No provision of the Tax Cuts and Jobs Act (TCJA) has received as much attention as the Sec. 199A Qualified Business Income (QBI) deduction. This provision potentially allows a taxpayer to pay tax on only eighty percent of their income from a wholly-owned, partnership or S-corporate business. As with most areas of the tax law, there are numerous requirements and limitations that can reduce or eliminate this deduction. Until recently, there were a number of items that were unclear from the language of the law itself. Yesterday afternoon the IRS provided guidance on how they will treat many aspects of this new law.
The TCJA created a new section, 199A, which allows a deduction of twenty percent of QBI. A taxpayer whose business produces one million dollars of net income only pays tax on eight hundred thousand. This effectively lowers the highest tax bracket from 37% to 29.6%.
However, for taxpayers filing joint with taxable income (before the deduction) above $315,000, or $157,500 if single, a couple of important limitations come into play:
- The total 20% deduction cannot exceed the higher of the following two limitations:
- 50% of W-2 wages paid by the business producing the QBI
- 25% of W-2 wages PLUS 2.5% of the cost of the depreciable assets of the business
- Specified service trades or businesses (SSTBs) do not qualify for this deduction – The law explicitly disqualifies businesses in the fields of:
- Actuarial science
- Financial services
- Brokerage services
- Trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owners
(The law left a large gray area for many other businesses that may or may not fit into these categories.)
These two limitations only apply once the taxable income of the taxpayer exceeds the threshold. However, all taxpayers cannot claim a QBI deduction in excess of twenty percent of their taxable income – before the QBI deduction but net of capital gains and after reductions for charity and other itemized deductions.
This sounds great but left us with many questions: How do we define Qualified Business Income? What’s included in W-2 wages and cost of depreciable assets? Is my business a specified service business?
Tax practitioners have been debating these issues since December. Now, the IRS has weighed in, publishing proposed regulations on how these items will be treated. Below are many of the questions that have been open, and how the IRS addressed them:
Qualified Business Income (QBI):
Q: What type of income is included in QBI?
A: The regulations clarify that QBI is income which arises from a trade or business that the taxpayer is involved in “with continuity and regularity”. The following types of income were specifically excluded:
- Capital gains including Sec 1231 gains
- Interest Income – unless properly allocable to a business
- Guaranteed payments (to a partner in a partnership)
- Employee wages –The regulations also close a loophole that prevents an employee from getting paid as an independent contractor for purposes of the QBI deduction
Q: Which payroll expenditures are included in “W-2 wages”?
A: The IRS regulations include not just wages but elective deferrals (such as 401(k) contributions) in W-2 wages. Also, if a business leases employees from a staffing agency, the regulations allow him/her to include their pay in calculating the W-2 wages paid from the business.
Q: If I own an S-corporation and pay myself a salary, is that included in W-2 wages?
A: While the regulations did not directly address this question, they did say that wages paid to “S-corp Officers” (which are often the shareholders,) are included. Also, the regulations said that such wages do decrease the net QBI from this business. It seems that the IRS will treat such wages as W-2 wages for purposes of this limitation.
Cost of Depreciable Assets:
Q: What is included in cost of assets?
A: Only depreciable assets are included, not land. They can be included for ten years from the date placed in service or the tax depreciable life of the asset – whichever is longer.
Q: What if I use bonus depreciation or Sec. 179 to completely write off the asset?
A: The regulations clarify that the assets are included in the cost of depreciable assets even if written off through bonus depreciation or Sec. 179.
Q: How are improvements to an existing property treated?
A: They don’t affect the existing asset that was improved. Rather, they are treated as a new asset whose life, for purposes of this limitation, begins when the new asset is placed in service.
Specified Service Trade or Businesses (SSTB):
Q: How do we define what is or is not included in the various categories of SSTBs?
A: The regulations defined most of the categories by specifying what is and what is not included (and thus eligible for the deduction):
- Includes: Services of doctor nurses and physical therapists
- Excludes: Medical payment processing, sales of pharmaceuticals or medical devices
- Includes: Professional advice and counsel to clients to assist the client in achieving goals and solving problems.
- Excludes: Sales services, training and educational courses
Consulting is still the biggest gray area as “advice” and “solving problems” can be understood quite broadly.
- Brokerage Services:
- Includes: Stock brokers
- Excludes: real estate agents and brokers, or insurance agents and brokers
- Reputation and skill of owner or key employee: The regulations basically define this as someone paid for use of their image, name, product endorsement and similar service.
Q: What if my business has multiple revenue streams and some are from one of these listed SSTBs?
A: The regulations provide a de-minimus exemption depending on the size of the business:
- For businesses with gross receipts less than $25 million the de-minimus exemption is: if up to ten percent of your income is from SSTB.
- For businesses with gross receipts greater than $25 million the de-minimus exemption is: if up to five percent of your income is from SSTB.
The regulations don’t specifically address how a business is treated if it is above the threshold. Would they treat all income as SSTB and disqualify it from the QBI deduction? That doesn’t seem likely. Rather they’d probably require the business to carve out their SSTB income.
Q: Can I split my SSTB into multiple entities so that some of my income qualifies for the QBI deduction?
A: There may be some opportunity for this, however, the IRS just made it harder. The regulations specify that if a non-SSTB entity has 50% or more common ownership with a SSTB, its revenue is subject to a test: if it derives 80% of its income from the affiliated SSTB, then the entity itself will be considered a SSTB. This may be common in the healthcare industry where the property-owning entity is separate from the operating entity but derives all its income from the operator.
Even if less than 80% of income is from the affiliated SSTB, the portion of income that is derived from the affiliated SSTB must be carved out and is not treated as QBI.
As is typical with all areas of tax law, further “clarification” can itself be hard to understand. It leads to new questions and also new opportunities. Rest assured that Bernath and Rosenberg is always available to assist and guide our clients through these complex but potentially beneficial new developments!
Joseph Fixler, CPA, is a Tax Manager at Bernath & Rosenberg. Since the introduction of the Tax Cuts and Jobs Act (TCJA), Joseph has become an expert in many aspects of the new tax law and provides education to clients and internal staff on relevant topics.