The tax deduction of 20% of qualified business income under Internal Revenue Code Section 199A is one of the most complex provisions of the Tax Cuts and Jobs Act enacted on December 22, 2017.
The requirements for qualifying for and computing this deduction add a layer of complexity to our tax laws for owners unincorporated businesses and S corporations similar to the complexity of the alternative minimum tax, the passive activity loss rules and the net investment income tax.
There are many questions about the details of how to apply the new rules. On August 8, 2018, the Internal Revenue Service issued proposed regulations (REG-107892-181) as its initial guidance. The IRS has asked for comments from the tax preparation and planning industry about the proposals and how to resolve some questions that are still unclear. The IRS wants to receive the comments by September 22, 2018 and has scheduled a public hearing on October 16, 2018. Taxpayers can rely on the proposed regulations until final regulations are issued. The regulations won’t be binding until final regulations are issued, except for the anti-abuse rule for multiple trusts, which is effective for taxable years ending after December 22, 2017.
I expect this deduction will be a huge area of litigation from disagreements between the IRS and taxpayers about Congress’s intent in enacting this tax benefit.
My printout of the IRS summary and text of the proposed regulations is 183 pages. I will only give some highlights here. I recommend that any individual, trust, partnership, LLC or S corporation with a trade or business (including rental real estate) should have its income tax returns prepared by a professional income tax return preparer for 2018 and be prepared to pay higher income tax return preparation fees than in the past. I also recommend that business owners should consult with their tax advisors well before the end of the year to find out how the tax law changes in the Tax Cuts and Jobs Act will affect them.
I apologize in advance if my explanation is confusing. Please get professional advice. Tax professionals should read the proposed regulations and get more detailed information in training courses and textbooks.
Effective for tax years beginning after December 31, 2017 and before January 1, 2026, noncorporate taxpayers, including individuals, estates and trusts, are eligible for a federal income tax deduction of 20% of qualified domestic trade or business income. (For this explanation, I will refer to the deduction as the 20% deduction for business income as shorthand.) The business income may be from an entity that is a sole proprietorship, a partnership (including most LLCs taxed as partnerships) or an S corporation. Income from a trade or business that is a specified service trade or business (SSTB) does not qualify for the deduction unless the taxpayer has taxable income of up to $415,000 for taxpayers filing a joint return ($315,000 threshold + $100,000 phaseout) or $207,500 for other taxpayers ($157,500 threshold + $50,000 phaseout.) The deduction for a trade or business that is not a SSTB may be subject to certain limitations, explained below.
In general, the deduction is limited to the greater of (a) 50% of the W-2 wages of the trade or business; or (b) the sum 25% of the W-2 wages of the trade or business plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property of the trade or business (generally, depreciable property.)
The wage and qualified property limitations don’t apply if the taxpayer has taxable income of not more than $157,500, or $315,000 for a joint return. The limitation is phased in for the next $50,000 of taxable income, or $100,000 for a joint return.
A 20% of business income deduction is also available for a partner’s share of income from a publicly traded partnership and for distributed income from an agricultural or horticultural cooperative or a REIT (real estate investment trust). This part of the 20% deduction for business income is not subject to the wages and property limitations that apply to other qualified business income.
The 20% deduction relating to distributed income from an agricultural or horticultural cooperative is reduced by the lesser of:
- 9% of the qualified business income with respect to the trade or business that is properly allocable to qualified payments received from the cooperative, or
- 50% of the W-2 wages of the trade or business that are allocable to the cooperative.
(The IRS said in the explanation for these proposed regulations that is plans to issue separate proposed regulations for cooperatives later this year. The IRS expects those proposed regulations will provide that only the patronage business of a relevant cooperative will qualify for the 20% deduction for business income.)
The total of these 20% deductions for business income can’t exceed the taxable income less net capital gains for the tax year. For the purpose of computing this limitation, the 20% deduction is disregarded.
The 20% deduction for business income is a separate deduction after determining adjusted gross income and before itemized deductions or the standard deduction.
