An Update on the Qualified Business Income Deduction Under IRC §199A

Kristi Jeffres, CPA (Nov, 2018)

The qualified business income (“QBI”) deduction has been one of the most talked about aspects of the Tax Cuts and Jobs Act. In our May Focus article, we took a look at how to calculate the 20% deduction, but there were many questions that we didn’t have answers to at that time. Are rental properties considered trades or businesses? Are architects and engineers considered a specified service trade or business? What happens when taxpayers have businesses that generate negative QBI? How can taxpayers qualify to aggregate multiple trades or businesses? In August, the IRS issued proposed regulations that have addressed these questions, and more.

Specified Service Trades or Businesses – what businesses fall into this category?

As discussed in our previous QBI article, specified service trades or businesses require additional phase-outs of the 20% QBI deduction based on taxable income levels. A specified service trade or business (“SSTB”) includes 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. The italicized portion of the definition is often referred to as the reputation or skill clause and has been a heavily debated topic. Many practitioners argued that most, if not all, businesses could make a case that the principal asset of their business is the reputation or skill of one or more of its employees or owners. The definition specifically excluded architects and engineers, but could they be considered an SSTB under the reputation or skill clause?

The proposed regulations issued by the IRS clarified the reputation or skill clause and noted that it was intended to target a specific set of trades or businesses and was not intended to inadvertently capture all trades or businesses. The proposed regulations state a trade or business meeting the definition of the reputation or skill clause includes any trade or business that receives fees, compensation, or other income for endorsing products or services; any trade or business in which a person licenses or receives fees, compensation or other income for the use of an individual’s likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity; and any trade or business of receiving fees, compensation, or other income for appearing at an event or on radio, television, or other media format. Accordingly, architects and engineers would not be considered specified SSTBs.

The IRS proposed regulations may also affect whether a business qualifies as an SSTB in various specific scenarios, which are detailed below. 

De Minimus Rule

If gross receipts from a taxpayer’s trade or business are $25 million or less and less than 10% of gross receipts are attributable to the performance of services, the trade or business of performing services is not considered a separate SSTB. Additionally, if gross receipts are greater than $25 million and less than 5% of gross receipts are attributable to the performance of services, the trade or business of performing services is not considered a separate SSTB.

Services provided to a commonly owned SSTB

If a non-specified service trade or business is providing 80% or more of its property or services to a commonly owned SSTB, the non-specified service trade or business will be re-characterized as an SSTB. This rule prevents taxpayers from separating activities into multiple trades or businesses to avoid being classified as an SSTB.

For example, assume a taxpayer owns a doctor’s office and a medical supply company. The medical supply company receives 90% of its business from sales to the doctor’s office with common ownership. Ordinarily, the medical supply company would not be an SSTB; however, because 80% or more of its business is generated from a specified service trade or business that has common ownership, it will be re-characterized as an SSTB.

Activity incidental to an SSTB

If a taxpayer has two trades or businesses that have 50% or more common ownership and one trade or business is an SSTB and the other is a non-specified service trade or business, and there is less than 5% of non-specified service trade or business activity, the entire business will be treated as an SSTB.

For example, suppose a taxpayer owns a hospital that operates a gift shop. In total, the revenue and expenses generated from the gift shop make up less than 5% of the total activity of the hospital and gift shop combined.  Even though the gift shop would ordinarily be a non-SSTB, it is treated as an SSTB because it is incidental to the hospital, which is an SSTB.

Rental Property – is it a qualified trade or business?

In order to take the QBI deduction, a taxpayer must own a qualified trade or business. IRC §199A does not define qualified trade or business, but the proposed regulations clarify that a qualified trade or business is any activity that is regularly and continuously carried on with an intent to make a profit.

One of the biggest questions that arose with the new §199A deduction was whether rental property would be considered a trade or business. The proposed regulations began to address this question, but left room for judgement. In general, rental property will be subject to a facts and circumstances test. The proposed regulations state that taxpayers need to consider the intent and involvement in the rental property when determining whether the activity rises to the level of a trade or business. Factors to consider include:

  • Is the taxpayer involved with the purchase of materials, payment of expenses, or collection of rent?
  • Does the taxpayer employ labor to manage the property?
  • Are maintenance and repairs provided for by the taxpayer?
  • How much effort has the taxpayer made to rent the property?

