IRS Provides QBI Deduction Guidance
The Tax Cuts and Jobs Act (TCJA) included a deduction for businesses that operate as pass-through entities (partnerships, S corporations, estates and trusts, and sole proprietorships), known as the qualified business income (QBI), or Section 199A, deduction.
The IRS issued proposed regulations for this deduction in August 2018. Now, it has released final regulations and additional guidance, just before the first tax season in which taxpayers can claim the deduction. Among other things, the guidance provides some clarity on who qualifies for the QBI deduction and how to calculate the deduction amount. The final regulations can be relied upon by taxpayers in filing their 2018 tax returns.
The QBI Deduction
The QBI deduction generally allows individuals and estates and trusts that receive income from pass-through entities to deduct up to 20% of the QBI passed through to them. QBI is the net amount of domestic source ordinary trade or business income (excluding reasonable compensation, certain investment items and guaranteed payments to partners for services rendered). The calculation is performed for each qualified business and aggregated. If the net amount is below zero, there is no QBI deduction in the current year and it’s treated as a loss in the following year, reducing that year’s QBI deduction, if any.
If a taxpayer’s taxable income exceeds $157,500 for single filers or $315,000 for joint filers, a wage limitation rule begins phasing in. Under the limit, the QBI deduction can’t exceed the greater of 1) 50% of the business’s 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).
For a partnership or S corporation, each partner or shareholder is treated as having paid W-2 wages for the tax year in an amount equal to his or her allocable share of the W-2 wages paid by the entity for the tax year. The UBIA of qualified property generally is the purchase price of tangible depreciable property held at the end of the tax year and is allocated to owners of pass-through entities in the same proportion that the depreciation expense is allocated to them.
The wage limitation is phased in for individuals with taxable income exceeding the above threshold amounts, over the next $100,000 of taxable income for married individuals filing jointly or the next $50,000 for single filers. The limit phases in completely when taxable income exceeds $415,000 for joint filers and $207,500 for single filers.
The amount of the deduction generally can’t exceed 20% of the taxable income less any net capital gains. If a taxpayer has $300,000 of QBI, $100,000 of net capital gains and the total taxable income is $350,000, the deduction is limited to 20% of $250,000, or $50,000.
The QBI deduction may be further limited for specified service trades or businesses (SSTBs). SSTBs include, among others, businesses involving law, financial, health, brokerage and consulting services, as well as any business (other than engineering and architecture) where the principal asset is the reputation or skill of an employee or owner. The QBI deduction for SSTBs is allowable at lower taxable income levels and begins to phase out at $315,000 in taxable income for married taxpayers filing jointly and $157,500 for single filers, and the QBI deduction for SSTBs is completely phased out at $415,000 and $207,500, respectively (the same thresholds at which the wage limit is completely phased in).
The QBI deduction applies to taxable income and doesn’t come into play when computing adjusted gross income (AGI). It’s available to taxpayers who itemize deductions, as well as those who don’t itemize, and to those paying the alternative minimum tax.
Rental Real Estate Owners
In order to receive the QBI deduction, a taxpayer’s activity has to rise to the level of a trade or business. One of the lingering questions related to the QBI deduction was whether a given rental real estate enterprise is a trade or business. The latest guidance (found in IRS Notice 2019-07) includes a proposed safe harbor that allows certain real estate enterprises to qualify as a trade or business for purposes of the deduction. Taxpayers can rely on the safe harbor until a final rule is issued.
Generally, individuals and entities that own rental real estate directly or through disregarded entities (entities that aren’t considered separate from their owners for income tax purposes, such as single-member LLCs) can claim the deduction if:
The 250 hours of services may be performed by owners, employees or contractors. Time spent on maintenance, repairs, rent collection, expense payment, provision of services to tenants and rental efforts counts toward the 250 hours. Investment-related activities, such as arranging financing, procuring property and reviewing financial statements, do not.
Be aware that rental real estate used by a taxpayer as a residence for any part of the year isn’t eligible for the safe harbor.
This safe harbor also isn’t available for property leased under a triple net lease that requires the tenant to pay all or some of the real estate taxes, maintenance, and building insurance and fees, or for property used by the taxpayer as a residence for any part of the year.
