Calculating W-2 Wages for Limitations on the QBI Deduction

Recently proposed IRS regulations on the new deduction for qualified business income (QBI) provide guidance on how to compute limitations on the deduction based on W-2 wages. As you've probably heard, the QBI deduction is complicated, and numerous rules and restrictions apply.

Important note: While new QBI deduction regulations are in proposed form, taxpayers can rely on them until final regulations are issued.

Overview of Limitations

In general, the limitations on the QBI deduction begin to phase in when the individual's (the pass-through entity owner's) taxable income (calculated before any QBI deduction) exceeds $157,500 or $315,000 for married couples who file jointly.

The limitations are fully phased in once taxable income exceeds $207,500 or $415,000 for married couples who file jointly. Above those thresholds, the QBI deduction for income from a non-service business is limited to the greater of:

• The individual's share of 50% of W-2 wages paid to employees during the tax year and properly allocable to QBI, or
• The sum of the individual's share of 25% of such W-2 wages plus the individual's share of 2.5% of the unadjusted basis immediately upon acquisition (UBIA) of qualified property.

The limitation based on the UBIA of qualified property is for the benefit of capital-intensive businesses. The UBIA of qualified property generally equals its original cost.

Qualified property means depreciable tangible property (including real estate) that:

• Is owned by a qualified business as of its tax year end,
• Is used by that business at any point during the tax year for the production of QBI, and
• Hasn't reached the end of its depreciable period as of the tax year end.

Specified Service Trade or Business

Under a special disallowance rule for specified service trades or businesses (SSTBs), QBI deductions based on SSTB income are phased out between taxable income (before any QBI deduction) of: 1) $157,500 and $207,500 or 2) $315,000 and $415,000 for a married joint-filing couple. If the upper limit is exceeded, the individual cannot claim any QBI deduction based on income from any SSTB, regardless of how much QBI or W-2 wages the SSTB may have.

Rentals to Controlled Businesses

Under a special rule, the rental or licensing of tangible or intangible property to a related business is treated as a business for QBI deduction purposes. The special rule applies only if the rental or licensing activity and the other business are commonly controlled (50% common ownership).

The final regulations clarify that this special rule is limited to situations in which the rental is to another business owned by the taxpayer or to a pass-through entity that's commonly controlled. For example, if an individual rents property to his or her 100%-owned S corporation, the rental activity would count as a business for QBI deduction purposes. On the other hand, renting property to a controlled C corporation won't count as a business for QBI deduction purposes.

Net Capital Gains

Taxpayers with investment interest expense (typically from brokerage firm margin accounts) can elect to treat net long-term capital gains and qualified dividends as ordinary investment income. This treatment can increase the taxpayer's allowable deduction for investment interest expense.

If this election is made, the final regulations clarify that it does not change the individual's net capital gain amount for purposes of the overall QBI deduction limitation.

W-2 Wages Allocable to QBI

For purposes of calculating W-2 wages for the QBI deduction limitation, the term "W-2 wages" refers to the total amount of compensation paid to an employee, including salary-reduction contributions to retirement plans (elective deferrals) and designated Roth contributions to retirement plans. W-2 wages don't include any amounts that aren't properly reported to recipients on Forms W-2.

W-2 wages must be determined separately for each qualified trade or business that's owned directly:

• By an individual via a sole proprietorship or a single-member limited liability company (SMLLC) treated as a sole proprietorship for tax purposes, or
• From an ownership interest in a pass-through entity, such as a partnership, an LLC treated as a partnership for tax purposes or an S corporation.

If W-2 wages are allocable to more than one trade or business, the percentage of total W-2 wages allocable to each trade or business follows the percentage allocation of deductions associated with those wages to each trade or business.

W-2 wages paid by a pass-through entity must be separately determined for each qualified trade or business conducted by the entity and separately reported to owners. An owner's allocable share of W-2 wages for QBI deduction purposes is determined in the same manner as the owner's allocable share of those wages under the normal federal income tax rules.

The individual can then choose to aggregate one or more businesses, and the W-2 wages paid by those businesses, if such aggregation is allowed.

Carryover of Negative QBI Amounts

If an individual's total QBI amount is less than zero, the negative amount is treated as negative QBI from a separate business in the individual's following tax year. This carryover rule doesn't affect the deductibility of losses under any other tax code provisions.

Important: W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of qualified property from a business that produces negative QBI for the current tax year aren't taken into account for purposes of the W-2 wage and UBIA of qualified property limitations. In addition, those W-2 wages and the UBIA of qualified property aren't carried over to the following tax year.

