Executive Summary
The recently enacted Tax Reform legislation provides tax relief for small business owners that operate their business as a pass-through entity in the form of a new tax deduction which is referred to as a Qualified Business Income (QBI) deduction. This article will provide details as to:
- Who is eligible to claim the new QBI deduction?
- How the deduction is calculated?
- What limitations and exceptions to the computation and eligibility exist?
- What unanswered questions exist and when IRS guidance is expected?
One of the stated objectives of the recently passed Tax Cuts and Jobs Act (H.R.1) was to increase U.S. global competitiveness and provide incentives for businesses to create more jobs in the U.S. One way in which this new law did so was by reducing corporate tax rates from 34 percent to 21 percent for businesses that operate as “regular” or C Corporations. How though, does this law help business owners that operate their businesses as pass-through entities?
Tax Relief for Pass-Through Entities
Key members of Congress demanded that tax relief also be provided to businesses that operate as “pass-through entities” to maintain parity in taxation between corporations and pass-through entities. This “pass-through entity” business structure is the most common form of business operation for small to large privately-held businesses.
Tax relief for pass-through entities is provided in the Tax Cuts and Jobs Act in the form of a “deduction” rather than a lowering of the tax rate; thus benefitting taxpayers at all income levels (but at varying amounts). Section 199A establishes a new deduction, referred to as the “deduction for Qualified Business Income,” which is equal to 20 percent of trade or business income effectively connected with a U.S. qualified trade or business.
While at first glance this seems to be fairly straightforward, this provision is full of definitional requirements, limitations, and exceptions, making this new deduction one of the most complicated provisions in the new tax law. So much for one of the other key objectives of tax reform – simplicity!
The QBI Deduction & Section 199A
The QBI deduction is effective for tax years beginning after 2017, but is subject to the sunset provision applicable to most of the individual tax provisions and expires for tax years beginning after 2025. Thus, a future Congress and President will need to reach an agreement on extending this QBI deduction, or it will expire. This temporary deduction is in contrast to the permanent reduction in tax rates for corporations. However, we all know in the tax world that the term “permanent” means until Congress decides to change it again.
New Section 199A is very complicated and offers challenges to taxpayers and tax advisors alike, as they digest and analyze this new law. But, change also presents opportunities for tax advisors to learn, analyze, and develop strategies to assist businesses in reducing taxes and providing additional capital to sustain and grow their businesses.
Taxation of Businesses – Background
To understand how Section 199A provides parity between C Corporations (both publicly-traded and privately-held ones) and pass-through entities, it is necessary to review the taxation of these two contrasting primary business forms.
C Corporations are entities that are separately taxed from their owners (shareholders). Prior to the passage of the new tax law, corporations were taxed under a graduated rate structure from 15 percent to 34 percent; with the top rate applying to taxable income over $100,000.
Under the new law, corporations are taxed at a flat rate of 21 percent, thus placing them in a tax environment which is competitive with other developed countries. This new tax rate applies right away in 2018; there is no phase-in period for this rate reduction.
Pass-through entities, which include sole proprietorships, partnerships, LLCs, and S Corporations, are generally not separately taxed entities, but rather “pass through” their income to their owners, which are typically individuals. Prior to the Tax Cuts and Jobs Act, individuals were taxed under a progressive income tax rate structure with seven tax brackets ranging from 10 percent to 39.6 percent. Under tax reform, Congress retained the seven tax bracket structure and reduced the top rate to 37 percent for married couples with taxable incomes over $600,000.
With the 20 percent deduction for QBI, the new Section 199A deduction effectively reduces the income tax rates across the board by 20 percent. So the top income tax rate on QBI is reduced to 29.6 percent (37 percent times 80 percent).
So how does a nearly 30 percent individual tax rate have parity with the new corporate tax rate that is a flat 21 percent? Businesses structured as C Corporations are subject to a second layer of taxation upon distribution of the company net profits to its shareholders as a dividend, liquidating distributions, or as part of the sale proceeds of company stock. The tax rate on this second layer of tax imposed at the shareholder level generally ranges from 15 percent to 23.8 percent, depending on the shareholders’ income levels.
Overview of Qualified Business Income Deduction
Let’s get back to the discussion on how the QBI deduction works and who is eligible to claim it. The QBI deduction applies to income flowing through from pass-through entities (S Corporations, partnerships, LLCs, and sole proprietorships). The deduction is available for individuals, trusts, and estates that own businesses operated as pass-through entities. In addition, it is available to the owners whether they are owners that materially participate in the business, or merely passive owners.
It all sounds simple so far, but this is where the complexities begin. IRC Section 199A(c) defines QBI as. “trade or business income that is effectively connected with a U.S. qualified trade or business.” As we unpack this definition, we first read that it only applies to business activities conducted in the U.S. Next, we must consider what is a “trade or business.” This term is not well defined in tax law, but generally requires that a business be conducted on a regular, substantial, and continuous basis.
