A deduction for qualified business income (“QBI”), set in motion by the Tax Cuts and Jobs Act (“TCJA”) back in August of 2018, is now fully available to partnerships, S corporations, limited liability companies, trusts, and sole proprietors who wish to take advantage of the deduction for the 2018 tax season. The IRS recently issued final regulations and additional guidance paving the way for small and mid-sized businesses operating as pass-through entities to claim the qualified business income deduction. The final guidance details who is eligible for the QBI deduction and how to calculate the amount of the deduction.
How the Qualified Business Income Deduction Works
Qualified business income is defined as the net amount of income, gains, deductions, and losses for services provided. However, some types of investments, partner payments, and reasonable compensation are not included as QBI. The new regs allow eligible partnerships, S corporations, limited liability companies, trusts, and sole proprietorships to claim up to 20% of qualified business income received as a deduction. For each qualified business, the calculation is performed and aggregated. The qualified business income deduction is reduced if the net amount falls below zero and the deduction is treated as a loss for the following year.
A wage limit starts to phase in if a taxpayer’s taxable income exceeds $157,500 for single filers or $315,000 for those who are filing jointly; and the limit fully phases in at $207,500 of taxable income for single filers, $415,000 of taxable income for joint filers. Under the limit, the deduction is not permitted to exceed the greater of 1) 50% of the business’ 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).
Each partner or shareholder within a partnership or S corporation receives his or her allocable share of W-2 wages paid by the entity. In general, the unadjusted basis immediately after acquisition of qualified business property is the purchase price of tangible, depreciable property held at the end of the tax year.
The qualified business income deduction may be limited for specified service trades or businesses (SSTBs). SSTBs include businesses where the primary offering is services-based and clients seek out that business based on the reputation of the business’ employees. Examples of SSTBs are law offices, accounting firms, financial services companies, healthcare organizations, and consultants, though engineering and architectural businesses are not considered SSTBs. The qualified business income deduction for SSTBs is subject to the same phase out thresholds as the wage limit.
It’s important to be aware that the qualified business income deduction applies to taxable income and doesn’t come into play when computing adjusted gross income (AGI). It’s available both to taxpayers who do and do not itemize their deductions, as well as to those who pay the alternative minimum tax.
QBI and Rental Real Estate
A proposed safe harbor in the new guidance, which can be used until a final rule is issued, permits certain real estate enterprises to qualify as a business for purposes of the qualified business income deduction.
Individuals and entities that own rental real estate properties either directly or through disregarded entities and that aren’t considered separate from their owners for income tax purposes (such as single-member LLCs) can claim the deduction if:
- Books and records are separately kept for each rental real estate entity,
- 250 hours or more of services are performed for that entity each year (for tax years through 2022), and
- The taxpayer maintains concurrent records that detail the types of services performed, the dates and hours they were performed, and who performed them (for tax years after 2018).
Employees, contractors, or even owners are allowed to participate in the 250 hours of service which can include time dedicated to repairing the property, tenant assistance, maintenance, rent collection, paying expenses, and more. Investment-related activities like finding financing and reviewing financials related to the property won’t count towards the 250 hours of service.
The safe harbor isn’t available if a taxpayer is using the rental real estate as a residence for any part of the year, if the property is leased under a triple net lease, or if, under the triple net lease, the property is used by the taxpayer as a residence for any part of the year.
Aggregating Trades and Businesses
The proposed regs offer business owners who own multiple businesses the opportunity to maximize their deductions, provided the individual businesses being aggregated are owned and operated as part of a larger, integrated business. The new rules provide for this type of aggregation for purposes of the W-2 wages and UBIA of qualified property limitations. Under the final regs, these aggregation rules have been retained, though they have been somewhat modified.
One such proposed rule change allows a taxpayer to aggregate on the basis of a 50% ownership test and requires that the ownership, must (1) be maintained for a majority of the taxable year and (2) must include the last day of the taxable year.
Assuming that a “relevant pass-through entity” (RPE) — for example a partnership or S corporation — meets the ownership test requirements (as well as certain other tests), the final regs allow aggregation for businesses the pass-through entity operates directly or through lower-tier pass-through entities, to calculate its qualified business income deduction. However, the proposed regs allow these entities to aggregate only at the individual-owner level. If the entity opts for aggregation, both the entity and its owners must report the combined QBI, wages, and UBIA of qualified property figures.
A taxpayer who doesn’t aggregate in one year can choose to aggregate in a future year, though once that taxpayer chooses to aggregate, he or she must continue to do so in subsequent years unless circumstances change significantly.
The final regs generally don’t allow an initial aggregation of businesses to be done on an amended return, though the IRS understands that many taxpayers may be unaware of the aggregation rules when filing their 2018 tax returns. In response to that awareness, the IRS will permit taxpayers to make initial aggregations on amended returns for 2018.
UBIA for Qualified Properties
The final regs also make some changes regarding the determination of unadjusted basis immediately after acquisition in qualified property. The proposed regs adjust UBIA for like-kind exchanges, involuntary conversions, and nonrecognition transactions.
UBIA of qualified property generally remains unadjusted as a result of these transactions under the final regs. Property contributed to a partnership or S corporation in a nonrecognition transaction will normally 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.
Limitations for Specified Service Trades or Businesses
In general, many were unclear on whether or not their trade or business qualified as an SSTB under the proposed regs. Responding to requests for further guidance on this point, the IRS noted that several factors that are particular to the individual circumstances of a particular business are necessary to make a proper determination.
With that caveat, the IRS did establish rules regarding certain kinds of businesses such as those for veterinarians who provide health services that make them subject to the SSTB limits. In contrast, brokers and insurance and real estate agents who don’t provide brokerage services aren’t subject to the limits.
In general, if the businesses share more than 50% common ownership, the proposed regs treat a business that provides more than 80% of its property or services to an SSTB as an SSTB. The final regs eliminate the 80% rule. As a result, 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.
The final regs also remove the “incidental to an SSTB” rule. The proposed rule requires businesses with at least 50% common ownership and shared expenses with an SSTB to be considered part of the same business for purposes of the deduction if the business’ gross receipts represent 5% or less of the total combined receipts of the business and the SSTB.
As long as separate books are kept, businesses with some income that is eligible for the deduction and some that isn’t can still claim the deduction on the qualifying income.
Deductions for REIT Investments
Individuals are allowed a deduction of up to 20% of the combination of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, including dividends and income earned through pass-through entities. Shareholders of mutual funds with REIT investments can apply the deduction.
Though the TCJA lowers the threshold for the underpayment penalty for taxpayers who take advantage of the qualified business income deduction to 5%, the rules are nuanced with much room for error. If you have questions about how to utilize the new QBI regs, please contact your Untracht Early advisor.