With the passing of the Tax Cuts and Jobs Act at the end of 2017, one of the most impactful changes made was the creation of the IRC section 199A deduction – otherwise known as the Qualified Business Income (QBI) deduction. This was a brand new deduction that allows non-corporate taxpayers who own pass through entities to deduct a percentage of their QBI – generally 20% – from taxable income and lower their tax liability
With being one of the major changes passed with the Tax Cuts and Jobs Act, there was naturally a lot of speculation about areas of the new law that weren’t crystal clear (and no surprise – there were plenty of those!). As the business world calculated potential ways to maximize the deduction, the Treasury Department and Internal Revenue Service were putting together some much awaited guidance. The proposed regulations on the Section 199A deduction were released on August 8th. If you would enjoy some late summer reading, the entire 180+ pages of the IRS regulations can be accessed here. If reading the entire document doesn’t interest you, here are some of the key updates that you might want to know:
Specified Service Trade or Business (SSTB)
Before the proposed regulations, the term “service business” was loosely defined, listing various service industries but including a catch-all of any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. How do you know if you are in a SSTB and why be concerned? There are several limitations on the QBI deduction, but one of the most notable is the limitation on specified service trades or businesses. For most non-SSTB businesses, the QBI deduction is subject to wage and capital limitations when the taxpayer’s income is above certain levels. However, for SSTBs, the deduction is completely phased out once the taxpayer’s taxable income exceeds $415,000 for a married couple filing jointly. Under the proposed regulations, some much needed clarity on the definition of a SSTB was provided through definitions and examples:
- Better definitions of what counted as an SSTB in specific fields. For example, in the health field a SSTB would include those directly treating the patient but probably not the company testing and selling pharmaceuticals and medical devices.
- A more narrow definition of the “catch-all” for non-specified fields – essentially, only activities like celebrity endorsements or appearances are included.
- A de minimis rule for businesses that sell both products and services. The rule allows businesses that average less than $25 million in gross receipts not to be treated as a SSTB as long as less than 10% of gross receipts are attributable to services from an SSTB field. This decreases to 5% for businesses that average over $25 million in gross receipts.
Although there will certainly still be questions, the definitions and examples provided in the proposed regulations offer guidance to many taxpayers who were questioning whether their business is considered an SSTB.
Related Entities and SSTB Determination
When the statute was initially finalized, one of the discussed planning strategies to reduce SSTB income was to split out any building (or other assets such as equipment) into separate businesses and charge rent back to the SSTB. This would reduce the SSTB income and allow the now separate rental income to qualify for a QBI deduction. The clarification in the regulations regarding this was not favorable for those types of transactions and effectively eliminated this as a QBI deduction planning strategy. Any business that provides 80% or more of its property or services to an SSTB and shares 50% or more common ownership with the SSTB is considered to be an SSTB itself as it relates to the QBI deduction. Additionally, even if the business provides less than 80% of its services to an SSTB, any income earned from the SSTB is still ineligible for the deduction.
Aggregation of Commonly Controlled Businesses
For a non-SSTB, the proposed regulations provide some relief on the deduction calculation in the form of an aggregation election. This means that a business with low income and high wages can be grouped together with a business with high income and low wages (which previously may have been limited) to figure the deduction. There are various rules concerning whether two companies may be aggregated. But, the calculation is done at the owner level, meaning owners can aggregate in whichever way will be most beneficial to them. This additional guidance is helpful in maximizing the full 20% deduction at the owner level, and in many cases, may eliminate the need for merging separate entities or restructuring payroll among a group of entities.
These are just three areas that were further clarified by the new proposed regulations. If you would like to continue learning about the Section 199A Deduction, here is a link to the IRS’s Frequently Asked Questions. As this new law is further analyzed and additional clarification is provided, we will be sure to provide additional updates.
Let’s talk. If you have any questions about how this law change will affect you and your business, we’d love to chat. Email us today!