When President Trump signed the Tax Cuts and Jobs Act (TCJA) into law in December 2017, much was made of the dramatic cut in corporate tax rates. But the TCJA also included a generous deduction for smaller businesses that operate as pass-through entities, with income that is “passed through” to owners and taxed as individual income.
The IRS issued proposed regulations for the qualified business income (QBI), or Section 199A, deduction in August 2018. Now, it has released final regulations and additional guidance, just before the first tax season in which taxpayers can claim the deduction. Among other things, the guidance provides clarity on who qualifies for the QBI deduction and how to calculate the deduction amount.
The QBI deduction generally allows partnerships, S corporations and sole proprietorships to deduct up to 20% of QBI received. QBI is the net amount of income, gains, deductions and losses (excluding reasonable compensation, certain investment items and guaranteed payments to partners) for services rendered. The calculation is performed for each qualified business and aggregated. If the net amount is below zero, it is treated as a loss for the following year, reducing that year’s QBI deduction.
If a taxpayer’s taxable income exceeds $157,500 for single filers or $315,000 for joint filers, a wage limit begins phasing in. Under the limit, the deduction can’t exceed the greater of 1) 50% of the business’s W-2 wages or 2) 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified business property (QBP).
The application of the limit is phased in for individuals with taxable income exceeding the threshold amount, over the next $100,000 of taxable income for married individuals filing jointly or the next $50,000 for single filers. The limit phases in completely when taxable income exceeds $415,000 for joint filers and $207,500 for single filers.
The amount of the deduction generally can’t exceed 20% of the taxable income less any net capital gains. For example, a married couple owns a business and has QBI with no net capital gains of $400,000 and taxable income of $300,000. Their combined QBI deduction is limited to 20% of $300,000, or $60,000.
The QBI deduction is further limited for specified service trades or businesses (SSTBs). SSTBs include, among others, businesses involving law, financial, health, brokerage and consulting services, as well as a number of other businesses where the principal asset is the reputation or skill of an employee or owner. The QBI deduction limitation for SSTBs begins to phase in at $315,000 in taxable income for married taxpayers filing jointly and $157,500 for single filers, phasing in completely at $415,000 and $207,500, respectively (the same thresholds at which the wage limit phases in).
Rental real estate owners
One of the lingering questions related to the QBI deduction was whether it was available for owners of rental real estate. The QBI deduction is available only to rental activities that rise to the level of being a “trade or business” – a phrase that is often found in the tax code, yet remains ill-defined. The latest guidance, IRS Notice 2019-07, includes a proposed safe harbor that allows certain real estate enterprises to qualify as a trade or business for purposes of the deduction. Taxpayers can rely on the safe harbor until a final rule is issued.
Generally, individuals and entities that own rental real estate directly or through disregarded entities can claim the deduction if:
- Separate books and records are kept for each rental real estate activity,
- For tax years after 2018, the taxpayer maintains contemporaneous records that track the services performed, the dates and hours they were performed and person who performed them,
- For taxable years through 2022, at least 250 hours of services are performed each year for either each rental activity or for allowable combined activities in total.
The 250 hours of services may be performed by owners, employees or contractors. Time spent on maintenance, repairs, rent collection, expense payment, provision of services to tenants and rental efforts counts toward the 250 hours. Investment-related activities, such as arranging financing, procuring property and reviewing financial statements, do not. Also, not included in satisfying the 250 hours test is time spent traveling to and from the properties.
This safe harbor also isn’t available for property leased under a triple net lease that requires the tenant to pay all or some of the real estate taxes, maintenance, and building insurance and fees, or for property used by the taxpayer as a residence for any part of the year.
Based on the strict qualifications above that allow rental activities to qualify as a trade or business and, thus, allow rental owners to claim the qualified business income deduction, work closely with your tax advisor to understand how the QBI deduction applies to you.
Aggregation of multiple businesses
It’s not unusual for small business owners to operate more than one business. The proposed regulations included rules allowing an individual to aggregate multiple businesses that are owned and operated as part of a larger, integrated business for purposes of the W-2 wages and UBIA of qualified property limitations, thereby maximizing the deduction. The final regulations retain these rules with some modifications.
