Congress permanently reduced the C corporation tax rate to 21% with the Tax Cuts and Jobs Act of 2017. This rate reduction does not apply to businesses not operating as C corporations, including:
- Business entities, such as partnerships, limited liability companies classified as partnerships, or S corporations for tax purposes.
- Sole proprietorships, farms, and certain businesses generating income from a real property business.
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.
To provide a benefit for these pass-through businesses, Congress created the Section 199A 20% deduction for qualified business income (QBI). The idea behind the deduction is relatively simple. A person in the highest marginal rate (37%) receiving $100 of QBI deducts $20 and applies its 37% tax rate only to $80 of income, resulting in a 29.6% effective tax rate on the $100 of QBI.
What is Qualified Business Income?
Rather than directly defining QBI, Section 199A instead defines it by exclusion. For example, Section 199A provides that QBI is not wage income or guaranteed payments.
Generally, QBI is income from an active trade or business, and does not include the following:
- Investment income like capital gains and losses, dividends (other than qualified REIT dividends), interest, other than trade or business interest (financial institution interest income does qualify, for example), commodity gains, other than trade or business income, non-hedging currency and derivative gains, and annuity income.
- Excluded service-based income (called income from a Specified Service Trade or Business, or SSTB) including income from any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, including investing and investment management, trading, or dealing 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 one or more of its employees or owners.
Common ownership between a SSTB and related business can cause the income from the related business to be treated as income from a SSTB (and thus not QBI).
There is uncertainty over whether income from a rental activity rises to the level of a trade or business generating QBI. Factors that could be relevant in the determination include:
- Whether books and records are maintained
- Time spent in the business
The government issued a Revenue Procedure (Rev. Proc. 2019-38) providing a safe harbor for classifying rental income as QBI, although the government also recognizes that a “rental real estate enterprise” failing to meet the safe harbor requirements may still be “treated as a trade or business for purposes of section 199A if the enterprise otherwise meets the definition of trade or business” under section 199A.
- One note of caution: the government warns that merely renting property on a triple net lease may not generate QBI.
Also, a “self-rental” rule applies for QBI purposes, meaning so long as an 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, resulting in the rental income qualifying as QBI.
Limiting Factors when Determining Qualified Business Income
Once income is determined to be QBI, the next consideration for taxpayers over the income threshold amounts is whether there are enough wages paid with that QBI. The QBI deduction is limited to 50% 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 with that QBI for the taxpayer to qualify for the full $20 deduction.
Congress also included an alternative test limiting the 20% QBI deduction to the sum of 25% of wages paid and 2.5% 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, making large real estate investments.
Threshold Amounts for Taxpayers with QBI
Taxpayers with taxable income under certain threshold amounts (indexed for inflation) are generally not affected by the wage limitation or UBIA limitation tests. These taxpayers can also claim the QBI deduction on SSTB income.
- For 2023, the taxable income thresholds are $364,200 for married filing joint and $182,100 for single filers (with a phase in ceiling for married filing joint at $464,200 and single filers at $232,100).
Business Aggregation for Section 199A
Even though the Section 199A deduction is generally specific to each trade or business, the regulations permit businesses to be aggregated together via an election for purposes of the Section 199A deduction, at either an individual or entity level. Aggregation can potentially allow taxpayers to maximize their Section 199A deduction.
For instance, aggregation could allow wages from one business to be used as part of the limitations test for another business, provided those two businesses are properly aggregated. Among the requirements for aggregation are common control between the aggregated businesses (generally 50% or more common ownership) and certain relatedness between the aggregated businesses, like providing similar products and services.
What the Future Looks Like for Section 199A and Qualified Business Income
The Section 199A deduction is presently scheduled to sunset after the 2025 tax year and the prospects for its extension are currently unclear. Still, this deduction, when maximized, can reduce a taxpayer’s rate by over 8%, so all effected taxpayers and organizations should work with a trusted advisor to ensure they are maximizing the Section 199A deduction for QBI.
Understanding the impact of these types of deductions is critical to your success.