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 may 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.
And then 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…
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 many won’t. Some of the adjustments will get complicated. So let me identify three situations where this occurs.
First, you want to be careful you don’t double-count a deduction. The final regulations, for example, specifically call out the self-employed health insurance deduction. And clearly sole proprietors and partnerships make that “other deductions” adjustment. But S corporation shareholder-employees also get to take the self-employed health insurance deduction. And you wouldn’t adjust the qualified business income in that case. (The reason? The self-employed health insurance has already reduced the qualified business income number on the S corporation tax return because it’s counted as part of the shareholder’s wages.)
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 adjust for the elective deferral chunk of a 401(k) deduction or Simple-IRA deduction for a sole proprietor 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.)
Third, finally, some things you might assume automatically get treated as qualified business income adjustments maybe don’t. The final regulations hint at a handful of examples of this situation pointing out,
The Treasury Department and the IRS decline to address whether deductions for unreimbursed partnership expenses, the interest expense to acquire partnership and S corporation interests, and state and local taxes are attributable to a trade or business as such guidance is beyond the scope of these regulations.
One way to explain the above lack of guidance? These items don’t necessarily “take into account” the income from the trade or business. And therefore they don’t necessarily adjust qualified business income.
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 $207,500 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 $207,500 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.
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.