Is the Qualified Business Income Deduction (20% QBI) 199A deduction right for you?

The IRS now offers a 20% deduction for all “pass-through businesses” – great news! However, modifications and restrictions apply…..

For tax years that begin after Dec. 31, 2017:

  • pass-through businesses, e.g.,
    • sole proprietorships,
    • partnerships,
    • limited liability companies and
    • S corporations,

may be able to take a deduction of up to 20% of their business income from a qualified trade or business (qualified business income (QBI) deduction). (Code Sec. 199A) The deduction can't exceed 20% of the excess of the taxpayer's taxable income over his net capital gain for the tax year.

Here are some planning ideas for taxpayers who may be able to qualify for the deduction:

Specified service trades or businesses

Specified service trades or businesses (SSTBs), e.g., businesses that involve performance of services in the fields of health, law, consulting, athletics, financial services and brokerage services, don't fully qualify unless the taxpayer's taxable income is equal to or below the threshold amount—$157,500 ($315,000 for married individuals filing jointly), indexed for inflation for tax years that begin after 2018—and don't qualify at all if the taxpayer's taxable income is above $207,500 ($415,000 for married individuals filing jointly), indexed for inflation after 2018.

  • As a result, taxpayers who are in those businesses need to make estimates of their 2018 taxable income and 2019 taxable income, and consider shifts of taxable income if those estimates indicate that either year's taxable income is likely to be near the $157,500 - $207,500 ($315,000 - $415,000 for married filing jointly) range. For example, a single self-employed lawyer who anticipates that he will have taxable income of $125,000 for 2018 and $200,000 for 2019 will be able to increase his 2019 QBI deduction if he can shift taxable income from 2019 to 2018 and/or shift deductible expenses from 2018 to 2019.
  • Taxpayers in SSTBs whose taxable income is too high to qualify for the new deduction should consider incorporating and/or changing/expanding their business model so that they are not SSTBs.
  • And, in certain cases, married couples may benefit from filing separately to avoid the SSTB limit.

Beware of “Cracking”

The IRS is making a special attack on businesses that provide services or property to businesses that are otherwise SSTBs. Recently released regulations state that an SSTB includes any trade or business that provides 80% or more of its property or services to an SSTB if there is 50% or more common ownership of the trades or businesses. If a trade or business provides less than 80% of its property or services to an SSTB and there is 50% or more common ownership of the trades or businesses, that portion of the trade or business of providing property or services to the 50% or more commonly-owned SSTB would be treated as a part of the SSTB under the proposed regulations.

This regulation was proposed in response to reports that some taxpayers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the pass-through deduction. IRS calls this “cracking” and believes this strategy is inconsistent with the purpose of Code Sec. 199A. Why, IRS, why???

IRS Provided Example: Law Firm is a partnership that provides legal services to clients, owns its own office building and employs its own administrative staff. Law Firm divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and through a contract with Partnership 1 provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Law Firm).

Because there is 50% or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 would be treated as one SSTB under the proposed reliance regs.

Taxpayers who are subject to the W-2 wages limitation.

Except as provided below, the QBI deduction cannot exceed the greater of:

  • 50% of the W-2 wages with respect to the qualified trade or business (W-2 wage limit), or
  • the sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property.” Qualified property is certain tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year.

The above limit does not apply for taxpayers with taxable income below the threshold amount (—$157,500 ($315,000 for married individuals filing jointly). The application of the limit is phased in for individuals with taxable income exceeding the threshold amount, over the next $100,000 of taxable income for married individuals filing jointly ($50,000 for other individuals).

The trade or business of the performance of employment services is not a qualified trade or business for purposes of the QBI deduction. As a result, an S corporation owner who qualifies for the QBI deduction, and for whom the W-2 wages limitation does not limit his deduction, will increase his QBI deduction by minimizing the amount of wages the S corporation pays him. However, where the W-2 wages limitation does limit his deduction, he may be able to increase his QBI deduction by increasing the amount of wages the S corporation pays him.

And, as indirectly illustrated by the above illustration, partnerships and sole proprietorships can benefit by converting to S corporation status. That is, a partnership or sole proprietorship cannot pay its owner(s) a salary and thus cannot take advantage of the technique of being able to take the deduction while in excess of the applicable threshold ($157K/315K). Converting the partnership or sole proprietorship to an S corporation opens up this planning technique.

Businesses that are subject to the W-2 wage limitation can also benefit by hiring employees instead of independent contractors.

EXAMPLE A sole proprietor who is not an SSTB earns $500,000 of QBI. Her business has no W-2 employees and no qualified assets; her QBI is determined after paying $100,000 to several independent contractors. She is over the phase-out limit, so her Code Sec. 199A deduction is zero because of the 50% W-2 wage limit. If, however, she hired employees to replace the independent contractors, her deduction would be $50,000 (50% of $100,000). (Note that, as a result of making this change, she would have additional payroll costs, and it might not sit well with the independent contractors if she wanted to hire the same people as employees—any of those people who themselves took QBI deductions will lose those deductions to the extent that their income converts to employment income.)

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