Under the new tax law enacted at the end of last year (Tax Reform and Jobs Act, Dec. 22, 2017), one of the provisions geared to the individual taxpayer was the ability for owners of a sole proprietorship, S-corporation, or partnership to receive a 20% deduction for qualified business income, also known as the Qualified Business Income deduction (QBI deduction). This additional deduction was geared to equalize the tax rates between individuals and corporations.
On August 8, 2018, the Treasury and IRS began to clarify certain aspects about the proposed regulation such as: who does the deduction apply to, how does a taxpayer qualify for the deduction, and the mechanics of calculating the deduction. The IRS has requested public comment and set a public hearing on the proposed regulations for October 18, 2018. Until final regulations are issued (and perhaps even after issued), several areas are still subject to interpretation and opinion. Calvetti Ferguson will focus on these questions in a series of articles geared toward educating and explaining the tax issues involved based on the proposed regulations and our experience.
While complex in its breadth and definition, we will keep this discussion practical and understandable. To better relate this information to your personal circumstances, we have organized our information into separate articles. Upcoming topics will provide a more in-depth look at the type of businesses that qualify and those which do not, as well as the mechanics of calculating the deduction. As you read through this article, you will find hyperlinks within the content leading to a deeper discussion of the terms in a glossary which are key to understanding the components of this new tax area. Use this as a starting point to discuss implications and specifics with your Calvetti Ferguson business advisor.
What is a qualified trade or business?
The definition for a business to be considered qualified is straightforward.
- The business must be a domestic business operated as a sole proprietorship or through a partnership, S-corporation, trust, or estate. Businesses operated as an LLC or LLP qualify.
- The activities of the business include all trades or business except those in the trade or business of performing services as an employee or as a Specified Service Trade or Business (SSTB). The proposed regulations extend the definition of trade or business to include the rental or leasing of tangible or intangible property to a related trade or business if they are commonly controlled.
What is the QBI deduction?
Generally, the deduction is equal to the lesser of two main items:
1. 20% of QBI plus 20% of qualified REIT dividends & qualified PTP income
2. 20% of taxable income minus any net capital gains
This deduction may be limited based upon the nature of the business that generates the income and the taxable income of the individual claiming the deduction.
Taxpayers who have interests in multiple trades or businesses producing qualifying business income need to evaluate each activity separately with regard to application of limitations and threshold amounts. Qualified business income is determined per business, not per taxpayer. The deduction is taken at the individual taxpayer level and applied after calculation of adjusted gross income. In effect, the deduction reduces the amount of your taxable income that is attributable to the qualified business.
Who can take the deduction?
The deduction is available to sole proprietors or business owners of pass-through entities such as S-corporations, limited liability companies, partnerships, or beneficiaries of certain trusts or estates.
Certain trusts and estates may take the deduction; however the rules are complex and require a separate article. The deduction is not available to corporations.
When does the deduction take effect?
Taxpayers can take the deduction for tax years beginning after December 31, 2017. The 2018 Individual Income Tax Return Form 1040 will include a line item used to report the deduction.
When does the deduction expire?
Currently, the deduction will not apply to tax years beginning after December 31, 2025.
What are the limitations on the deduction?
For taxpayers with joint returns in 2018 with taxable income below $315,000 or $157,500 for other returns (taxable income is determined before any application of the 20% Qualified Business Deduction), the deduction as identified above applies.
For taxpayers who have taxable income above these threshold amounts, the limitations are determined by the makeup of the qualified business income, and whether or not it is considered a Specified Service Trade or Business (SSTB).
If the business is considered an SSTB and taxable income exceeds the threshold, the deduction decreases until completely phased out at $415,000 for joint filers and $207,500 for all other taxpayers.
1. 50% of W-2 wages paid by the qualifying business
2. 25% of W-2 wages plus 2.5% of unadjusted basis of property immediately after acquisition (UBIA)
UBIA is an important factor in situations where a business has qualified business income, but has few or no employees, and therefore no W-2 wages. Using the alternative option of 2.5% of UBIA calculation may create the opportunity to benefit from the QBI deduction which may otherwise not be available.
How does a taxpayer determine whether a business activity is a SSTB?
The proposed regulations introduce new tracking and reporting requirements for taxpayers and businesses. Partnerships and S-corporations, termed relevant passthrough entities (RPE), are required to determine whether the income generated by the entity stems from a SSTB to be reported to the partners and shareholders. The RPE will also have to compute and report each partner and shareholder’s allocable share of QBI, wages, and UBIA. Therefore, each partner and shareholder can apply the various limitations at the individual level.
Individuals directly conducting a business as a sole proprietorship, or through a LLC disregarded for tax purposes, will make the SSTB determination at the individual level along with the computation of the various limitations. In situations where a taxpayer believes an activity is misclassified as an SSTB, or other information is incorrectly reported, this departure should be reported with the filing of the tax return.
Can taxpayers aggregate related businesses?
Related business can be aggregated into one activity for purposes of the QBI deduction. Businesses operated through a pass-through entity can be combined with a taxpayer’s business. Each entity needs to have qualifying income for the deduction. By aggregating the businesses, an entity that has greater profit, but low W-2 wages can be combined with a pass-through entity that has high W-2 wages and low profits, resulting in a greater 20% deduction. Once a taxpayer chooses to aggregate two or more activities, they must be consistently reported and aggregated for all subsequent taxable years, unless there is a change in facts and/or circumstances modifying how the business qualifies.
What is the impact of changes in the substantial understatement penalty?
