The 2017 Tax Act, officially named “An Act to Provide for Reconciliation Pursuant to Titles II and V of the Concurrent Resolution on the Budget for Fiscal Year 2018” but often referred to as the “Tax Cuts and Jobs Act”, introduced the “Qualified Business Income Deduction” or “QBI Deduction” contained in Internal Revenue Code (IRC) §199A . The actual name is, however, more symbolic of the complicated and even convoluted way this extremely favorable deduction is calculated. (Fortunately, some of the complications were eliminated in the Consolidated Appropriations Act, 2018 enacted March 23, 2018.) Recently released proposed regulations add clarity but also raise additional questions.
Since the QBI deduction introduces a whole new set of acronyms, let’s start with a glossary to assist in understanding what they all mean and, hopefully, keeping them straight.
|Individual||Individual||An individual, trust (other than a grantor trust), estate or other person eligible to claim the Code Section 199A deduction.|
|QTB||Qualified Trade or Business||A very broad category of business activities, but subject to numerous highly technical requirements and limitations.|
|TI||Taxable Income||Defined for QBID only, as TI determined after all above and below the line deductions but without regard to Section 199A.|
|QBI||Qualified Business Income||Items of income, gain, deduction and loss from domestic business activities connected with the conduct of a trade or business within the United States. It is not necessary to actively participate.|
|QBID||Qualified Business Income Deduction||Generally 20% of QBI subject to certain limitations and thresholds.|
|SSTB||Specified Service Trade or Business||Any trade or business involving the performance of services except engineering and architectural services.|
|IT||Initial Threshold||TI of $157,500 for single filers and $315,000 for joint filers|
|MT||Maximum Threshold||TI of $207,500 for single filers and $415,000 for joint filers|
|SSTB Limitation||Specified Service Trade or Business Limitation||Taxpayers with a SSTB can enjoy the QBID only if their TI is less than certain thresholds. Phases out between the IT and the MT. Once the MT is reached no QBID is allowed. “Poor Lawyer Exception”|
|UBIA||Unadjusted Basis Immediately After Acquisition||Original basis of assets for which the depreciable period is the later of (1) 10 years from the placed-in-service date or (2) the last day of the last full year in the MACRS recovery period, determined without considering the alternative depreciation system (ADS)|
|W&P Limitation||Wage and Property Limitation||The greater of 50% of the W-2 wages or the sum of 25% of the W-2 wages plus 2.5% of the UBIA of all qualified property. Phases in between the IT and the MT for non-SSTB. “Good Planner Exception”|
|CQBIA||Combined Qualified Business Income Amount||The sum of the QBI for each QTB plus 20% of the aggregate amount of the qualified REIT dividends and qualified publicly traded partnerships (PTP) income of the taxpayer for the taxable year|
|TIL||Taxable Income Limit||The QBID is limited the 20% of TI minus capital gains|
The qualified business income deduction (QBID) is potentially available to all taxpayers with qualified trade or business (QTB) income other than C corporations, including estates and trusts with qualified business income (QBI). Generally, except for non-grantor estates and trusts, the QBID is taken at the individual taxpayer level. The eligibility list includes individuals operating a QTB through a sole proprietorship (including through a single member LLC), as well as individuals who are owners of pass-through entities, including S corporations, partnerships and grantor trusts. Basically, any individuals who operate a Schedule C or F business, or who report income from a business activity on Schedule E, may be eligible to claim the to claim the QBI deduction. The QBI deduction specifically does NOT apply to W-2 wages.
Subject to limitations based on the type of business involved, the amount of wages paid and/or the original purchase price of property placed in service in connection with the business, the QBI deduction is equal to 20% of QBI.
The deduction provided in Code Section 199A(a) is the lesser of: (a) the combined qualified business income amount (CQBIA) (which in many or most cases will be equal or approximately equal to 20% of QBI), or (b) 20% of the excess of taxable income over net capital gains (the “taxable income limitation”).
The basic concept seems deceptively simple. Unfortunately, as with most tax law, the exceptions, thresholds and limitations can result in some very complex calculations. Let’s take it step by step.
Step One: Calculate TI
The QBI deduction starts with taxable income (TI). A taxpayer must first run all his/her tax information through the complex structure of the Internal Revenue Code before beginning to calculate the deduction. This would include all calculations for passive activity, basis, at risk, bonus depreciation, itemized deductions, etc.
Step Two: Identifying QBI
The first step in computing QBID is identifying qualified business income (QBI) from each of the taxpayer’s Section 162 trades or businesses. Generally, QBI includes Items of income, gain, deduction and loss from domestic business activities connected with the conduct of a trade or business within the United States. In addition, according to proposed regs, rental or licensing of tangible or intangible property (ex. rental activity) that does not rise to the level of a Code Sec. 162 trade or business is nevertheless treated as a trade or business for purposes of QBID, if the property is rented or licensed to a trade or business which is commonly controlled (self-charged rent). QBI doesn’t include investment income such as capital gains and losses, dividends, interest income (unless properly allocable to a trade or business), and commodity and foreign currency gains. QBI specifically excludes reasonable compensation paid to the taxpayer, guaranteed payments and payments to partners acting outside their capacity as a partner. It also does not include any qualified REIT dividends or qualified publicly traded partnership income come.
