The Tax Cuts and Jobs Act of 2017 (TCJA) introduced the Qualified Business Income deduction (QBI) under Code Section 199A, whereby pass-through entity owners (partnerships, LLCs, LLPs. S-Corps, and sole proprietors) could be eligible to deduct up to 20% of the profits generated by those entities. If only it were that simple!
How it Works
The 20% deduction depends on the nature of the business and the level of your overall personal taxable income. An owner of a “Specified Service Trade or Business” (SSTB), which is specifically listed as a service in the fields of health, law, accounting, athletics, performing arts, financials services, brokerage services, consulting or “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of the owners or employee “can take the full 20% deduction if taxable income is below a threshold amount. Once over the threshold, there is a phase-out of the deduction until a cap is reached. The threshold amount is $315,000 on a joint return and $157,500 for all other taxpayers. The phase-out range is $100,000 on a joint return and $50,000 for all others, resulting in a cap of $415,000 on a joint return and $207,500 otherwise. Once this cap is reached, an SSTB does not qualify for any of the deduction. Note that engineers and architects were specifically carved out as not being an SSTB.
A “Qualified Trade or Business”, which is any business other than an SSTB, can also fall within ranges. Below the threshold, as noted above, 20% is available. Over the threshold, there are limits based on W-2 wages the business pays and the amount of original cost depreciable property that the company owns.
Proposed and Final Regulations
There were quite a few questions and uncertainties when the law was enacted. In August 2018, the Internal Revenue Service introduced six proposed regulations in an effort to alleviate some of this confusion. In January 2019, the IRS introduced final regulations that further clarify ambiguities and that tweak certain passages in the proposed regulations. This article will discuss some of the more salient issues and is not intended to be all inclusive.
Business Entity K-1 Reporting
First, pass-through entities must report to the owners their allocable share of Qualified Business Income, W-2 wages and qualified property attributable to each trade or business, and whether a business is an SSTB. If the pass-through entity fails to report any of these factors to the owners, that factor will be presumed to be zero.
Owners’ compensation, whether a salary from an S-corporation or guaranteed payments from a partnership, isnot considered QBI.
If an individual or pass-through entity is engaged in more than one qualified trade or business, that individual or pass-through entity may, but is not required, to aggregate those businesses. To qualify:
- The same person or group of persons must own, directly or indirectly, 50% or more of each trade or business.
- That ownership must exist for a majority of the taxable year, which includes the last day of the taxable year.
- Each trade or business must have the same taxable year.
- None of the trades or businesses is an SSTB.
- The trades or businesses must satisfy at least two of the following factors:
- They must provide products, property or services that are the same or customarily offered together.
- They share facilities or significant centralized business elements, such as personnel, accounting, legal, manufacturing, human resources, etc.
- They are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (such as supply chain interdependencies).
The taxpayer may aggregate businesses operated directly and operated via a pass-through entity. Once a taxpayer aggregates two or more businesses, the taxpayer must consistently aggregate those business in all subsequent years, unless there is a change in facts and circumstances or a new business is added. Electing to aggregate your business entities may help you maximize the deduction depending on your situation.
There are disclosure requirements related to the aggregation each year. If a taxpayer fails to disclose, the IRS may disaggregate the businesses. However, if this happens, the taxpayer may re-aggregate after three years.
Further SSTB Clarification
The proposed and final regulations also clarified with respect to an SSTB what was meant by the phrase “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners”. The IRS clarified “reputation or skill” to now fall under a much more narrow three criteria:
- Endorsing products or services
- Use of an individual’s image, likeness, name, signature, voice, trademark, or any symbol with the individual’s identity OR
- Appearing at an event or on radio, television, or another media format.
Further clarification was also provided with respect to the de minimis rule. There is a de minimis rule whereby a business with gross receipts of $25 million or less is not an SSTB if less than 10% of its gross receipts are attributable to one of the fields mentioned above. For a business with more than $25 million of gross receipts, the same rule applies except that the floor is 5% instead of 10%.
Rental Real Estate Activities
The final regulations also clarified uncertainties revolving around rental real estate activities. The IRS received a flurry of questions as to when rental activity qualifies as a trade or business with respect to the 199A pass-through deduction.
The IRS has issued a proposed revenue procedure that would provide a safe harbor for taxpayers.
Under this safe harbor, a “rental real estate enterprise” would be treated as a trade or business if at least 250 hours of services are performed each tax year with respect to the activity/enterprise. This includes services performed by owners, employees, and independent contractors inclusive of time spent on repairs, maintenance, rent collection, bill pay, services to tenants, and efforts to rent the property. Hours pertaining to time spent in the owner’s capacity as an investor, such as arranging financing and procuring property, will not be considered hours of service with respect to the enterprise.
As you can see the 20% pass-through deduction has quite a few moving parts. We can help you navigate and maximize this deduction. If you would like to discuss tax planning in this or any other areas of new Tax Reform, please feel free to contact us.