20% QUALIFIED BUSINESS INCOME DEDUCTION UPDATE
New, anticipated guidance has been provided with the proposed regulations under IRC § 199A, taking effect in 2018. The proposed regulations address application of IRC § 199A in terms of definitions, rules for aggregation of trades or businesses, rules for classifying specified service trades or businesses (SSTB), and specific parameters for limitations.
To recap some of the basics, IRC § 199A allows for eligible taxpayers to receive a deduction of up to 20% of the combined business income of individuals with qualified business income (QBI) from a partnership, LLC, S corporation, or sole proprietorship and up to 20% of qualified REIT dividends and publicly traded partnership income. There is a separate deduction provided under IRC § 199A for specified agricultural or horticultural cooperatives. The sum of these amounts is the combined business income amount. The deduction is generally the lesser of the combined business income amount or 20% of the taxable income less the taxpayer’s net capital gain.
The 20% QBI deduction is determined separately for each qualified trade or business. QBI is the net amount of income, gain, deduction, and loss from your trade or business. Above certain thresholds, the deduction for each qualified trade or business is limited to the greater of 50% of the taxpayer’s allocable share of W-2 wages paid by the business or 25% of the taxpayer’s allocable share of the W-2 wages paid plus 2.5% of the taxpayer’s share of the unadjusted basis of the “qualified” property” held by the business.
For businesses under common control, the proposed regulations added a provision allowing them to aggregate W-2 wages if using a common payroll or wages are paid through a third-party such as a professional employer organization as long as the wages are paid on behalf of the businesses generating QBI.
Further, the proposed regulations introduced a new aggregation rule allowing aggregation of multiple businesses as long as a majority interest is held in each of the aggregated businesses, none of the aggregated businesses are an SSTB, and at least two of the following requirements are met: (1) the businesses provide the same products or services or provide products and services that are paired together; (2) the businesses use the same facility or have common administrative elements; (3) the businesses operate in synergistic fashion.
There are exceptions to QBI for income from an SSTB. Specified service trades or businesses are those specifically involving the performance of services in the fields of accounting, actuarial science, athletics, brokerage services, consulting, financial services, law, performing arts, or those that the principal asset is the reputation or skill of one or more of its employees or owners. An exclusion from QBI of income from an SSTB is phased in for taxpayers with income in excess of $157,500 ($315,000 for joint filers) after which point the deduction is phased out or eliminated. At taxable income levels below the $157,000/$315,000 threshold, the SSTB exception does not apply.
In defining what is and what is not an SSTB when preparing the proposed regulations, the IRS and Treasury looked to the “ordinary meaning” of service business and excluded from their definition of financial services the businesses of banking, real estate and insurance brokers, architects, and engineers.
For purposes of SSTB, the Proposed Regs define consulting to mean providing professional advice and counsel to clients to assist the client in achieving goals and solving problem, including lobbyists. The performance of services in the field of consulting does not include the performance of services other than advice and counsel. It is common for a business to provide consulting services in connection with the purchase of goods by customers. A business is not an SSTB if less than 10% of gross receipts (5% if gross receipts are over $25 million) are attributable to performance of services in a specified service activity. Also, if providing ancillary consulting services not separately billed, the business is not in the field of consulting.
Perhaps most significant, the Proposed Regs narrowly define “the principal asset is the reputation or skill of one or more of its employees or owner.” The meaning of the reputation or skill clause limits this to businesses that receive income for (1) endorsing products or services, (2) licensing or receiving income for use of an individual’s image, likeness, name, signature, voice, trademark, or other symbol associated with an individual’s identity, and (3) receiving appearance fees or income, such as from social media, radio, television, or video games.
The IRC § 199A deduction is taken from adjusted gross income, not for adjusted gross income so it is taken “below the line.” Although the IRC § 199A deduction is taken after adjusted gross income is determined, it is not an itemized deduction, meaning that it is available to both those who itemize and those who claim the standard deduction. The IRC § 199A deduction also only reduces a taxpayer’s liability for income taxes so it will not reduce a taxpayer’s self-employment income or net investment income. Most state returns, including Oklahoma, begin with Federal AGI and will therefore not have a benefit from the §199A deduction.
The IRC § 199A deduction is a great benefit for taxpayers with pass-through income. The rules may seem somewhat complicated and burdensome given that tracking income and loss allocations and carryover amounts will become more important, but IRC § 199A provides planning opportunities around the new thresholds and phase-outs. QBI strategies will be a key focus in any future tax planning for pass-through income. The proposed regulations provide beneficial guidance but are not final regulations and are subject to change.