By: Jen Shah, CPA • Director of Tax Services
As published in American Horse Council‘s Tax Bulletin #392
A new Section 199A deduction (referred to as the QBI deduction in this article) may be available to horse and farm owners (non-c corporations) for calendar years 2018 through 2025. This new deduction is intended to compensate businesses that do not benefit from the sharply decreased corporate tax rates and provides a 20% deduction of qualified business income (“QBI”) and also includes ordinary dividends received from a real estate investment trust and income from publicly traded partnerships.
QBI is the net income, if any, after calculating all income, gains, deductions, and losses with respect to each of a taxpayer’s U.S. businesses but does not include investment income. The QBI deduction is calculated at the owner, partner, or shareholder level. Since most thoroughbred owners conduct operations as sole proprietorships or via flow-through entities, this QBI deduction may be valuable to those with profitable businesses while requiring others with business losses to reduce this deduction.
The QBI deduction cannot exceed 20% of taxable income in excess of net capital gains (calculated prior to the QBI deduction). In the interest of limiting the deduction to bona fide “small business,” the new regulations phase-in limitations that apply to income above threshold amounts.
If taxable income exceeds $157,500, two additional limitations are phased in over the next $50,000 of taxable income and are fully phased in at $207,500. The phase-in for joint return filers begins at $315,000 and applies to the next $100,000 of taxable income until fully phased-in at $415,000. These thresholds are adjusted for inflation after 2018.
The first limitation is based on the greater of either 50% wages paid, or a combination of 25% of wages plus 2.5% of the basis of qualified depreciable property. The second removes specified service trades or businesses (SSTBs) from eligibility. SSTBs include service-oriented businesses such as consulting and athletics. Examples of SSTBs in the horse industry are equine vets, consultants, jockeys, and perhaps even racehorse owners (finalized regulations are unclear whether or not horse racing specifically is an SSTB). Again, these last two limitations only apply if taxable income exceeds the above-noted thresholds.
The default is to calculate the QBI deduction and related limitations separately for each business, unless a taxpayer elects to aggregate qualifying businesses. IRS issued final regulations in early February that summarize which businesses qualify and how to aggregate. This article addresses these aggregation rules and how they may apply to horse and farm owners.
For those familiar with the grouping elections used to determine material participation under the passive activity rules, unfortunately, the aggregation rules for this QBI deduction differ substantially. In general, businesses are eligible to be aggregated for purposes of calculating the QBI deduction if the following criteria are met (Regulation 1.199A-4(b)):
- The same person or groups of persons (via the related party attribution rules under 267(b) or 707(b)) owns 50% or more of each business to be aggregated;
- The above ownership exists for the majority of the taxable year, including the last day of the year;
- All activity reported by the businesses is reported on returns within the same taxable year together;
- None of the businesses are specified service trades or businesses (SSTBs).
- And all businesses that are aggregated satisfy at least two of the following:
- The business provides products, property or services that are the same or customarily offered
- The business shares facilities or significant centralized business elements, such as personnel, ac counting, legal, other overhead (manufacturing, purchasing, HR) or information technology;
- The businesses are operated in coordination with one or more of the businesses in the aggregated group (for example, in a supply chain)
The net effect of aggregation is that the QBI deduction and the wage and depreciable property basis limitations are calculated in total for the aggregated group, as opposed to separate calculations for each business. Pass-through entities may elect to aggregate at the entity level (in which case, the owners are also bound by this aggregation), or owners may elect aggregation when filing their respective individual tax returns.
Clear as muck, right? Let’s walk through some examples to illustrate how this may apply in common horse and farm ownership scenarios. For all of the below, the individuals are US citizens operating US businesses.
Example 1
A owns 100% of an LLC that owns the farm and conducts horse breeding activities and 100% of another LLC in which A conducts the horse sales consignment business. The sales consignment LLC sells the foals produced by the horse breeding LLC and horses on behalf of other clients. The office administration and accounting for both LLCs are done by the same personnel.
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A meets the ownership test (owns 100% of each). The horse businesses have centralized administrative functions, generate products (horses) and services (boarding by the farm for the consignment) which are typically offered in conjunction with one another, and the farm provides foals for the consignment business to sell. As such, A may elect to aggregate these LLCs.
