IRS Greatly Expands Frequently Asked Questions for §199A on Website - And S Corporation Owners Aren't Going to Like the Final Answer

The IRS for the second year in a row snuck a nasty surprise into a frequently asked question section of their website just before the tax filing deadline.  In 2017 the nasty surprise related to the denial of refunds to taxpayers who overpaid taxes but were eligible for the installment payment of the §965 transition tax.

This year’s “April surprise” arrived in the form of a massive expansion of the IRS’s set of frequently asked questions on their website related to the §199A qualified business income deduction (Tax Cuts and Jobs Act, Provision 11011 Section 199A - Qualified Business Income Deduction FAQs).[1]  The April 11 update expanded the FAQ from 12 questions to 33, and saved what many will see as the bombshell for the last question.

The page as it existed prior to the April 11 revision can be accessed at the Internet Archive Wayback machine, looking at the April 7 snapshot.[2]

Many of the answers will not be surprising at all to most practitioners.  One will likely cause some who had elected to use the proposed regulations to question whether that accomplished what they though it did, but the IRS position is one that many commentators had already suggested might be the position.  And one result will likely shock a much larger number of observers, as the author of the FAQ has somehow decided that the language of §199A(c)(3)(A) allows the IRS to force a double deduction for an S corporation shareholder’s self-employed health insurance deduction.

The most surprising answer for many is found in question and answer 33, which provides:

Q33. Health insurance premiums paid by an S-Corporation for greater than 2% shareholders reduce qualified business income (QBI) at the entity level by reducing the ordinary income used to compute allocable QBI. If I take the self-employed health insurance deduction for these premiums on my individual tax return, do I have to also include this deduction when calculating my QBI from the S-Corporation?

A33. Generally, the self-employed health insurance deduction under section 162(l) is considered attributable to a trade or business for purposes of section 199A and will be a deduction in determining QBI. This may result in QBI being reduced at both the entity and the shareholder level. (emphasis added)

The IRS had not provided for the treatment of self-employed health insurance in the original proposed regulations, adding the provision specifically including them as a deduction in computing qualified business income only in the final regulations.[3]  The final provision provides:

(vi) Other deductions. Generally, deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of section 199A and this section are otherwise satisfied. For purposes of section 199A only, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.

Given the impact of that provision as interpreted by the FAQ, some might argue that the IRS should have issued the above in proposed form first where it seems likely commentators would have objected to a doubling up of the deduction.  But that was not the route the IRS decided to take.

Some practitioners had suggested that the use of the proposed regulations, where none of the issues of the deduction for self-employment taxes, qualified plan contributions for a self-employed person or the self-employed health insurance deduction were directly addressed, would allow for ignoring those deductions on 2018 returns in computing QBI.  In question 32 the IRS took the position many had suspected they would—the final regulations represented only a clarification and not a change in treatment for those items. Even if the 2018 proposed regulations were used, QBI is still reduced for those items.

Question and Answer 32 provides:

Q32. I was told that I can rely on the rules in the proposed regulations under § 1.199A-1 through 1.199A-6 to calculate qualified business income (QBI) for my 2018 tax return. Does this mean I do not have to include adjustments for items such as the deductible portion of self-employment tax, self-employed health insurance deduction, or the self-employed retirement deduction when calculating my QBI in 2018?

A32. Section 199A(c)(1) defines qualified business income as the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. Proposed regulation § 1.199A-1(b)(4) followed this definition, providing that QBI is the net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business as determined under the rules of 1.199A-3(b). Section 1.199A-1(b)(5) of the final regulations retains this rule, also providing that QBI means the net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business (or aggregated trade or business) as determined under the rules of 1.199A-3(b).

Section 1.199A-3(b)(2) defines the term “qualified items of income, gain, deduction, and loss” as items of gross income, gain, deduction, and loss to the extent such items are effectively connected with the conduct of a trade or business within the United States (with certain modifications) and included or allowed in determining taxable income for the taxable year.  The final regulations add additional clarity in § 1.199A-3(b)(1)(vi), which provides that generally deductions attributable to a trade or business are taken into account for purposes of computing QBI to the extent that the requirements of section 199A and § 1.199A-3 are satisfied. For purposes of section 199A only, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404 are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.

The above the line adjustments for self-employment tax, self-employed health insurance deduction, and the self-employed retirement deduction are examples of deductions attributable to a trade or business for purposes of section 199A. There is no inconsistency between the proposed and final regulations on this issue.  QBI must be adjusted for these items in 2018. (emphasis added)

The passthrough entity portion of the FAQ is more taxpayer friendly and clarifies some key points.

One key question many had asked was how partnerships and S corporations should handle items that are subject to limitation or special treatment that can only be determined at the shareholder level.  Q&A 28 indicates that the passthrough entity must provide detailed information to the equity holder to allow them to make the appropriate adjustments to QBI that can only be computed at that level:

Q28. If a pass-through entity has one business, is it only required to provide one dollar amount for the QBI?