A qualified trade or business (QTB) is generally defined as any trade or business other than the business of performing services as an employee or a specified service trade or business (SSTB).
A SSTB is one that involves the performance of services in the in the fields of health, law, consulting, athletics, financial services, brokerage services, or 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. Engineering and architectural services are specifically excluded. Some commentaries question whether the “reputation or skill” clause might pull engineering and architectural services back into the definition of SSTB. However, based on the proposed regs, it appears the IRS interprets the “reputation or skill” clause narrowly to apply to endorsements; license of an individual’s image, likeness, voice and the like; and appearance fees.
There is an exception that allows taxpayers with lower income to treat SSTB income as a nonservice business for Section 199A purposes. However, this exception is only fully available for taxpayers with 2018 taxable income below the initial threshold (IT) of $315,000 if married filing jointly ($157,500 for all others). The exception is fully phased out when 2018 taxable income is $415,000 or more if married filing jointly ($207,500 for all others). Taxpayers with income above the maximum threshold (MT) can’t treat any income from a SSTB as QBI.
New proposed regulations provide for a de minimis rule. If less than 10% (5% for entities with receipt of more than $25 million) of QBI is from an SSTB, it can be ignored, and the entire business is treated as eligible for QBID. It is unclear if specified service income in excess of 10%/5% taints the whole business or only the specified service income.
QBI losses can be carried forward and treated as a loss from QTB in the next year. This functions much like the passive activity loss limitation. According to proposed regs, losses or deductions that were disallowed for tax years beginning before January 1, 2018 are not taken into account for purposes of computing QBI in future years. Code Sec. 199A carryover rules do not affect the deductibility of the losses for purposes of other provisions of the Code.
If a taxpayer has an overall loss after qualified REIT dividends and qualified PTP income are combines, the portion of the individuals QBID related to the qualified REIT dividends and qualified PTP income is zero for the year. This overall loss does not affect the taxpayer’s QBI but is instead carried forward and used to offset combined REIT dividends and qualified PTP income in the succeeding year(s). Yet another new tracking requirement!
New proposed regulations state that only losses suspended (suspended basis/at risk/passive activity losses) after 2017 reduce QBI in the future. Since there is currently no “ordering” to suspended losses, additional tracking will be required.
Step Three: Computing QBID
Once QBI is identified for each QTB, the next step is computing the deductible for each trade or business. Generally, the deductible amount is 20% of QBI for each QTB. However additional limits apply for taxpayers with TI above the IT and are phased in completely at the MT.
For taxpayers with TI above the MT, the QBID is limited to the greater of (1) 50% of the W-2 wages paid by the business or (2) 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of the business’s qualified property. These limitations, commonly referred to as the wage & property limitation (W&P Limitation), phase in between the same initial and maximum thresholds that apply to the SSTB.
For those taxpayers with TI between the IT and the MT, the phase-in is computed by determining the amount by which 20% of QBI exceeds the W&P Limitation (the excess amount). The taxpayer’s phased in limit equals the excess amount multiplied by the percentage obtained when dividing the amount of taxable income that exceeds the threshold by $100,000 ($50,000 for non-joint filers).
W-2 Wages. For purposes of the limitation, these are total wages subject to withholding, elective deferrals, and deferred compensation paid by the QTB during its calendar year ending in the taxpayer’s taxable year, provided such compensation is properly allocable to QBI. Additionally, the business must file Form W-2 reporting such wages.
Proposed regs state that, in the case of W-2 wages that are allocable to more than one trade or business (Ex. leased employees or common paymaster), the portion of the W-2 wages allocable to each trade or business is determined in the same proportion to total wages as the deductions associated with those wages are allocated amount the particular trades or businesses.
Notice 2018-64, 2018-35 IRB contains a proposed revenue procedure that sets out 3 methods for calculating W-2 wages.
Also, the proposed regs indicate that there is a W-2 wages-paid limitation for high-income individuals that applies even if the person isn’t engaged in a specified service business. It caps the deduction at the basic 20% of QBI from the business or, if lower, a figure that looks at W-2 wages paid by the business and the unadjusted basis of tangible, depreciable property used in the business and not fully depreciated.
Qualified Property. For purposes of the limitation, this is depreciable property held by the business and available for use at the end of the year that is used in the production of QBI. The depreciable period is the later of (1) 10 years from the placed-in-service date or (2) the last day of the last full year in the MACRS recovery period, determined without considering the alternative depreciation system (ADS). The depreciable period for purposes of QBID is not the same as the depreciation (or recovery) period for income tax purposes. Let’s hope our depreciation software will calculate this for us. If not, this provision could be a logistical nightmare.
In the case of a pass-through entity, each owner is allocated their proportionate share of the W-2 wages and qualified property of the entity. It has been suggested that partnerships might have the flexibility to cause specific partners to be allocated W-2 wages and unadjusted basis, by making special allocations of wage expenses and depreciation deductions. When preparing pass-through entity tax returns, it will be necessary to gather this information, determine the allocations and to report it on the owners’ K-1s.
