The AICPA Tax Executive Committee wrote the IRS seeking clarification regarding the informal guidance on IRC §199A issues found in the IRS’s frequently asked questions (FAQ)[1] and various form instructions.[2]

The IRS has surprised many tax professionals with some of the positions taken by the agency in the FAQ and in certain 2020 form instructions issued after the final regulations for most of §199A were issued in January 2019. This letter deals with issues in two broad areas, those of self-employed deductions and charitable contributions.

As the AICPA letter notes:

We urge that you provide additional certainty regarding which deductions are not reductions for QBI. Specifically, we recommend that Treasury and the IRS confirm that various self-employed deductions under sections 164(f), 162(l), and 404 are not automatically reductions of QBI, and update form instructions to reflect the same treatment for a charitable deduction under section 170.[3]

Self-Employed Deductions

The AICPA begins by looking at Question 32 found on the IRS website. That Q&A reads:

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 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.[4]

First, the AICPA objects to use of gross income, rather than net income, to allocate the expenses between those allocable to qualified business income (QBI) and those allocable to non-QBI income:

However, the FAQ does not distinguish the type of income (QBI versus non-QBI income) for which the deductions are related. Treasury Reg. § 1.199A-3(b)(1)(vi) provides that deductions such as those above 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. We recommend that taxpayers allocate the various deductions proportionately to the businesses based upon relative net income, rather than gross income.[5]

The letter also indirectly goes after the conclusion found in Q&A 33 related to the deduction for self-employed health insurance by an S corporation. Although the letter does not formally discuss Question 33, it uses the analysis of Question 32 to clearly push for no effective double reduction of QBI by the S corporation shareholder for self-employed health insurance. Question 33 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.[6]

The AICPA letter indicates that this sort of deduction should be deemed directly related to the additional wages reported in the Form W-2 of the shareholder, with a similar result for partnership guaranteed payments for such premiums:

To the extent any of the deductions are allowed or allowable due to the taxpayer’s wage income or guaranteed payments under section 707©, the IRS should provide that the deduction is attributable to non-QBI income. As such, taxpayers would not reduce QBI for such portion of the deduction. In order to provide clarity and avoid unnecessary confusion, the FAQ should clarify that taxpayers must determine and subtract only the QBI-related portion of these deductions.[7]

The letter also adds three specific fact situations they believe should be added to the FAQ:

a. Self-employed health insurance under section 162(l) is not a reduction of QBI if the income is associated with non-QBI income such as wage income (for the S corporation shareholder) or a guaranteed payment (for the partner of a partnership). An employee’s Form W-2, Wage and Tax Statement, must report the amounts paid by an S corporation for accident and health insurance covering a 2% shareholder-employee as wages (Rev. Rul. 91-26). As the only means of obtaining the section 162(l) deduction for a greater than 2% shareholder is through Form W-2 reporting, the section 162(l) deduction is attributable to wage income, which is not QBI. The same analysis applies to partners of partnerships, who are required to report health insurance paid on their behalf by the partnership as guaranteed payments (Rev. Rul. 91-26).

b. The deduction for one-half of the taxpayer’s self-employment tax under section 164(f) is not a reduction of QBI if the income associated with the self-employment tax is not QBI (such as, the self-employment tax attributable to guaranteed payment income).

c. Qualified retirement plan contributions of a partner are not reductions of QBI to the extent attributable to guaranteed payment income.[8]

This section concludes with a reminder that some of these deductions could be related to a specified service trade or business (SSTB), and thus should not reduce QBI in cases where the SSTB isn’t part of QBI:

Additionally, guidance should also provide that deductions attributable to QBI, including the items listed above, along with unreimbursed partnership expenses and interest expense to acquire ownership interests in pass-through entities, are classified with consideration between SSTB or non-SSTB status.[9]

Charitable Contributions

The IRS also created a stir when it mentioned charitable contributions as a possible item reducing QBI. The AICPA uses as an example language from the instructions to Form 8995:

Form 8995 instructions include the following sentence regarding determining QBI:

“This includes, but isn’t limited to, charitable contributions, unreimbursed partnership expenses, business interest expense, deductible part of self-employment tax, self-employment health insurance deduction, and contributions to qualified retirement plans.”

Similar instruction language appears for Form 8995-A and for the QBI Flow Chart, Figure 1 in the instructions for Forms 8995 and 8995-A.

