April 12, 2018
The long expected corporate tax rate reduction was enacted into law as part of the 2017 Tax Cuts and Jobs Act, taking the rate paid by C corporations down to 21 percent. Yet this rate reduction only affects businesses classified as C corporations for tax purposes. Other businesses not organized as C corporations cannot use this new rate. These non C corporation businesses include:
Collectively, these non C corporation businesses are often referred to as “pass-through” businesses because the income and loss generated by the business is passed through to the economic owners who then pay the tax. Given that many businesses today operate in a form other than a C corporation, Congress was pressured to come up with a mechanism to reduce the tax burden on these pass-through businesses.
The answer is the new Section 199A 20 percent deduction for qualified business income (QBI). The idea behind the deduction is relatively simple and can be illustrated with a straight forward example. A person in the highest marginal rate (37 percent) receiving $100 of QBI deducts $20 and applies its 37 percent tax rate only to $80 of income, resulting in a 29.6 percent effective tax rate on the $100 of QBI. As with many things in the tax code, however, a seemingly simple concept becomes increasingly complex as the various definitional terms and statutory limitations are explored.
Qualified Business Income
For starters, the 20 percent QBI deduction only applies to QBI, and QBI is defined as domestic, net business income. QBI does not include wages or guaranteed payments. QBI also does not include certain investment income and income from certain service-based businesses.
The exclusion of investment income from the definition of QBI makes sense from a policy perspective because many of the listed items already garner beneficial tax treatment, and the items are not generated in a trade or business. The exclusion of service-based business income, however, has created confusion. While the enumerated businesses such as law or accounting clearly do not produce QBI under the statute (unless a taxpayer makes under a certain taxable income threshold, which we will discuss shortly), the application of the last clause focusing on any trade or business where “the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners” is uncertain. Read to the extreme, this clause could deem almost any business to be a service-based business. After all, what business does not rely upon the reputation and skill of its employees or owners? Clearly, congressional intent was not to categorize all businesses as service-based businesses that do not generate QBI, but it will be up to the U.S. Treasury Department and IRS to promulgate regulations, with examples, illustrating the meaning of this clause.
Congress explicitly called for the application of the 20 percent QBI deduction to dividends paid by REITs as well as income from publicly traded partnership interests. And interestingly, there is no prohibition in the statute singling out rental income, so it appears income from a real property trade or business (but not from a real property investment activity) may qualify as well.
It’s also important to realize that nothing in the statute limits the type of entity (so long as the entity is not a C corporation) able to generate QBI. Entities classified as trusts, partnerships, and S corporations can all generate QBI. Further, there is no requirement that an entity even be formed, because sole proprietorships can also generate QBI.
Wage/Depreciable Basis Limitation
Once income is determined to be QBI, the next consideration for taxpayers over the income threshold amounts (discussed below) is whether there are enough wages paid along with that QBI. The new statute limits the 20 percent QBI deduction to 50 percent of the wages paid as part of that business. In the above example, with $100 of QBI and a $20 deduction, there would need to be $40 of wages paid along with that QBI in order for the taxpayer to qualify for the full $20 deduction. For instance, if the business generated gross receipts of $140 and paid $40 of wages (with no other expenses), 50 percent of the wages paid equals $20 and therefore the $20 deduction (again, computed as 20 percent of the $100 QBI) is not limited. But if the business only paid $20 of wages with $120 of gross income and generated the same $100 of QBI, the taxpayer could only claim a $10 deduction.
Congress also included an alternative test limiting the 20 percent QBI deduction to the sum of 25 percent of wages paid and 2.5 percent of the taxpayer’s unadjusted basis in “qualified property” of the business. Qualified property generally means depreciable property held by the business whose depreciable life has not expired by the end of the taxable year. This alternative test will be useful to any business investing significant capital into depreciable property. One example is real property businesses, like real estate funds, that make large real estate investments.
Unmarried taxpayers and married separate filers with taxable income up to $157,500 (phasing out over the next $50,000), as well as joint filers with taxable income up to $315,000 (phasing out over the next $100,000), can disregard the rules relating to service-based businesses and to the wages-paid limitation. The new law allows taxpayers with taxable income under the threshold amounts to make full use of the 20 percent QBI deduction even if the income came from a service-based business or if there are not enough wages paid as part of the business. So a doctor or lawyer filing jointly with taxable income of $300,000 can claim the 20 percent QBI deduction on their business income from their medical practice or law practice (but not on any wages or guaranteed payments they receive).
Partners and S corporation shareholders receiving QBI on a Schedule K-1 will take into account the various limitations and then report the 20 percent QBI deduction on their individual tax returns. This means partnerships and S corporations will need to indicate on their Schedules K-1 what income qualifies as QBI and also indicate the amount of the partner’s or S corporation shareholder’s allocable shares of wages paid and unadjusted basis in qualified property.
The 20 percent QBI deduction is subject to an overall limitation equal to 20 percent of a taxpayer’s total taxable income. Also, the 20 percent QBI deduction is intended to be a “below the line deduction,” meaning it is taken into account after a taxpayer’s adjusted gross income is determined. However, the deduction is available regardless of whether a taxpayer itemizes deductions or takes the standard deduction.
New law raises questions
There are many open and unanswered questions regarding the application of the 20 percent QBI deduction. Many of these questions will hopefully be answered with upcoming guidance from the Treasury Department and IRS, but, in the meantime, below are a few to consider.
Ask Your Tax Advisor
The new 20 percent QBI deduction, while not a model of tax simplification, is a powerful tool that will reduce the taxes associated with income from many pass-through businesses. Further, this tool may encourage pass-through businesses to stay in their current form, rather than converting to a C corporation. But the new law also has created questions as to its application, and we may not have answers until the Treasury Department and the IRS provide further guidance. Any business operating in pass-through form should consult with tax advisers to model out the various tax implications and consider possible restructuring steps.
If you have questions concerning the new 20 percent QBI deduction or other aspects of the Tax Cuts and Jobs Act, contact your Eide Bailly professional.