As we pass the 3rd Quarter estimated tax deadline for 2018, we shift ahead in thinking about year-end planning and projections. One of the biggest tax planning opportunities arising from the Tax Cuts and Jobs Act is the new 20% Qualified Business Income (QBI) Deduction for business owners of sole proprietorships and pass-through entities.
Due to the highly technical nature of the following content, we remind you to contact your tax advisor before making any tax-related decisions. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice.
As we pass the 3rd Quarter estimated tax deadline for 2018, we shift ahead in thinking about year-end planning and projections. One of the biggest tax planning opportunities arising from the Tax Cuts and Jobs Act is the new 20% Qualified Business Income (QBI) Deduction for business owners of sole proprietorships and pass-through entities. A good summary of the bill as initially passed on December 22, 2017 can be found in an article previously provided by the Journal of Accountancy. Up to this point, practitioners have brainstormed several planning ideas but have been unable to execute given the lack of authoritative guidance on this highly complicated new tax law. On August 8, 2018, proposed regulations were released providing very thorough guidance while still leaving many unanswered questions.
Key provisions we learned from the Proposed Regulations:
Qualified Business Income (QBI)
The proposed regulations confirmed the following items ARE included in QBI:
- Self-Rental Income
- Ordinary Gain under Section 751(a) for unrealized receivables and under Section 751(b) for inventory (both related to ordinary income recapture on the complete sale of business assets or sale of a partnership interest)
- Disallowed losses after December 31, 2017
- Section 481(a) Adjustment arising after December 31, 2017 (related to income/(loss) as a result of an accounting method change)
The proposed regulations confirmed the following items that ARE NOT included in QBI:
- Section 1231 income treated as a capital gain or loss (related to the sale of property used in a trade or business)
- Net Operating Losses
- Guaranteed Payments
QBI for Multiple Trade or Businesses
If a taxpayer has multiple trade or businesses and one or more of the businesses have QBI of less than zero (loss), the losses must be allocated proportionately to each of the positive QBI businesses. The resulting net QBI for each business is used to compute the 20% QBI deduction. If combined QBI of all businesses is less than zero, there is no deduction for the current year and the net loss is carried forward to reduce QBI in the following year. However, the applicable wages and qualified property amounts are NOT carried forward to the next year.
Definition of a Trade or Business
A taxpayer must be in a “qualified trade or business” in order to qualify for the deduction. Nowhere in the Tax Code is a “trade or business” specifically defined. This remains true even after the proposed regulations. The proposed regulations apply the definition of a “Trade or Business” to be consistent with its meaning under Section 162(a) which is derived from prior case law. The one addition provided by the proposed regulations is that self-rental activities are treated as a trade or business if there is common ownership of greater than 50%.
Specified Service Trade or Business (SSTB)
The original TCJA bill left many unanswered questions on which professions specifically would fall under this definition that provides unfavorable treatment. Business owners that fall within the definition of an SSTB will be completely phased out of the deduction once taxable income at their personal income tax level exceeds $415,000 for joint filers and $207,500 for all other filers.
The proposed regulations clarified the following professions performing services within these categories to fall within the definition of an SSTB:
- Health
- SSTB - Individuals providing healthcare related services directly to patients (doctors, nurses, pharmacists, veterinarians)
- Not an SSTB
- Manufacturers of medical equipment
- Health clubs
- Law
- Accounting
- Actuarial Science
- Performing Arts
- Consulting
- Athletics
- Financial Services, Brokerage Services, or Investment Management
- SSTB – Financial advisors, asset managers, investment bankers, etc.
- Not an SSTB - Traditional bankers, lenders, real estate agents/brokers, and insurance agents/brokers
- Trading or Dealing
- Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners – A business will be considered an SSTB for this purpose if it generates revenue from appearances on radio or television events, from endorsements of products or services, or from using an individual’s image, name, trademark, etc. Prior to the proposed regulations, many practitioners originally thought this would be a “catch all” provision that would apply to many businesses that rely on the skills of their employees. Instead, the specific applicability of this provision will ultimately not affect many taxpayers.
Specified Service Trade or Business - De Minimis Safe Harbor
- Trade or Business Gross Receipts < $25 Million - Business will NOT be considered an SSTB if less than 10% of the gross receipts are attributable to services performed in the fields as defined above for an SSTB.
- Trade or Business Gross Receipts > $25 Million - Business will NOT be considered an SSTB if less than 5% of the gross receipts are attributable to services performed in the fields as defined above for an SSTB.
Determining W-2 Wages for Purposes of the Wage and Property Limitation
The proposed regulations confirm the following:
- Form W-2 wages are required to be reported and filed with the Social Security Administration on or before 60 days after the due date to qualify for this purpose.
