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Certain pass-thru entities (sole-proprietorships, S-Corporations, Partnerships, and certain Trusts) may qualify for a deduction of the lesser of 20% of Qualified Business Income (QBI) or 50% of certain wages paid. Section 199A, was ambiguous at best when written, however through final regulations issued by the IRS this week, there is more certainty.
QBI generally includes a Schedule C business, an owner's share of nonpublicly traded partnership income, and S corporation income. Proposed regulations section 1.199A-1(b)(13) clarifies that income from rental activities that rise to the level of an IRC section 162 business activity is QBI; substantial case law exists holding that rental real estate activities generally rise to the level of a section 162 business activity, except in triple net lease arrangements, where the tenant is responsible for taxes, insurance, and repairs. In addition, income from rental activities that do not rise to the level of a section 162 business activity is QBI if tangible property is rented to a related business that is commonly controlled (but only for purposes of section 199A).
The income or loss can be either active or passive under IRC section 469. The code section itself excludes from QBI a number of items, such as wages, capital gains and losses, dividends, interest income, guaranteed payments to partners under section 707(c), REIT dividends, and income from a publicly traded partnership.
The proposed regulations further clarify items of QBI. Proposed Treasury regulations section 1.199A-3(b)(2)(ii)(J) states that partnership payments under IRC section 707(a) are not QBI; section 1.199A-3(b)(1)(i) states that ordinary income from IRC section 751(a) or (b) partnership payments can be included in QBI if all other requirements are met; and section 1.199A-3(b)(2)(ii)(A) clarifies that QBI does not include IRC section 1231 gains and losses.
IRC section 199A specifically refers to the trade or business definition in IRC section 864(c), substituting "qualified trade or business within the meaning of section 199A" in place of "nonresident alien individual or foreign corporation" and "foreign corporation." An important implication of this definition is that only income "effectively connected with a United States trade or business" qualifies as QBI. For example, a U.S. partner of a partnership that operates a trade or business in both the United States and a foreign country would only include the items of income, gains, deductions, and losses that would be effectively connected with a United States trade or business.
Furthermore, the explanation of the proposed regulations clarifies that "effectively connected" under IRC section 864(c) is by itself insufficient; the income or deduction must also be in connection with a trade or business. Certain items in the tax code are allowed to be treated as "effectively connected" even though they do not rise to the level of a trade or business (e.g., foreign persons elect to treat income from real property interests as effectively connected, deductible expenses for theft losses, and charitable contributions). These items are not included in QBI calculations.
QBI very likely does not include activities defined as a hobby under IRC section 183, which defines an activity "not engaged in for profit" (i.e., a hobby) as an activity other than one covered under IRC section 162.
Section 199A defines the calculation of QBI as income, gain, deduction, and loss included or allowed in determining taxable income for the taxable year. QBI is therefore calculated after the passive loss limitations under IRC section 469 and the new loss limitations under section 461(l). Although net operating loss (NOL) carryovers generally are not QBI, any carryover NOL caused by section 461(l) will be QBI if all other requirements are met.
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