qbid

Article Dean Dorton

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)):

  1. 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;
  2. The above ownership exists for the majority of the taxable year, including the last day of the year;
  3. All activity reported by the businesses is reported on returns within the same taxable year together;
  4. None of the businesses are specified service trades or businesses (SSTBs).
  5. And all businesses that are aggregated satisfy at least two of the following:
    1. The business provides products, property or services that are the same or customarily offered
    2. The business shares facilities or significant centralized business elements, such as personnel, ac counting, legal, other overhead (manufacturing, purchasing, HR) or information technology;
    3. 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.

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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