A28. The pass-through entity is required to provide the owners QBI information necessary for the owner to compute the deduction. If the entity only has ordinary income from a single trade or business, tit may be appropriate to reflect one QBI amount. Items from a pass-through entity are required to be separately stated due to the potential of unique treatment on one or more owners’ returns. Items not included in current year taxable income are not included in QBI. Therefore, additional details will also need to be provided for the owners. If for example, in addition to ordinary income the owner is allocated a section 179 deduction, since the 179 deduction may be limited, the detail would be required in order for the owner properly to determine the current year QBI. (emphasis added)

Also note that the rules to separately state items from each activity for the application of the at-risk rules and passive activity loss limitation rules still apply even when a pass-through entity chooses to aggregate a trade or business for the purposes of section 199A.

Note that practitioners have reported that tax software generally is not making such adjustments to any amounts reported by the passthrough entity.  Practitioners will need to make manual calculations for these items, including the impact of passive loss, basis and at-risk limitations on QBI for each trade or business.

The FAQ goes on to discuss additional complexities involved with flow through entities in Q&A 29:

Q29.My income is under the threshold amount and I only have income from W-2 wages and a partnership interest. Does my QBI equal the amount of partnership income reported on Schedule K-1?

A29. Maybe. As discussed in Q&A 4, QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business. To determine the total amount of QBI, the taxpayer must consider deductions not reported on Schedule K-1 that are related to the trade or business. (emphasis added) This could include unreimbursed partnership expenses, business interest expense, the deductible part of self-employment tax, the self-employment health insurance deduction, and self-employed SEP, SIMPLE, and qualified plan deductions in addition to other adjustments. Amounts received as guaranteed payments and payments received by a partner for services under section 707(a) are not QBI and are not eligible for the deduction.

In Q&A 23 the IRS discusses how to apply the loss limitation and carryover rules to §199A issues:

Q23. Can you explain in more detail how losses that are limited by basis, at-risk, or passive activity rules affect the deduction?

A23. Items not included in taxable income are not qualified items of income, gain, deduction, or loss and are not current year QBI. If a taxpayer has a suspended loss that is allowed against current year taxable income, whether the loss reduces QBI depends on whether the loss was limited before or after January 1, 2018.

If the loss was disallowed before 2018, the loss is never taken into account for purposes of computing QBI. This means the taxpayer must keep track of pre-2018 disallowed losses, so that they can be excluded them from QBI in the year the loss is allowed.

If the loss was generated after 2018, it is included in QBI if it is a qualified item deduction or otherwise loss that would otherwise be included in QBI, but not until the year it is included/allowed in taxable income.

Disallowed, limited, or suspended losses must be used in order from the oldest to the most recent on a first-in, first-out (FIFO) basis.

The FAQ also clarifies that the passive loss limitation issue also “spills over” into publicly traded partnership QBI calculations:

Q31. In 2018, I receive a Schedule K-1 allocating a PTP loss. The loss is not currently allowable due to the passive activity rules. Is it used in computing the REIT/PTP component?

A31. No. Since the loss is not included in taxable income for 2018, it is not used in computing the QBI deduction in 2018. In a later taxable year, when the loss is allowable, the loss generated in 2018 will be used in computing the REIT/PTP component.

Some questions had been asked regarding whether real estate professionals get a “pass” on having to analyze their rentals for qualification as a trade or business for §199A purposes.  Q&A 17 gives a clear “no” answer to that question.

Q17. If someone is a real estate professional, will their rental real estate qualify for the deduction?

A17. The deduction is not based on whether the taxpayer qualifies as a real estate professional under section 469. Rental real estate may constitute a trade or business for purposes of the QBI deduction if the rental real estate:

•           Rises to the level of a trade or business under section 162,

•           Satisfies the requirements for the safe harbor provided by Notice 2019-07, or

•           Meets the self-rental exception (i.e., the rental or licensing of property to a commonly controlled trade or business conducted by an individual or RPE).

Whether rental real estate rises to the level of a trade or business under section 162 depends on all the facts and circumstances. To be engaged in a trade or business under section 162, the taxpayer must be actively involved in the activity with continuity and regularity and the primary purpose for engaging in the activity must be for income or profit.

Throughout the past filing season, a number of practitioners asking questions in online discussion groups have seemed to want to apply “material participation” requirements to obtain the §199A deduction.  Q&A20 clearly states that the concept of material participation is not applicable to qualification for the §199A deduction.

Q20. Do I have to materially participate in a business to qualify for the deduction?

A20. No. Material participation under section 469 is not required for the QBI deduction. Eligible taxpayers with income from a trade or business may be entitled to the QBI deduction (if they otherwise satisfy the requirements of section 199A) regardless of their involvement in the trade or business.

Advisers should remember that IRS website FAQs are not authority, nor are they subjected to the level of review that would face a more formal IRS document.  But it is reasonable to expect that, unless the provisions are revised by the IRS, that agents are likely to turn to these FAQs for use in interpreting the regulations and law.

Advisers who face an agent attempting to use the FAQ to support a position on exam may want to direct the agent to SBSE Memo SBSE-04-0517-0030 where agents are specifically cautioned regarding the limitations of FAQs.  See our article on this issue, IRS Warns Agents Against Using IRS Website FAQs to Sustain Positions in Exam, that was posted in May of 2017.