(Also published in MA Society of CPAs’ SumNews, March 2018 and NH Society of CPAs’ CPA Connections, June 2018)
To the surprise of many, the federal tax legislation that was the focus of last fall’s Congressional session, the Tax Cuts and Jobs Act of 2017 (the “TJCA”), was enacted December 22, and largely became effective January 1. The deduction for business income from a pass-through entity has been one of the most keenly anticipated features of the Act. This article will highlight features of the deduction with which financial advisors will want to be familiar.
A new section of the Internal Revenue Code (“Section 199A”) provides a deduction for “qualified business income” or “QBI” of a non-corporate taxpayer. The deduction is generally 20% of the taxpayer’s QBI from a partnership, S corporation or sole proprietorship. The deduction reduces the taxpayer’s taxable income (but not adjusted gross income).
Previously, income earned through a partnership, sole proprietorship or S corporation by an individual was taxed at rates of up to 39.6%. The TJCA reduced this top individual rate to 37%. If the QBI deduction applies, income from a pass-through entity will be taxed at rates of up to 29.6% (i.e., 37% x (100%-20%). Complex limitations, however, change this result in a variety of particular circumstances.
A glance at the statute reveals that the deduction formula itself is quite complex. Shorn of references to limitations and special deductions for qualified cooperative dividends, qualified REIT dividends and qualified publicly-traded partnership income, however, the deduction is revealed to be equal to the “combined qualified business income amount” of the taxpayer. The combined qualified business income amount is generally equal to the sum of 20% of the taxpayer’s QBI for each qualified trade or business carried on by him.
What is “Qualified Business Income”?
QBI is the net amount of items of income, gain, deduction and loss with respect to any qualified trade or business of the taxpayer that are effectively connected with the conduct of a U.S. trade or business (as defined in the statute describing taxation of foreign corporations) and included or allowed in determining taxable income for the tax year. Since the deduction applies to partnerships and S corporations at the partner or shareholder level, each partner or S corporation shareholder takes into account his allocable share of each item of income, gain, deduction or loss.
As a net amount, the combined qualified business amount can be negative. Any negative amount is carried over and reduces QBI in succeeding years. Note that a negative amount is not treated as a net operating loss.
Importantly, the definition of QBI does not include wages earned as an employee, reasonable compensation paid to the taxpayer by the qualified trade or business, guaranteed payments, and payments to a partner not acting his capacity as a partner for services. Thus, Section 199A creates a new incentive to characterize income as business income rather than compensation. Note that the reference to “reasonable compensation” in the statute does not limit its application to the shareholders of an S corporation, which suggests an advantage for other types of pass-through entities, but it remains to be seen whether the IRS will attempt to apply a similar concept to service-providing partners or sole proprietors who try to characterize all of their income from a qualified business as QBI. QBI also does not include investment income, such as capital gain or loss, interest income or dividend income.
Limits on the Deduction
There are two main limitations on the QBI deduction: 1) the specified services limitation and 2) the wage and property limitation (each described further below). These limitations and a host of incompletely defined terms create opportunities for planning and/or confusion.
As noted above, QBI must relate to a “qualified trade or business” which is defined as any trade or business other than a “specified service trade or business” or the trade or business of performing services as an employee. This exclusion from the definition of a qualified business was, according to the Conference Report for the TJCA, intended to prevent high-income taxpayers from attempting to convert wages or other compensation for personal services into QBI that is deductible. The term trade or business is not defined in Section 199A, nor is any definition referenced.
A “specified service trade or business” is defined by reference to the definition of a trade or business in Section 1202(e)(3)(A) without regard to the words “engineering” or “architecture”, which leaves us with “health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, 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”; and also includes a trade or business that involves the performance of services consisting of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. Income from these disfavored businesses cannot be treated as QBI if the taxpayer’s taxable income exceeds certain inflation-adjusted thresholds (in 2018, $415,000 for married, filing jointly, and $207,500 for all filing statuses). The benefit of the deduction starts to phase out earlier (at $315,000/$157,500 in 2018). Thus, if a married partner in an accounting firm has taxable income of $500,000 and his allocable share of partnership income is $300,000, he cannot take the deduction. But if his total taxable income were $300,000, he could take a deduction of $60,000.
In contrast, if he were a partner in a non-specifically listed business that could make a case that its principal asset is something other than the skill of its owners or employees, say a retailer or a real estate developer, he might be eligible for the full deduction. But one more limitation may apply to eliminate the deduction. Above the taxable income threshold described above, a wage and property limitation applies as well. Once over the threshold, a taxpayer can only deduct 20% of QBI up to the greater of (1) 50% of the taxpayer’s allocable share of “W-2 wages” that are “properly allocable to” the qualified business, or (2) the sum of 25% of the taxpayer’s allocable share of W-2 wages properly allocable to the business, plus 2.5% of the taxpayer’s allocable share of the unadjusted basis of all “qualified property” immediately after acquisition of such property held by the business.