Triple net leases are common in rental agreements, but based on the facts above it may be difficult to argue qualified trade or business status for taxpayers engaged in triple net leases. If the taxpayer is not paying utilities, paying for insurance, and is not involved in maintaining the property, there may not be regular and continuous involvement with the property.  

There was one safe harbor put into place in the proposed regulations with regard to self-rental property. If a taxpayer is renting property to another entity with common ownership, the rental income received will be considered qualified trade or business income eligible for the §199A deduction. Practitioners have requested that there be additional safe harbor tests implemented into the final regulations, but for now, there is extensive case law to rely on when determining if a rental property will constitute a trade or business.

Qualified Business Income (“QBI”) – how to handle businesses with negative QBI

What happens when taxpayers have multiple trades or businesses, but one of the businesses generates negative QBI? There is a netting rule that comes into play here. If there is a net positive QBI when all trades or businesses are combined, the loss must be allocated to the profitable businesses proportionately. If the net amount of QBI is negative when all trades or businesses are combined, the net negative QBI is carried forward as a loss from a single qualified business in the following year and the analysis for netting will be applied again in year two. Let’s take a look at a few examples for clarification.

Example #1: Net positive QBI

Taxpayer owns Business A, Business B, and Business C. In year one, Business A has positive QBI of $10,000, Business B has positive QBI of $10,000, and Business C has negative QBI of $5,000. When the three trade or businesses net their QBI the result is positive $15,000. Therefore, the $5,000 negative QBI from Business C is allocated proportionately to Business A and Business B. After netting, Business A has positive QBI of $7,500 and Business B has positive QBI of $7,500. Business C has QBI of $0, as it was allocated to Business A and Business B.

Example #2: Net negative QBI

In year one, Business A has positive QBI of $10,000, Business B has positive QBI of $10,000, and Business C has negative QBI of $30,000. When the three trade or businesses net their QBI the result is negative QBI of $10,000. After netting, Business A has QBI of $0, Business B has QBI of $0, and Business C has negative QBI of $10,000. Business C’s negative QBI is carried forward as a separate trade or business in Year 2.

In year two, assume the taxpayer no longer owns business C, but instead has ownership in Business D. Business A has positive QBI of $5,000, Business B has positive QBI of $5,000, and Business D has positive QBI of $10,000. Even though the taxpayer is no longer invested in Business C, there was still a carryover of negative $10,000 from year one that needs to be netted proportionately against Business A, Business B, and Business D. After netting, Business A has positive QBI of $2,500, Business B has positive QBI of $2,500 and Business D has positive QBI of $5,000.

Note: netting only applies to the QBI portion of the calculation, taxpayers do not combine W-2 wages of the businesses or the cost of qualifying property when netting QBI.

Aggregation of Trade or Businesses – what are the rules?

Taxpayers have the option to aggregate multiple trades or businesses on their personal tax returns. Aggregation is different from netting, which is discussed above. When a taxpayer chooses to aggregate trades or businesses, the QBI amount, W-2 wages, and the cost of qualifying property from each trade or business is aggregated together as if it were from one trade or business.

In order to qualify for aggregation, entities must be commonly controlled.  Entities are commonly controlled if owned 50% or more, directly or indirectly, by the same person or groups of persons and satisfy two of the three following tests:

  1. The trades or businesses provide products and services that are the same or customarily offered together;
  2. The trades or businesses share facilities or share significant business elements such as personnel, accounting, legal, manufacturing, purchasing, human resources, or IT resources; and,
  3. The trades or businesses are operated in coordination with or reliance upon, one or more of the aggregated businesses in an aggregated group (supply chain interdependencies).

The choice to aggregate trades or businesses is made at the individual level and is an irrevocable election, with a required statement to be attached to the return annually. The decision to aggregate will vary from taxpayer to taxpayer, but if a taxpayer has multiple businesses that generate QBI and only one pays W-2 wages, aggregating may increase the deduction the taxpayer is eligible for.

It is important to note that the rules for aggregation are separate from the IRC §469 passive activity grouping rules. It is quite possible that taxpayers may group businesses for purposes of the passive activity loss rules, and will aggregate different businesses for the IRC §199A deduction. Taxpayers will need to keep track of these elections separately. 

If you have any questions, or if you would like to speak with one of our tax professionals to analyze your potential section 199A deduction, please contact us at (315) 471-9171.

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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