QBI deduction: Interaction with various Code provisions.

• Author: Odom, Michael T.
• Position: Qualified business income

The qualified business income (QBI) deduction of Sec. 199A can result in significant savings for individuals, estates, and trusts. To maximize the deduction, it is important for tax practitioners to understand the interaction between various Code provisions so that items of income and deduction are included in QBI in the same period as the income and deductions are included in calculating regular taxable income. This discussion focuses on how Sec. 1231 and various loss disallowance provisions affect the QBI deduction, which was created by the law known as the Tax Cuts and Jobs Act, PL. 115-97.

If a taxpayer has one qualified business, the calculation of the QBI deduction is fairly straightforward. If, however, a taxpayer has multiple qualified businesses, the calculation becomes more challenging. This is especially true when the taxpayer is not actively participating in all the businesses. When a business disposes of assets used in a qualified trade or business, Sec. 1231 comes into play to determine the nature of the realized gain or loss from the disposition.

As a refresher, QBI must be calculated for each trade or business activity separately (Sec. 199A(b)).To be included in QBI, the activity must be included or allowed in determining taxable income for the tax year (Sec. 199A(c)(3) (A)(ii)). Various Code provisions suspend recognition of gains and losses in a tax year, including installment sale rules (Sec. 453); basis rules (Secs. 704(d) and 1366(d)); at-risk rules (Sec. 465); passive loss rules (Sec. 469); and excess business loss rules (Sec. 461(1)). In addition, the calculation of QBI includes only qualified income, gain, deduction, or loss (Sec. 199A(c)(3)). One item that is expressly excluded from the calculation of QBI is capital gain or loss, and therefore, on the disposition of business use assets, a determination must be made whether the nature of the gain or loss is ordinary or capital.

QBI and Sec. 1231

Under Sec. 1231, a netting process must be used to determine the nature of the income or loss. Gains and losses from all activities, including publicly traded partnerships (PTPs), must be netted to determine if there is a net Sec. 1231 gain or a net Sec. 1231 loss. The preamble to the Sec. 199A regulations makes clear that:

* Net unrecaptured Sec. 1231 gain is characterized as long-term capital gain and is excluded from QBI;

* Net Sec. 1231 loss is characterized as ordinary loss and is included in QBI; and

* The character then tracks back to the trade or business that disposed of the assets (TD. 9847).

If the net Sec. 1231 loss stems from multiple activities, then the loss would need to be allocated pro rata to each activity to determine the QBI for each activity.

How is Sec. 1231(c) recapture handled? Sec. 1231(c) recapture occurs when ordinary losses have been claimed in the five prior years and there is Sec. 1231 gain in the current year. The gain is converted from capital gain to ordinary gain to the extent of unrecaptured losses. Ordinary gain or loss under Sec. 1231 is included in QBI. The preamble to the Sec. 199A regulations states that applying Sec. 1231(c) recapture rules and allocating gain to multiple activities is beyond the scope of those regulations and that taxpayers should apply the Sec. 1231(c) recapture rules in the same manner as they would otherwise (TD. 9847).

A reasonable position would be to treat these losses like the regulations treat carryover losses from years prior to 2018, which is to apply them on a first-in, first-out (FIFO) basis. Therefore, to the extent the recaptured income is from years prior to 2018, the income would be excluded from QBI. Because this income must be used to determine the QBI of specific activities, then the unrecaptured Sec. 1231(c) amounts should be allocated pro rata and tracked by year and by activity. Another, more taxpayer-friendly position is to include the current-year...