“W-2 wages” are amounts described in Section 6051(a)(3) and (8) that are paid with respect to employment of employee. Generally, this includes all wages paid to any employee (section 3401(a) definition) and elective deferrals into 401(k) plans and Section 457 plans, including Roth contributions. It does not include guaranteed payments, so the owner of a closely-held partnership considering a profits interest plan to incentivize employees will want to consider the effect that turning employees into owners will have on his QBI deduction.
“Qualified property” is tangible property of a character subject to the allowance for depreciation under section 167. The property must be held by and be available for use in the qualified trade or business at the close of the taxable year and used in the production of QBI at any point during the taxable year. Property is “qualified property” only during the first 10 years it is placed in service, or if longer, during the applicable recovery period under section 168 (the regular, not alternative depreciation system recovery period). The unadjusted basis of qualified property taken into account is not reduced by any depreciation deductions. Note that in certain cases, even fully depreciated property (or potentially even property which the taxpayer has elected to expense) may be used to calculate the limit.
A partner’s allocable share of a partnership’s W-2 wages is determined in the same manner as his allocable share of the partnership’s wage expenses. A partner’s allocable share of a partnership’s unadjusted basis of partnership property is determined in the same manner as the partner’s allocable share of depreciation. For purposes of an S corporation, an allocable share is the shareholder’s pro rata share of an item.
Again, threshold amounts are $315,000 in 2018 for a married taxpayer filing jointly and $157,500 for all other filing statuses; both the specified service business limit and the wage and property limit are phased in over the next $100,000 or $50,000, respectively. Thus, the deduction is phased out above the threshold for income from a specified service business and completely unavailable when the taxpayer’s taxable income is $50,000 or $100,000 over the threshold. The deduction limit based on wages and property is phased in above the threshold. So, married joint filers with 2018 taxable income under the $315,000 need not concern themselves with either limit, but if they have 2018 taxable income over $415,000, they will be ineligible for QBI deductions from specified services trades or business and subject to the wage and property limit with respect to other trades or businesses.
As an example of the operation of the wage and property limit, consider a taxpayer who is a 90% owner of an engineering firm organized as a partnership. It generates net ordinary income of $4,000,000 in 2018. Let us assume that the taxpayer takes the position on his return that his is a non-specified service business and that this position prevails, consistent with apparent legislative intent. The business paid W-2 wages of $1,000,000 and the unadjusted basis of its qualified property is $100,000. The taxpayer is allocated 90% of all partnership items. The taxpayer’s tentative QBI deduction is 20% x 90% x $4,000,000, or $720,000. However, the QBI deduction is limited to the greater of (i) 50% of the his allocable share of W-2 wages, 50% x 90% * $1,000,000, or $450,000, or (ii) 25% of his allocable share of W-2 wages 25% x 90% x $1,000,00, or $225,000, plus 2.5% of his share of the unadjusted basis of qualified property, 2.5% * 90% x $100,000, or 2,250, for a total of $227,250. The taxpayer can therefore deduct $450,000.
Note that the second prong of the limitation means that, even over the threshold, the owner of a qualified business with no employees may be able take advantage of the QBI deduction.
Planning for the QBI Deduction
In the partnership context, this limitation may make incentivizing employees with ownership interests undesirable, since the resulting conversion of W-2 wages into guaranteed payments would decrease the deduction available to existing owner. On the other hand, such a strategy might be desirable for a business owned by a taxpayer to whom the wage and property limits are unlikely to apply or for whom the reduction in the QBI deduction was insignificant.
In light of the limitations described above, many commentators have suggested potential strategies for restructuring businesses to maximize the availability of the deductions. Businesses will have to consider such proposals in light of their particular circumstances. For instance, business owners should consider how steps to maximize the QBI deduction will affect their state tax liability. In a state like New Hampshire that imposes tax directly on pass-through entities, increasing QBI by reducing compensation may increase state tax liability. In particular, a New Hampshire S corporation shareholder who chooses to forego a compensatory payment from the corporation in order to increase the QBI deduction on his federal individual return may be subject to increased New Hampshire business profits tax. It is an open issue whether the owner of a New Hampshire sole proprietorship or a partnership that takes a “reasonable compensation” deduction for business profits tax purposes has reduced QBI.
Any client considering significant restructuring to take advantage of the deduction should also be aware that the deduction is effective only until December 31, 2025 (unless extended by Congress), and that Treasury has indicated that definitional, computational, and anti-abuse guidance will be forthcoming. It is possible that such guidance will close off potential loopholes or interpret the law in unexpected ways.