As you may have already heard, the tax reform bill signed into law on December 22, 2017 provides for a maximum 20% deduction in qualified business income (“QBI”) received by an owner of a pass-through entity (“QBI Deduction”). The QBI Deduction is especially beneficial to taxpayers because it the taxpayer’s reduces taxable income and is available to itemizers and non-itemizers.
The QBI Deduction presents potential tax-saving opportunities to business owners who meet certain criteria. The criteria from the Internal Revenue Code (“Code”) have been broadly simplified below. Please note that the Code is more detailed and more specific limitations and thresholds may apply depending on a particular taxpayer’s circumstances. As always in tax, the devil is in the details.
QBI Deduction Requirements and Opportunities
- Requirement: The QBI Deduction is only available to business owners, not employees;
- Opportunity: If you are an employee, but you could perform your job as an independent contractor for your current employer or clients, then you may benefit from forming your own business entity and conducting business as an independent contractor. You would need to weigh the benefits you receive as an employee (employer-sponsored health insurance, pre-tax accounts for spending and retirement savings, etc.) against the savings you could realize as an independent contractor.
- Requirement: The business entity must not be taxed as a C Corporation (i.e. uses a Form 1120 for federal income tax filings);
- Opportunity: If your business is currently a C Corporation, there may benefits for converting to a pass-through entity, which is taxed as a partnership, S-Corporation, or disregarded entity (i.e. single member limited liability company).
- Requirement: QBI is only income from an active trade or business.
- QBI excludes:
- Capital gains and losses;
- Interest income that is not allocable to a trade or business;
- Gains or income from certain commodities and foreign currency transactions;
- Gains or income from certain notional principal contracts;
- Any amount received from an annuity which is not received in connection with the trade or business; and
- Any deduction or loss allocable to the items listed above.
- QBI also excludes:
- Reasonable compensation for services; and
- Any guaranteed payment to a partner for services rendered.
- Opportunity: It is currently unclear whether a rental business is considered an active trade or business and thus its rental income included in QBI. It may depend on the activities of the rental business such as whether the business conducts passive triple net leasing compared with the active rental and management of multiple properties.
- QBI excludes:
- Requirement: If the business owner has taxable income below $157,500 ($315,000 if jointly filing) before applying the QBI Deduction, then the business owner would likely not be limited by the field of business or the limitations based on the wages and, in some cases, assets of the business;
- Opportunity: Depending on your tax profile, you may already benefit from the QBI Deduction or with tax structuring you may be able to make use of it.
- Requirement: If the business owner has taxable income above $157,500 ($315,000 if jointly filing) (“Initial Threshold”), there are phase in limits for the full application of the field of business limitation and the limitations based on the wages and, in some cases, assets of the business.
- Opportunity: Although the QBI Deduction would not be as beneficial as if you were under the Initial Threshold, the QBI Deduction may present opportunities in the future if you or your spouse plans to change careers or forecasts changes in taxable income.
- Requirement: If the business owner has taxable income above $207,500 ($415,000 if jointly filing) (“Final Threshold”), then QBI Deduction is limited by the field of business and the wages and, in some cases, assets of the business.
- This is where things get complicated. We will tackle the field of business limitation first because this can be a total knockout for a particular business. We will then look at the limitation based on the wages and, in some cases, assets of the business because this limitation reduces the QBI Deduction.
- Field of Business Limitation: Once the business owner’s taxable income is above the Final Threshold, then the business owner cannot receive any QBI Deduction for income from businesses in specified fields. The specified fields that are excluded from the QBI Deduction are the performance of services in the fields of:
- Actuarial Science;
- Performing Arts;
- Financial Services;
- Brokerage Services;
- Investing and investment management, trading, or dealings in securities, partnership interests, or commodities; and
- any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees.
- Opportunity: Although the list of excluded business fields seems straight forward, there is currently very little interpretation on what each listed field means and what is encompassed by the exclusion. This is a large grey area in the QBI Deduction rules. Depending on how a business owner characterizes his business, there may be arguments that the business does not fall within the excluded business fields.