For example, the proposed rules allow a taxpayer to aggregate trades or businesses based on a 50% ownership test, which must be maintained for a majority of the taxable year. The final regulations clarify that the majority of the taxable year must include the last day of the taxable year.
The final regulations also allow a “relevant pass-through entity” — such as a partnership or S corporation — to aggregate businesses it operates directly or through lower-tier pass-through entities to calculate its QBI deduction, assuming it meets the ownership test and other tests. The proposed regulations had allowed these entities to aggregate only at the individual-owner level.
A taxpayer who doesn’t aggregate in one year can still choose to do so in a future year. Once aggregation is chosen, though, the taxpayer must continue to aggregate in future years unless there’s a significant change in circumstances.
The final regulations generally don’t allow an initial aggregation of businesses to be done on an amended return, but the IRS recognizes that many taxpayers may be unaware of the aggregation rules when filing their 2018 tax returns. Therefore, taxpayers may make initial aggregations on amended returns for 2018 only.
UBIA in qualified property
The final regulations also make changes regarding the determination of the unadjusted basis immediately after acquisition in qualified property. The proposed regulations adjust UBIA for non-recognition transactions (where the entity doesn’t recognize a gain or loss on a contribution in exchange for an interest or share), like-kind exchanges and involuntary conversions.
Under the final regulations, UBIA of qualified property generally remains unadjusted as a result of these transactions. Property contributed to a partnership or S corporation in a nonrecognition transaction usually will retain its UBIA on the date it was first placed in service by the contributing partner or shareholder. The UBIA of property received in a like-kind exchange is generally the same as the UBIA of the relinquished property. The same rule applies for property acquired as part of an involuntary conversion.
Many of the comments the IRS received after publishing the proposed regulations asked for further guidance on whether certain types of businesses are in an out-of-favor Specified Service Trade or Business group. Finalized guidance illuminated certain situations. For example, veterinarians provide health services, so these business owners have SSTBs, but real estate and insurance agents and brokers do not have SSTBs.
The final regulations retain the proposed rule limiting the meaning of the “reputation or skill” clause, also known as the “catch-all.” The clause applies only to cases where an individual or a relevant pass-through entity is engaged in the business of receiving income from endorsements, the licensing of an individual’s likeness or features, or appearance fees.
The IRS also uses the final regulations to put a lid on the so-called “crack and pack” strategy, which had been suggested by some commentators as a way to minimize the negative impact of the SSTB limit. This strategy would have allowed entities to split their non-SSTB components into separate entities that charged the SSTBs fees, with these fees then being converted to non-SSTB income. Under final regulations, however, when a business provides property or services to an SSTB with 50% or more common ownership, the portion of that business providing property or services to the SSTB will be treated as a separate SSTB.
Note, though, that businesses with some income that qualifies for the deduction and some that doesn’t can still separate the different activities by keeping separate books to claim the deduction on the eligible income. For example, banking activities (taking deposits, making loans) qualify for the deduction, but wealth management and similar advisory services don’t, so a financial services business could separate the bookkeeping for these functions and claim the deduction on the qualifying income.
Despite myriad IRS guidance for a number of industries and activities, there will still be many taxpayers who will be in a grey area and will need to consult with their tax advisor for a clearer picture of if, and how, their passthrough business will generate a QBI deduction.
The TCJA allows individuals a deduction of up to 20% of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, including dividends and income earned through pass-through entities. The new guidance clarifies that shareholders of mutual funds with REIT investments can apply the deduction. The IRS is still considering whether PTP investments held via mutual funds qualify.
Proceed with caution
To add pressure to understanding how this section of tax law applies to you, the tax code imposes a penalty for underpayments of income tax that exceed the greater of 10% of the correct amount of tax or $5,000. Although the threshold drops to 5% for QBI deduction-related underpayments, it remains paramount to explore your tax benefit from this, and other aspects of the new tax law, with caution and thoughtfulness. Please reach out to me with any questions you have and let me know how I can help you best understand and apply the QBI deduction to your particular situation.