There will be significant changes in how relevant passthrough entities (RPEs), individuals, trusts, and estates (taxpayers) report their activities qualifying for the deduction under Section 199A in 2019. This article reviews the information contained in new IRS forms and instructions under Section 199A and briefly discusses how Section 199A information reported by partnerships will be adjusted under the new centralized partnership audit procedures.
Reporting the Deduction for 2018
For taxable years beginning in 2018, the primary guidance for taxpayers with qualified business income (QBI) under Section 199A was found in a simplified worksheet in the instructions to Form 1040, U.S. Individual Income Tax Return, the instructions to Form 1041, U.S. Income Tax Return for Estates and Trusts, and Worksheet 12-A (with four accompanying schedules) in Publication 535, Business Expenses. Individuals generally could use the worksheet in the instructions to Form 1040 (Simplified Worksheet) if their 2018 taxable income before the QBI deduction was less than or equal to $157,500 ($315,000 if married filing jointly) and they were not patrons in a specified agricultural or horticultural cooperative (Specified Cooperative). Any other taxpayers needed to use Worksheet 12-A and accompanying schedules. Those four schedules were:
Schedule A Specified Service Trades or Businesses (SSTB)
Schedule B Aggregation of Business Operations
Schedule C Loss Netting and Carryforward
Schedule D Special Rules for Patrons of Agricultural or Horticultural Cooperatives (Coop)
Not every taxpayer needed to complete every schedule—only the schedules that were relevant to their tax returns.
Taxpayers were not required to attach the Simplified Worksheet or Worksheet 12-A to their returns. Taxpayers also were not required to attach Schedules A, C, or D to their returns. Taxpayers and RPEs that aggregated two or more trades or businesses, however, generally were required to include an aggregation schedule including the information in Schedule B with their returns. Failure to disclose these aggregations could cause the trades or businesses to be disaggregated.
Reporting the Deduction for 2019
Starting in 2019, any taxpayer claiming a deduction under Section 199A will be required to complete either Form 8995, Qualified Business Income Deduction Simplified Computation or Form 8995-A, Qualified Business Income Deduction.
Taxpayers generally will be allowed to use a new form―Form 8995―to figure the QBI deduction if their taxable income before the QBI deduction is less than or equal to the taxable income thresholds for 2019 (see below) and they are not patrons in a Specified Cooperative. Taxpayers who complete Form 8995 will be required to attach it to their return.
Taxpayers that are not eligible to use Form 8995 are required to use another new form―Form 8995-A. Form 8995-A contains substantially the same information formerly contained in Worksheet 12-A, but unlike that worksheet, Form 8995-A will need to be attached to the taxpayer’s return. The information that, in 2018, was used to complete the four schedules to Worksheet 12-A will be entered into the corresponding schedules (A, B, C, and D) to Form 8995-A. The information in the new schedules is substantially the same as the information in the old schedules, but each of the four new schedules (if applicable) will be filed with the IRS along with Form 8995-A.
New Taxable Income Thresholds
The taxable income thresholds in Section 199A are indexed for inflation. For taxable years beginning in 2019, the taxable income threshold is $160,725 for taxpayers who are married filing separately, $321,400 if married filing jointly, and $160,700 for other taxpayers. For taxable years beginning in 2020, the thresholds are $163,300 for taxpayers who are married filing separately, $326,600 if married filing jointly, and $163,300 for other taxpayers. See Revenue Procedure 2019-44.
New Details on the Components of QBI
The IRS also has released instructions for Form 8995 and Form 8995-A. The new instructions include a detailed flowchart to help taxpayers determine which items should be included in QBI.
The instructions describe a new category of items that RPEs, estates, and trusts will need to report separately for each trade or business so that owners can determine the extent to which the items are includable in QBI at the owner level based on their individual circ*mstances (QBI/Qualified PTP Items Subject to Taxpayer-Specific Determinations). These items are reported by RPEs to their owners on Statement A - QBI Pass-Through Entity Reporting (see below). The instructions explain that items reported by a partnership, S corporation, estate, or trust as QBI/Qualified PTP Items Subject to Taxpayer-Specific Determinations are not automatically includible in QBI at the owner level. To determine if the item of income, gain, deduction, or loss is includible in QBI the owner must look to how it is reported on the owner’s federal tax return. For example, Section 1231 gains and losses reported by an RPE may or may not be included in QBI at the owner level, depending on whether they are characterized as capital or ordinary. Other examples include involuntary conversions and interest expense incurred by an RPE with respect to debt-financed distributions.
The instructions also indicate that interest expense on indebtedness incurred to acquire an interest in an RPE can affect QBI from the RPE, and that unreimbursed expenses incurred by an owner with respect to an RPE’s business can reduce the QBI from the RPE. These topics have not previously been addressed in IRS guidance.
Reporting by Partnerships and S Corporations
In 2018, partnerships reported Section 199A information on Schedule K-1 (Form 1065), Partner’s Share of Income, Deductions, Credits, etc., using several codes in box 20, including codes Z (Section 199A QBI), AA (W-2 wages), AB (UBIA of qualified property), AC (qualified REIT dividends), and AD (qualified PTP income). S corporations reported Section 199A information on Schedule K-1 (Form 1120-S), Shareholder’s Share of Income, Deductions, Credits, etc., using several codes on box 17, including codes V through Z. In 2019, however, all Section 199A information will be reported using a single code for partnerships (box 20, code Z) and S corporations (box 17, code V).
