The new Section 199A deduction gets complicated for dozens of reasons. But one nearly hidden complexity? The qualified business income adjustments, or QBI adjustments, taxpayers may need to make in order calculate the deduction.
Example: Your business shows a $100,000 profit. But you may not get to plug that $100,000 into the Section 199A calculations. You may first need to adjust the number for what the regulations call “other deductions.”
This short blog post, therefore, describes how these qualified business income adjustments for “other deductions” work.
Specifically, I’ll identify the adjustments the final regulations explicitly require. I’ll point out some of the other adjustments which people probably need to make. And then I’ll talk about how to allocate “other deductions” when a taxpayer owns multiple trades or businesses.
Note: If you’re not yet familiar with how the Section 199A works, take a peek at this other blog post: Pass-through Income Deduction: Top 12 Things Every Business Must Know.
Qualified Business Income Adjustments (aka “QBI Adjustments”)
Okay, so an unfortunate reality. In order to calculate your Section 199A deduction, you may need to adjust the qualified business income number that appears on a K-1 from an S corporation, partnership, trust or estate, on a Schedule C, or on a Schedule E.
More specifically, you need to deduct from the qualified business income number any additional deductions connected or “attributable” to the trade or business.
Here’s the actual language from the final Section 199A regulations:
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 provide some examples of “attributable” deductions, pointing out that you need to adjust the qualified business income for the self-employment tax deduction, the self-employed health insurance deduction, and for contributions to qualified retirement plans.
The final regulations also provide the rule you use to identity “attributable” deductions. You consider a deduction “attributable” if
…the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction…
And this bit of additional guidance: The Form 8995 instructions point to additional deduction adjustments a business owner makes. The three big deductions include charitable contributions made by the business, interest expense on a loan used to purchase a business, and then the un-reimbursed partnership expenses paid by a partner.
Example Qualified Business Income Adjustments
Say, for example, that you own a sole proprietorship that generates $108,000 of bottom line profit.
Further say that you take an $8,000 self-employment tax deduction, a $10,000 self-employed health insurance deduction, and a $10,000 SEP-IRA contribution deduction. Note these deductions total $28,000.
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 formula equals $80,000.
By the way? If you enjoyed a $108,000 partnership profit share and reported the same $28,000 of deductions on your tax return? Your adjusted qualified business income also equals $80,000.
The Complicated QBI Adjustments
Some of the QBI adjustments will work as simply as the preceding paragraphs illustrate. But some won’t. Some of the adjustments will get complicated.
First, for example, the Form 8995 instructions direct taxpayers to deduct the self-employed health insurance deduction an S corporation shareholder or partner pays twice.
No, sorry, I’m not joking. See this blog post for the ugly details: How the IRS Destroyed the Section 199A Deduction for Small Business S Corporations and Partnerships.
Second, you want to look for other deductions that while not explicitly called out in the final regulations also take into account the “individual’s gross income from the trade or business.”
For example, following this rule, you might need to adjust for the elective deferral chunk of a 401(k) deduction or Simple-IRA deduction for a sole proprietor, shareholder-employee or partner. Why? That elective deferral number does take into account the trade or business income. (The total income from a sole proprietorship or partnership interest matters in terms of the total elective deferral and profit sharing match.)
Allocating Adjustments Across Multiple Trades or Businesses
If the extra fiddle-faddling described in the earlier paragraphs wasn’t enough, taxpayers and their accountants need to keep in mind one other complication.
In a situation where the “other deductions” are attributable to multiple trades or businesses, you or your accountant need to adjust the qualified business income amounts for each trade or business for the “other deductions.” You make the adjustments on a basis proportionate to “the gross income received from the trade or business.”
For example, suppose some single taxpayer earns $100,000 in guaranteed payments from one partnership conducting a non-specified-service trade or business, earns another $100,000 from a sole proprietorship conducting non-specified-service trade or business, and then yet another $100,000 from a law firm partnership which is a specified service trade or business.
To keep the example simple, assume this taxpayer’s taxable income exceeds $210,700 and that W-2 wages and depreciable property don’t limit the taxpayer’s Section 199A deduction.
If the single taxpayer reports a $15,000 self-employment tax deduction, $5,000 of that deduction gets allocated to the guaranteed payments, $5,000 to the sole proprietorship, and $5,000 to the law firm.
