This article will focus on the Internal Revenue Code (“IRC”) §199A, which provides a new deduction of up to 20% of a taxpayer’s Combined Qualified Business Income Amount (“CQBIA”) starting in 2018. A full description of §199A provisions is beyond the scope of this article, which will provide a high-level overview of the deduction and some preliminary thoughts. Taxpayers stand to save up to 7.4% on their Federal taxes related to CQBIA, and this significant benefit is deservedly getting a lot of attention.
SOURCES OF QUALIFIED BUSINESS INCOME (“QBI”)
In the text of the TCJA, the §199A provisions were added under Part II – Deduction for Qualified Business Income of Pass-Thru Entities, and many in the tax community had expected that this new deduction would only apply to trade or business income allocated to an individual from a partnership or S-Corporation. However, the text of §199A itself does not limit the deduction to amounts allocated from pass-thru entities, apparently expanding the population of taxpayers who stand to benefit.
At a high level, QBI consists of the net ordinary rate income a taxpayer receives during a year from a qualified trade or business (“QTB”). The new deduction can be up to 20% of a taxpayer’s CQBIA, which consists of the following items:
1) QBI allocated to taxpayers from passthrough entities.
2) QBI reported directly on “Schedule C” of form 1040 (single-member LLCs and sole proprietorships).
3) Qualified REIT dividends.
4) Qualified PTP income.
The calculation of CQBIA will not be as simple as combining the net taxable income from the above sources; certain limitations need to be applied separately to each source of QBI, presenting its own set of challenges.
DEFINING A QTB
QTB is defined broadly as any trade or business other than (1) a specified service trade or business (“STB”), or (2) being an employee. STBs are defined largely by reference to IRC §1202 provisions (with certain modifications), as well as investing and investment management, and trading or dealing in securities, partnership interests, or commodities.
It remains unclear at this point when a given activity will rise to the level of being a QTB. Would an actively managed rental real estate property be viewed differently than a triple-net lease? Given that REIT dividends qualify for the 20% QBI deduction, and that REITs are intended to be passive in nature, there does not appear to be a reason rents within a REIT would be treated differently than those from a property in a partnership.
It is also unclear how taxpayers can “group” different items under §199A. Could trade or business activities in separate passthrough entities be “grouped” using a similar approach to the IRC §469 passive activity rules, or will there be new standards under §199A? There are many questions that will require additional guidance from the government.
LIMITATIONS ON QBI DEDUCTION
Taxpayers with taxable income below $175,000 ($315,000 for joint returns) may be able to claim the QBI deduction even if their income is from a STB. Taxpayers with income above the threshold amounts may be eligible for a partial QBI deduction, but high earners are not eligible for a QBI deduction from STBs, and are also subject to additional limitations. The QBI deduction for high-income taxpayers, still subject to the overall 20% of CQBIA limitation, also cannot exceed the greater of (A) 50% of the taxpayer’s W-2 wages from that QTB or (B) 25% of the taxpayer’s W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property. Accordingly, where a taxpayer’s taxable income exceeds certain threshold amounts, the QBI deduction must be supported by the taxpayer’s share of these certain business attributes. These limitations are clearly intended to benefit taxpayers who pay wages to employees and make capital expenditures within the U.S.
THE TAKEAWAYS
The new QBI rules may appear fairly simple in concept, but there are many important questions without answers, and the devil will be in the details. Taxpayers will need to monitor developments in this area, and may need to consider modifications to their current structures, as well as their ability to produce the necessary information for owners to calculate the QBI deduction. It will also be very interesting to see how the IRS coordinates these new provisions with recently released rules that were intended to simplify audits of passthrough entities and allow the IRS to make certain adjustments at the entity level; the actual impact to owners of a change in passthrough amounts will now be even harder to determine.
David Erard is Tax Partner with HCVT. He has over 18 years of experience providing tax consulting, compliance and structuring service to clients in the private equity and real estate industries. He advises his clients on fund formations, exit, and asset acquisition and divestiture during the investment cycle and regularly consults with clients to assist with business and tax provisions of partnership/operating agreements. Connect with him at (714) 361-7620 or via [email protected].
HCVT provides tax, audit and assurance, business management, and mergers & acquisition services. The team consists of over 550 members, including over 100 partners and principals. HCVT serves its clients from eight offices in Southern California and offices in Northern California, Ft. Worth, Texas and Park City, Utah. To learn more about HCVT, see www.hcvt.com.
