Tax Planning/Tax Opinions Articles – Business Taxes
Generally for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026, the Act adds a new section, Code Sec. 199A, “Qualified Business Income,” under which a non-corporate taxpayer, including a trust or estate, who has qualified business income (QBI) from a partnership, S corporation, or sole proprietorship is generally allowed a deduction equal to the lesser of 20% of QBI (not including net capital gains) or 50% of W-2 wages paid by the partnership, S corporation, or sole proprietorship. But the deduction can’t exceed the taxpayer’s taxable income, reduced by net capital gain.
This is a significant tax deduction taking effect in 2018 under the TCJA. It should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship. This income is sometimes referred to as “pass-through” income.
The deduction is 20% of your “qualified business income (QBI)” from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your trade or business. The business must be conducted within the U.S. to qualify, and specified investment-related items are not included, e.g., capital gains or losses, dividends, and interest income (unless the interest is properly allocable to the business). The trade or business of being an employee does not qualify. Also, QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership’s business.
The deduction is taken “below the line,” i.e., it reduces your taxable income but not your adjusted gross income. But it is available regardless of whether you itemize deductions or take the standard deduction. In general, the deduction cannot exceed 20% of the excess of your taxable income over net capital gain. If QBI is less than zero it is treated as a loss from a qualified business in the following year.
Rules are in place (discussed below) to deter high-income taxpayers from attempting to convert wages or other compensation for personal services into income eligible for the deduction.
For taxpayers with taxable income above $157,500 ($315,000 for joint filers), an exclusion from QBI of income from “specified service” trades or businesses is phased in. These are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners. Here’s how the phase-in works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), all of the net income from the specified service trade or business is excluded from QBI. (Joint filers would use an amount $100,000 above the $315,000 threshold, viz., $415,000.) If your taxable income is between $157,500 and $207,500, you would exclude only that percentage of income derived from a fraction the numerator of which is the excess of taxable income over $157,500 and the denominator of which is $50,000. So, e.g., if taxable income is $167,500 ($10,000 above $157,500), only 20% of the specified service income would be excluded from QBI ($10,000/$50,000). (For joint filers, the same operation would apply using the $315,000 threshold, and a $100,000 phase-out range.)
Additionally, for taxpayers with taxable income more than the above thresholds, a limitation on the amount of the deduction is phased in based either on wages paid or wages paid plus a capital element. Here’s how it works: If your taxable income is at least $50,000 above the threshold, i.e., $207,500 ($157,500 + $50,000), your deduction for QBI cannot exceed the greater of (1) 50% of taxpayer’s allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition of tangible depreciable property used in the business (including real estate). So if your QBI were $100,000, leading to a deduction of $20,000 (20% of $100,000), but the greater of (1) or (2) above were only $16,000, your deduction would be limited to $16,000, i.e., it would be reduced by $4,000. And if your taxable income were between $157,500 and $207,500, you would only incur a percentage of the $4,000 reduction, with the percentage worked out via the fraction discussed in the preceding paragraph. (For joint filers, the same operations would apply using the $315,000 threshold, and a $100,000 phase-out range.)
Other limitations may apply in certain circumstances, e.g., for taxpayers with qualified cooperative dividends, qualified real estate investment trust (REIT) dividends, or income from publicly traded partnerships.
Obviously, the complexities surrounding this substantial deduction can be formidable, especially if your taxable income exceeds the threshold discussed above. If you wish to work through the mechanics of the deduction with me, with particular attention to the impact it can have on your specific situation, please give me a call.
The amount of the deduction (QBI deduction) is generally 20 percent of the taxpayer’s qualifying business income from a qualified trade or business.
Example: In 2018, Joe receives $100,000 in salary from his job at XYZ Corporation and $50,000 of qualified business income from a side business that he runs as a sole proprietorship. Joe’s QBI deduction for 2018 is $10,000 (20% of $50,000).
The QBI deduction is claimed by individual taxpayers on their personal tax returns. The deduction reduces taxable income, and is not used in computing adjusted gross income. Thus, it does not affect limitations based on adjusted gross income.
An explanation of the main rules for the QBI deduction follows.
Different Rules Apply at Different Levels of Taxable Income
One of the most important things to understand about the QBI deduction is that the rules that apply to individuals with taxable income below certain thresholds in a given tax year are simpler and more permissive than the ones that apply to income above those thresholds. For 2018, the threshold amount is $315,000 for married taxpayers filing a joint return, and $157,000 for all others.
There are actually only two rules that are waived for taxpayers with income below the threshold, but the impact can be profound. These are: (1) a rule that disqualifies income from a broad range of service businesses (referred to as “specified service trades or businesses”) from the QBI deduction; and (2) a rule that limits the QBI deduction to a percentage of W-2 wages paid by a business. Both are discussed below.
Other rules, such as one preventing individuals from claiming the QBI deduction for employment income, apply to all taxpayers, regardless of their level of taxable income.