Note that neither the guaranteed payments nor the law firm profits count as qualified business income. Guaranteed payments are not qualified business income, period. The law firm profits are not qualified business income because the taxpayer’s income exceeds $210,700 and that means profits from a specified service trade or business don’t count as qualified business income either.
Accordingly, in the end, this taxpayer’s qualified business income would equal $95,000, calculated as the $100,000 in sole proprietorship profits minus $5,000 of the self-employment tax deduction.
And this maybe obvious comment: A taxpayer or tax accountant might also need to make the same sorts of proportionate allocations for self-employed health insurance deductions or pension fund contributions.
Final Thoughts
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, don’t assume the tax software will correctly make all these adjustments for you. Hopefully the software will get better as time goes by. But at this point, we continue to hear from other CPAs that their software is, er, well, pretty basic in terms of the Section 199A calculations.
Harry Sit says
What about the next phrase after “taking into account” — “on a proportionate basis”? The elective deferral can be a fixed number. It’s not necessarily “on a proportionate basis.”
Steve says
Hi Harry,
I think Reg. Sec. 1.199A-3(b)(vi) says you adjust for other deductions that take into account the gross income from the trade or business. And that you allocate other deductions proportionally if you need to allocate.
I.e., I don’t read the final reg to say that you would only adjust for deductions that “take into account the gross income” AND “work proportionally”.
This becomes clearer if one sees the entire paragraph–something I should have done above:
Matt says
This ruling also makes it more attractive (than it was before the ruling) to elect S corp status compared to sole prop schedule C. Under an S corp, the net effect of the half SE deduction still reduces income taxes, but it’s because it’s an 1120s deduction that never hits the 1040 so it doesn’t get directly penalized by this new ruling. Solo 401k contributions also get to shelter under the S corp so long as they’re elective deferrals, since they are part of wages and thus were already excluded from QBI.
By my calculations on $100k business profit and an example $19k Solo 401k contribution, this ruling would raise the tax burden on schedule C by $1147, and have no effect on the corresponding S corp.
Steve says
Hi Matt,
I may not understand but I think the retirement plan adjustments and SE health insurance work the same way for both S corp and sole prop. For both entity types, you would one way or another adjust QBI for the entire retirement plan or all of the SE insurance (subject to the wrinkle that Harry Sit brings up in his comment.)
The SE taxes would work a little different, but it seems like that’s only because with an S corp you’re going to have a smaller employer employment tax deduction and so a larger QBI number. Maybe this is what you mean or point to?
Matt says
I was thinking about SE taxes and the employer side of payroll taxes wrong. In my incorrect fantasy world above, the employer side of payroll taxes weren’t subtracted from profit to calculate what QBI is, but in reality they are. However as you mentioned the generally smaller overall payroll taxes with an S Corp do help.
I do however believe that you are not penalized by this ruling on $19k employee deferral under an S Corp while you would be with a schedule C. Am in understanding that wrong? That money is already subtracted as part of the owners salary, and the owner may do whatever he/she wants with it such as put up to $19k into a solo 401K. If you go over that into the profit sharing portion then you DO have to explicitly subtract it to calculate QBI.
With no S Corp there is no clean distinction between the employer deferral and profit sharing portion of contributions so you are forced to subtract it all from your initial QBI.
Happy to be corrected on any misunderstandings. I’m just an interested hobbyist acting as CFO for my wife’s new small (1 person) business. Your website has been immensely helpful in this pursuit so thank you for all that you do!
Steve says
Yeah I am thinking the same way. I.e., we don’t have to adjust for the employee elective deferral with an S corporation (because the elective deferral adjustment is already embedded in the shareholder-employee wages). But we do for the sole proprietor.
BTW, I think (and assume you also think) the same sort of accounting occurs with partner guaranteed payments. Some amount that’s already been removed from QBI because it’s part of a guaranteed payment doesn’t reduce QBI a second time.
Bradley Smith says
I read where it is acceptable to ask a question on a previous blog post, so here goes.
Regarding your post on 199A and rentals, my first inclination was to use the safe harbor as a minimum qualification for T or B status for rental real estate. However, now that Pub 535 has eliminated “extensive” from the description, I think I plan to use the safe harbor principles as a guideline for determining T or B status., In doing so, it would not necessarily require 250 hours. I would still ask clients to have separate books/records and to maintain a log/calendar. It seems such would support the regularity/continuity requirements, and I see no problem with the profit motive in most real estate investors.
