How the QBID Can Impact the Accuracy Related Penalty for Underpayment

 

Starting in 2018, taxpayers that have income from a pass-through business will be able to claim the Qualified Business Income Deduction (“QBID”) which was enacted as part of the Tax Cuts and Jobs Act (“TCJA”). This deduction has various limitations and it has some complex provisions and/or calculations. It is found in Section 199A of the Internal Revenue Code and for owners of pass-through businesses the QBID will be a deduction that allows the taxpayer to reduce their taxable income by up to twenty percent (20%) of the Qualified Business Income from that business.

One aspect of the QBID that has not been widely publicized is Congress also modified Section 6662 of the Internal Revenue Code to include a provision regarding QBID. Historically, Section 6662 is the provision in the tax code that allows the IRS to impose an accuracy related penalty when a taxpayer significantly overstates expenses or understates income on their tax return.

The accuracy related penalty is equal to 20% of any underpayment of federal income taxes that results from the negligent or the erroneous reporting of income on a tax return. To trigger the accuracy penalty the ultimate tax liability must be understated by the greater of ten percent (10%) of the corrected tax or $5,000. These limitations on this penalty have the effect of restricting the application of any accuracy related penalty for taxpayers with an ultimate tax liability of less than $50,000 to situations when the understatement of their tax is $5,000 or more. For higher income taxpayers (those with an ultimate tax liability of at least $50,000), the 10% of corrected tax provision will have to be met before any penalty is applicable.

With the passage of the TCJA, a special rule will now be applied to the accuracy related penalty whenever the taxpayer claims QBID on a tax return. Starting in 2018, the threshold to trigger the penalty for returns with QBID is five percent (5%) of the corrected tax liability or $5,000 whichever is greater. This change will result in more returns meeting the $5,000 threshold for understatement because the application of 5% (rather than 10%) of corrected tax as a threshold will impact fewer higher income returns. Basically, the 5% limitation will not be relevant unless the return has an ultimate tax liability of $100,000 or more.