Qualified Trades or Businesses
The QBI deduction can only be claimed for income from a qualified trade or business.
A qualified trade or business means any trade or business other than:
(1) a specified service trade or business; or
(2) the trade or business of being an employee.
Specified service trade or business. A “specified service trade or business” is defined as any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing in securities, partnership interests, or commodities, and 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. Engineering and architecture services are specifically excluded from the definition of a specified service trade or business.
Some of the categories and fields listed in the previous paragraph are fairly clear in their meaning. Others – such as “consulting” and “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” – are vague, and will be difficult to apply until the IRS provides guidance.
Special rule where taxpayer’s income is below a specified threshold. The rule disqualifying specified service trades or businesses from being considered a qualified trade or business does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the restriction is phased in over a range of $50,000 in taxable income ($100,000 for joint filers). If an individual’s income falls within the range, he or she is allowed a partial deduction. Once the end of the range is reached, the deduction is completely disallowed.
Employees vs. independent contractors. The rule that taxpayers cannot claim a QBI deduction on their employment income is clear. But it isn’t always clear when an individual is an employee versus being an independent contractor – and unlike employees, independent contractors are eligible for the QBI deduction. The more favorable treatment of independent contractors for purposes of the new deduction creates new opportunities, but also new pitfalls. If you’re currently an employee and find yourself considering a switch to becoming an independent contractor, we should discuss the implications for both employment taxes and any potential QBI deduction.
Qualified Business Income
Qualified business income (QBI) means the net amount of qualified items of income, gain, deduction, and loss with respect to the qualified trade or business of the taxpayer.
Compensation paid to partners and S corporation shareholders. QBI does not include any amount paid by an S corporation that is treated as reasonable compensation of the taxpayer, or any guaranteed payment (or other payment) to a partner for services rendered with respect to the trade or business.
Example: Monica is a shareholder in, and sales manager for ABC, an S corporation that is a qualified trade or business. During the tax year, she receives reasonable compensation of $250,000 from ABC for her services as its sales manager. In addition, her pro rata share of ABC’s net income, its only item of income or loss, is $175,000. Monica’s qualified business income from ABC is $175,000. This is the amount eligible for the 20% QBI deduction.
‘Domestic’ requirement. Items are treated as qualified items of income, gain, deduction, and loss only to the extent they are effectively connected with the conduct of a trade or business within the United States.
Investment income. Qualified items do not include specified investment-related income, deductions, or losses, such as capital gains and losses, dividends and dividend equivalents, interest income other than that which is properly allocable to a trade or business, and similar items.
REIT dividends, cooperative dividends, and publicly traded partnership income. Qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income are not included in the definition of QBI, but these items are eligible for a separately calculated 20 percent deduction.
Calculating the QBI Deduction for Each Trade or Business
The QBI deduction for a qualified trade or business is the lesser of:
(1) 20 percent of qualified business income; or
(2) the greater of: (a) 50 percent of the business’s W-2 wages (applies to most businesses), or (b) an amount based on a more complex formula involving the business’s W-2 wages and its depreciable property (see “Alternative limitation for rental real estate activities”, below).
The amount in (2), above, is referred to as the “W-2 wage limitation”.
Example: Susan, a single taxpayer, owns and operates a sole proprietorship that sells cupcakes. The cupcake business pays $100,000 in W-2 wages and has $350,000 in qualified business income. For the sake of simplicity, assume the business has no depreciable property, so the W-2 wage limitation is based on 50 percent of the business’s W-2 wages (not the more complex formula involving wages and property). Susan’s QBI deduction is $50,000, which is the lesser of (a) 20 percent of $350,000 in qualified business income ($70,000), or (b) 50 percent of $100,000 of W-2 wages ($50,000).
Alternative limitation for rental real estate activities. The more complex formula referred to in (2), above, which typically applies mainly to rental real estate activities, calculates the W-2 wage limitation by adding 25 percent of the business’s W-2 wages to 2.5 percent of the original tax basis of the business’s depreciable property that’s still within its depreciable period at the end of the tax year.
Phase-in of W-2 wage limitation. The W-2 wage limitation does not apply to individuals with taxable income of less than $157,500 ($315,000 for joint filers). After an individual reaches the threshold amount, the W-2 limitation is phased in over a range of $50,000 in taxable income ($100,000 for joint filers).
Calculating the QBI deduction for multiple business. If you own more than one qualifying trade or business, the QBI deduction must be calculated separately for each business. This requirement can sometimes reduce the overall deduction by preventing W-2 wages or qualified property from one business from being used to increase the deductible amount from another business.
Loss carryovers. If the net amount of qualified business income from all qualified trades or businesses during the tax year is a loss, it is carried forward as a loss from a qualified trade or business in the next tax year (and reduces the qualified business income for that year).
