On Aug. 8, 2018, the Internal Revenue Service (IRS) issued proposed regulations on the new tax deduction for certain qualified business profits on entities other than C-corporations. The change was contained in the federal tax overhaul passed late last year.
The new deduction takes effect this year through 2025 and allows many owners of sole proprietorships, partnerships, trusts, limited liability corporations (LLCs), and S corporations to deduct up to 20 percent of their qualified business income.
The deadline for comments on the proposed rule is Oct. 1, 2018. However, the IRS indicated that applicable businesses may rely on the proposed guidance until it publishes final rules.
Individual taxpayers may operate a business as a sole proprietorship, partnership, S corporation, or LLC. Under previous law, general partnerships, S-corps, and most LLCs have not paid taxes at the business level. Instead, they allocated business income among the owners, who paid the corresponding taxes on their individual returns. Individual owners were thus subject to their individual income tax rates, which reached 39.6 percent at the top tax bracket. The tax reform bill, however, reduced this top bracket for individuals to 37 percent beginning in 2018.
Under the new provisions, individual taxpayers doing business as sole proprietors, S-corps, or partnerships may be entitled to a deduction up to 20 percent of their domestic qualified business income (QBI). In general, QBI is the net amount of income, gain, deduction, and loss with respect to the taxpayer's qualified trade or business. The QBI does not include specified investment-related income, deductions, losses, or an S corporation shareholder's reasonable compensation or guaranteed payments.
Additionally, previous-year losses must be carried forward to offset the amount of QBI subject to the deduction.
Trusts and estates are eligible for the deduction.
Overview of IRS proposed guidance
In several areas, the statute did not define the functions of the various guardrails and limitations. The IRS attempted to address these open questions, requesting stakeholder comments. Overall, the guidance highlighted the tremendous complexity of applying all pertinent factors to calculate the right deduction, particularly if an individual owns interest in more than one business or has exceeded one or more of the various thresholds.
See below for a general overview of this complex proposed rule. Keep in mind that the guidance contains many nuances that affect individual circumstances.
Limitations and thresholds
- In general, if income is less than $157,500 for individuals or $315,000 for married couples filing jointly (these thresholds are indexed annually), the deduction is equal to the lesser of 20 percent of the QBI or 20 percent of taxable income, excluding net capital gains.
- If income is greater than $157,500 for individuals or $315,000 for married couples filing jointly, the deduction is limited to the lesser of the amount from the QBI/income test above or the greater of:
- 50 percent of W-2 wages paid to employees of the business, or
- The sum of 25 percent of the W-2 wages paid to employees (only QBI) plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of all qualified property.
- If income is between the $157,500 threshold ($315,000 for joint filers) and phase-in limits of $207,500 ($415,000 for joint filers), an additional calculation is necessary to mitigate the reduction by the W-2/UBIA qualified property.
- Specified Service Trade or Business (SSTB) — An SSTB is not eligible for the deduction after the maximum phase-in over the threshold. For individuals in 2018 it's $207,500; if married it's $415,000.
- Includes any trade or business providing services in the fields of health, law, accounting, actuarial sciences, performing arts, consulting, athletics, financial services, brokerage services, investment management, trading, dealing in securities, or the principal strength of the business hinges on the reputation or skill of one or more of its owners.
- Does not include engineering or architecture trades or businesses.
- Is delineated in the IRS guidance with a test for the degree to which a business engages in the defining activity, further limiting the deduction.
- Calls for an additional calculation for taxpayers with income between the threshold and the phase-in limit threshold: $157,500 ($315,000 for joint filers) and phase-in limits of $207,500 ($415,000 for joint filers).
- Publicly Traded Partnership (PTP) and Qualified Real Estate Investment Trust (REIT) dividends have separate rules that apply to the deduction calculation. Notably, the W-2 and qualified property limitations do not apply.
- Carryover Losses: The IRS clarifies that even though losses may be carried over into future years, this does not affect the deductibility of the loss for other sections of the code outside of 199A.
- Segregated from carryover losses are PTP and REIT dividends from QBI. If the PTP and REIT amounts are negative, they would be treated as zero for the year and thus do not reduce QBI in that year. The loss is carried forward to offset future-year PTP and REIT dividends.
- Aggregation: The IRS requests comments on the proposed aggregation method to help determine its appropriateness.
- Aggregation of separate entities is permitted, but not required, if certain conditions are met.
- Aggregation rules are complex and leave many open questions. The difficulty of aggregation increases with tiered structures having multiple owners and various businesses.
W-2 income limitation
The IRS, in conjunction with the proposed guidance, issued Notice 2018-64, which clarified the definition and permitted methods to calculate W-2 wages for calculating the W-2 limitation. It provides three methods to figure W-2 wages for the company's common-law employees and officers:
- Unmodified box 1 method — The simplest approach uses the lesser amount recorded in box 1 or box 5 of Form W-2.
- Modified box 1 method — Starts with box 1, adding back particular deferred compensation items and subtracting other items. This approach is more complicated but more accurate.
- Tracking wage method — Makes appropriate modifications to tracked wages subject to federal income tax.
The IRS also clarifies W-2 calculation methods for a short tax year.
Reporting requirement for relevant pass-through entities
Pertinent pass-through entities — sole proprietorships, partnerships, LLCs, and S corporations are pass-through entities for federal income tax purposes — must:
- Calculate the relevant QBI, W-2 income, UBIA-qualified property to each owner — both passive and active — as well as whether income is associated with an SSTB. Pass-through entities must also report qualified REIT dividend and PTP income; and
- Report on or with Schedule K-1 issued to owners.
PTPs are required to report the same, except W-2 wages and UBIA property.
The proposed IRS regulations also:
- Define items to include and exclude when determining QBI;
- Give further clarification on UBIA (unadjusted basis immediately after acquisition) qualified property to calculate the limitation;
- Make clear that the 199A deduction will not reduce net earnings for self-employment tax or net investment income tax; and
- Note that Puerto Rico W-2 wages are generally excluded from the calculation for W-2 . However, for the purpose of 199A wage calculation, the exclusion is ignored, including Puerto Rico income in the calculation
Although many questions remain about the proposed regulations on the new tax deduction for certain qualified business profits, they offer a framework for its application. Business owners will need to assess how the new rules affect their tax structure — a task complicated by numerous caveats and carve-outs in the provision. It's important to understand the benefits for particular business arrangements and how to take advantage of any opportunities.
Employers should also be aware of how state tax laws mirror or diverge from the federal code. Further benefits from the new deduction may arise at the state level. The situation is evolving as states assess the regulation's impact on their budgets, and how their populations will fare under the federal tax overhaul.