The 20% deduction for business income that is allowed when computing regular taxable income is also allowed for the alternative minimum tax. No separate computation is required.
Domestic trade or business income (Qualified Business Income)
The IRS states in the proposed regulations that it will follow the rules under Internal Revenue Code Section 162 to determine whether the entity is a trade or business. This provides a resource of past litigation for determining whether or not it is a trade or business.
There is an exception for the rental or licensing of tangible or intangible property to an entity that is commonly controlled (explained below.) If the entity the property is rented or licensed to qualifies as a trade or business, the rental or licensing income will also be trade or business income, even if the entities don’t qualify to be aggregated (also explained below.) It’s not clear that this except applies of the controlled business that the property is rented or licensed to is a C corporation, since C corporations aren’t eligible for the 20% deduction for business income.
Other than this exception, the proposed regulations do not go into detail about rental real estate income. There is an example in the proposed regulations where rental real estate income other than to a commonly-controlled entity qualifies for the deduction. There are court cases where rental from a triple-net lease is considered investment income and not trade or business income. Some, but not all, rental real estate operations should qualify for the deduction. I recommend that rental real estate operations that claim the deduction should issue Form 1099 to noncorporate payees to whom payments for services and interest expenses are paid.
The income must be effectively connected with the conduct of a trade or business within the United States. A determination might have to be made whether income and related deductions have a foreign source and not qualify for the deduction. A trade or business conducted in Puerto Rico is considered to be conducted within the United States.
Interest income is trade or business income only if it relates to a trade or business. That would usually be interest income of a bank for business loans or interest received for late payments of accounts receivable. Interest income for investment of working capital, reserves or similar accounts doesn’t related to a trade or business.
Dividends income does not relate to a trade or business.
Short and long-term capital gains are not trade or business income.
W-2 income, compensation for services received other than in the capacity as a partner and guaranteed payments received for services rendered to the trade or business are not trade or business income. (Profitable partnerships and LLCs taxed as partnerships might want to restructure their compensation for partners from guaranteed payments to special allocations of income.)
Guaranteed payments from a partnership or an LLC taxed as a partnership in lieu of interest for the use of capital are not trade or business income. (Again, profitable partnerships might want to restructure these arrangements to special allocations of income.)
S corporations that pay dividends to their shareholders and pay them low or no W-2 income will find the IRS is even more aggressive to recharacterize dividends as reasonable compensation, not qualifying for the 20% of business income deduction. The proposed regulations clarify that the reasonable compensation issue will only apply to S corporations in the context of this deduction.
Ordinary income from the disposition of business assets, such as depreciation recapture, is trade or business income.
Unadjusted basis immediately after acquisition (UBIA) of qualified property
Congress enabled trades and businesses that don’t have significant payrolls to get some benefit from the 20% deduction for business income by incorporating an alternative limitation based on investment in depreciable property.
Qualified property is depreciable property that meets three conditions:
- It’s held by and available for use in the trade or business at the close of the taxable year;
- It’s used to produce qualified business income during the taxable year; and
- The depreciable period for the property hasn’t ended before the close of the taxable year of the individual or the passthrough entity.
Any depreciable addition to or improvement to qualified property is treated as separate qualified property first placed in service on the date the addition or improvement is placed in service.
Property is not qualified property if it is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in the trade or business for at least 45 days before disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the 20% of business income deduction.
Depreciable basis adjustments relating to changes in partnership ownership under Internal Revenue Code Sections 734(b) and 743(b) are not qualified property.
The depreciable period is the period beginning on the date the property was first placed in service by the individual or passthrough entity and ending on the later of (1) the date 10 years after that date, or (2) the last day of the last full year in the Modified ACRS recovery period of the property. For most personal property, this will be 10 years; for residential real estate, 27.5 years; and for commercial real estate, 39 years. There is no change in the depreciable period when the taxpayer elects to expense the property or claims bonus depreciation.
This means taxpayers will often have depreciable property still on their books and records that won’t qualify for this limit.