The instructions to the 2019 Form 1065 and instructions to the 2019 Form 1120-S each contain three statements that partnerships and S corporations, respectively, should use to provide Section 199A information to their partners or shareholders. Those three statements are:
Statement A QBI Pass-Through Entity Reporting. This statement shows QBI items and other necessary information separately for each trade or business (or aggregated trade or business), and any qualified publicly-traded partnership (PTP) items, as well as any qualified REIT dividends.
Statement B QBI Pass-Through Entity Aggregation Election(s). This statement is used for RPEs that aggregate multiple trades or businesses.
Statement C QBI Pass-Through Entity Reporting—Patrons of Specified Agricultural and Horticultural Cooperatives. This statement is used by RPEs that are patrons in a Specified Cooperative to show QBI items and other necessary information for each trade or business.
Although the statements themselves are not mandatory, partnerships and S corporations are required to present Section 199A information to their owners in a format “substantially similar” to the statements contained in the instructions.
Adjustments to Partnership-Related Items
The Bipartisan Budget Act of 2015 (BBA) created a new centralized partnership audit regime generally effective for partnership tax years beginning after 2017, replacing the consolidated audit rules enacted by the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA). Under the new rules, adjustments to partnership-related items (PRIs) generally are made at the partnership, rather than the partner, level. Section 6221(a). If the adjustments result in an imputed underpayment (IU), the partnership must pay the IU in accordance with Section 6225, unless the partnership makes a “push out” election under Section 6226.
For this purpose, Treasury Regulation Section 301.6241-1(a)(6)(ii) clarifies that PRIs include any item or amount with respect to the partnership that is relevant in determining the U.S. federal income tax liability of any person under chapter 1 of the tax code, or any partner’s distributive share of any such item or amount. For this purpose, an item or amount is with respect to the partnership if the item or amount is shown or reflected, or required to be shown or reflected, on the partnership’s return for the partnership’s taxable year or is required to be maintained in the partnership’s books or records. Examples of PRIs include (i), the character, timing, source, and amount of the partnership’s income, gain, loss, deductions, and credits; (ii) the partnership’s basis in its assets; (iii) the amount and character of partnership liabilities and any changes to those liabilities from the preceding year; (iv) any item or amount resulting from an election under Section 754; and (v) partnership allocations and any special allocations. See Treas. Reg. Section 301.6241-1(a)(6)(v).
Very generally, a misstatement of PRIs may give rise to an IU that is determined by multiplying the dollar value of the error by the highest tax rate applicable to individuals or corporations. Section 6225(b) and Treas. Reg. Section 301.6225-1(b)(1) (providing a detailed process for determining an IU). See also IRS Interim Guidance Memorandum LB&I-04-1019-010.
Many of the items that partnerships are required to report under Section 199A may constitute PRIs that could factor into the computation of an IU. For example, overstating QBI by $10,000 potentially could give rise to an IU of $3,700. If so, this amount would be disproportionate to the maximum tax benefit claimed by the partners, because $10,000 of QBI produces, at most, a deduction of $2,000. For a partner with a marginal tax rate of 37%, this would yield a tax benefit of $740. Moreover, for various reasons, some or all of a partnership’s partners may not derive any benefit from an allocation of QBI. For example, some of the partners could be corporations, and others might have losses from other trades or businesses. The deduction also is limited to 20% of each partner’s taxable income (other than net capital gain) and may be subject to limitations based on wages and the unadjusted basis of qualified property, or the SSTB limitation.
The partnership may request various modifications to the amount of an IU under Section 6225(c) and the regulations thereunder. For example, if partners amend their returns to reflect the effect of a partnership adjustment under Section 6225(c)(2)(A), or the partnership and its partners use the alternative (pull-in) procedure of Section 6225(c)(2)(B), the partnership’s IU could be reduced. If the IRS adjusts Section 199A information in a partnership-level audit, the partnership may wish to consider requesting modifications under Section 6225(c) to reduce the amount of its IU.
Alternatively, the partnership might want to elect to push out the adjustments under Section 6226 using Form 8985, Pass-Through Statement – Transmittal/Partnership Adjustment Tracking Report (Required Under Sections 6226 and 6227) and Form 8986, Partner’s Share of Adjustment(s) to Partnership-Related Item(s) (Required Under Sections 6226 and 6227). The instructions to Form 8985 and 8986 contain examples illustrating how the BBA procedures apply to Section 199A information that is adjusted at the partnership level where those adjustments are pushed out to the partnership’s partners. Assume that a partnership has one trade or business that is an SSTB and is not a patron in a specified agricultural or horticultural cooperative. On its filed return, the partnership reported the following items as a summary of all the Section 199A related amounts generated by the partnership.
In a partnership-level audit, the IRS determines that ordinary income should be increased by $20,000, royalty income should be increased by $10,000, other deductions should be decreased by $40,000, and that all of the adjustments are qualified items of income, gain, deduction, and loss that should be included in QBI. If the partnership makes a valid election to “push out” this adjustment to its partners under Section 6226, it would furnish Form 8986 to each of its partners, attaching a table showing each partner’s share of these items before and after the adjustments, and each partner’s share of the adjustment. In addition, the partnership would file Form 8985 with the IRS, showing the partnership’s total amounts of these items before and after the adjustments, and the amount of the adjustments.
Conclusion
The Section 199A deduction for qualified business income is complex. By creating these important forms and the accompanying instructions, the IRS has painted a more complete picture of how RPEs should provide information required by their owners to compute the deduction correctly.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Author Information
Matthew Lay is a Managing Director in the passthroughs group in the Washington National Tax office of Deloitte Tax LLP. Before joining Deloitte, Matthew worked for the Passthroughs and Special Industries division in the IRS Office of Chief Counsel in various roles, specializing in the taxation of partnerships.
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