Since Congress passed the Tax Cuts and Jobs Act at the end of 2017, dealership owners have been patiently awaiting further guidance from the Treasury and the IRS regarding implementing the new section 199A 20 percent deduction on qualified business income for owners of pass-through businesses (generally entities including partnerships, LLCs taxed as partnerships, S corporations, and sole proprietors). Initial guidance was provided when proposed regulations were released on August 8. Even though the regulations are “proposed,” taxpayers can rely on them pending the issuance of final regulations.
The proposed regulations rely upon the traditional definition of a trade or business, which is provided for in Code section 162. This reliance raises some uncertainty in the context of rental income. For instance, a common operating structure in the dealership industry is to rent certain business real estate from a related entity. The question is whether that rental income qualifies as QBI for the 20 percent deduction.
The proposed regulations provide a helpful rule for these situations. If the operating business and real estate entity are under common control and the real estate is used in the operating trade or business, the real estate entity is treated as part of the operating business. This means the rental income qualifies as QBI and the taxpayers owning the real estate may qualify for the 20 percent QBI deduction. It is also important to note that this real estate entity may not have identical ownership to the dealership but is likely owned by a combination of family members who may or may not have ownership in the operating entity. The regulations state that common control is achieved with direct or indirect common ownership of more than 50 percent of each entity, which means that an individual is considered to own the interest of their spouse, parents, children, and grandchildren. As a result, if a large ownership portion of a dealership operating entity has been transitioned down to the second generation of the family, but the real estate entity is still owned by the parents (first generation), the rental income to the parents may still be considered QBI.
Once income is determined to be QBI, several limits can result in a reduced or disallowed deduction. For example, the QBI deduction cannot exceed 50 percent of total wages paid as part of a business. For those businesses without substantial wages, an alternative test provides that the QBI deduction cannot exceed 25 percent of wages plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of certain qualified property.
A potential issue raised by these limitations is the use of related entities to conduct payroll and other back-office functions. For instance, a group of dealerships under common control may use a single payroll entity to pay wages for all employees. Each of those dealerships technically has no direct employees, and there was some concern that income from those dealerships would be limited by the W-2 wage limitation. Fortunately, the proposed regulations allow businesses to make use of certain W-2 wages paid by another entity as long as the business is considered the “common law employer,” even if that business did not technically issue the W-2. In the example above, this means that each of the dealerships (assuming they are the common law employer) would be allocated a portion of the wage expense paid by the payroll entity for purposes of the W-2 wage limitation. Additionally, the proposed regulations allow wages paid by certain third-party payors (such as professional employer organizations) to count towards the W-2 wage limitation as long as the wages are paid to “common law” employees of the business generating QBI.
The proposed regulations also provide a new aggregation rule to allow taxpayers to group various related businesses together for purposes of the section 199A deduction. Under this new rule, aggregation of multiple businesses is allowed, but not required, if the following requirements are met:
Taxpayers may find it beneficial to aggregate businesses for several reasons, including administrative efficiencies and allowing related businesses to share W-2 wages and UBIA for purposes of the various limitation tests. Aggregating also allows businesses the ability to net together income and loss for purposes of the overall section 199A deduction.
For example, an individual taxpayer has taxable income in excess of the applicable taxable income thresholds and owns three dealerships (dealerships X, Y and Z). If each dealership generates $200,000 of QBI, but only dealership Y pays wages and has UBIA, non-aggregation results in the taxpayer not being able to claim the section 199A deduction for the QBI from dealership X and Z (because of the W-2 wage and UBIA limitation). However, if the dealerships are appropriately aggregated, the taxpayer can use the wages and UBIA from dealership Y when applying the various limiting tests for the income from dealership X and Z, because the total income from all the dealerships is treated as if it was generated from a single trade or business. Furthermore, if the above example had a related real estate entity into or leased certain operating facilities to dealerships X, Y and Z, the income from that rental entity could also be considered QBI and receive the 20 percent deduction by virtue of the self-rental rule discussed above. This assumes that the total wages in the aggregated group are high enough to avoid the W-2 wage limitation on the QBI deduction.
Aggregation is generally made at the individual level. Therefore, partnerships, LLCs taxed as partnerships, and S corporations need to provide the necessary information on the respective Schedules K-1 to allow partners and shareholders to aggregate. It is important to note that the choice to aggregate is generally binding for all future tax years unless there is a change in facts and circumstances.
In summary, the proposed regulations provide helpful guidance to the dealership industry on a variety of open questions raised with the passage of section 199A. The proposed rules in many instances can be considered taxpayer-friendly. Given all the additional definitions and rules, dealerships and other businesses or taxpayers who are potentially eligible for the section 199A deduction should consult with their tax advisor to consider eligibility, the various limitations and whether any steps can be taken to maximize the deduction. Please contact your Eide Bailly professional today.