Section 199A Deductions
Reader B.B. from Miami Beach asked a such
Are NRAs with pass-through U.S. entities eligible for the [IRC Section 199A] deduction?
What follows is my incomplete answer. A complete answer would require me to fully understand Section 199A. And I would rather die in a fire than become intimate with Section 199A.
Foreshadowing the Denouement
Short answer: I think so.
Let’s be precise. I am talking about a nonresident alien who has effectively connected income
. With that clarification, I think a Section 199A deduction is allowed because:
- Section 199A doesn’t say a nonresident alien is forbidden from taking the deduction; and
- A nonresident alien with effectively connected income will have the right type of income–the kind of income that generates a Section 199A deduction.
- The 199A deduction is “connected with income which is effectively connected with the conduct of a trade or business within the United States”.
Proving a Negative = Nonresidents Get a Deduction
Let’s look first at Section 199A to see if Congress hardwired anything in there to ban nonresident aliens from taking a deduction.
“Taxpayers” Get the Deduction
This is how Section 199A begins:
(a) In the case of a taxpayer other than a corporation, there shall be allowed as a deduction for any taxable year an amount equal to the sum of —
Section 199A’s tax deduction (however it is calculated) is limited to taxpayers who are not corporations.
A nonresident alien is a human. A human is not a corporation.
No Limits to Domestic Taxpayers Found
I looked at Section 199A. Then I looked at the Conference Report to Accompany H.R. 1
(warning: massive PDF) to read what the Conference Committee wrote about Section 199A.
There is no mention of nonresidents or foreign taxpayers anywhere.
Nonresidents Are Taxpayers
What is not forbidden is permitted. Since nonresident aliens are taxpayers and because they are not corporations, at least on its face Section 199A will permit them to enjoy a tax deduction.
All the Elements Are Satisfied: Nonresidents Get the Deduction
How Section 199A Works
Section 199A is designed to give a tax deduction to (some) taxpayers. Humans and passthrough entities to be precise.
I will attempt to abstract away as much complexity as I can. Here is how Section 199A works:
- [The right kind of income] + [page after page of comically bad requirements, limits, computation rules, etc.] = [tax deduction].
Section 199A is a cluster.2
I commend to you Charles Rubin’s anguished post about Section 199A
— written on the day before Christmas.
Charles made his point forcefully, eloquently, and politely. I, unfortunately, have a potty mouth and referred to Section 199A with a truncated swear word.3
I cannot write a post like his, though I wish I had.
First, Assume Away Most of the Complexity
Let’s assume all of the comically bad elements of Section 199A are completely satisfied. It’s the right kind of business.4
Everything else in Section 199A is fine.
We’re just missing one element to figure out whether our nonresident alien can claim a Section 199A deduction. Income.
Second, Prove a Nonresident Will Have the Essential Ingredient for the Deduction
Having assumed away all of the complexity that Charles Rubin so professionally ridiculed, our formula looks like this:
- [The right kind of income] + [all other conditions have been satisfied] = [tax deduction].
Qualified Business Income
The “right kind of income”, for Section 199A, is “qualified business income”.
This is what Section 199A(a) says:
In the case of a taxpayer other than a corporation, there shall be allowed as a deduction for any taxable year an amount equal to the sum of—
(1) the lesser of—
(A) the combined qualified business income amount of the taxpayer, or
[gratuitous complexity commences].
The point is simple: the basic building block of Section 199A is this idea of “qualified business income”. The Conference Report
summarizes the Senate’s version of Section 199A like this:
For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer generally may deduct 23 percent of qualified business income from a partnership, S corporation, or sole proprietorship, as well as 23 percent of aggregate qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income.5
The percentage became 20% when the House and Senate hashed our their differences.6
Note well: the deduction is a percentage of “qualified business income”. Plus other junk for the type of income that supports the Section 199A deduction, because Congress rolls over and plays dead for lobbyists.
What Does “Qualified Business Income” Mean?
What is “qualified business income”? Well, it’s certain types of income from certain types of business:
(1) IN GENERAL. — The term “qualified business income” means, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. * * * *7
To understand the definition “qualified business income” we need to understand two other definitions:
- “qualified items of income, gain, deduction, and loss”, and
- “qualified trade or business”.
Qualified Trade or Business: Assume
Section 199A deductions are only allowed for the “right” kind of businesses. Let me just say that law firms are not allowed to take a Section 199A deduction. This helps explain why I am so bitter. 🙂
Look at Section 199A(d) to understand what “qualified trade or business” means. And let’s assume that we have a qualified trade or business.
Qualified Items of Income Necessarily Exist
This is what matters, and this is why a nonresident alien should be entitled to a Section 199A deduction. (Assuming of course that all of the other rococco requirements of Section 199A are satisfied).
Qualified items of income (and deductions, gains, and losses) are defined as follows:
(A) IN GENERAL. — The term “qualified items of income, gain, deduction, and loss” means items of income, gain, deduction, and loss to the extent such items are—
(i) effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c), determined by substituting “qualified trade or business (within the meaning of section 199A)” for “nonresident alien individual or a foreign corporation” or for “a foreign corporation” each place it appears), and
(ii) included or allowed in determining taxable income for the taxable year.8
In other words, “qualified items of income” etc. is defined exactly like “effectively connected income” is defined.
So Qualified Business Income Necessarily Exists
This means that a nonresident alien who has effectively connected income (for Federal income taxation purposes generally) will also necessarily have qualified items of income, etc. (for Section 199A purposes).
And if the nonresident alien has qualified items of income, those items (income and deduction, gain and loss) will be added up and become “qualified business income”.
199A Deduction Should Be Connected with ECI
One limitation of deductions a nonresident alien can take is that the deduction must be “connected with income which is effectively connected with a conduct of a trade or business within the United States”.9
The regulations give us the following allocation method:
A deduction shall be considered definitely related to a class of gross income and therefore allocable to such class if it is incurred as a result of, or incident to, an activity or in connection with property from which such class of gross income is derived.10
To trigger the 199A deduction, the income must be qualified business income. Qualified business income must be effectively connected with a US trade or business. We can say that the 199A deduction is triggered by the effectively connected income.
This permits the 199A deduction under the general limitation of deductions for nonresident aliens.
Conclusion and Implications
I think a nonresident alien who is engaged in business in the United States will be entitled to take a Section 199A deduction, assuming all of the conditions in Section 199A are satisfied. There is nothing about nonresident status that would disqualify the person from taking the deduction.
However, few well-advised nonresident aliens would operate active U.S. businesses through pass-through entities. This exposes them to estate tax risk. The people who can take advantage of this income tax deduction are the ones who have rolled the mortality dice, betting that they will sell the U.S. business assets before they die. (Frankly, it’s usually a good bet).
For them, I encourage you to go bang your head against the Section 199A wall. For everyone else, look at C corporation structures, because a U.S. subsidiary/foreign parent is what I normally see.