Special Rules for Partnerships and S Corporations
In the case of a partnership or S corporation, the business income deduction applies at the partner or shareholder level. Each partner in a partnership takes into account the partner’s allocable share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages for the taxable year equal to the partner’s allocable share of W-2 wages of the partnership. Similarly, each shareholder in an S corporation takes into account the shareholder’s pro rata share of each qualified item and W-2 wages.
Taxable Income Limitation on the QBI Deduction
If your taxable income (reduced by any income taxed at capital gain rates and before applying any QBI deduction) is less than your qualified business income, the QBI deduction is limited to 20 percent your taxable income (reduced by any income taxed at capital gain rates).
Example: Cynthia owns and operates LittleCo, a sole proprietorship that is a qualified trade or business. Cynthia has $100,000 in qualified business income from LittleCo, and no other items of income or loss. She has a total of $25,000 in above-the-line and itemized deductions. Her taxable income, prior to applying any QBI deduction, is $75,000. Cynthia’s QBI deduction is $15,000, which is the lesser of her QBI deduction for LittleCo ($20,000 = 20% x $100,000 QBI) or 20 percent of her taxable income taxed at regular tax rates ($15,000 = 20% x $75,000 taxable income).
The effect of this limitation is to ensure that the 20 percent QBI deduction rate isn’t applied to more income than the amount taxed at regular tax rates. The limitation mainly applies in situations where most or all of a taxpayer’s income is qualified business income. Taxpayers with a significant amount of non-QBI income taxed at regular rates (e.g., salary or wage income, spousal salary or wage income, taxable interest income, etc.) will generally not see their QBI deduction reduced by the taxable income limitation.
Concluding Thoughts
As you can see, even the main rules for the QBI deduction are quite complicated.
If you’d like to discuss the availability of the QBI deduction for an existing business, or for one you are considering starting or investing in, please don’t hesitate to call.
The availability of the 20 percent deduction for qualified business income (QBI deduction) with respect to a rental real estate activity.
If all the general requirements (which vary based on your level of taxable income) are met, the deduction can be claimed for a rental real estate activity – but only if the activity rises to the level of being a trade or business. An activity is generally considered to be a trade or business if it is regular, continuous, and considerable.
Because determining whether a rental real estate enterprise meets the applicable criteria for a trade or business can be difficult, the IRS has provided a safe harbor under which such an enterprise will be treated as a trade or business for purposes of the QBI deduction. For this purpose, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.
Generally, you may either treat each interest in similar property held for the production of rents as a separate rental real estate enterprise or treat interests in all similar properties held for the production of rents as a single rental real estate enterprise. For purposes of applying the safe harbor, properties held for the production of rents are similar if they are part of the same rental real estate category. The two types of rental real estate categories for the purpose of combining properties into a single rental real estate enterprise are residential and commercial. Thus, commercial real estate held for the production of rents may only be part of the same enterprise with other commercial real estate, and residential properties may only be part of the same enterprise with other residential properties.
Once you treat interests in similar commercial properties or similar residential properties as a single rental real estate enterprise under the safe harbor, you must continue to treat interests in all similar properties, including newly acquired properties, as a single rental real estate enterprise. However, if you choose to treat an interest in each residential or commercial property as a separate rental real estate enterprise, you may choose to treat your interests in all similar commercial or all similar residential properties as a single rental real estate enterprise in a future year.
While commercial and residential real estate may not be part of the same enterprise, you have the option of treating an interest in mixed-use property as a single rental real estate enterprise or bifurcating the interest into separate residential and commercial interests.
Under the safe harbor, a rental real estate enterprise will be treated as a trade or business if the following requirements are satisfied during the tax year with respect to the rental real estate enterprise:
(1) Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
(2) For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise. For rental real estate enterprises that have been in existence for at least four years, in any three of the five consecutive tax years that end with the tax year, 250 or more hours of rental services are performed per year with respect to the rental real estate enterprise.
(3) The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: (i) hours of all services performed; (ii) description of all services performed; (iii) dates on which such services were performed; and (iv) who performed the services. If services with respect to the rental real estate enterprise are performed by employees or independent contractors, the taxpayer may provide a description of the rental services performed by such employee or independent contractor, the amount of time such employee or independent contractor generally spends performing such services for the enterprise, and time, wage, or payment records for such employee or independent contractor. These records are to be made available for inspection at the request of the IRS. The contemporaneous records requirement does not apply to tax years beginning before January 1, 2020.
For purposes of the safe harbor, rental services include:
· advertising to rent or lease the real estate;
· negotiating and executing leases;
· verifying information contained in prospective tenant applications;
· collecting of rent;
· daily operation, maintenance, and repair of the property, including the purchase of materials and supplies
· management of the real estate; and
· supervision of employees and independent contractors.
Some types of rental real estate are not eligible for the safe harbor. Real estate used by a taxpayer (including an owner or beneficiary of passthrough entity) as a residence for any part of the year is generally not eligible for the safe harbor. Nor is real estate rented or leased under a triple net lease.