In Part 1 of this Tax Cuts and Jobs Act QBI deduction series, we discussed the computation of the deduction and the limitations on the deduction based on wages, property, and taxable income. In Part 2, we will discuss the businesses that qualify for the deduction and the types of income that qualify. (Please note that the discussion below is based on the statute and committee explanations and is subject to change with additional guidance.)
The legislation describes which trades or businesses are eligible for the deduction by defining those that are not eligible for the deduction. These ineligible businesses are defined as “specified service” trades or businesses. The statute provides that the specified service trades or businesses below do not qualify for the deduction:
- Services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage
- Any trade or business where the principal asset is the reputation and skill of one or more employees or owners
- Services involving investing, investment management, trading, or dealing in securities, partnership interests, or commodities
Additionally, performing services as an employee does not qualify. Even though these businesses do not qualify for the deduction, there is an exception to this disallowance, if the taxable income of the taxpayer is below a certain amount, which will be discussed in Part 3 of this series.
The listing of the various disqualified businesses above raises several questions since the businesses are very broad. For example, performing arts and athletics are not eligible, but is operating a theatre or athletic facility, or leasing the facility to the operator, also ineligible? Do consulting services include management services? Additionally, the application to businesses where the principal asset of the business is the reputation or skill of the employees or owners is uncertain. Does this apply only to pure service businesses, or does it apply to such businesses as restaurants, home improvement, and so forth?
Additionally, no guidance has been issued with respect to multiple businesses owned by the same taxpayer. For example, a taxpayer may own three businesses—a manufacturing business, a sales business, and a management company that manages both businesses. The deduction may be significantly different depending on whether these businesses are grouped as one or treated as separate for the calculation of the deduction. However, at this time there is no guidance on how to treat these related businesses.
The deduction applies to qualified business income from a business that is conducted in the United States. Accordingly, businesses operated outside the United States do not qualify. Guidance is needed for businesses with operations within and outside the United States.
Qualified business income is the sum of all income, gain, deduction, and loss from the business that is reportable or allowable in determining taxable income. This does not include nonbusiness and investment income in the form of short-term and long-term capital gains, dividends, interest, commodity, and foreign currency gains and losses, and other investment income, and the deductions related to nonbusiness and investment income. Additionally, it does not include wages paid to an S corporation shareholder or certain guaranteed and other payments to partners for services.
One item of business income where the application is unclear is capital gains and losses from a business. For example, the gain on the sale of a building used in a business or rented to a tenant may already be taxed at 20%. The additional deduction could lower the effective rate of tax on this gain to 16%.
As noted in Part 1 of this series, income from partnerships and S corporations qualify for the deduction at the partner or shareholder level. This pass-through entity will be required to provide the required information related to business income, wages, and property to its partners or shareholders to permit them to calculate their deduction for each separate business. The pass-through entities may need to provide this information for multiple businesses if the entity has more than one business. Guidance is needed to determine the number of qualified businesses in these circumstances and the allocation of income, gains, deductions, and losses to each separate business.
Additionally, trusts and estates may both claim the deduction at the trust or estate level and distribute business income, wages, and property amounts to beneficiaries based on distributable net income so that they can claim a deduction. The rules related to trusts, estates and beneficiaries are complex and beyond the scope of this article.