REG-112176-18: Charitable Contributions & SALT Credits

The Internal Revenue Service (IRS) provides guidance on the Qualified Business Income (QBI) deduction, also known as the Section 199A deduction. It was established by the Tax Cuts and Jobs Act of 2017 (TCJA) and is a temporary deduction set to expire for tax years beginning after December 31, 2025.

Determining Eligibility for the QBI Deduction

The QBI deduction is available to individuals, some trusts, and estates with income from a pass-through business. These structures include sole proprietorships, partnerships, and S corporations, where business income is passed through to the owners and reported on their personal tax returns. The deduction is not available to C corporations or for income earned as an employee.

A factor for eligibility is whether the operation is a “Specified Service Trade or Business” (SSTB), where the principal asset is the reputation or skill of its employees or owners. Fields classified as SSTBs include health, law, accounting, actuarial science, performing arts, consulting, athletics, and financial services. Architects and engineers are explicitly excluded from this definition.

Classification as an SSTB does not automatically disqualify a business from the deduction. Instead, owners of SSTBs are subject to income limitations. If an owner’s taxable income is below an annual threshold, they may claim the full deduction, but as income rises above this threshold, the deduction is phased out and eventually eliminated.

Defining Qualified Business Income

Qualified Business Income (QBI) is the foundation of the deduction calculation. It is the net amount of qualified items of income, gain, deduction, and loss from a qualified trade or business within the United States. The calculation starts with the business’s net profit but requires several adjustments.

Several types of income must be excluded from the QBI calculation to ensure the deduction applies to active business income rather than investment returns. Items not included in QBI are:

• Capital gains and losses
• Certain dividends
• Interest income not properly allocable to the trade or business
• Reasonable compensation paid to an S corporation owner-employee for their services
• Guaranteed payments made to a partner for services rendered to the business

Calculating the QBI Deduction

The basic deduction is the lesser of two amounts: 20% of the taxpayer’s QBI or 20% of their taxable income before the QBI deduction, reduced by any net capital gain. For many taxpayers with taxable income at or below the annual threshold, the calculation does not proceed beyond this initial step.

When a taxpayer’s taxable income surpasses the annual threshold, the deduction may be limited. This limitation is based on the greater of either 50% of the W-2 wages paid by the business or a combination of 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of all qualified property. UBIA is the original cost of tangible, depreciable property used in the business when it was placed in service.

For an SSTB, the deduction begins to phase out for taxpayers with income above the lower threshold amount. As income moves through the phase-in range, the amount of QBI, W-2 wages, and UBIA of qualified property that can be considered is reduced. Once a taxpayer’s income exceeds the upper threshold of this range, the QBI deduction for that SSTB is completely eliminated.

Aggregation and Anti-Abuse Rules

The regulations allow taxpayers to aggregate, or group, multiple trades or businesses to calculate the QBI deduction. A taxpayer might do this to maximize the deduction when one business has high QBI but low W-2 wages or property basis, while another has lower QBI but higher wages or property basis. By combining them, the wage and property basis limitation is applied to the combined QBI of the aggregated group.

To be eligible for aggregation, several requirements must be satisfied. The same person or group of people must own 50% or more of each trade or business for the majority of the tax year. The businesses must also satisfy at least two of three other factors: they provide products or services that are the same or customarily offered together, share facilities or centralized business elements, or operate in coordination with each other.

The guidance also includes anti-abuse rules to prevent taxpayers from circumventing the limitations, particularly those for SSTBs. One prohibited strategy is “cracking,” where a business might separate its non-SSTB functions from its SSTB functions into different legal entities. For example, a law firm might create a separate entity to own its office building and lease it back to the firm. The regulations state that if a business provides property or services to a commonly controlled SSTB, that portion of its business is treated as part of the SSTB.