This issue of “what is a trade or business” for QBI purposes probably has the most significance in the area of real estate. The Section 199A deduction was clearly intended to also apply to real estate activities, but the question arises as to when a rental real estate activity constitutes a “trade or business.” Most likely, the typical “triple net lease” arrangement would not rise to this level of a trade or business and would not be eligible for the deduction for QBI. But, this is one of many questions and issues in which guidance is needed from the IRS, and the Service is already working on these items.
The new law specifically excludes wages paid to an employee and guaranteed payments received from a partnership from the definition of a trade or business activity. This income is considered received for services rendered and is taxed as all other forms of ordinary income.
Specified Service Trades or Businesses
The most complicated and uncertain aspect of the definition of business income eligible for the QBI deduction is the phrase “qualified trade or business.” Section 199A specifically excludes “specified service trades or businesses” as defined in existing tax law under Section 1202 relating to an exclusion on the gain for the sale or exchange of small business stock.
These excluded service businesses include businesses in the fields of law, health, accounting, actuarial science, performing arts, consulting, athletics, financial services, 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.” Congress removed engineering and architectural as specified service trades or businesses for Section 199A purposes, but added investments and investment management services to the list of “ineligible” business.
What do these businesses have in common and why are they excluded? They are all considered service-related businesses, and Congress felt that the owners are really receiving compensation for services rendered which should be taxed at regular rates.
Qualified Business Income Deduction – Computations, Limitations, and Complexities
After going through all of the qualifying rules, we would assume that the computation of the deduction must at least be simple. Wrong again. There are several limitations and exceptions to apply.
We start with the simple computation: The Section 199A deduction is QBI x 20 percent. But the QBI deduction is subject to several limitations.
- Wage Limitation
First is the wage limitation. Under the wage limitation, the QBI cannot exceed the greater of:
- 50% of wages from the qualified business (wage component); or
- 25% of wages from the qualified business, plus 2.5% of the unadjusted cost basis of depreciable property used in the trade or business (capital component).
The wage limitation is designed to insure the business pays wages for services rendered (wage component). The capital component is designed to reward the capital investment required to operate a trade or business, but one that has little payroll and the most applicability to real estate activities.
- Combined QBI Limitation
Second is the combined QBI limitation. Under the combined QBI provision, the amount deductible is the sum of the deductible amounts computed separately for each trade or business operated by a taxpayer. If one or more trades or businesses owned by the taxpayer has a net tax loss, no Section 199A deduction is available for that business and the net loss must be carried forward (for purposes of Section 199A only) and reduce future QBI for such trade or business.
- Taxable Income Limitation
Finally, we have the taxable income limitation. The QBI deduction is further limited to 20 percent of a taxpayer’s taxable income in excess of “net capital gains.” Therefore, if a taxpayer’s QBI is partially sheltered by allowable deductions including itemized deductions, retirement plan contributions, self-employed health insurance, etc., the QBI deduction can be reduced. Since net long-term capital gains and qualified dividends are already taxed at favorable rates, this income is also excluded in the taxable income limitation computation to avoid providing taxpayers with a double benefit.
Exceptions to the Limitations
No tax law is complete without exceptions, and this is true with regard to the new QBI deduction. Section 199A provides a “taxable income exception” designed to benefit lower-to-middle income pass-through business owners. Under this exception, if a taxpayer’s taxable income is less than a “threshold amount” ($315,000 for married couples and $157,500 for all other filers), neither the “Wage Limitation” nor the exclusion from eligibility from Section 199A for “Specific Services Trades or Businesses” (discussed above) apply. This exception is fully phased-out once a taxpayer’s taxable income exceeds $415,000 ($207,500 for all other filers).
Illustration: If a married physician operates a trade or business as a flow-through entity, and the QBI from the medical practice is $250,000 and the couple’s overall taxable income is $300,000, they are eligible for the full 20% QBI deduction of $50,000. This QBI deduction is available since their combined taxable income is less than the threshold amount of $315,000, notwithstanding that the business is a Specified Service Trade or Business.
As noted above, there are many unanswered questions that will require guidance from Congress and/or the IRS as to the application of the new QBI deduction. Several significant areas of uncertainty relate to the definition of specified service trades or businesses and how a business’s activities, including real estate, may be combined or separated to achieve the most favorable tax results.
The tax advisors at Sikich LLP have followed this provision through the legislative process and will continue to monitor developments as the IRS issues guidance so we can better serve and advise our clients. We have also prepared comprehensive analyses of the entity selection factors and models to assist clients in selecting or changing the form of business entity. Please contact your Sikich tax advisor with any questions you have.