Failure to qualify under the safe harbor does not preclude the taxpayer from otherwise establishing that a rental real estate enterprise is a trade or business for purposes of the QBI deduction.
Aggregation of Multiple Businesses
The proposed regulations include rules allowing an individual to aggregate multiple businesses that are owned and operated as part of a larger, integrated business for purposes of the W-2 wages and UBIA of qualified property limitations, thereby maximizing the deduction. The final regulations retain these rules with some modifications.
For example, the proposed rules allowed a taxpayer to aggregate trades or businesses based on a 50% ownership test, which must be maintained for a majority of the taxable year. The final regulations clarify that the majority of the taxable year must include the last day of the taxable year.
The final regulations also allow a “relevant pass-through entity” — such as a partnership or S corporation — to aggregate businesses it operates directly or through lower-tier pass-through entities to calculate its QBI deduction, assuming it meets the ownership test and other tests. (The proposed regulations allowed these entities to aggregate only at the individual-owner level.) Where aggregation is chosen, 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 still choose to do so in a future year. Once aggregation is chosen, though, the taxpayer must continue to aggregate in future years unless there’s a significant change in circumstances.
The final regulations generally don’t allow an initial aggregation of businesses to be done on an amended return, but the IRS recognizes that many taxpayers may be unaware of the aggregation rules when filing their 2018 tax returns. Therefore, it will permit taxpayers to make initial aggregations on amended returns for 2018.
UBIA in Qualified Property
The final regulations also make some changes regarding the determination of UBIA in qualified property. The proposed regulations adjust UBIA for nonrecognition transactions (where the entity doesn’t recognize a gain or loss on a contribution in exchange for an interest or share), like-kind exchanges and involuntary conversions.
Under the final regulations, UBIA of qualified property generally remains unadjusted as a result of these transactions. Property contributed to a partnership or S corporation in a nonrecognition transaction usually will 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.
Specified Service Trade or Business Limitations
Many of the comments the IRS received after publishing the proposed regulations sought further guidance on whether specific types of businesses are SSTBs. The IRS, however, found such analysis beyond the scope of the new guidance. It pointed out that the determination of whether a particular business is an SSTB often depends on its individual facts and circumstances.
Nonetheless, the IRS did establish rules regarding certain kinds of businesses. For example, it states that veterinarians provide health services (which means that they’re subject to the SSTB limits), but real estate and insurance agents and brokers don’t provide brokerage services (so they aren’t subject to the limits).The final regulations also reinforced that the making of loans is a qualified activity. Further, the final regulations revised the definition of a dealer in securities so that a debt fund that originates loans should now also be considered as a qualified activity.
The final regulations retain the proposed rule limiting the meaning of the “reputation or skill” clause, also known as the “catch-all.” The clause applies only to cases where an individual or a relevant pass-through entity is engaged in the business of receiving income from endorsements, the licensing of an individual’s likeness or features, or appearance fees.
The IRS also uses the final regulations to put a lid on the so-called “crack and pack” strategy, which has been promoted as a way to minimize the negative impact of the SSTB limit. The strategy would have allowed entities to split their non-SSTB components into separate entities that charged the SSTBs fees.
The proposed regulations generally treated a business that provides more than 80% of its property or services to an SSTB as an SSTB if the businesses share more than 50% common ownership. The final regulations 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 regulations 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’s gross receipts represent 5% or less of the total combined receipts of the business and the SSTB.
Note, though, that businesses with some income that qualifies for the deduction and some that doesn’t, can still separate the different activities by keeping separate books to claim the deduction on the eligible income. For example, banking activities (taking deposits, making loans) qualify for the deduction, but wealth management and similar advisory services don’t, so a financial services business could separate the bookkeeping for these functions and claim the deduction on the qualifying income.
The TCJA allows individuals a deduction of up to 20% of their combined qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income, including dividends and income earned through pass-through entities. The new guidance clarifies that shareholders of mutual funds with REIT investments can apply the deduction. The IRS is still considering whether PTP investments held via mutual funds qualify.
Proceed with Caution
There are many other provisions in the guidance that will be covered at a later time, but in the meantime please contact your Citrin Cooperman adviser or a member of our Citrin Cooperman Federal Tax Policy Team to find out how we can help you and answer all of your questions regarding the QBI deduction.