If property is acquired in a Section 1031 tax-deferred exchange or in an involuntary conversion under Internal Revenue Code Section 1033, the depreciable period of the disposed property will continue to apply for the carryover basis portion of the basis, and the depreciable period will start on the replacement date for any additional basis for the replacement property.
Property acquired in a nonrecognition transaction, such as a contribution to a partnership, will continue to have the depreciable period of the contributor.
Inherited property is acquired on the date of death.
The unadjusted tax basis is the cost that would be eligible for depreciation. The tax basis is determined disregarding basis adjustments for tax credits claimed or for expensing the property under Internal Revenue Code Section 179. However, any tax basis adjustment for the personal use of the property does apply and that part isn’t included as qualified property for the limitation.
W-2 wages is not necessarily the same as the amount claimed as the deduction for wages on the taxpayer’s federal income tax return.
For example, wages could be capitalized to manufactured property. Also, the business might report using the accrual method of accounting, but W-2 wages are always reported using the cash method. A trade or business could have a fiscal year. The W-2 wages are determined using a calendar year.
W-2 wages for the limitation computation are the wages reported on Form W-2 paid by the person/business during the calendar year ending during the taxable year. For example, if a trade or business has a taxable year ending June 30, 2019, it would use W-2 wages reported for calendar year 2018.
In determining W-2 wages for the limitation computation, an individual or passthrough entity may include W-2 wages paid by another person/business and reported by the other person/business on Forms W-2 with the other person/business listed as the employer on Box c of Forms W-2 when the W-2 wages were paid to common law employees or officers of the individual or passthrough entity for their employment by the individual or passthrough entity. In such cases, the individual/business that reported the wages on Form W-2 may not include those wages to compute its limitation.
Each individual or passthrough entity that directly conducts more than one trade or business must allocate those wages among its various trades or businesses, according to the trade or business that generated those wages. Then the wages must be allocated to the qualified business income of the trade or business. (This may be more difficult than it sounds, and arguments with the IRS about it are likely.)
A passthrough entity must determine and report W-2 wages for each trade or business conducted by the entity. If a passthrough entity doesn’t determine and report W-2 wages for each trade or business conducted by the entity, W-2 wages are presumed to be zero.
W-2 wages do not include any amount which is not properly allocable to qualified business income. For example if a taxpayer reports wages paid to a household employee on Form W-2, those wages are not included for this limitation.
W-2 wages includes the amount reported as wages in Box 1 of Form W-2 for an employee, plus amounts the employee has elected to defer, such as contributions to a 401(k) plan. These amounts are reported in box 12 of Form W-2. Elective Roth contributions are already included in taxable wages and are not added.
The IRS has issued a proposed revenue procedure relating to alternative methods for computing W-2 wages. (Notice 2018-64, August 8, 2018.) According to the proposed revenue ruling, wages reported on Form W-2 should be reduced by wages that aren’t subject to income tax withholding, including supplemental unemployment compensation benefits.
Forms W-2 provided to statutory employees (the “Statutory Employee” box in Box 13 should be checked) are not included in W-2 wages for the limitation computation.
The wages must be reported on Form W-2 to the Social Security Administration. W-2 wages don’t include any amounts not properly included in a W-2 Form filed with the SSA on or before the 60th day after the due date, including extensions, for Form W-2. So, be diligent about filing Forms W-2 and the transmittal Form W-3 on time. (The due date of Form W-2 is January 31 of the year following the calendar year to which it relates. Corrected Forms W-2 are due on or before January 31 of the year following the year in which the correction is made.) Each Form W-2 together with its accompanying Form W-3 will be considered a separate information return and each Form W-2c (corrected W-2) and its accompanying Form W-3c will be considered a separate information return.
If a corrected Form W-2 is filed with the SSA before the 60th day after the original due date (including extensions), the corrected Form W-2 wages are used as W-2 wages for the limitation computation. According to the proposed regulations, corrected W-2 wages for corrected Forms W-2 filed 60 days or later after the original due date (including extensions) are only used as W-2 wages for the limitation computation if the wages are decreased on a Form W-2c.
The proposed regulations include methods of determining W-2 wages when there is a change of ownership for a business and for short taxable years. Those rules are beyond the scope of this summary.
Trade or businesses are under common control if the same person or group of persons, directly or indirectly, owns 50% or more of each trade or business. For an S corporation, ownership is determined based on the issued and outstanding shares. For a partnership (including an LLC taxed as a partnership), ownership is determined for the capital or profits of the partnership. The test applies to the ownership for the majority of the tax year at issue.
When determining control, an individual is considered to own the interest owned, directly or indirectly, by the individual’s spouse (unless legally separated under a decree of divorce or separate maintenance) and the individual’s children, grandchildren, and parents.
Note that common control applies based on the facts even when a taxpayer owns a minority interest in a trade or business. For example, that individual might own a minority interest in a trade or business and also in a rental property leased to the trade or business. If the trade or business and the rental property are 50% or more owned by the same individuals, minority owners still treat them as under common control and can treat the rental income as trade or business income under the safe harbor.
Specified service trades or businesses (SSTB)
Specified service trades or businesses are involved in performing services in one or more of the following fields: health (care), law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, (securities) brokerage services, (securities and commodities) trading, dealing in securities, or 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 or owners.
The proposed regulations elaborate on the fields and state that it is the nature of the work done and not licensure that determines whether a trade or business is a SSTB. For example, an unlicensed bookkeeping service is considered an accounting business so it is a SSTB.
Businesses involved in the research, testing and manufacture of pharmaceuticals or medical devices are not considered “health” businesses, and neither are health clubs/gymnasiums.
Banks are not considered financial services businesses.
Consulting means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems. Consulting provided incidental to selling products or software at no additional fee for the service is not “counted” as consulting services.
The biggest concern of the tax planning and preparation of the community is the last field. Almost any businesses could be considered have as its principal asset the reputation or skill of its employees or owners. The IRS laid this concern to rest by only including the following types of trades and businesses:
- A trade or business in which a person receives fees, compensation, or other income for endorsing products or services,
- A trade or business in which a person licenses or receives fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, or
- Receiving fees, compensation, or other income for appearing at an event or on radio, television or another media format.
The term fees, compensation or other income includes the receipt of a partnership interest or S corporation stock with their corresponding distributive shares of income, deduction, gain or loss.
For a trade or business with gross receipts of $25 million or less for a taxable year, a trade or business is not a SSTB if less than 10% of the gross receipts of the trade or business are attributable to the performance of services in a specified field.
For a trade or business with gross receipts of more than $25 million, the threshold is 5% of gross receipts.
Any trade or business that provides 80% or more of its property or services to a SSTB and there is 50% or more common ownership, directly or indirectly, in the trades or businesses, will be treated as a SSTB.
If a trade or business provides less than 80% of its property or services to a SSTB and there is 50% or more common ownership, directly or indirectly, in the trades or businesses, that portion of the trade or business of providing property or services to the commonly-owned SSTB is treated as part of the SSTB.
For this purpose, indirect common ownership is determined under Internal Revenue Code Sections 267(b) and 707(b).
If a trade or business that otherwise would not be treated as a SSTB has 50% or more common ownership, directly or indirectly, with a SSTB, and has shared expenses with the SSTB, then that trade or business will be treated as incidental to and part of the SSTB if the gross receipts of the trade or business represents no more than 5% of the combined gross receipts of the trade or business and the SSTB in a taxable year.
Trade or business of performing services as an employee
Income of a trade or business performing services as an employee doesn’t qualify for the 20% deduction for business income.
The determination of whether a trade or business is performing services as an employee is not solely determined based on whether the individual performing the services is treated as an employee for federal employment tax purposes.
For this purpose, an individual who was properly treated as an employee for Federal employment tax purposes by the person or business to who he or she provided services and who subsequently is treated as other than an employee by such person for providing substantially the same services to that person/business or a related person/business, is presumed to be in the trade or business of performing services as an employee with regard to those services. The presumption also applies if the individual provides services directly or indirectly through an entity or entities.
The presumption may be rebutted if the individual shows that, under Federal tax law, regulations and principles, including common-law employee classification rules, the individual is performing services in a capacity other than as an employee.
Electing to aggregate different trades and businesses and treat them as one for computing the 20% deduction is one of the most important elections for the 20% deduction for business income.
For example, business A has taxable income of zero, W-2 wages of $100,000 and no depreciable assets. Business B has taxable income of $100,000, no W-2 wages and no depreciable assets. If these businesses are reported separately, there is no 20% deduction for their operations. If they are aggregated, the 20% deduction before the overall taxable income limitation would be $20,000, which is the lesser of 20% of $100,000 (income) = $20,000 or 50% of $100,000 (W-2 wages) = $50,000.
Aggregation is not required. Different taxpayers that own the same trades and businesses can make different aggregation elections; some might choose not aggregate while others will choose to aggregate.
Taxpayers that elect to aggregate two or more trades or businesses must continue to do so in future taxable years, unless one or more of the businesses becomes ineligible, such as when there no longer is common control.
Taxpayers may elect to aggregate a new trade or business with a previously existing group.
This election is separate from the passive activity loss grouping rules. Qualification as a real estate professional and electing to combine all real estate activities has no effect for aggregation under these rules.
A trade or business that is a specified service trade or business (SSTB) can’t be aggregated with another trade or business.
In order to otherwise qualify for aggregation, the trades or businesses must be commonly controlled (see above explanation) and satisfy at least two of the following factors:
- The trades or businesses provide products and services that are the same or customarily offered together.
- The trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources.
- The trades or businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group (such as supply chain interdependencies.)
For each taxable year, individuals must attach a statement to their federal income tax returns identifying each trade or business that is aggregated. The statement must include:
- A description of each trade or business;
- The name and employer identification number for each entity in which a trade or business is operated;
- Information identifying any trade or business that was formed, ceased operations, was acquired, or was disposed of during the taxable year; and
- Such other information that the IRS requires in forms, instructions or published guidance.
If the individual fails to attach the required statement, the IRS may disaggregate the individual’s trades or businesses.
Pass-through entity reporting
Passthrough entities, including partnerships, LLCs taxed as partnerships, S corporations, estates and trusts, must report to their owners and beneficiaries the information required for the owners and beneficiaries to compute their 20% deduction for business income. The information will be included on Schedule K-1 or a statement attached to Schedule K-1 that is issued to its owners or beneficiaries.
That information will include, for any trade or business engaged in directly by the entity:
- Each owner’s allocable share of qualified business income (QBI), W-2 wages, and unadjusted basis immediately after acquisition (UBIA) of qualified property; and
- Whether any of the trades or businesses is a specified service trade or business (SSTB.)
The entity must also report on an attachment to Schedule K-1 the QBI, W-2 wages, UBIA and SSTB determinations for any other passthrough entity in which the reporting passthrough entity owns a direct or indirect interest.
This information must be reported despite aggregation by the owners of the passthrough entities, because the aggregation election is made by the individual owner.
If the required information isn’t reported by the passthrough entity, the owner’s share of the QBI, W-2 wages and UBIA of qualified property will be presumed to be zero.
Trusts and estates will allocate the reportable items to the trust or estate and the beneficiaries of the trust or estate in proportion of the allocation of the trust’s or estate’s distributable net income. If the trust or estate makes no distributions and none of its income is required to be distributed, all of the reportable items will be allocated to the trust or estate. If the trust or estate has no distributable net income, all of the reportable items will be allocated to the trust or estate.
Trade or business losses for computing the 20% of business income deduction will be separately accounted for. Losses that are tax deductible for computing taxable income might not be deductible when computing the 20% of business income deduction.
Regular tax net operating losses are not allowed when computing qualified business income for the 20% of business income deduction.
Losses or deductions that were disallowed, suspended, limited or carried over from taxable years ending before January 1, 2018 will be disallowed when computing qualified business income for the 20% of business income deduction.
Previously disallowed losses or deductions from taxable years ending after December 31, 2017 under the passive activity loss rules, at risk rules or from insufficient basis that are subsequently allowed when computing taxable income will be taken into account when computing qualified business income for the 20% of business income deduction.
Passthrough entities report the income or loss for each trade or business that they conduct to the owners of the entity. The loss limitations are applied at the level of the individual owner, estate or trust.
When any trade or business has a loss for a taxable year, that loss is allocated pro-rata according to the taxable income before the loss of any other trades or businesses of the taxpayer who is the owner or beneficiary computing taxable income. The net income amount will be considered to be zero. The W-2 wages and UBIA limitations for that trade or business are disregarded. The W-2 wages and UBIA limitations only apply for trades or businesses with positive taxable income after reduction from the losses of any trades or business that have losses.
If the total of the taxable income for the trades or businesses of the taxpayer is a loss, that loss is disallowed for the taxable year and the 20% of business income deduction is zero. The loss is carried for to the next taxable year and is considered to be the loss of a separate trade or business when making the 20% of business income deduction computation.
For example, Jane Taxpayer has three trades or businesses to report on her 2018 income tax returns, A, B and C. None of these businesses have depreciable property since Jane leases the equipment. For 2018, A has $25,000 of taxable income, B has $75,000 of taxable income, and C has a taxable loss of ($50,000.) The W-2 wages for 2018 are $25,000 for A, $20,000 for B and $10,000 for C. To compute the 20% of business income deduction, C’s taxable loss is allocated 25% to A, or ($15,500) and 75% to B, or ($37,500). After subtracting the allocated losses, the 20% deduction for A’s income is $9,500 X 20%, or $1,900, limited to 50% of A’s W-2 wages, $12,500, or $1,900. The 20% deduction for B’s income is $37,500 X 20%, or $7,500, limited to 50% of B’s W-2 wages, $ 10,000, or $7,500. The W-2 wages for C are disregarded for this computation.
If the taxable loss for C in the previous example was ($120,000), the total loss for all of the trades or businesses would be ($20,000). There would be no 20% deduction for business income for 2018 and the $20,000 loss would be carried over to 2019, and would be treated as a loss from a separate trade or business other than A, B or C.
When computing the 20% of business income deduction for REIT dividends and qualified publicly traded partnership income, any losses from publicly traded partnerships are combined with the income of other publicly traded partnerships and REIT dividends. The deduction is 20% of any positive total. If the total is a loss, the 20% deduction for REIT dividends and qualified publicly traded partnership income is zero. The loss is carried forward to combine with REIT dividends and qualified publicly traded partnership income for the next taxable year.
Since each trust has its own threshold for applying the W-2 wages and UBIA limitations and for the phaseout of the deduction relating to SSTB income, there is a potential for abuse by individuals creating multiple trusts to hold ownership interests in family trades and businesses.
There is an anti-abuse provision in Internal Revenue Code Section 643 which aggregates two or more trusts and treats them as a single trust if such trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and if a principal purpose for establishing such trusts is the avoidance of Federal income tax. When applying this rule, spouses are treated as one person.
Under the proposed regulations, it is presumed that multiple trusts with the same grantor or grantors and substantially the same primary beneficiary or beneficiaries that hold trade or business interests are established to avoid Federal income tax. Therefore, the trusts will be aggregated and treated as a single trust, unless there is a significant non-tax (or non-income tax) purpose that could not have been achieved without the creation of these separate trusts.
After reading this report, I hope you will appreciate the complexity of this new deduction. This is not a simple matter for reporting using consumer tax return preparation software. Making errors in choices for elections and failure to report correctly can result in a smaller deduction or in losing the deduction altogether. You have to get the right figures in the right boxes. There are penalties from overstating the deduction that I haven’t discussed here.
Tax practitioners should study the details for computing the deduction seriously and business owners should seek professional help when planning for and reporting the deduction.