Tax reform: small business deduction regulations are here
But expect further guidance...
Brock R. Yates, CPA, MT
With the enactment of the Tax Cuts and Jobs act in December of 2017, arguably one of the greatest benefits for taxpayers (and an area of extreme confusion) is Section 199A, or as many know it – the 20% deduction on qualified business income. Well, Christmas came early for us CPAs. The Treasury and IRS recently released proposed regulations which aim to answer many of the looming questions regarding the application of this law. It’s a lot of mumbo jumbo at this point for CPAs to piece through, but it sheds some light to how the IRS and Treasury are hoping to enforce these rules. There’s a ton to disseminate here, so let’s jump right in to how this affects you.
Qualified Business Income. To understand the proposed regulations, it’s important that we get a base understanding of the rule itself. Section 199A allows a 20% deduction of “Qualified Business Income” (QBI) to the owner of a passthrough entity, including partnerships, S Corporations and disregarded entities such as sole proprietorships. QBI is income from the business that is not:
- Investment income (dividends, interest not earned in the course of business, capital gains, etc.)
- Foreign income and currency translation income
- Wages and guaranteed payments made to owners
The deduction is limited to the lesser of 20% of QBI, or the greater of:
- 50% of W-2 wages paid by the business, or
- 25% of W-2 wages paid by the business, plus 2.5% of Qualified Property (QP)
Wages are those that are paid in the normal course of business. An interpretation of the proposed regulations shows that this includes wages to shareholders, which could make S Corporations a very attractive option for obtaining a full deduction for those who are over the income threshold. (For more on the income threshold, keep reading.)
Consider two identical businesses, one an S corporation and one a sole proprietorship. There are no other employees in either business. The S Corporation is required by law to pay a reasonable wage, which is now included in the limitation calculation. The sole proprietor is not allowed to pay a wage to himself – his wage limitation is zero, and therefore, he cannot take a deduction.
Qualified property. Qualified business property is any fixed asset that is eligible for tax depreciation (things like raw land and inventory are out) immediately after purchase. So, no depreciation is factored into this limitation, including bonus depreciation and Section 179 expensing. The assets are factored into this limitation for the greater of:
- 10 years, or
- The asset’s useful tax life
So, a piece of equipment with a tax life of seven years is factored into the QP calculation for 10 years. A 39-year commercial property is factored into the calculation for 39 years.
There is a large caveat – the above limitation does not apply to taxpayers who fall under the income threshold, which is taxable income under $315,000 for married filing joint ($157,500 for all other filing statuses). Therefore, their deduction is simply 20% of the QBI.
Example 1: Taxpayer A, married, owns business XYZ, an S Corporation. XYZ pays A wages of $100,000 and passes through QBI of $150,000 to A. A’s total taxable income is $250,000 (assume no deductions). The wages are subject to A’s marginal rates and are not included in the QBI calculation; however, A is allowed a deduction of $30,000 ($150,000 QBI * 20%) against all her other taxable income.
A couple of important things to note. This deduction is not:
- A credit of 20% or a 20% tax rate on the income. It is a deduction against other income.
- Taken at the business level. It is taken at the partner or shareholder level and all appropriate limitations are factored on the individual’s tax returns.
For married taxpayers over the income threshold (over $315,000 of taxable income), the limitation mentioned above begins to phase-in until $415,000 of taxable income is reached, at which point it is fully phased in. A full deduction may still be allowed, even with taxable incomes over the high limit of $415,000; however, you need to check that enough wages are paid, or enough property is in the business.
Example 2: Taxpayer B, married, owns Business Z, an S Corporation. Z passes through to B $500,000 of QBI and pays him a wage of $200,000. So, B’s taxable income is $700,000 (assume no deductions). B’s portion of the wages paid in Z to employees and shareholders is $1,000,000. Assume there is no QP in Z. B’s deduction is the lesser of $100,000 ($500,000 * 20%) or the greater of $500,000 (1,000,000 * 50%) or $250,000 (1,000,000 * 25% + 0 * 2.5%). B’s deduction is $100,000.
Specialized service trades or businesses
Certain trades or businesses, known as Specialized Service Trades or Businesses (SSTB), are not so lucky with this deduction. For taxpayers engaged in an SSTB with taxable income of $315,000, the 20% deduction begins to phase out until $415,000 of taxable income is reached, where the deduction is lost entirely. What are SSTBs? The statute names a few industries specifically, including:
- Health care
- Accounting (darn!)
- Performing arts
- Brokerage and investment services
Example 3: Same facts as Example 2, except Z is an accounting firm. Because B’s taxable income is over $415,000, no QBI deduction is allowed.
The statute specifically excludes from SSTB’s engineers and architects, presumably because they are involved with creating tangible goods as opposed to simply providing services.
