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Article Dean Dorton

In the first two parts of this Tax Cuts and Jobs Act QBI deduction series, we discussed the computation of the deduction and the businesses and income that qualified for the deduction. In Part 3, we will discuss special rules applicable to specified service businesses and other provisions. (Please note that the discussion below is based on the statute and committee explanations and is subject to change with additional guidance.)

As noted in Part 2, the qualified business income deduction generally does not apply to the specified service businesses listed in the article. However, there is an exception for otherwise nonqualifying businesses if the owner’s taxable income is below a certain amount. The owner of a specified service business can claim the full deduction otherwise available for a qualified trade or business if the owner’s taxable income does not exceed $315,000 on a joint return and $157,500 on all other returns. If the owner’s taxable income is between $315,000 and $415,000 on a joint return, or between $157,500 and $207,500 on all other returns, then the owner can claim a reduced deduction. The deduction is equal to the deduction otherwise available for a qualified trade or business multiplied by the applicable percentage. If the owner’s taxable income exceeds the upper amount, no deduction is allowed.

As an example, assume that joint filers operate a specified service business and have taxable income of $375,000 for 2018, which is $60,000 over the threshold. Also assume that the deduction allowable for a qualified trade or business with the same business income, wages, and property is $50,000. Since this is a specified service business the otherwise allowable deduction is 40% (the applicable percentage) of this amount or $20,000 (100% – $60,000 / $100,000 = 40%). As one may note from the computation in Part 1 and this computation, between the threshold amounts and the threshold amounts plus $100,000 or $50,000, depending on the filing status, the wage and property limitations are phased in and the specified service business deduction is phased out. The final deductible amount, after combining all separate business deductions and 20% of REIT and publicly-traded partnership income, is then subject to the taxable income limitation.

As noted in Part 2, there is some uncertainty as to how broadly the definition of specified service trade or business will be implemented. Additionally, if a sole proprietorship or other pass-through entity conducts both a qualified trade or business and a specified service business, there is currently no guidance on how to determine the business income, wages, and property allocable to each. If a taxpayer has both types of businesses in separate entities but there are transactions among the entities, such as rent, interest, or management fees, will this require adjustments in determining business income subject to the deduction?

The qualified business income deduction does not reduce the amount of income subject to self-employment tax, nor would it appear to reduce the net income for purposes of calculating contributions to self-employed retirement plans, although no guidance in this area has been issued. The deduction reduces the taxpayer’s taxable income, not the taxpayer’s adjusted gross income, and the deduction is not included in itemized deductions. The deduction is not adjusted in arriving at alternative minimum taxable income.

One area of uncertainty is the interaction of this deduction with the passive activity limitations. The passive activity regulations permit a taxpayer to treat certain activities as separate activities or to group activities based on regulatory criteria. Since the qualified business income provisions do not reference the passive activity rules and do not permit the grouping of businesses, guidance will be needed to determine the relationship between these provisions, and planning for individuals with multiple activities and businesses may need to be reconsidered.

The qualified business deduction is also impacted by other provisions of the Tax Cuts and Jobs Act. The Act created a new limitation on the deductibility of business interest expense by individual taxpayers conducting business as sole proprietors, partners, or S corporation shareholders. Although the qualified business income deduction does not reduce the deduction for interest, the interest limitation will impact the amount of business income subject to the qualified business income deduction. We will discuss the interest limitation in an upcoming article.

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Article Dean Dorton

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.

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Article Dean Dorton

The Tax Cuts and Jobs Act includes a new deduction for individual business owners who conduct their activities through a sole proprietorship, partnership, or S corporation. Trusts and estates are also eligible to claim the deduction. The deduction is effective for taxable years beginning after December 31, 2017, but continues only through taxable years beginning prior to December 31, 2025. In a series of three articles, we will discuss the new deduction, its complexities, and its uncertainties. (Please note that the discussion below is based on the statute and committee explanations and is subject to change with additional guidance.)

