Aug 15 Tax Alert: Proposed Regulations Issued for the 20% Qualified Business Income Deduction
On August 8, 2018, the Treasury Department and the IRS issued proposed regulations that provide guidance on Code Section 199A (added by the Tax Cuts and Jobs Act), which permits certain taxpayers a deduction up to 20% of their Qualified Business Income (“QBI deduction”).
Qualified Business Income is income from either a pass-through entity (i.e. partnership or S-Corporation) or owners of sole proprietorships. The QBI deduction applies to tax years from 2018 through 2025, and is determined at the individual, estate or trust level. Subchapter C-Corporations are excluded from this benefit.
Brief Background of the QBI Deduction:
- The 20% QBI deduction is limited to the greater of 50% of the W-2 wages with respect to the qualified trade or business, or the sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
- The resulting deduction is then subject to a second limitation equal to 20% of the excess of taxable income for the year over the sum of net capital gain.
- The resulting QBI deduction sum may not exceed the taxpayer’s taxable income (reduced by net capital gain).
The Proposed Regulations provide further interpretation of various industries that primarily provide a service to its customers. These Trades or Businesses are referred to as a “Specified Service Trade or Business” (SSTB).
A SSTB is ineligible to claim the QBI deduction once the taxpayer’s taxable income reaches a certain threshold – $157,500 in the case of single taxpayers and $315,000 in the case of joint return filers – and is phased out over $50,000 above the threshold amount ($100,000 in the case of joint return filers).
Proposed Regulations Issued for the 20% QBI Deduction Address the Following Key Items:
- Allocation of income or loss items not clearly attributable to a single trade or business. If an individual or a pass-through entity has items of either income or loss which is attributable to more than one trade or business, the individual or pass-through entity must allocate those items among the several trades or businesses to which they are attributable using any reasonable method. The chosen method for each item must be consistently applied from one taxable year to the next.
- Aggregation of commonly controlled businesses. Aggregation is permitted but is not required at the individual taxpayer level. Once elected, it cannot be revoked. If aggregation is done, none of the businesses can be from a SSTB and the taxpayer must demonstrate that the businesses are in fact part of a larger, integrated trade or business. Furthermore, the same person or group of persons, directly or indirectly, must own more than 50% of each business to be aggregated. The proposed regulations provided several factors to consider here and the final determination of how this will be reported by the taxpayer has not been finalized.
- W-2 wages attributable to a trade or business. Taxpayers that hire and pay a third-party professional employer organization (with the third-party payor as the employer listed in Box C of the Form W-2) can include those in computing QBI as long as those wages are in relation to common law employees or officers of the taxpayer (based on State law determination).
- Allocation of W-2 wages amongst several trades or businesses. W-2 wages allocable to more than one trade or business can be allocated in the same proportion as to the deductions associated with those wages allocated among a particular trade or business. Accordingly, Form W-2 wages are properly allocable to QBI if the corresponding wage expense is taken into account when computing QBI.
- Reasonable compensation to S-Corporation shareholder-employee. All wages paid to any S-Corporation shareholder-employee are not included towards the calculation of the W-2 wage limitations.
- Treatment of Code Section 1231 gains and Sec. 1231 losses. To the extent a gain or loss is treated as capital, it is not included in QBI. Specifically, if a Code Sec. 1231 gain is treated as capital gain, it is not included in QBI. Conversely, if a Code Sec. 1231 loss is treated as ordinary loss, it must reduce QBI.
- Previously suspended losses. Several sections of the Internal Revenue Code provide for disallowance of losses and deductions in certain cases (i.e. Code Sec. 465, Code Sec. 469, Code Sec. 704(d), and Code Sec. 1366(d)). Generally, the disallowed amounts are suspended and carried forward to the following year, at which point they are re-tested and may become allowable. The Proposed Regulations provides that, to the extent that any previously disallowed losses or deductions are allowed in the tax year, they are treated as items attributable to the trade or business. However, losses or deductions that were disallowed for tax years beginning before Jan. 1, 2018 are not taken into account for purposes of computing QBI.
- SSTB de minimis exceptions. The Proposed Regulations provide a de minimis exception that will allow a business that both sells product and performs services to avoid being treated as a SSTB. The de minimis exception allows a Trade or Business not to be considered a SSTB if its gross receipts are less than $25 million (in a taxable year) and if less than 10% of the gross receipts of the business are attributable to the performance of services in one of the disqualified fields. If a business has gross receipts more than $25 million, a similar de minimis rule exists, and only 10% is replaced by 5%.
The Proposed Regulations effectively provides guidance on a broad basis and does not encompass fact patterns to a taxpayer’s individual situation and circumstances. We recommend you consult with your tax advisor for specific advice regarding your QBI deduction.
Sax LLP will continue to keep you informed as new legislation is developed and additional information is released. For more information, or if you have any questions or concerns, feel free to reach out to a Sax advisor at (973) 472-6250 or visit www.saxllp.com.
George Livanos, CPA, MST is the Tax Partner-in-Charge of Sax LLP’s Real Estate Practice, specializing in corporate, partnership and individual income taxation. He has more than 30 years of experience advising both publicly and privately held businesses on the latest tax laws, and the potential effects of proposed tax legislation. George can be reached at [email protected].
Michael Benguigui, CPA is a Senior Manager at Sax LLP and a member of the firm’s Tax and Real Estate Practices. He specializes in tax and accounting services for property owners, developers and private equity investors. Michael can be reached at [email protected].