Last week the IRS released RIN 1545-BO71 which they announce as
final regulations concerning the deduction for qualified business income under section 199A of the Internal Revenue Code.
It is noteworthy that some of these changes are not yet incorporated in tax preparation software, but they can certainly affect this deduction as it relates to the retired household. This rule will affect a range of individuals, from large pass-through businesses such as S-Corporations or business partnerships earning millions of dollars, to individuals with small dividends received from a REIT mutual fund. For the purposes of this article, I'll be focusing primarily on the retired household who may have small business income, but which relies to some extent for income from the qualified dividends from large corporations and ordinary income dividends from REIT shares, all held in taxable accounts. It is also important to note that as an update to the original guidance, qualifying 199A dividends passed through by funds (open end, closed end and ETFs) will also be eligible for the 199A deduction, and will be so included in the fund's (or the brokerage's consolidated) 1099-DIV, box 5.
The simple description of this deduction is that it allows the household to deduct 20% of the pass-through income it receives from REITs, Master Limited Partnerships (MLPS) which the IRS refers to as Publicly Traded Partnerships or PTPs. They mean the same thing, but in this article I'll use the IRS term of PTP. This 20% deduction will be taken on line 9 of the new form 1040.
But like so many things that sound easy, the actual calculation is a bit more difficult. The following is the calculation for Qualified Business Income (QBI), as derived from the worksheet in the Instructions for Form 1040, p.36.
This worksheet, which I have set up in Excel, will take into account business QBI in the first section and 199A dividends from REITs and MLPs in the second section. The total of each of these is added and multiplied by 20%. The third section of the worksheet calculates the household’s “Income Limitation”, which for some households, will limit the QBI deductions. So let’s look at this a line at a time.
What is the household’s pass-through Reported Business Income? The worksheet instructions simply says to Enter
Your qualified business income, which includes items of income, gain, deduction, and loss from your trades or businesses that are effectively connected with the conduct of a trade or business within the United States.
Although not explicit, this implies line 31 of Schedule C or line 3 of Part II of Schedule C-EZ as the starting amount. Deductions to this are described by the Rule as any sources of income included in the first line that are not related to the business. It will include non-business investment income such as non-business interest, options trading, capital gains, income from litigation settlement or other non-business income as listed in the instructions to the 1040.
Where things can get interesting, are additional deductions that must be taken by the household. From the final Rule the IRS says
for purposes of section 199A, 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.
Thus, even though these deductions are taken by the business owner on Schedule 1 Adjustments to Income (formerly, Above-The-Line deductions) and not on Schedule C, they must also be deducted from QBI. This could have a major negative impact on the total 199A deduction, line 9 of the 1040, if the small business owner pays medical insurance premiums for themselves, along with ½ Self-Employment tax and any contributions to a retirement plan, these must reduce the net income of the pass-through business. (note: as of this writing, the IRS has not taken a position on Medicare Part B, Part D and Medigap insurance premium inclusion in this calculation for those age 65 and older)
The net QBI is then multiplied by .2 (20%) to determine the small business owner’s QBI.
In the second section, total of all REITs 199A Dividends as shown in box 5 of the 2018 1099-DIV: Most REITs have not distributed these yet even though they are supposed to be mailed out by January 31. (My Fidelity account states that our 1099-DIV will not be available until 2/15 due to delays in getting 1099-DIV data from several REITs, although this may vary between brokerages).
The total of all MLP 199A qualifying distributions: This number will be reported in box 20, code Z. The IRS has modified the K-1s Box 20 codes. New codes have been added for the Qualified Business Income deduction, to include code Z, section 199A income; code AA, section 199A W-2 wages; code AB, section 199A unadjusted basis; code AC, section 199A qualified REIT dividends; code AD, section 199A qualified PTP income. I don't hold any PTPs anymore, but per the IRS information site, K-1's must be mailed out by March 15. One would logically think that box 1 of the K-1 should be the PTPs QBI, as all other forms of investment income have already been accounted for in other boxes of the K-1. But I've read nothing on how much, if any, the Code Z QBI should differ from box 1 amounts. What is important to those holding MLPs is these usually show negative earnings and so if their Code Z amounts reflect these negative earnings, this will reduce any REIT 199A dividends, and if the household holds many such PTPs with negative income, the entry in the worksheet may be $0 for 199A dividends. Any negative Investment (REIT plus PTP) 199A income amount will carry over to future years calculations.
The Rule requires that the REITs or PTPs providing the income meet a 45-day holding period, although the rule does not say if these are consecutive days, they are prior to the dividend being paid or any 45 day period beginning 45 days prior to the dividend being paid and ending 45 days following the payment of the dividend, although this seems the most logical definition.
If the net of these REITs and PTP income is negative, this will result in a zero investment 199A but it will not reduce small business QBI. However, the negative amount must be carried forward to future investment QBI
The household business QBI deduction is added to the 199A dividend deduction. This amount will then be compared to the household income limitation amount.
The third section of the QBI calculation is the income limitation amount. This is calculated by subtracting net Capital Gains from Taxable income as given by line 10 of the 1040 BEFORE the 199A deduction. The change that surprised many is the calculation of 'Net Capital Gain", which the Rule defines as the household Long Term Capital Gains plus all Qualified Dividends. The capital gains for those who file Schedule D will be the lesser of lines 15 or 16 of Schedule D. If Schedule D is not required, the Capital gains will be from line 13 of Schedule 1. The Qualified Dividends will be from Schedule 1 line 3a of the new 1040. Why are these combined to provide Net Capital Gains for determining the income limitation amount? Other than stating it, the Rule does not describe why, other than to mention both are taxed at the same rate. This amount is multiplied by .2 (20%) to determine household income limitation amount The actual Qualified Business Income deduction will be lesser of these two amounts: the household QBI deduction and the household income limitation.
So if the household’s Taxable Income - Net Capital Gains is greater than the household’s business QBI + (REIT + PTP) 199A dividend, then the household will be able to deduct the full 20% of the latter. But for those households whose taxable income has a higher percentage of QD + LTCG, may find their total QBI deduction reduced. Let’s look at an example using a fairly typical retired household with pass-through business income:
In this example, the retired household has $15,000 of 1099-MISC income from teaching part time at a local private college. Most household income is from a pension, social security and a smaller amount from investment income representing 16% of household income. The $63,400 Taxable Income is reduced by the 'Net Capital Gain' of QD+LTCG = $11,000 to $52,400. 20% of this is greater than the 20% of 199A dividends, so the household will receive the full 20% QBI deduction, as it is smaller than the income limitation amount.
But what about a retired household whose REIT and QD income is much greater?
For a household that invests in a taxable account for most of its income through dividends, where the AGI and taxable income are the same, but REIT dividends plus Qualified Dividends plus Long Term Capital Gains represent 60+% of household income: Here the Taxable Income is reduced by $40,000 of QD+LTCG, hence the income limitation is reduced below the household QBI calculation, which will reduce the QBI deduction from $6,000 to $4,680.
The new QBI for retired households will provide a nice deduction for many whose investments are held in taxable accounts and an even greater deduction if the household has a pass-through business. However, the amount of the deduction may be reduced if a higher percent of the household AGI is from QBI income. The only way the household will know is to do their own calculation.
My thanks to @FinancialDave for his assistance in testing these calculations. But if there are any errors in the above, that mistake will belong entirely to me.
As always, the Excel SS I’ve developed is available to anyone who sends me a PM with an e-mail address to send it to.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.