The qualified business income (QBI) deduction is a 20% deduction from the net taxable business income of each separate qualified trade or business of the taxpayer, regardless of whether the business is conducted as a sole proprietorship or through a pass-through entity, such as a partnership or S corporation. The deduction is applicable regardless of whether the taxpayer has an active or passive role (for example, as a limited partner) in the operation of the business. Additionally, the new law provides for a 20% deduction with respect to certain qualified income from real estate investment trusts (REITs) and publicly-traded partnerships (PTPs).

The 20% deduction for each separate trade or business is subject to certain limitations related to wages paid and depreciable property owned and used by the business. There is an additional limitation for the combined business income deduction for each separate trade or business and the deductions related to REIT and PTP income based on the taxable income of the individual taxpayer. After this limitation is applied, the deduction is increased if the taxpayer has qualified cooperative dividends.

Although the next article will cover in more detail the definition of a qualified trade or business and type of business income that qualifies for the deduction, it should be noted that based on the statutory language, most retail, manufacturing, and real estate businesses, and many service businesses, should qualify. However, certain service businesses will not qualify for the deduction if the owner’s taxable income exceeds a certain amount.

As noted above, the qualified business income deduction is calculated separately for each qualified trade or business and then the combined amount is subject to the taxable income limitation. In determining the deduction for each separate business, the calculation begins with 20% of the net taxable business income of the business. This is the maximum deduction applicable to that business. There are special rules applicable to businesses with losses, which we will address later.

The next step is to determine the limitation based on the wages paid by the business and the depreciable property owned and used by the business. This limitation is only applicable if the owner’s taxable income for the year exceeds a certain “threshold amount” for the taxable year. The threshold amount for 2018 is $315,000 for taxpayers filing joint returns and $157,500 for all other taxpayers. These amounts will be adjusted for inflation. The limitation is “phased-in” after taxable income exceeds these amounts and is fully applicable when taxable income exceeds $415,000 and $207,500, respectively.

Generally, the deduction for each separate business is limited to the greater of two amounts.

The first amount is 50% of the “W-2 wages” of the business. W-2 wages include wages paid by the business that are subject to withholding plus certain deferred wages, such as Section 401(k) contributions. So, for example, if a business had $200,000 of wages paid including deferrals, this limitation amount would be $100,000.

The second limitation amount is the sum of 25% of W-2 wages plus 2.5% of qualifying depreciable property owned and used by the business. The property generally must be real property or personal property that was acquired within the last 10 years. The 2.5% is applied to the original cost or basis of the property, rather than the remaining undepreciated cost. Assuming the business in the above example had $1 million of qualifying property at the end of the tax year, this second limitation would be the sum of 25% of $200,000 for the wage component plus 2.5% of $1 million for the property component, or $50,000 + $25,000 = $75,000.

Accordingly, the higher of the two limitation amounts is $100,000, so the qualified business income deduction for this separate business would be limited to $100,000, regardless of the whether the 20% of business income was a higher amount. However, if the 20% amount is less than the limitation, say $50,000 in this example, then the deduction is limited to the 20%, or $50,000 in this example.

As noted above, the sum of the deductions for each separate trade or business, plus 20% of qualified REIT and PTP income, is limited by the taxable income of the owner (or owner and spouse if filing jointly). The combined deduction is limited to 20% of the taxable income in excess of capital gains and certain cooperative dividends. Although guidance has not been published, capital gains as defined in the legislation include capital gains from the sale of assets used in a business. The lower of these two amounts, plus 20% of certain cooperative income, is the final deductible amount on the tax return. The deduction cannot exceed taxable income for the year.

As noted above, there are special rules regarding losses at businesses that qualify for the new deduction. Generally, if a taxpayer has multiple businesses, a loss at one business will reduce the combined deduction for all other separate businesses with positive income for the tax year. Additionally, an overall loss for all businesses for the tax year will be carried over to the next tax year and reduce the deduction in the succeeding tax year.

In the next article, we will discuss the types of trades or businesses and the income that qualifies for the new deduction.

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