Although losses are usually beneficial for tax purposes, losses from passthrough entities potentially adversely affect the 20% qualified business income (QBI) deduction under Sec. 199A. These losses, referred to as negative QBI or qualified business losses, decrease positive QBI from other sources, and the remaining losses carry forward to offset future QBI, thereby reducing the amount eligible for the 20% QBI deduction.
This article examines the treatment of negative QBI and provides planning opportunities to limit the detrimental tax effects. This is especially relevant now that many businesses will incur losses due to the COVID-19 pandemic.
OVERALL NEGATIVE QBI
The first scenario involving negative QBI is an overall loss experienced by a passthrough entity owner. This situation entails a business owner of one or more entities that incur a net negative QBI amount. An overall negative QBI results in zero QBI deduction for the owner.
Under Regs. Sec. 1.199A-1(d)(2)(iii)(B), the negative overall QBI amount carries forward to the succeeding year and is treated as arising from a separate trade or business. Those losses carry over indefinitely until completely offset by positive QBI. The W-2 wages and unadjusted basis immediately after acquisition (UBIA) of qualified property amounts, which potentially limit the QBI deduction, are disregarded and do not carry forward. Example 1 illustrates overall negative QBI.
Example 1: T is the sole owner of two S corporations, A and B. The 2019 QBI information for these S corporations is as shown in the table "QBI Information From Example 1." T's 2019 QBI deduction is zero because there is an overall net qualified business loss of $15,000. The $15,000 net negative QBI amount carries forward and offsets future QBI. The 2019 W-2 wages and UBIA of qualified property amounts are ignored and do not carry forward.
OVERALL POSITIVE QBI AFTER NETTING
If an owner of multiple passthrough entities has positive net QBI but at least one business has negative QBI, then the negative QBI must be allocated among all of the positive QBI businesses in proportion to the positive QBI generated by each business. The W-2 wages and UBIA of qualified property from the loss businesses are disregarded in this situation. In this case, the netting process assumes entities are not aggregated for QBI purposes. Example 2 demonstrates the netting process with positive overall QBI.
Example 2: J owns three partnerships, X, Y, and Z, that are not aggregated and are not specified service trades or businesses (SSTBs), which have their own limits on the QBI deduction. J is subject to the W-2 wages and UBIA of qualified property limitations based on her 2019 taxable income of $600,000. J's share of the 2019 QBI information for these partnerships is shown in the table "J's Share of QBI From Example 2." Partnership Z's negative QBI offsets the positive QBI from partnerships X and Y proportionately based on the QBI generated by X and Y. Partnership Z's W-2 wages and UBIA of qualified property amounts are ignored. The QBI deduction related to Partnership X is limited to 50% of the entity's W-2 wages amount.
Example 3: Assume the same facts as in Example 2, except there is an additional $30,000 negative QBI carryover from the previous year (see the table "J's Share of QBI From Example 3").
The prior-year negative overall QBI amount is treated as arising from a separate trade or business. Similar to the qualified business loss from Partnership Z, the negative QBI carryover is allocated proportionately to partnerships X and Y based on the positive QBI generated by these entities. Again, the 50% of W-2 wages limitation applies to the QBI deduction related to Partnership X.
Regs. Sec. 1.199A-4 allows passthrough entity owners to elect to aggregate businesses when calculating the QBI deduction if certain criteria are met. The aggregation election allows the business owner to treat multiple businesses as a single business for QBI deduction purposes. Aggregation may be beneficial to share the W-2 wages and UBIA of qualified property amounts among the entities, thereby potentially increasing the QBI deduction. Aggregation eliminates the netting process mentioned above, which allocates negative QBI amounts proportionately based on the income-generating entities' QBI amounts.
The aggregation rules require that there be at least 50% common ownership in the entities included in the aggregation, that none of the entities are SSTBs, and that the aggregated businesses share certain common elements, among other stipulations. The aggregation election is made at the owner level, and once entities are aggregated, a significant change in facts and circumstances is required to discontinue aggregation.
Example 4: Assume the same facts as in Example 2, except J elects to aggregate partnerships X, Y, and Z. The table "QBI Deduction Calculation When J Elects to Aggregate Partnerships X, Y, and Z" shows the QBI deduction calculation in that case.
Aggregation results in a larger total QBI deduction for J because the W-2 wages from the loss entity, Partnership Z, are included in the QBI calculation. In Example 2, the QBI deduction related to Partnership X was limited based on this entity's W-2 wages.
LOSSES LIMITED BY BASIS, AT-RISK, AND PASSIVE ACTIVITY LOSS RULES
Losses generated in 2018 or after that are subject to the basis, at-risk, or passive activity loss rules reduce QBI when the losses reduce taxable income. These losses carry over for QBI purposes until reducing taxable income. When those losses are allowed, they reduce QBI from the oldest to the most recent losses under the first-in, first-out approach.
Losses subject to these limitations that originated before 2018, before the QBI rules took effect, do not reduce QBI when the losses are included in taxable income and do not carry over for QBI purposes.
QUALIFIED REIT DIVIDENDS AND PTP INCOME
Losses arising from qualified REIT dividends and publicly traded partnership (PTP) income are classified separately from other sources of QBI. A business owner with negative overall qualified REIT dividends and PTP income receives a zero QBI deduction related to this category. The overall loss amount carries forward to offset future qualified REIT dividends and PTP income. A taxpayer may therefore have two categories of negative QBI carryforward amounts: one from the QBI component and one from the qualified REIT dividends and PTP income component.
Several planning opportunities are available to limit the adverse tax effects of negative QBI. Taxpayers and practitioners should first consider aggregating entities as mentioned above. An analysis of the taxpayer's circumstances is required to determine whether removing the loss netting process and including the W-2 wages and UBIA of qualified property of loss entities is advantageous. But consider that the aggregation election is irrevocable unless circumstances change substantially.
Another planning opportunity relates to the payment of W-2 wages. A business owner of two related entities should consider paying W-2 wages from the profitable entity, not the loss entity. This may be beneficial for QBI deduction purposes because the loss entity's W-2 wages are ignored in the above-mentioned netting process when the entities are not aggregated. Switching payroll from the loss entity to the profitable entity may result in a larger QBI deduction for a high-income owner subject to the W-2 wages and UBIA of qualified property limitations. Any shifting of payroll should reflect the economic reality of the services performed by employees based on the taxpayer's facts and circumstances.
A final planning opportunity is to consider whether business activities constitute a trade or business that generates qualified business income or loss. The QBI deduction regulations define a trade or business with reference to Sec. 162. Activities such as hobbies and rental activities with no active management, which do not satisfy the Sec. 162 trade or business requirements, are not considered trades or businesses for QBI purposes. These activities often generate losses that should not be treated as negative QBI.
ADVISE TAXPAYERS ABOUT NEGATIVE QBI
The COVID-19 pandemic will increase losses for many businesses. Practitioners may wish to consider planning opportunities to curtail negative QBI amounts. They may also want to educate clients about the treatment of negative QBI and discuss planning opportunities such as aggregation. Practitioners and taxpayers alike should monitor potential future IRS guidance that may limit the effects of negative QBI.
About the author
Alex K. Masciantonio, CPA, is a senior tax manager with Gunnip & Company LLP in Wilmington, Del.
To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, a JofA senior editor, at Sally.Schreiber@aicpa-cima.com.
- "Optimal Choice of Entity for the QBI Deduction," The Tax Adviser, March 2020
- "Mechanics of the New Sec. 199A Deduction for Qualified Business Income," JofA, May 2018
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