The Increased Importance of Income Sourcing in a Post-Tax Reform World

The Tax Cuts and Jobs Act of 2017 (TCJA), signed into law in late 2017, included significant changes to the tax environment in the United States. One of the largest changes was the addition of the qualified business income (QBI) deduction. The QBI deduction allows for a deduction of up to 20 percent of the qualified business income from partnerships, limited liability companies (LLCs), S corporations, trusts, estates, and sole proprietorships. Learn more about the QBI deduction.

One significant nuance of the QBI deduction involves a rule related to sourcing. Under TCJA, only taxable items of income, gain, deduction, or loss that are effectively connected with the conduct of a trade or business within the U.S. are eligible to be taken into account in the computation of QBI. Therefore, the determination of whether the income, gain, deduction, or loss is U.S. sourced or foreign sourced becomes critically important.

General Income Sourcing Rules

The rules around sourcing are complex and are found in Internal Revenue Code Sections 861-865. Here are some general and common rules on sourcing different types of income:

¹ If services are provided both inside the U.S. and abroad, the allocation is generally determined using a location-per-day methodology.

² Exception per IRS Section 865: If the gains for personal property are attributable to a fixed place of business in a foreign country and are subject to at least 10 percent tax, they will be foreign sourced.

Rules for U.S. Residents and Nonresidents

Some additional rules related to sourcing for both U.S. residents and nonresidents have to do with sales through offices or fixed places of business. The QBI rules state that qualified trade or business income must be effectively connected with a U.S. trade or business to determine eligibility for the QBI deduction.

• For U.S. residents who maintain an office or other place of business in a foreign country, and with income that does not qualify for an exception (exceptions are sales of inventory, recovery of depreciation, contingent sales of intangible property, sales of good will, or sales of affiliated foreign stock), sales of personal property attributable to an office or other fixed place of business will be foreign source income. A further requirement to meet the exception is that the income is subject to tax equal to 10 percent and actually paid to a foreign country.
• For nonresidents who maintain an office or fixed place of business in the U.S., income from any sale of personal property (including inventory) attributable to the office shall be U.S. source income. This scenario overrides all the sourcing rules above. The only exception for this rule is if the nonresident sells inventory property for use, disposition, or consumption outside of the U.S. and has an office in a foreign country that materially participated in the sale. However, double taxation treaties may mitigate the U.S. tax impact of this rule. This exception also applies to U.S. persons for purposes of determining the QBI deduction.

The QBI deduction applies at the individual or shareholder level. With respect to partnership and S corporations, the character and source of the income, determined at the entity level, carries over to the partners or shareholders in their distributive share of the flow-through income. However, the sourcing of the underlying income of the partnership or S corporation’s foreign operations will solely depend on the source of income based on the classifications listed above.

Prior to TCJA, taxpayers were typically incentivized to treat as much income as possible as a foreign source to maximize available foreign tax credits as a way to offset residual U.S. income taxation. However, under the new rules, QBI does not generally include foreign source income. As a result, taxpayers may need to revisit the sourcing treatment of income to maximize the QBI deduction. Please reach out to your KSM advisor if you have any additional questions.