- Opportunity: If your business performs multiple different business activities within a single entity, it would be beneficial to run the non-excluded business activities through an entity separate from the excluded business activities. The non-excluded business activities would avoid being tainted by the excluded business activities and you could take the maximum allowable QBI Deduction for the income from the non-excluded business entity. For example, if an individual, Z, owns one business entity, A. A is a single-person accounting firm and an office equipment retailer. Z could ensure that he would receive his maximum allowable QBI Deduction amount from the retail business income by creating a new entity, B, owned directly by Z whose only business activity was the office equipment retailing. A would remain the accounting firm.
- Limitation based on wages and, in some cases, assets of the business: Once the business owner’s taxable income is above the Initial Threshold, then the business owner’s QBI Deduction may be limited by the wages and, in some cases, assets of the business.
- The potential limitation (“Potential Limitation”) is based on the greater of:
- 50% of the W-2 wage expense of the business; or
- The sum of 25% of the W-2 wage expense of the business plus 2.5% of the basis of the business’ depreciable property (“Business Property”).
- The calculations for the Business Property amount are specified in greater detail in the Code. It is thought that the Business Property deduction was added to the QBI Deduction rules to benefit property developers who have large amounts of the Business Property.
- If the business owner’s taxable income is above the Final Threshold, then the lesser of the Potential Limitation or QBI Deduction is used for the allowable deduction amount. If the Potential Limitation is less than the QBI Deduction, then the Potential Limitation is used. If the QBI Deduction is less than the Potential Limitation, then then the QBI Deduction is used.
- If the business owner’s taxable income is above the Initial Threshold, but below the Final Threshold, then there are complex phase in rules to calculate what percentage of the QBI Deduction can be used.
- The potential limitation (“Potential Limitation”) is based on the greater of:
- Opportunity: Business owners may be able to reasonably shift their wage expenses or structure their business entities to increase the Potential Limitation amount so as to lessen the effects of the Potential Limitation amount so as to lessen the effects of the Potential Limitation on their final QBI Deduction amount. One idea is to pay all employees from a particular entity to increase the limitation for that particular trade or business.
- For example, it may be beneficial for an owner-operated architecture firm with one employee (the owner) (“Bob”) to be taxed as an S Corporation (“S”) so that Bob can make use of the QBI Deduction. S Corporations can pay their shareholders W-2 wages, whereas owners of partnerships and sole proprietorships cannot pay their owners W-2 wages. Let’s assume that (i) S pays Bob $50 of income in wages, (ii) S has QBI of $150, and (iii) Bob’s individual taxable income is above the Final Threshold. Bob could take a deduction of $25, which is the lesser of 50% of $50 ($25) or 20% of $150 ($30). If S were a sole proprietorship, Bob’s deduction would likely be $0, which is the lesser of 50% of $0 ($0) or 20% of $150 ($30). Bob could benefit from the QBI deduction based on his share of the business income and the W-2 wage expenses of S.
- Even if the business owner jumps through all the hoops above, the QBI Deduction could be limited by his capital gains or total taxable income. The theory is that Congress only wanted to provide the QBI Deduction to income taxed as ordinary income, not any income taxed at a lower rate.
- Opportunity: After assessing the tax effects on a business owner from a pass-through entity, it may be beneficial to convert the entity from a pass-through entity to a C Corporation. Congress lowered the C Corporation tax rate from 35% to 21%. Depending on the tax profile of business owner and the business entity, it may be beneficial to remain as a C Corporation or for a pass-through entity to convert to a C Corporation. The business owner would want to examine other factors such as future income projections, desire for dividends (distributions out of the business), and succession plans, to name a few, when determining which type of business entity best meets his goals.
At the moment, the IRS has not issued any guidance regarding the QBI Deduction. Any of the requirements and opportunities could change as the IRS and Congress revise and interpret the Code. There are many areas of the QBI Deduction that are unclear and grey.
We would be happy to assist with determining whether any potential opportunities exist for you or your business. We are familiar with working with accountants and can work with your current tax team to structure your business in a tax efficient manner, including forming new business entities or drafting organizational documents for business entities changing their tax status. We will continue to track the IRS and Congress for any new tax reform updates on this issue and others.
Disclaimer: This summary provided above is for general informational purposes only, and is not the provision of accounting, business, financial, investment, legal, tax, or other professional advice or services. This summary is not intended to substitute for the individualized professional advice for your particular business or personal circumstances. Please consult your professional advisors before making any decisions that may affect your business or individual finances. Sands Anderson PC shall not be responsible for any loss incurred by any person who relies on this summary.