This New Tax Break Can Make a Big Difference for Small Business Owners
The IRS has issued eagerly-awaited regulations that provide details on the new deduction for up to 20% of qualified business income (QBI) from pass-through entities. The QBI deduction was a major piece of the Tax Cuts and Jobs Act. It’s available for tax years beginning in 2018-2025 to eligible individuals, estates, and trusts that own interests in pass-through entities.
For QBI deduction purposes, pass-through entities are defined as sole proprietorships, single-member (one owner) LLCs that are treated as sole proprietorships for tax purposes, partnerships, LLCs that are treated as partnerships for tax purposes, and S corporations.
While the QBI deduction is available to individuals, estates, and trusts, the proposed regulations refer to all three as “individuals.”
QBI deduction basics
QBI means the net amount of qualified items of income, gain, deduction, and loss from an eligible business that’s operated via a pass-through entity.
The QBI deduction does not reduce your adjusted gross income (AGI). In effect, it’s treated the same as an allowable itemized deduction.
The QBI deduction does not reduce your net earnings from self-employment for purposes of the dreaded self-employment tax nor does it reduce your net investment income for purposes of the dreaded 3.8% net investment income tax on higher-income folks.
Income from the business of being an employee does not count as QBI. Ditto for reasonable salary collected by an S corporation shareholder-employee and guaranteed payments received by a partner (or an LLC member treated as a partner for tax purposes) for services rendered to a partnership (LLC).
While the new QBI deduction regulations are in proposed form, you can rely on them until final regulations are issued. What follows is a summary of the most-important points in the proposed regulations.
What is an eligible business?
In defining what constitutes a business for QBI deduction eligibility purposes, the IRS decided to go with the Internal Revenue Code Section 162 definition, because it is derived from longstanding case law and IRS guidance. However, this stance is a cop out. Perhaps most importantly, it does not definitively clarify when a rental activity can qualify as a Section 162 business for QBI deduction purposes. Presumably, your typical rental real-estate activity would be considered a Section 162 business, but we don’t know for sure. We await meaningful guidance on this important issue.
QBI deduction limitations
The QBI deduction limitations begin to phase in when your taxable income (calculated before any QBI deduction) exceeds $157,500 or $315,000 if you are a married-joint filer.
When the limitations are fully phased in (once taxable income exceeds $207,500 or $415,000 for married joint-filers), your QBI deduction is limited to the greater of (i) your share of 50% of W-2 wages paid to employees during the tax year and properly allocable to QBI or (ii) the sum of your share of 25% of such W-2 wages plus your share of 2.5% of the unadjusted basis immediately upon acquisition (UBIA) of qualified property.
The limitation based on the UBIA of qualified property is for the benefit of capital-intensive businesses like manufacturing or hotel operations. Qualified property means depreciable tangible property (including real estate) that (i) is owned by a qualified business as of its tax year-end, and (ii) is used by that business at any point during the tax year for the production of QBI and (iii) had not reached the end of its depreciable period as of the tax year-end. The UBIA of qualified property generally equals its original cost when it was first put to use in your business.
In any case, your QBI deduction cannot exceed the lesser of:
1. 20% of QBI, plus 20% of qualified REIT dividends, plus 20% of qualified income from publicly-traded partnerships. Or...
2. 20% of your taxable income calculated before any QBI deduction and before any net capital gain amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).
Aggregating business to minimize or avoid the QBI deduction limitations
Aggregating businesses can allow an individual with taxable income high enough to be affected by the limitations based on W-2 wages and the UBIA of qualified property to claim a bigger QBI deduction than if the businesses were considered separately.
For instance, say you are a high-income individual who owns an interest in one business with lots of QBI but little or no W-2 wages and an interest in a second business with minimal QBI, but lots of W-2 wages. Aggregating the two businesses can result in a healthy QBI deduction, while keeping them separate could result in a lower deduction or maybe no deduction at all. However, tests set forth in the proposed regulations must be passed for you to be allowed to aggregate businesses.
Key Point: You cannot aggregate a specified service trade or business (SSTB, defined below) with any other business, including another SSTB.
Specified service trades or businesses
The proposed regulations define what is meant by the term specified service trade or business (SSTB). Status as an SSTB (or not) is critically important, because QBI deductions based on SSTB income begin to be phased out when your taxable income (calculated before any QBI deduction) exceeds $157,500 or $315,000 if you are a married joint-filer. Phase out is complete when taxable income exceeds $207,500 or $415,000 for a married joint-filer. At that point, you are not allowed to claim any QBI deduction based on income from any SSTB.
What is a specified service trade or business?
In general, a specified service trade or business (SSTB) means any trade or business involving the performance of services in one or more of the following fields:
• Health, law, accounting, and actuarial science (architecture and engineering firms aren’t considered SSTBs).
• Financial, brokerage, investing, and investment management services.
• Dealing in securities, partnership interests, or commodities.
• Athletics and performing arts.
• Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.
Before the proposed regulations were released, there was concern that the last definition could snare unsuspecting businesses like local restaurants with well-known chefs.
Thankfully, the proposed regulations limit the last definition to trades or businesses that meet one or more of the following descriptions:
• One in which a person receives fees, compensation, or other income for endorsing products or services.
• One that receives fees, licensing income compensation, or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbol associated with that individual’s identity.
• One that receives fees, compensation, or other income for appearances at an event or on radio, television, or another media platform.
The bottom line
The proposed QBI deduction regulations are lengthy and complex. This column only scratches the surface of the proposed rules. You may need to employ a tax professional to help you sort through the details and get the best QBI deduction results in your specific circumstances.
If so, it will probably be money well-spent.
By Bill Bischoff for The Tax Guy