Proposed Regulations Clarify Tax Reform’s Business Income Deduction for Pass-Through Entities– August 22, 2018

The IRS recently released highly anticipated regulations addressing the deduction of up to 20% of qualified business income (QBI) from pass-through entities — a deduction also known as the pass-through deduction, the QBI deduction or the Section 199A deduction. The deduction was a major component of the Tax Cuts and Jobs Act, which became law late last year.
 
(Read about the provision in our previous post: “Tax Reform Watch: Pass-Through Entities and the Qualified Business Income Deduction.”)
 
The proposed regulations, while not yet final, have answered some of the key questions taxpayers have been asking, such as what specifically qualifies as a specified service trade or business (SSTB) and guidance on combination techniques to maximize the deduction. The regulations also provide a lot of definitional clarity, guidance on the computational mechanics and sent off a warning shot pertaining to people considering changing status from an employee to a contractor as well as people considering the use of multiple trusts to work around certain income limitations. 

Deduction Limitations and When Businesses Can Be “Aggregated”

When an individual owns interests in several qualifying non-SSTB businesses, the individual can potentially choose to aggregate the entities and treat them as a single business for purposes of: 

  • Calculating QBI and
  • Calculating the QBI deduction limitation based on 50% of W-2 wages paid by a business to generate QBI or the limitation based on 25% of such W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property used to generate QBI. 

Generally businesses must have common ownership, the same fiscal year and not be in a specified service trade or business as discussed below. However, there is an added test of meeting two of the three following criteria: 

  1. Products or services are customarily offered together,
  2. Facilities or business elements are shared, or
  3. The businesses have a supply-chain or similar style interdependency. 

Why Aggregating Businesses Could Pay Off

Aggregating businesses can allow an individual with higher taxable income to claim a larger QBI deduction when the limitations based on W-2 wages and the UBIA of qualified property would otherwise reduce or eliminate the allowable deduction.
 
For example, if a high-income individual owns an interest in one business with high QBI but little or no W-2 wages and an interest in another business with minimal QBI but significant W-2 wages, aggregating the two could result in a healthy QBI deduction. Keeping them separate could result in a lower deduction or maybe no deduction at all. 

Specified Service Trades or Businesses

The proposed regulations define specified SSTBs. The status as an SSTB is important, because QBI deductions based on SSTB income begin to be phased out after an individual’s taxable income (calculated before any QBI deduction) exceeds $157,500 ($315,000 for a married joint filer).
 
The proposed regulations also include anti-abuse rules intended to prevent service business owners from separating out parts of what otherwise would be an integrated SSTB — such as an optometrist practice’s sales of vision care items, or the rental of the law firm's building from an entity owned by the same partners in an attempt to qualify the separated part for the QBI deduction.
 
In general, an SSTB is a trade or business that performs services in one or more of the following fields: 

  • Health,
  • Law,
  • Accounting,
  • Actuarial science,
  • Consulting,
  • Financial, brokerage, investing or investment management,
  • Trading,
  • Performing arts, and
  • Athletics. 

In addition, an SSTB can be any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.
 
What’s a trade or business where the principal asset is the reputation or skill of an owner or employee? Good question. Before the proposed regulations were released, there was concern that this SSTB definition could snare unsuspecting businesses, such as a restaurant with a well-regarded chef.
 
Thankfully, the proposed regulations limit this definition to trades or businesses that meet one or more of the following descriptions: 

  • One in which a person receives fees, compensation or other income for endorsing products or services,
  • One that licenses or receives fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark or any other symbol associated with that individual’s identity, or
  • One that receives fees, compensation or other income for appearing at an event or on radio, television or another media format. 

View our chart detailing how the regulations categorize various service businesses for purposes of the deduction.
  
Overall, the proposed QBI deduction regulations are lengthy and complex. This article only scratches the surface of the proposed rules. Work closely with your tax advisors to sort through the details to get the best QBI deduction results in your specific circumstances.
 
Download our podcast on the proposed regulations (and subscribe to be notified of our future podcasts on tax reform) on iTunes or GooglePlay, or listen right from our website.
 
Click here for a simplified chart on how to calculate the deduction.
 
Please contact a member of your service team, or contact Mike Kolk at mkolk@cohencpa.com for further discussion.
 
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.