The AICPA notes that this can be read to imply that all charitable contributions paid by a passthrough entity reduce QBI, stating:

The above language has caused confusion in the tax practitioner community. Some tax preparers are uncertain whether these instructions suggest the reduction of QBI by any charitable contribution paid by an entity generating QBI. Business deductions under section 162 may reduce QBI. However, charitable contributions which are unrelated to the taxpayer's trade or business are not business deductions and should not reduce QBI.[10]

The AICPA notes that those items listed as charitable contributions on a K-1 are being deducted under IRC §170, something radically different from expenses deducted under IRC §162:

For purposes of section 170, a contribution is a voluntary transfer of money or property that is made without receipt or expectation of financial or economic benefit commensurate with the amount of the transfer. Conversely, payments or transfers of property to a charitable organization, which bear a direct relationship to the taxpayer’s trade or business and which are made with a reasonable expectation of a financial return commensurate with the amount of the payment or transfer, may constitute allowable deductions as trade or business expenses rather than charitable contributions. Additionally, regulations under section 162 generally permit a deduction for expenditures for institutional or good will advertising that keeps a taxpayer’s name before the public, provided the expenditures are related to the patronage a taxpayer may reasonably expect in the future (e.g., promoting sales, generating new business, etc.).[11]

Or, to put it in its most basic terms, the letter goes on to say:

If payments are made to an entity described in section 170(c) for business purposes (such as goodwill advertising), the expense is generally reported as a section 162 business expense. It is not a separately stated item and may reduce QBI. However, an expenditure to an organization described in section 170(c) for charitable purposes is required to be separately stated (sections 703(a)(2)(C) and 1363(b)(2)). This expenditure is not a business expense under section 162 and should not reduce QBI.[12]

The AICPA then challenges the IRS, pointing out that if they take a different view, the agency needs to provide additional guidance of when non-§162 payments to a charity are somehow a deduction related to a trade or business for §199A purposes:

However, if Treasury and the IRS take a different stance and require taxpayers to treat section 170 charitable contributions as business expenses (for purposes of QBI), additional guidance is needed. Specifically, taxpayers would need guidance on how to determine the QBI reduction recognizing that charitable contributions are limited based upon adjusted gross income (AGI) (i.e., 60%, 50%, 30% and 20% limitations). Treasury and the IRS would also need to provide guidance on the ordering rules for when charitable contribution carryovers reduce QBI and rules for pre-2018 carry forwards. Finally, estates and trusts would need guidance on how to allocate the charitable deduction to QBI when (1) distributions are made out of the estate or trust to beneficiaries, (2) when the trust or estate elects to treat charitable contributions as being paid in the preceding taxable year, and (3) when section 681 limits the 642© deduction.[13]

[1] “Tax Cuts and Jobs Act, Provision 11011 Section 199A — Qualified Business Income Deduction FAQs,” IRS website, January 10, 2020, https://www.irs.gov/newsroom/tax-cuts-and-jobs-act-provision-11011-section-199a-qualified-business-income-deduction-faqs

[2] “Guidance on the Qualified Business Income Deduction Under Section 199A,” AICPA letter to IRS, March 4, 2020, https://www.aicpa.org/content/dam/aicpa/advocacy/tax/downloadabledocuments/20200304-aicpa-comments-on-section-199a.pdf (retrieved March 13, 2020)

[3] “Guidance on the Qualified Business Income Deduction Under Section 199A,” p. 1

[4] “Tax Cuts and Jobs Act, Provision 11011 Section 199A — Qualified Business Income Deduction FAQs,” IRS website, January 10, 2020

[5] “Guidance on the Qualified Business Income Deduction Under Section 199A,” p. 3

[6] “Tax Cuts and Jobs Act, Provision 11011 Section 199A — Qualified Business Income Deduction FAQs,” IRS website, January 10, 2020

[7] “Guidance on the Qualified Business Income Deduction Under Section 199A,” p. 3

[8] “Guidance on the Qualified Business Income Deduction Under Section 199A,” p. 3

[9] “Guidance on the Qualified Business Income Deduction Under Section 199A,” pp. 3-4

[10] “Guidance on the Qualified Business Income Deduction Under Section 199A,” p. 4

[11] “Guidance on the Qualified Business Income Deduction Under Section 199A,” p. 4

[12] “Guidance on the Qualified Business Income Deduction Under Section 199A,” p. 5

[13] “Guidance on the Qualified Business Income Deduction Under Section 199A,” p. 5