On the other hand, if A owns 100% of another LLC that is a car dealership, aggregation of the car dealership with the above two LLCs would not be allowed since the car dealership is not a related business to the horse operations (no centralized business functions and no similar products or services).
Example 2
Same as Example 1, except A, B, C and D each own 25% of both the horse LLCs.
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Since the same ownership group (A/B/C/D) together own at least 50% of each LLC (in this case, they own 100% of each of the LLCs), A/B/C/D may each choose whether or not to aggregate these LLC interests with their respective individual tax returns. A/B/C/D do not have to be related parties, as defined by Section 267(b) or 707(b), in order to meet the ownership test here.
Example 3
A owns a 10% interest in each of 4 different LLCs which are pinhooking operations. These pinhooks are managed by the same group which provides administrative functions and manages all of the LLCs. Another person, B, owns 60% of these same 4 LLCs.
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Because B meets the ownership test (60% ownership) and these businesses have centralized administrative functions and all produce horses, both A and B may each elect to aggregate these LLCs with their respective individual tax returns.
This example demonstrates that A does not have to meet the 50% ownership test in order to elect to aggregate as long as other members of these entities do meet the ownership test. This is particularly challenging when a minority owner does not know the other owners, and the regulations do not require that pass-through entities provide this information to minority owners.
The above examples walk through the tests for whether or not businesses are even eligible to aggregate, but I have not yet addressed specifically why someone may want to aggregate. Let’s review the following scenario for a person who exceeds the income threshold and is subject to the wage and depreciable property limitations for QBI deduction purposes to illustrate the potential reduction in federal taxable income by aggregating qualified businesses:
LLC #1 (Breeding operation): QBI = $250K; Wages = $125K; Qualifying Property = $300K
LLC #2 (Sales consignment): QBI = $750K; Wages = $200K; Qualifying Property = $50K
LLC #3 (Pinhook): QBI = $100K; No wages or qualifying property
All of the above are eligible to be aggregated. Below are the summary results if the QBI deduction is calculated separately or if the LLCs are aggregated:
| A | B | C | D | Lesser of A/D | |
|---|---|---|---|---|---|
| LLC: | 20% QBI | 50% Wages | 25% Wages + 2.5% Property | Wage/Property Limit (Greater of B or C) | Overall QBI Deduction Limit |
| LLC #1 | $ 50,000 | $ 62,500 | $ 38,750 | $ 62,500 | $ 50,000 |
| LLC #2 | $ 150,000 | $ 100,000 | $ 51,250 | $ 100,000 | $ 100,000 |
| LLC #3 | $ 20,000 | $ — | $ — | $ — | $ — |
| Calculated Separately | $ 150,000 | ||||
| Aggregated | $ 220,000 | $ 162,500 | $ 90,000 | $ 162,500 | $ 162,500 |
In this particular example, aggregation increases the QBI deduction by $12,500. There would be other scenarios where aggregation provides a decreased QBI deduction, so it is important to fully evaluate the decision of whether or not to aggregate prior to filing the federal tax return. This is particularly important in the first year when the opportunity to aggregate exists.
A disclosure statement is filed with the annual tax return if the taxpayer elects to aggregate businesses for the QBI deduction. This aggregation statement must include a description of each business, the name and Employer Identification Number (EIN), information regarding any formation, acquisition or disposal during the year, and an identification of any aggregated business of a pass-through entity in which an ownership interest is held. Failure to disclose the required information allows the IRS to disaggregate.
Once the decision to aggregate is made, it is effective for the current year and all subsequent years. With the exception of the 2018 calendar year, an initial aggregation election may not be made on an amended tax return. Note that if aggregation is not chosen in the initial year, however, it may be elected in subsequent years.
The aggregation rules further compound what is already a very complex QBI deduction calculation for pass-through entities and qualifying owners. In addition, these aggregation rules force minority owners who invest in similar but multiple businesses to confirm operational items and ownership information. Complicating matters, the law does not require the pass-through entity to provide this information to owners so that they may determine if aggregation is even an option.
Given that the decision to aggregate may not be made annually but is rather a multi-year decision, those who have businesses that may qualify for the QBI deduction should consider extending 2018 Federal tax returns to fully address the issue and other QBI calculation considerations.
Please note: Minor edits have been made to this article since being published in the American Horse Council’s Tax Bulletin.