The proposed regs clarify that Section 179 and the additional first-year depreciation doesn’t affect the applicable recovery period for QBID purposes. However, UBIA does reflect the reduction in basis for the percentage of the taxpayer’s use of the property for other than trade in the taxpayer’s trade or business (non-business use).
Proposed regs also explain that if a taxpayer has QBI of less than zero from one trade or business, but has overall QBI greater than zero when all of the taxpayer’s trades or businesses are taken together, then the taxpayer must offset the net income in each trade or business that produced net income with the net loss form each trade or business that produced net loss before the taxpayer applies the W&P limits. The taxpayer must apportion the net loss amount the trade or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the W&P limitation, the gain or income in respect to each trade or business (as offset by apportioned losses) is the taxpayer’s QBI with respect to that trade or business. The W-2 wages and UBIA of qualified property from the trades or businesses which produced negative QBI are not taken into account for purposes of QBID and are not carried over into subsequent years.
In addition, proposed provide for an elective aggregation regime. If certain requirements are met, taxpayers who engage in more than one trade or business may – but are not required to – aggregate trades and businesses, treating them as a single trade or business for purposes of applying the W&P limitation. Once aggregation is chosen, it must be consistently reported in all subsequent years. Annual reporting is required.
These rules are complex and depend on several variables. The table below summarizes the computation for each of the taxpayer’s QTBs.
|Nonservice Business||Specified Service Business|
|Taxable income of $315,000 ($157,500 for non-joint) or less||20% of QBI||20% of QBI|
|Taxable income greater than $315,000 but less than $415,000 ($157,500/$207,500 for non-joint)||Same as above, W&P limitation phase in||Amount of income that is QBI is phased out: W&P limitation is phased in|
|Taxable income of $415,000 ($207,500 for non-joint) or more||20% of QBI subject to the W&P limitation||No deductible amount|
Step Four: Determining the CQBIA
Once calculated, the QBID for all QTBs are combined with 20% of qualified real estate investment trust (REIT) dividends and qualified PTP income. The W&P limitation does not apply to the REIT and PTP component of the deduction. The result is the combined qualified business income amount (CQBIA).
A qualified REIT dividend is any dividend from a REIT received during the tax year that isn’t a Section 857(b)(3) capital gain dividend income under IRC Sec. 1(h)(11).
Qualified PTP income is the sum of (1) the net amount of the taxpayer’s allocable share of each qualified item of income, gain, deduction, and loss from a Section 7704 PTP that isn’t treated as a corporation for tax purposes and (2) any gain recognized by the taxpayer upon the disposition of a PTP interest to the extent it’s treated as an amount realized from the sale or exchange of property other than a capital gain.
Step Five: Calculating the Final Deduction
The final QBID is the lesser of (1) the CQBIA amount or (2) 20% of the excess, if any, of the TI over the sum of net capital gains and the aggregate amount of qualified cooperative dividends; plus, the lesser of (1) 20% of the aggregate amount of the qualified cooperative dividends for the taxable year, or (2) taxable income reduced by the net capital gain. This is known as the taxable income limit (TIL).
Entity Considerations. In the case of an S corporation, the IRS requires that a shareholder receive reasonable compensation from the S corporation for his services. Neither these wages nor guaranteed payments to partners qualify for QBI. In contrast, in the case of a business conducted by a sole proprietor or a single member LLC that is treated as a disregarded entity, all the business’s income can be QBI. Also, because of the exclusion of SSTB, it might be beneficial to break down income streams into multiple entities. However, it appears this can only be done as long as the businesses aren’t under “common control.”
In addition, when you combine a 21% corporate rate, a 100% Section 1202 exclusion for owners of a C corporation, and the uncertainty of a Section 199A deductions for owners of a pass-through entity, business owners might want to take a close look at forming or convert to a C Corporation.
Deduction for Specified Agricultural or Horticultural Cooperatives. A specified agricultural or horticultural cooperative is entitled to a deduction equal to 9% of the lesser of (1) the “qualified production activities income” of the cooperative for the taxable year or (2) the taxable income of the cooperative for the taxable year (calculated without regard to certain patronage dividends, per-unit retains, and non-patronage distributions.) Basically, this cooperative-level deduction is very similar to the domestic production deduction (DPAD). The cooperative will be able to either pass the deduction through to its patrons or retain the deduction for its own use. As a result, patrons will be unable to definitively calculate their QBID until notified by the cooperative about whether or not the cooperative elected to pass the deductions through to the patrons.
Substantial Understatement Penalty. For a taxpayer claiming the QBID, the 20% accuracy penalty for substantial understatements of income tax applies if the understatement exceeds the lesser of (1) 5% (instead of the usual 10%) of the tax required to be shown on the return, or (2) $5,000.
Filing Status Optimization. The interplay between QBI and TI in a joint versus separately filed return may result in a substantial tax savings to file separately, especially if one of the spouses has high income and the other owns a SSTB.
Planning Opportunities. Given the complexity of the new deduction as well as some other tax law changes, it’s a good idea to get a head start on determining the affects on each individual tax situation in 2018. We would love to schedule a planning meeting with you.