807 / How is an S corporation’s deduction for qualified business income determined?

Entities that are taxed under the rules governing pass-through taxation are generally entitled to a 20 percent deduction for qualified business income (QBI, see Q ). This deduction is equal to the sum of:

(a)  the lesser of the combined qualified business income amount for the tax year or an amount equal to 20 percent of the excess of the taxpayer’s taxable income over any net capital gain and cooperative dividends, plus

(b)  the lesser of 20 percent of qualified cooperative dividends or taxable income (reduced by net capital gain).¹

The sum discussed above may not exceed the taxpayer’s taxable income for the tax year (reduced by net capital gain). Further, the 20 percent deduction with respect to qualified cooperative dividends is limited to taxable income (reduced by net capital gain).

The deductible amount for each qualified trade or business is the lesser of:

(a)  20 percent of the qualified business income with respect to the trade or business or

(b)  the greater of (x) 50 percent of W-2 wage income or (y) the sum of 25 percent of the W-2 wages of the business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all qualified property (see Q ).²

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Planning Point: The regulations provide guidance on how UBIA should be calculated in the case of a like-kind exchange or involuntary conversion. The regulations follow the Section 168 regulations in providing that property acquired in a like-kind exchange, or by conversion, is treated as MACRS property, so that the depreciation period is determined using the date the relinquished property was first placed into service unless an exception applies. The exception applies if the taxpayer elected not to apply Treasury Regulation § 1.168(i)-6. As a result, most property acquired in a like-kind exchange or involuntary conversion under the new rules will have two relevant placed in service dates. For calculating UBIA, the relevant date is the date the taxpayer places the property into service. For calculating its depreciable period, the relevant date is the date the taxpayer placed the original, relinquished property into service.

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Concurrently with the regulations, the IRS released Notice 2018-64, which contains a proposed revenue procedure with guidance for calculating W-2 wages for purposes of the Section 199A deduction for qualified business income. This guidance was finalized in Revenue Procedure 2019-11. The guidance provides three methods for calculating W-2 wages, including the “unmodified box method”, the “modified Box 1 method”, and the “tracking wages method”. The guidance further specifies that wages calculated under these methods are only taken into account in determining the W-2 wage limitations if properly allocable to QBI under Proposed Treasury Regulation § 1.199A-2(g).

The unmodified box method involves taking the lesser of (1) the total of Box 1 entries for all W-2 forms or (2) the total of Box 5 entries for all W-2 forms (in either case, those that were filed with the SSA by the taxpayer for the year). Under the modified Box 1 method, the taxpayer subtracts from its total Box 1 entries amounts that are not wages for federal income tax withholding purposes, and then adds back the total of Box 12 entries for certain employees. The tracking wages method requires the taxpayer to actually track employees’ wages, and
(1) total the wages subject to income tax withholding and (2) subtract the total of all Box 12 entries of certain employees.

Revenue Procedure 2019-11 clarifies that, in the case of short taxable years, the business owner is required to use the “tracking wages method” with certain modifications. The total amount of wages subject to income tax withholding and reported on Form W-2 can only include amounts that are actually or constructively paid to the employee during the short tax year and reported on a Form W-2 for the calendar year with or within that short tax year. With respect to the amounts reported in Box 12, only the portion of the total amount reported that was actually deferred or contributed during the short year can be included in W-2 wages.

If the taxable income is below the applicable threshold levels (see Q ), the deduction is simply 20 percent.³

If the taxable income exceeds the relevant threshold amount, but not by more than $50,000 ($100,000 for joint returns), and the amount determined under (b), above, is less than the amount under (a), above, then the deductible amount is determined without regard to the calculation required under (b). However, the deductible amount allowed under (a) is reduced by the amount that bears the same ratio to the “excess amount” as (1) the amount by which taxable income exceeds the threshold amount bears to (2) $50,000 ($100,000 for joint returns).

The “excess amount” means the excess of amount determined under (a), above, over the amount determined under (b), above, without regard to the reduction described immediately above.

“Combined QBI” for the year is the sum of the deductible amounts for each qualified trade or business of the taxpayer and 20 percent of the taxpayer’s qualified REIT dividends and qualified publicly traded partnership income.⁴

Qualified REIT dividends do not include any portion of a dividend received from a REIT that is a capital gain dividend or a qualified dividend.⁵

“Qualified cooperative dividends” includes a patronage dividend, per-unit retain allocation, qualified written notice of allocation, or any similar amount that is included in gross income and received from (a) a tax-exempt benevolent life insurance association, a mutual ditch or irrigation company, cooperative telephone company, like cooperative organization or a taxable or tax-exempt cooperative that is described in section 1381(a), or (2) a taxable cooperative governed by tax rules applicable to cooperatives before the enactment of subchapter T of the Code in 1962.⁶

“Qualified publicly traded partnership income” means the sum of:

(1)  the net amount of the taxpayer’s allocable share of each qualified item of income, gain, deduction, and loss from a publicly-traded partnership that does not elect to be taxed as a corporation (so long as the item is connected with a U.S. trade or business and is included or allowed in determining taxable income for the year and is not excepted investment-type income, also not including the taxpayer’s reasonable compensation, guaranteed payments for services or Section 707(a) payments for services), and

(2)  gain recognized by the taxpayer on disposing its interest in the partnership that is treated as ordinary income.⁷

See Q 8581 - Q 8601 for a more detailed discussion of the Section 199A regulations.