In the above instance, we would not elect the safe harbor or even aggregation unless aggregating is necessary to maximize the deduction. Have your thoughts evolved on this issue at all?
Steve says
Bradley, I *totally* agree with you. And my own thought path has looked like yours. After draft pub 535 appeared, I thought, geez… no clean way for typical small rental property owners to take Section 199A. And at about that point, I updated the Section 199A real estate trade or business definition blog post. HOWEVER, I think now what I once thought… which is profit motive and continuity requirements should be EASY to meet… and then someone just needs to show regularity. Like you, it sounds like, I think clients need to be cautious about not using safe harbor and instead going with Section 162 trade or business requirement. They may need to defend their accounting to an IRS agent who thinks the safe harbor is a sort of minimum. But the final regs are pretty clear. And they provide best guidance.
Bradley Smith says
Thanks Steve. I always appreciate your thoughts. I have been a silent reader for a long time.
Sam L says
Re: the S Corp where husband and wife are the only employees you wrote in a post that “If you and your spouse both work in the foreign S corporation as shareholder-employees, you can double the excluded income by both using the exclusion.”https://evergreensmallbusiness.com/s-corporations-with-foreign-shareholder-employees/
I’m confused. Say they make $140K together. $40K isn’t excluded if they file jointly. Are you saying that they could each individually file and get the approx $140K exclusion (FEIE) on all their income?
Steve says
Yes.
Michael says
Steve,
I also read about your rules for submitting comments on previous topics to your current post. So, here it goes.
Regarding the “final” version of Publication 535 and Worksheet 12-A/Schedules A-D in Chapter 12, I am trying to understand the following changes to Schedule A from the “draft” version of Publication 535:
1. Schedule A is for SSTBs in the income range. The draft version of the schedule simply determines the applicable percentage of QBI, W2 and UBIA and forwards those adjusted figures to Schedule C or Part II of the worksheet as applicable.
The “final” version of Schedule A breaks the schedule into two parts. “Part I – Non-Publicly Traded Partnership” and “Part II – Publicly Traded Partnership”. Schedule A/Part I is the same as the “draft” version of the schedule. Only now, it appears to apply for SSTBs in the income range that are also a Non-Publicly Traded Partnership.
Schedule A/Part II of the “final”, which did not appear in the “draft”, determines the applicable percentage of qualified PTP or loss and forwards those adjusted figures to Part IV of the worksheet.
Does this mean that SSTBs that are in the income range and are a PTP do not have their QBI, W2 and UBIA adjusted? Under this scenario, my interpretation of the schedule is that only Part II (adjustment of PTP income or loss) would apply, If this is the case, then the double phase-out you wrote about in your post: “Section 199A Deduction Phase-out Calculations” does not seem to apply for PTPs? Is this correct?
I have not found any instructions in Publication 535 covering these changes to Schedule A, which is unfortunate. I was hoping you might have some insight/comments as to the change and feedback on my interpretation above.
Thanks so much for your articles. They are very helpful.
Steve says
I wonder if what you’re noticing reflects two subtleties. First, the Section 199A deduction for REIT dividends and qualifying PTP income doesn’t look at W-2 wages or UBIA (“unadjusted basis immediately after acquisition”). Second, the Treasury clarifying in final regulations that SSTB status does apply (potentially) to PTPs. (See, e.g., page 24 in the final regulations.)
This does mean, as you point out, that a PTP owner could only see her or his deduction phased out once and for SSTB status… and not twice for both SSTB status and inadequate W-2 or UBIA.
Michael says
Steve,
Thank you for your reply and the reference to the final regulations.
Your feedback is much appreciated.
Rita says
I qualify as a real estate professional for purposes of the Net Investment Income Tax. Does that have any effect on my situation in qualifying as a trade or business for farm ground that we cash rent to others.
Steve says
Not really. Separate issue.
Jori Scruggs-Brown says
I have read that single-rental entities cannot be aggregated to meet the safe harbor, but what about a partnership that has several rental properties? Does each rental activity within the partnership have to meet it on its own or does spending 250 hours on all the properties meet the requirement?
Steve says
A partnership would determine whether its activities make up a single trade or business or multiple trades or businesses. I would think that if a partnership holds ten properties, for example, that it might group those activities as a single trade or business.
I see this an analogous to a business that sells ten products. Surely that business often treats those ten products as a single trade or business.
And just to make this point clear, grouping ten properties or ten products isn’t “aggregating” and shouldn’t require the election to aggregate.