Double dipping is not overreaching for businesses with fiscal years beginning in 2017 and ending in 2018. Recent IRS guidance indicates that the qualified business income (QBI) deduction under Section 199A, i.e., the pass-through entity deduction, and the domestic production activities deduction (DPAD) under Section 199 are both available in full for those fiscal year taxpayers.
Congress implemented the DPAD in 2005 to provide an incentive for manufacturing and production activities in the United States. The DPAD benefits a wide variety of qualifying businesses, including manufacturers, film producers, construction businesses, engineering or architectural businesses, and many others.
Overview and Compliance
Qualifying businesses of C corporations, sole proprietorship's, estates and non-grantor trusts receive a tax deduction equal to 9 percent of their qualified production activities income (QPAI), which cannot exceed their taxable income (or adjusted gross income for individuals, estates or non-grantor trusts). QPAI is essentially the excess of gross receipts attributable to qualifying activities over the related cost of goods sold and other expenses, losses, or deductions. Form 8903 is used to calculate the DPAD and claim the deduction. The form must be attached to the taxpayer’s income tax return for the year in which the DPAD is claimed.
In the case of a partnership or S corporation that is engaged in a qualifying business, the QPAI is allocated to business owners who then claim the 9 percent deduction on their allocated QPAI. Owners claim the DPAD on Form 8903 using the information provided by the entity.
Changes under the New Tax Law
The tax reform law known as the Tax Cuts and Jobs Act (TCJA) repealed the DPAD for tax years beginning after Dec. 31, 2017, because the TCJA introduced the QBI deduction for tax years beginning after Dec. 31, 2017 for pass-through entities. The QBI deduction is available for any taxpayer other than a corporation or a specified service trade or business (SSTB). The QBI deduction is equal to 20 percent of qualified business income from a qualified trade or business. This amount cannot exceed the excess (if any) of:
- The taxable income of the taxpayer over
- The taxpayer’s net capital gain.
Similar to QPAI with respect to the DPAD, QBI consists of the net amount of qualified items of income, gain, deduction and loss with respect to any qualified trade or business conducted within the United States. Investment related income and deductions are excluded from QBI.
The deduction is applied at the partner or shareholder level in the case of a partnership or S corporation.
Effective Date for the QBI Deduction
The QBI deduction is available for tax years beginning after Dec. 31, 2017. Recent proposed regulations for the QBI deduction provide additional guidance about determining QBI and the other informational items needed to support the deduction (e.g., W-2 wages and unadjusted basis immediately after acquisition of qualified property). If an individual receives any of these items from a business with a taxable year that begins before Jan. 1, 2018 and ends after Dec. 31, 2017, such items are treated as having been incurred by the individual during the individual's taxable year in which or with which the business taxable year ends. In layman’s terms, the entire fiscal year of business activity is treated as incurred during 2018 – including the portion actually incurred prior to 2018 – when received by an individual with a 2018 tax year.
This is great news for 2018 fiscal year businesses because it means the entire fiscal year of activity can be taken into account for purposes of the QBI deduction even though some of the activity arose prior to 2018. So what about the repeal of the DPAD?
As stated previously, the DPAD is repealed effective for taxable years beginning after Dec. 31, 2017. The Large Business & International division of the IRS issued a directive on Nov. 21, 2018, stating that taxpayers should not claim the DPAD for 2018 or later years, unless any of the following applies:
- Their taxable year began before January 1, 2018;
- The DPAD results from being a shareholder or partner in an S Corporation or partnership with a taxable year that began before January 1, 2018;
- The DPAD results from being a beneficiary of an estate or trust with a taxable year that began before January 1, 2018; or
- The DPAD results from being a patron of an agricultural or horticultural cooperative with a taxable year that began before January 1, 2018.
Furthermore, the directive has also been incorporated in the draft Form 8903 instructions issued by the IRS in December 2018. This makes it clear that individual taxpayers can claim the DPAD with respect to QPAI from flow through entities having fiscal years ending in 2018 – without exception for any QPAI incurred subsequent to 2017 – on their 2018 fiscal year end tax returns. Also, the draft 2018 Form 1040 instructions state that taxpayers who have a DPAD from fiscal year pass-through entities generated in a tax year beginning before Dec. 31, 2017 should include such a deduction in the total on Line 36, Schedule 1, and identify the deduction as “DPAD.”
This guidance is incredibly positive for individual taxpayers because it means that individuals can take into account the entire 2018 fiscal year of activity for both the QBI and the DPAD.
Tax Compliance Challenges for Fiscal Year Businesses
As stated previously, a business with a fiscal year beginning in 2017 and ending in 2018 generates items of QBI for the entire fiscal year that must be reported to business owners. Such fiscal years are reported using 2017 tax forms (e.g., the 2017 Form 1065 or the 2017 Form 1120S). Since the 2017 tax forms do not provide any guidance regarding the QBI information to be provided to owners, such fiscal year filers would need to turn to the 2018 draft Form 1065 or Form 1120S instructions for guidance.
The draft instructions state that in order to allow owners to correctly figure the QBI deduction, the business must attach a statement to its Schedule K-1, separately identifying each trade or business and identifying any SSTB.
For each trade or business, the business must state, using the same box numbers as shown on Schedule K-1, the amount of the following:
- Section 199A qualified business income
- W2 wages from qualified trade or business
- Unadjusted basis on acquisition of qualified property
- Section 199A REIT dividends
- Qualified publicly traded partnership (PTP) income
Further, if the business has more than one trade or business, the business must enter an asterisk on each Schedule K-1 and enter “STMT” in the right column to indicate that the information is provided on an attached statement.
With these reporting requirements, businesses may face acute reporting challenges as such information may need to be compiled and reported manually, where automated reporting may not be available for the 2017 tax year.
With the repeal of the DPAD and the introduction of the new QBI deduction, the IRS took a very taxpayer-friendly position on the availability of both provisions with regard to the entire 2018 fiscal year of business activity. This may help to ensure a smooth administration during the transition phase and resolve some unfortunate outcomes for taxpayers in certain circumstances. As a result, taxpayers are in a uniquely advantageous position where they may be able to claim both the DPAD and the QBI deduction for a business with a fiscal year beginning in 2017 and ending in 2018, thereby doubling up their tax savings.
For more information on the DPAD and the QBI deduction, please contact your local CBIZ MHM tax professional.
Published on January 17, 2019