By now, most have already heard plenty about the many opportunities and several pitfalls within the complex new tax law passed as part of the Tax Cuts and Jobs Act (TCJA). Of particular interest to many operating their business as a pass-through entity is the 199A deduction—the 20 percent deduction for qualified business income (QBI).
Although it appears simple on the surface, the underlying calculations with the deduction are quite complex. While the calculation is done at the individual taxpayer level, quite a bit of analysis and information is determined at the entity level. This means that partnerships and S Corporations are now ‘on the hook’ to disclose additional information on their tax returns and Schedule K-1s issued to their members and shareholders, along with other required work which can be quite burdensome. Let's take a closer look at the work ahead.
199A deduction overview
As a quick overview, the 199A deduction is the lesser of 20 percent of QBI or 20 percent of taxable income over net capital gains. QBI includes income from a qualified trade or business, plus qualified REIT dividends and qualified publicly traded partnership income (PTP). Limitations apply to the 199A deduction for taxpayers with taxable income over $321,400 (MFJ) or $160,700 (all other). Ultimately, the individual taxpayer does the calculation. However, the pass-through entity is now tasked with providing the information needed to determine QBI as well as items and amounts relevant, should the income limitations apply.
New requirements for pass-through entities
- Determination if the business activity rises to the level of a "trade or business" as only "trade or business" income and deductions are eligible for the 199A deduction. Depending on the type of business activity, this is not necessarily cut and dried and may be more challenging for rental activities.
- Assuming an activity rises to the level of a trade or business, the next step is to determine whether the trade or business is a "specified service trade or business" (SSTB). This is extremely important, as additional limitations apply to SSTBs. If a business has activities that are both SSTB and non-SSTB, it places an additional burden on preparers to dissect and understand all the activities of a trade or business, no matter how small. For years starting in 2019, if a trade or business activity has gross receipts of less than $26 million, but more than 10 percent of those receipts relate to SSTB activities, based on the proposed regulations, the entire business would be deemed an SSTB. If a trade or business gross receipts are more than $26 million, the amount of receipts allowed related to SSTB activities drops to 5 percent.
- Determination of QBI, "qualified" items of income, gain, loss, or deduction from the business. Not all income and deductions of a business qualify for the 199A deduction. These include specified investment-related income, guaranteed payments, and reasonable compensation for S Corporation shareholders.
- As individuals are subject to limitations if their taxable income exceeds the threshold amounts, pass-through entities will now need to disclose additional information to each owner on their Schedule K-1. The limitations are based on the greater of either 50 percent of allocable wages or 25 percent of allocable wages, plus 2.5 percent of UBIA.
A look at allocable share
Things to keep in mind regarding the allocable share of W-2 wages for each trade or business:
- Pass-through entities will need to know the definition of a "W-2 wage" for purposes of 199A and determine the "allocable share of W-2 wages" for each pass-through owner.
- Special rules apply if a group of entities pays its employees through a professional employment organization ("PEO").
- IRS Notice 2018-64 requires the use of one of three methods to determine the amount of wages.
- Accountants will need to certify with clients that wages were included in a return filed with the Social Security Administration on or before the 60th day after the due date, including extensions. Any wages not reported on timely filed returns cannot be considered.
Allocable share of the unadjusted basis of property immediately after acquisition (UBIA) of qualified property (generally, cost basis not including reductions for regular and bonus depreciation or section 179).
So, what is the definition of qualified property for purposes of 199A? Unfortunately, it is NOT the same as other property already reported and tracked on business depreciation records!
- Tangible property subject to depreciation, used in the trade or business at the close of the year for the production of QBI.
- The "depreciable period" has not ended before the close of the tax year.
- Depreciable period begins when the property is placed in service and ends on the later of 10 years after placed in service or the last day of the last full year of the recovery period.
- Some property does not qualify as UBIA and special rules apply for Section 1031, 1033, and 168(i)(7) transactions. Basis adjustments made with a Section 754 election, for example, do not qualify.
- This will require yet another set of fixed assets reports to be added to the book, federal, alternative minimum tax, and various states.
- Additional elections are available in determining UBIA that will need to be evaluated.
- If the pass-through entity fails to report these items, the owner's share of such items is presumed to be zero.
A look at aggregation
QBI is the lesser of 20 percent of QBI or the greater of the wage or wage/property limitation and is calculated for each separate business. One opportunity for individuals to maximize their 199A deduction is to aggregate their non-SSTB businesses together to take advantage of higher allocable wages and/or UBIA from one trade or business to increase the overall 199A deduction.
However, in order to do this, individual taxpayers will need to know detailed ownership of each trade or business and how they relate together. Businesses may be aggregated only if an individual can demonstrate that the same person or group of persons, directly or indirectly, owns 50 percent or more of each trade or business to be aggregated. Ownership must exist for the majority of the taxable year and all items of the trade or businesses to be aggregated must be reported on returns with the same taxable year. This will require probing into ownership structures across businesses if not already known.
The trade or businesses looking to be aggregated must also satisfy at least two of three factors:
- Provide products/services that are similar or customarily offered together.
- Share facilities or significant centralized business elements.
- Are operated in coordination with, or reliance upon, one or more of the aggregated businesses in the aggregated group.
Individuals choosing to aggregate non-SSTB business will be required to annually disclose a description of each trade or business, name and EIN of each entity in which a trade or business is operated, information identifying any trade or business that was formed, ceased operations, was acquired or was disposed of during the taxable year, and such other information as the Commissioner may require.
Aggregation of businesses is made at the individual owner level and the benefit can be very significant. However, it will require the gathering of additional information that is not currently required to be disclosed on pass-through entity returns. Pass-through entities are also required to report to each partner or shareholder their allocable share of qualified REIT dividends and qualified PTP income as this is also used in the calculation of the Section 199A deduction.
The 199A qualified business income deduction is certainly a win for individual taxpayers operating in the pass-through form. It puts these business owners on a more level playing field with their corporate counterparts. Unfortunately it is going to add administrative burden to both businesses and their accountants to best take advantage of this new opportunity. In order for taxpayers to receive the maximum benefit, they will need to work closely with their advisors. Feel free to contact our experts at The Bonadio Group to learn more.
This material has been prepared for general, informational purposes only and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Should you require any such advice, please contact us directly. The information contained herein does not create, and your review or use of the information does not constitute, an accountant-client relationship.