- Businesses can choose one of three methods (Notice 2018-64) for determining W-2 wages:
- Unmodified Box Method – Lesser of the sum of all entries in Box 1 or Box 5 of all Form W-2s filed with the Social Security Administration.
- Modified Box 1 Method – Sum of Box 1 entries from all Form W-2s filed plus amounts reported in Box 12 that are properly coded D, E, F, G, and S (related to retirement plan salary deferrals) minus amounts included in Box 1 that are treated as wages under section 3402(o) such as supplemental unemployment compensation.
- Tracking Wages Method – Taxpayer actually tracks total wages subject to Federal income tax withholding and adds the amounts reported in Box 12 of Form W-2s that are properly coded D, E, F, G, and S (related to retirement plan salary deferrals).
- Wages reported by other parties such as professional employer organizations still qualify for purposes of the wage limitation test.
- In general, the W-2 wage limitation is applied separately for each trade or business unless a grouping election is made as discussed later. Wages that are allocable to more than one trade or business will be allocated to the same trade or business that the wage deduction occurs (for purposes of the wage limitation).
Determining Unadjusted Cost Basis of Qualified Property for Purposes of the Wage and Property Limitation
The proposed regulations confirm the following:
- Property purchased during the last 60 days before year-end and sold within 120 days after cannot be included as “qualified depreciable property” for purposes of the wage and property limitation tests unless the property was used in the business for at least 45 days prior to the sale, or the taxpayer can provide evidence that the transaction was not executed solely for increasing the QBI deduction.
- Basis adjustments under Section 734 or 743 are not considered separate qualified property. These types of basis adjustments are related to a previous partnership step-up or step-down in the basis of the assets as a result of a sale or exchange of a partnership interest or a distribution of partnership property.
Aggregation of Multiple Trade or Businesses
If specific criteria tests are met, a taxpayer can elect to treat multiple trade or businesses as a single trade or business for purposes of applying the wage and capital limitation tests. The election is irrevocable, made at the owner level, and must be applied consistently on an annual basis unless there is a significant change in the facts. The grouping election for this purpose is not the same as the grouping election under Section 469 as it relates to the passive activity rules. Whether this election will be beneficial will vary case by case. The criteria that must be met in order to make this election include the following:
- All of the following:
- Each trade or business must qualify separately as a trade or business
- None of the trade or businesses can be a Specified Service Type Business (SSTB)
- Each trade or business must have the same tax year
- There must be a 50% or more common ownership among the trade or businesses included in the aggregation
- Plus 2 of the following:
- The products or services are virtually the same or offered together
- Facilities or business elements are shared by the trade or businesses (i.e. centralized human resources)
- The trade or businesses within the group coordinate with or rely upon each other
Anti-Avoidance Provisions
The following items were specifically addressed to prevent taxpayers from circumventing the intention of the law as passed by Congress. Prior to the issuance of the proposed regulations, practitioners had proposed some of these strategies.
- Multiple Trusts - Multiple trust owners will be treated as one if all of the trusts have substantially the same grantors and beneficiaries and the principal purpose is to avoid federal income tax.
- Employees vs. Independent Contractors - If businesses attempt to convert employees into independent contractors, the individuals will still be considered employees for purposes of the deduction if they continue to provide essentially the same service.
- “Crack and Pack” – To prevent SSTBs from segregating their business in order to qualify for the deduction for the administrative portion of their business, the proposed regulations provide that an SSTB includes any trade or business with 50% or more common ownership (directly or indirectly) that provides 80% or more of its property or services to an SSTB.
Other Miscellaneous Provisions
- The 20% QBI deduction does not reduce self-employment income, net investment income, or the basis in the taxpayer’s investment.
- The deduction calculation is identical for AMT purposes (no AMT adjustment for this purpose).
- For non-grantor trusts, QBI is determined at the trust level. If there is a distribution to the beneficiary, the beneficiary’s share of the QBI and W-2 wages is allocated based on the portion of the trust’s DNI that is deemed distributed to the beneficiary for the taxable year.
- Pass-through entities will be required to provide each owner with their share of Qualified Business Income, W-2 wages, the unadjusted basis immediately after acquisition (UBIA) of qualified depreciable property, and the determination of whether the entity is an SSTB.
Key items still to be determined under future guidance
While the proposed regulations do state that they may be relied upon pending the issuance of final regulations, they do not carry the full force of the law and there are still many unanswered questions and potential changes that could occur prior to the issuance of final regulations.
- How is the unadjusted basis of qualified property determined (for purposes of the wage and property limitations) if you dispose of a significant portion of your qualified property prior to year-end?
- Further guidance is needed to address the mechanics applied to tiered entity structures.
- Do rental real estate businesses and activities rise to the level of a trade or business? What about for real estate professionals?
- Application and ordering of suspended loss carryovers.
This post was co-written with Scott Ngo, CFP®, AIF®, CPA, PFS, Wealth Manager