Taxpayers should be aware if they claim the QBI deduction they may be subject to an increased accuracy-related penalty. The penalty is equal to 20% of any underpayment of federal tax if the understatement of tax is more than the greater of 5% (not the usual 10%) of the tax required to be shown on the return for the tax year, or $5,000. A risk/benefit consideration may be appropriate in situations where the benefit of the QBI deduction is not worth the potential penalty exposure because the 5% of tax relates to all income, not just qualified business income.
What are key terms and definitions important to understanding the QBI deduction?
What is a qualified trade or business?
This term includes any trade or business other than a specified service trade or business or the trade or business of being an employee. Real Estate leasing activities may qualify for the 20% deduction, depending on facts and circumstances, such as the type of rental, the owner’s involvement and the number of properties. Self-rental activity between “commonly controlled” entities (which is defined as common ownership of 50% or more in each entity) may be included as a qualified trade or business.
What is Qualified Business Income (QBI)?
QBI is the income of a trade or business that is passed through to the individual taxpayer/owner. QBI is the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer. To be considered qualified items of income, gain, deduction, and loss they must be:
- Included or allowed in the determination of the taxpayer’s taxable income for the year
- Effectively connected with a trade or business in the United States or Puerto Rico
QBI does not include:
- Amounts paid by an S-corporation that are treated as reasonable compensation to the taxpayer/owner
- Short- or long-term capital gain or loss
- Interest income not allocable to the business
- Guaranteed payments by a partnership to a partner for services rendered with respect to the trade or business
- Any amounts paid by a partnership to a taxpayer acting other than in his capacity as a partner for services
- Specified investment related income, short or long-term gains or losses, dividends, or interest income
What is a Specified Service Trade or Business (SSTB)?
An SSTB includes any trade or business involving the performance of services in the fields of:
- Performing arts
- Actuarial services
- Financial services
- Brokerage services
A “catch-all” provision includes any trade or business where the principal asset of the trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of a service consisting of investment management, trading, or dealing in securities, partnership interests, or commodities.
Engineering and architecture are not considered SSTBs. Entities that are set up to provide management, billing, wholesaling, or other product or services to a SSTB will be considered an extension of that business if there is at least 50% common ownership.
The proposed regulations limit the application of the term, “reputation or skill”, to trades or business involving the receipt of income for endorsing products, services, licensing, or receiving income for the use of and individual’s publicity rights or receiving appearance fees.
What is the threshold amount?
The threshold amount determines when both the W-2 wage limitation and the exclusion related to the specified service trade or business begins. If taxable income is less than the threshold amount, neither the W-2 wage limitation, nor the specified service trade or business exclusion apply. The threshold amount is $157,500 for single filers and $315,000 for joint filers. The threshold amounts are adjusted for inflation for tax years beginning after 2018.
What is the applicable percentage?
The applicable percentage equals taxable income of the taxpayer more than the threshold amount as a percentage of $100,000 for joint filers, or $50,000 for all others. This percentage represents the amount by which the taxpayer’s excess taxable income has reduced their qualified business income.
What is the W-2 wage limit?
The W-2 wage limit is the greater of 50% of the taxpayers share of the entities W-2 wages paid or the sum of 25% of the W-2 Wages allocated to the taxpayer plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of all qualified property. When a taxpayer’s taxable income is below the threshold amount, the W-2 wage limitation does not apply. If the taxpayer’s taxable income is greater than the threshold amount, the W-2 wage limitation phases in over the next $100,000 of income for joint filers and $50,000 for single filers. The W-2 wage limitation does not apply to qualified REIT dividends or qualified PTP income.
What are W-2 wages?
W-2 wages include total wages subject to withholding, elective deferrals, and deferred compensation paid by the qualified trade or business with respect to employees of the qualified owner as part of the year-end reporting on Schedule K-1, or as part of the year-end information provided to the owner. Taxpayers may include wages paid for employees even if the wages are reported by a payroll agent.
Wages do not include items such as guaranteed payments, or any amount that is not deductible to the qualified business; and any amounts that are not properly reported to the Social Security Administration on or before the 60th day after the due date for filing the return.
What is the unadjusted basis of qualified property immediately after acquisition (UBIA)?
The UBIA is the taxpayer’s share of the qualified property held by the business entity as of the date of acquisition, before any reduction for subsequent depreciation. Immediately after acquisition means the date the property is placed in service, whether or not the property is purchased or produced.
What is qualified property?
Qualified property includes tangible property subject to depreciation that is held by and used in the qualified trade or business at the end of the tax year, used in production of qualified business income, and property which the depreciable period has not ended before the end of the tax year. Special basis adjustments for qualified property held by partnerships are not considered. If property is purchased within 60 days of the taxable year-end and disposed of within 120 days without having been used, the property is not considered qualified unless the taxpayer demonstrates a useful purpose.
What is the applicable depreciable period?
The depreciable period begins on the date the property is first placed into service and ends on the later of: 10 years after the date placed in service; and the last day of the last full year of the applicable recovery period that applies to the property under the depreciation rules of IRC Sec. 168.
What is a qualified REIT Dividend?
Dividends received from a real estate investment trust that is not a capital gain dividend or a qualified dividend are considered Qualified REIT Dividends.
What is a relevant pass-through entity (RPE)?
An RPE is a business entity that is responsible for reporting any QBI, W-2 wages, UBIA of qualified property or SSTB determination to the underlying taxpayer. The information is usually reported on Schedule K-1. If an RPE fails to separately identify or report the information to the owner/shareholder/partner, the percentage share is presumed to be zero.
Additional articles discussing aspects of the Qualified Business Deduction will be available on the Calvetti Ferguson website on topics such as “Understanding the Specified Service Trade or Business”, “The Mechanics of Calculating the Qualified Business Deduction”, and “Aggregating Related Business” in the near future.