The Tax Cuts and Jobs Act (TCJA) introduced a significant new deduction which affects individuals with “qualified business income” (QBI) from a partnership, S corporation, LLC or sole proprietorship.
This deduction, under Section 199A of the Internal Revenue Code, is intended to provide some tax rate parity for non-C corporate taxpayers. The IRS has issued guidance on the TCJA over the past year and a half clarifying numerous items related to QBI.
What Is Qualified Business Income?
The statute defines QBI as your allocable share of the items of income, after deductions, from your trade or business. The business must be conducted within the U.S. to qualify. Specified investment-related items such as capital gains or losses, dividends, and interest income are not included (unless the interest is allocable to the business). The trade or business of being an employee also does not qualify.
Additionally, 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. If a taxpayer has multiple businesses, you generally determine QBI separately for each business.
If a taxpayer has QBI, they may qualify for this new tax deduction. The deduction, which is taken below the line, reduces taxable income, not adjusted gross income. In general, this deduction cannot exceed 20% of the excess of your taxable income over net capital gains. If QBI is less than zero, it gets treated as a loss from a qualified business in the following year.
Two special limitations fall under the general rules of this section, and they apply to individuals with higher taxable incomes. These limitations are phased-in when joint taxable income exceeds $315,000 (or $157,500 for all other filers).
The first limitation phases out QBI for high-income earners in a specified service trade or business (SSTB) such as health, law, accounting, actuarial science, performing arts, consulting, athletics, financial, brokerage, investment management, and securities trading and dealing–anywhere the principal asset is the “reputation or skill” of one or more employees or owners.
If you are in one of these service fields and your joint taxable income exceeds $415,000 (or $275,000 for all other filers), the deduction for that business will be zero.
The second limitation, for high-income earners, is based on W-2 wages-paid and/or capital (capital is measured by the unadjusted basis of certain business assets). It applies even if the individual is not engaged in an SSTB as listed above. This limitation caps the deduction at the lesser of 1) 20% of QBI from the trade or business, or the greater of 2a) 50% of W-2 wages paid by the business and 2b) 25% of W-2 wages plus 2.5% of capital.
Recent IRS Guidance on QBI
As with all tax legislation, the devil is in the details. The IRS has issued proposed regulations and final regulations regarding QBI. For this reason, it is wise to consult a tax professional for guidance on these matters. Two of these items, which you may find relevant though, are exceptions to the general rules of how the IRS addressed SSTB trades listed in the TCJA and clarification of QBI on real estate rental activities (see next month’s newsletter when this topic will be addressed). An example of the exceptions provided includes health clubs, real estate brokers and insurance agents which are specifically excluded from the “specified service” definition. Additionally, businesses with little service income received relief under a de minimus rule.
The de minimus rule for service based income is as follows. Firms with $25 million or less of gross receipts aren’t specified service businesses if less than 10% of their gross receipts are attributed to the performance of services in a specified service field. This de minimus percentage drops further to 5% for larger firms with more than $25 million in gross receipts.
Another important easing for non-specified service businesses, outside the service fields above, but where the principal asset is the reputation or skill of its employees, owners, or principals is the IRS interpretation of the “reputation or skill” clause. The IRS has interpreted this clause narrowly to apply to endorsements, which may include the license of an individual’s image, likeness, voice, and appearance fees.
The IRS also clarified its view of a planning strategy, which emerged shortly after the TCJA was finalized. The strategy was to break up, or crack, an existing trade or business, creating parts which could then individually qualify as non-SSTBs and claim the QBI deduction.
The August 2018 guidance clarified the IRS view on this strategy. The IRS stated that when an SSTB has common ownership with a related business, the income generated by this related business for services or property provided to the SSTB will be treated as income of the SSTB.
On the reporting front, the proposed regulations also coined a new term, relevant passthrough entities (RPE), as it pertains to the tracking and reporting requirements when it comes to QBI. RPE is used to describe S corporations and Partnerships which will be required to determine whether the income generated stems from SSTB activities.
The RPE will also be required to compute and report to each partner/shareholder their allocable share of QBI, wages, and the unadjusted basis of the entity’s assets to allow each partner/shareholder to apply various limitations at the individual level.
The Path Ahead
While the new QBI deduction brings significant tax savings to the table, it also brings new compliance and recordkeeping burdens. Taxpayers and businesses should begin, as soon as possible, to design and implement internal recordkeeping, accounting, and tracking systems to help meet the various reporting requirements when the tax returns are filed.
Planning done before the fact will always help to ensure you make the best decision for your business and personal financial future. For more information or help in reviewing your planning as it pertains to this opportunity, contact your tax professional.
Bryan T. Snyder, CPA
Manager, Tax & Compliance