The proposed regulations provided more clarity to the SSTB standards, though, I believe questions will still linger. One of the sticking points was a line in the initial law that mentioned that an SSTB was any business “where the principal asset was the skill or reputation of one or more of its employees or owners.” This line threw CPAs and taxpayers into a frenzy. It seemed too large of a catch-all and would impact otherwise non-SSTB businesses. Consider a restaurant owned by a world-famous chef. Of course, the skill or reputation of that chef would be a huge asset to the business, and would by definition, make that restaurant an SSTB, when other restaurants without the chef’s name would be non-SSTB businesses.
Luckily, the proposed regulations have a very narrow view of this catch-all standard. Essentially, if you receive money for endorsing a product, licensing your image or receive fees for appearances, that is deemed to be an SSTB. In the example above, if our chef also put his name on a brand of kitchen knives, he would have two separate trades – one as a restauranteur, a non-SSTB, and one as an endorser of products, which would meet the catch-all standard of an SSTB.
A last distinction made by the proposed regulations relates to the “Brokerage and Investment Services” standard for SSTBs. The proposed regulations clarified that this includes those services related to securities and securities management. So, real estate brokers and real estate management companies are deemed to not be SSTBs. In an area like Phoenix, where real estate is such a large part of the local economy, this is sure to be a huge benefit.
Trade or business distinction
The proposed regulations clarified that each separate business seeking to pass through QBI to owners must meet the standard of a “trade or business.” In the case of normal operating entities, this isn’t a problem. However, where we run into issues is with rental real estate. There have been numerous court cases and regulations defining what is a trade or business, and usually there needs to be continuous input of time by an individual in the pursuit of income or profit. Rental real estate, depending on the facts and circumstances, may fail to reach this level, and therefore, would not be eligible for the deduction. More guidance is likely needed on this.
The only exception that is made is rental of property to commonly controlled entities. In this case, the rental entity is deemed to be a “trade or business.” More on commonly controlled entities below.
Aggregation rules – aka grouping
Consider a taxpayer who owns two businesses – an operating company and a rental property. The rental property is leased to his other business and generates income. However, there are no wages, and if the QP is not very high, it is likely that any income from the rental would be disallowed for QBI purposes. Enter the new “grouping” rules, which, per the proposed regulations, allow taxpayers to aggregate entities for purposes of the QBI deduction. In the example mentioned above, the rental and operating company would be grouped on the taxpayer’s return via an election and the rental could use the operating entities’ W-2 wages and property for calculating QBI and vice versa.
To be able to group entities for 199A purposes on an individual basis, the following rules must be met:
- The same person or group of persons must own, directly or indirectly, 50% or more of each business to be aggregated (including family attribution) – i.e., common control
- The “control” test is met for the “majority” of the tax year
- Businesses must share the same tax year
- None of the businesses may be SSTBs
- They must provide similar services, share facilities or operations or be operated in coordination with one another
Also, a key point: you do not have to own 50% or more to aggregate – you just have to prove that someone does.
Wages paid by others
Wages paid by professional employer organizations (PEOs), or management companies, to other entities can be allocated to the correct entity. This can help in instances where the operating company doesn’t necessarily pay the wages, but the workers are common law to the operating company. Before the proposed regulations, there was fear the management companies and PEOs would be the only ones able to use the W-2 wages for the limitation calculation.
What about losses?
The statute clearly mentions that each business is to calculate its QBI separately (absent a grouping election). Questions remained about what would happen to entities with income when there were also entities with losses. Would only that entity have a carryforward loss to offset future QBI? The proposed regulations require a “netting approach” and an allocation of the losses across the other entities with income, which helps cut down potential abuse in this area.
Section 1231 gains and losses
Section 1231 gains have interesting character in that they are generally capital, if a gain, and ordinary, if a loss. Given the treatment of capital gains as non-QBI, there were questions about whether 1231 gains would be permissible as QBI. The regulations mention that, given their rate preference, 1231 gains are not permitted as QBI. However, a 1231 loss would reduce QBI since it is ordinary. The only time a 1231 gain would be allowed as QBI would be if it is recharacterized as ordinary under the rules of 1231, which are outside the scope of this article.
The Section 199A proposed regulations provide much in the way of relief, but also raise other questions that will need further clarification. As is procedure with proposed regulations, practitioners, taxpayers and the general public have 45 days from the date of publishing (August 8, 2018) to provide commentary for review. You can provide commentary here. After that, the final regulations will be released. If there are any changes, we will be sure to keep you updated. You can subscribe to our Tax Insights blog for the latest information, and as with all complex tax matters, be sure to consult your Henry+Horne CPA with any questions. Our tax professionals help clients in a variety of industries including construction, dealerships, restaurants, technology and more.