Determining W-2 wages is an important aspect of computing the new qualified business income (QBI) deduction, under which qualifying individuals, partnerships, S corporations, trusts, and estates may be allowed a deduction of up to 20% of QBI.
This is because, for individuals with taxable income exceeding the threshold amount ($157,500, or $315,000 for joint returns), a limit is imposed on the QBI deduction based on the greater of either: (i) the W-2 wages paid, or (ii) a combination of the W-2 wages paid and the unadjusted basis immediately after acquisition (UBIA) of qualified property attributable to the trade or business. Proposed reliance regulations provide guidance on calculating the W-2 wages of a trade or business that are allocable to QBI.
The W-2 wages limitation will be familiar to practitioners since it is modeled after the one that had applied to the pre-2018 Domestic Production Activities Deduction (DPAD) under former Section 199. The W-2 wages rules of Section 199A’s proposed reliance regulations generally follow the rules under the pre-2018 DPAD. However, unlike the pre-2018 DPAD, the W-2 wages limitation in Section 199A applies separately for each trade or business.
Proposed reliance regulations establish a three-step process to determine W-2 wages paid with respect to a trade or business that are allocable to QBI. The three steps are: (1) determination of total W-2 wages paid for the tax year; (2) allocation of the W-2 wages among trades or businesses; and (3) identification of W-2 wages of each trade or business that are allocable to the QBI of the trade or business. A proposed Revenue Procedure (that may be relied on) provides three methods for calculating W-2 wages for purposes of the QBI deduction. The first method (the unmodified Box method) is a simplified calculation. The second method (the modified Box 1 method) and the third method (the tracking wages method) provide for greater accuracy. These three calculation methods are substantially similar to the methods used for purposes of the pre-2018 DPAD.
Since practitioners and the IRS have over a decade of experience applying the pre-2018 DPAD’s W-2 wages rules, the determination of W-2 wages for purposes of the QBI deduction will be an easy pivot for practitioners now switching clients to the new deduction. Of course, this element is just one piece of the complex puzzle. That’s why practitioners will find it helpful to review the operation and calculation of the QBI deduction in the Tax Advisors Planning System (Title 1, “Choice of Entity”).
To read more about the impact of Section 199A Qualified Business Income Deduction, please check out the following blog posts: