Qualified Business Income Deduction – Where Are We Now That IRS Regulations Have Been Published?

The following SC&H Group “2018 Tax Roadmap” blog post focuses on key changes the Tax Cuts and Jobs Act made for the qualified business income deduction. This material has been updated with the publication of critical IRS guidance issued August 8, 2018. See our original post here.

Background: There is a significant new tax deduction taking effect in 2018 under the new tax law. It should provide a substantial tax benefit to individuals with “qualified business income” from a partnership, S corporation, LLC, or sole proprietorship. This income is sometimes referred to as “pass-through” income.  The deduction has been called the pass through entity deduction as well as the qualified business income (“QBI”) or the Section 199A deduction. We will use the QBI deduction moniker.

The QBI deduction equals 20% of your qualified business income, subject to many restrictions and exclusions. We will endeavor to discuss these and highlight the key elements of the IRS proposed regulations. The regulations do provide much needed clarity in many areas, though it is expected that final regulations, which could come out before Tax Season 2018, will both provide more clarity in certain areas and perhaps ease the reporting burden in a few areas as well.

What did we learn from the 184 pages of IRS proposed regulations?

  • All pass through entity returns are more complex now. All partnerships and S corporations with owners other than C corporations – will be required to provide the owners of the entity all the data they need to compute the QBI deduction on their individual returns – for each trade or business reported within that entity. This, unless adjusted in the final regulations, will require substantial effort for entities that own multiple businesses. K-1’s will now be longer and the disclosures even more important.
  • Specified Service Trades or Businesses (“SSTB”) definition will come from Internal Revenue Code Section 1202 and 448. This was a wise move, as there is plenty of case law and rulings from which to obtain guidance as to which businesses will qualify for QBI or not. Those on the bubble who will get the deduction – insurance brokers, real estate management, bankers/lenders. Consultants – you will need to dig into the case law and if you give advice, you likely do not get the deduction.
  • How is a trade or business defined? We have been directed to look at Internal Revenue Code (“IRC”) 162, which is not ideal, as we were hoping we could look to the guidance issued on the net investment income tax under IRC 1411 several years back. Rental activities will be iffy and triple net lease activities may not rise to the level of a trade or business, so there would be no QBI deduction for those activities – unless the one exception is available, see the next bullet.
  • Self-rental activities. Here the IRS provided favorable guidance allowing for the rental of real or intangible property to be considered a qualifying trade or business if the property is rented to a related party and that business is not a disqualified SSTB.
  • W-2 compensation – How is this treated when a business borrows labor from a related party, utilizes a PEO, etc.? Good news again, the IRS is allowing an allocation of W-2 labor among businesses and entities. Proper and consistent methodology for the allocation is needed of course, with W-2 labor allocations following the employer for common law purposes.
  • De minimis amount of SSTB activity. The regulations provide welcome relief to businesses that have some disqualified income from a SSTB (perhaps a product company that provides some consulting) – as long as that amount is less than 10% of total revenue if the business is under $25 million in sales or under 5% if the business is larger. The converse is also true – if a SSTB has less than 10% of its revenue from qualified sources, all of the income will remain disqualified from the QBI deduction.
  • Entities providing services or property to a SSTB will be treated as a SSTB when there is 50% or more common ownership and 80% or more of the property or services of the related entity is provided to the SSTB. This eliminates one of the more widely discussed ideas to obtain QBI for law firms, health care providers, etc.
  • Aggregation is a new concept that will apply to the computation of QBI. Similar, but different in many key ways, to the grouping rules under IRC 469, aggregation will allow for commonly owned, managed and/or interrelated businesses to have their W-2 and asset basis calculations combined for purposes of QBI. This will help owners of multiple businesses where one might have high net income and low labor, while the other has low net income and high labor.  While helpful, it will also reduce the amount of gamesmanship that might have occurred without this rule. Implementing this rule will prove cumbersome in most cases. You cannot aggregate a SSTB and rental activities cannot be aggregated unless they rise to the level of an IRC 162 trade or business. The process is elective and the election is made at the owner, not the entity level. A taxpayer must attach a statement to their tax return each tax year listing each trade or business aggregated.
  • Is the QBI deduction allowed under AMT? The answer here is yes. Note however, that for almost every state (including all the Mid-Atlantic States) the QBI deduction will not exist.
  • Certain types of income, QBI or not? 1231 capital gains and losses are not QBI, while ordinary income and loss from 1231 are QBI if the other requirements are met. Income recognized under IRC 751 (“hot asset income”) are also QBI assuming all other requirements are met.

What’s next with QBI? The IRS is holding a hearing on October 16th and will be receiving public comments over the next month or so. Final regulations could come out before tax season and key open issues remain such as ordering rules for when losses from pass-through entities are limited (due to basis, passive loss rules, etc.), aggregation simplification (we hope!), a friendlier definition of trade or business for real estate activities and perhaps more clarity around the de minimis rule (if you have 11% of tainted income in your business, is all of the income tainted or perhaps just 11%?). Check back with us in a couple of months for more analysis and news on QBI.

Do you need assistance assessing the impact of the TCJA? Please contact us if you have any questions as you navigate 2018 tax planning.

2019 Tax Planning