by substituting “qualified trade or business” for “controlled foreign corporation”). e. Any item of income, gain, deduction, or loss taken into account under section 954(c)(1)(F) (determined without regard to clause (ii) thereof and other than items attributable to notional principal contracts entered into in transactions qualifying under section 1221(a)(7)). f. Any amount received from an annuity which is not received in connection with the trade or business. g. Any item of deduction or loss properly allocable to an amount described in any of the preceding clauses. E. Losses 1. Taxpayers who have losses with respect to at least one QTB will necessarily fall into one of three categories: a. First, those with one or more QTBs who have net losses with respect to all QTBs. b. Second, those with net losses with respect to some QTBs, net income with respect to other QTBs, and net loss overall. c. Third, those with net losses with respect to some QTBs, net income with respect to other QTBs, and net income overall. 2. For taxpayers in the first category, the resulting negative total QBI amount is carried over and treated as a QBI loss from a QTB in the succeeding taxable year. 3. For taxpayers in the second category, the net negative QBI amount is carried over and treated as a QBI loss from a QTB in the succeeding taxable year,

4. For taxpayers in the third category, with net losses with respect to some QTBs, net income with respect to other QTBs, and net income overall, the regulations require taxpayers to net QBI income against QBI loss. F. Treatment of Reasonable Compensation and Guaranteed Payments. – Qualified business income does not include— 1. Reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business1 , 2. Any guaranteed payment described in section 707(c) paid to a partner for services rendered with respect to the trade or business, and

3. To the extent provided in regulations, any payment described in section 707(a) to a partner for services rendered with respect to the trade or business G. Qualified REIT Dividends. - The term “qualified REIT dividend” means any dividend from a REIT received during the taxable year which: (1) is not a capital gain dividend, and (2) is not qualified dividend income. A REIT dividend is not a qualified REIT dividend if the stock with respect to which it is received is held for fewer than 45 days. H. Qualified PTP Income - The term “qualified publicly traded partnership income” means the sum of (1) the net amount of such taxpayer's allocable share of income, gain, deduction, and loss from a publicly traded partnership plus (2) any gain or loss attributable to assets of the publicly traded partnership giving rise to ordinary income that is considered attributable to the trades or businesses conducted by the partnership.

IV. Relevant Passthrough Entities

A. Overview 1. The regulations create the term “relevant passthrough entity” (“RPE”) to include partnerships (except for PTPs which are treated separately) and S corporations that are directly or indirectly owned by at least one individual, trust, or estate.

1 In the preamble to the proposed regulations, Treasury and the IRS stated that “[t]he rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in QBI.

2. A trust or estate is also an RPE to the extent that it passes through QBI, W-2 wages, UBIA of qualified property, qualified REIT dividends, or qualified PTP income to a beneficiary or beneficiaries. 3. A taxpayer calculates the §199A deduction with regard to relevant items that the taxpayer receives directly and the taxpayer's allocable share of items from RPEs. 4. In the case of a partnership or S corporation, the §199A deduction is determined at the partner or shareholder level. B. Partners in Partnerships 1. Each partner takes into account the partner's allocable share of each of the partnership's qualified items of income, gain, deduction, and loss; is treated as having W-2 wages and UBIA of qualified property equal to the partner's allocable share of the partnership's W-2 wages and UBIA of qualified property. 2. Each partner takes into account the partner's allocable share of the partnership's qualified REIT dividends and qualified PTP income. C. Shareholders of S Corporations 1. Similarly, each S corporation shareholder takes into account the shareholder's pro rata share of each of the S corporation's qualified items of income, gain, deduction, and loss; is treated as having W-2 wages and UBIA of qualified property equal to the shareholder's pro rata share of the S corporation's W-2 wages and UBIA of qualified property; 2. Each shareholder takes into account the shareholder's pro rata share of the S corporation's qualified REIT dividends and qualified PTP income.

Interactive Exercise 3

Which of the following is a “qualified trade of business” for purposes of Sec. 199A: A. A specified service trade or business B. A trade or business of performing services as an employee C. A trade or business under section 162 trade or business other than the trade or business of performing services as an employee

A is Incorrect – Under the Regulations a “qualified trade or business” is defined as any trade or business other than (i) a “specified service trade or business” or “SSTB”, or (ii) the trade or business of performing services as an employee. B is Incorrect - The trade or business of performing services as an employee is not a trade or business for purposes of § 199A. C is Correct - Under the Regulations a “qualified trade or business” is defined as any trade or business other than (i) a “specified service trade or business” or “SSTB”, or (ii) the trade or business of performing services as an employee.

Interactive Exercise 4

Which of the following is a “qualified item” of purposes of the Sec. 199A. A. Income, gain, deduction, and loss to the extent effectively connected with the conduct of a trade or business within the United States. B. Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss. C. Any dividend, income equivalent to a dividend, or payment in lieu of dividends.

A is Correct - The term “qualified items of income, gain, deduction, and loss” means items of income, gain, deduction, and loss to the extent such items are: (1) effectively connected with the conduct of a trade or business within the United States; and (2) included or allowed in determining taxable income for the taxable year. B is Incorrect - Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss is not be taken into account as a qualified item of income, gain, deduction, or loss C is Incorrect - Dividends, income equivalent to a dividends, or payment in lieu of dividends are excluded from the definition of “qualified items”, except any amount described in section 1385(a)(1).