Calculating UBIA of Qualified Property

In calculating the UBIA of qualified property, the final regulations set forth the following rules:

• Each partner's share of the UBIA of qualified partnership property follows how depreciation is allocated for book purposes under the partnership tax allocation regulations as of the last day of the partnership's tax year. The same rule applies to members of LLCs treated as partnerships for tax purposes.
• Each shareholder's share of the UBIA of qualified S corporation property follows the shareholder's stock ownership percentage as of the last day of the S corporation's tax year.
• For qualified property acquired from a decedent and immediately placed in service, the UBIA of the property generally equals its fair market value on the date of the decedent's death.
• The UBIA of qualified property received in a Section 1031 like-kind exchange (replacement property) generally equals the UBIA of the property that's relinquished in the exchange. However, if the taxpayer receives money or non-like-kind property (boot) in the exchange or gives up money or non-like-kind exchange property in the exchange, the taxpayer's UBIA in the replacement property must be adjusted accordingly.
• When qualified property that's not of like kind to the relinquished property is received in a Section 1031 exchange, the received qualified property is treated as separate qualified property that's placed in service when placed in service by the taxpayer that receives the replacement property.

In addition, a basis adjustment to a partner's (LLC member's) share of partnership (LLC) qualified property when a partnership (LLC) interest is transferred is treated as qualified property to the extent the basis adjustment reflects an increase in the fair market value of the underlying partnership property. The final regulations include a procedure to implement this rule. The basis adjustment is treated as a separate item of qualified property that's placed in service when the transfer of the partnership (LLC) interest occurs.

Detailed Guidance on Calculating W-2 Wages

The IRS issued Notice 2018-64 on the same day as the proposed QBI deduction regulations were issued. Notice 2018-64 sets forth the following methods for calculating W-2 wages for QBI deduction limitation purposes:

Unmodified box method. This technique calculates W-2 wages by taking into account, without modification, the lesser of:

• The total entries in Box 1 (wages, tips, and compensation for federal income tax purposes) of all Forms W-2 filed with the Social Security Administration (SSA) by the taxpayer for employees of the taxpayer, or
• The total entries in Box 5 (wages and tips for the Medicare tax component of the FICA tax) of all Forms W-2 filed with the SSA by the taxpayer for employees of the taxpayer.
• Under the modified box 1 method, W-2 wages are calculated by:
• Totaling the amounts in Box 1 of all Forms W-2 filed with the SSA by the taxpayer for employees of the taxpayer,
• Subtracting amounts included in Box 1 of Forms W-2 that aren't wages for federal income tax withholding purposes (such as salary-reduction contributions to retirement plans), and
• Adding the total of the amounts that are reported in Box 12 of Forms W-2 that are properly coded D, E, F, G and S (employee salary-reduction contributions to retirement plans).

Tracking wages method. Here, the taxpayer tracks total wages subject to federal income tax withholding and makes appropriate modifications. Specifically, W-2 wages are calculated under this method by:

• Totaling the amounts of wages subject to federal income tax withholding that are paid to employees of the taxpayer and reported on Forms W-2 filed with SSA for the calendar year, and
• Adding the total of the amounts that are reported in Box 12 of Forms W-2 that are properly coded D, E, F, G and S (employee salary-reduction contributions to retirement plans).

Any of these methods can be used by taxpayers that use a fiscal year end, rather than a calendar year end for federal income tax purposes. If the taxpayer doesn't use the calendar year, W-2 wages are calculated based on wages paid to employees during the calendar year that ends with or within the taxpayer's tax year.

The tracking wages method must be used to calculate W-2 wages for short years (years with less than 12 months). If the taxpayer has a short tax year, W-2 wages include only wages paid to employees during the short tax year plus employee salary-reduction contributions to retirement plans made during the short tax year.

Overall QBI Deduction Limitation

Under the overall limitation, an individual's QBI deduction can't exceed the lesser of:

• 20% of QBI plus 20% of qualified REIT dividends plus 20% of qualified income from publicly-traded partnerships (PTPs), or
• 20% of the individual's taxable income calculated before any QBI deduction and before any net capital gain amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).

Need Help?

The proposed QBI deduction regulations are long and complicated. This article only covers one aspect of them, and not every detail has been covered. Your Porte Brown tax advisor can sort through your situation to help you maximize the QBI deduction.