In Part 1 of this article, we discussed the definitions of which businesses qualified for the new 20 percent business deduction (Qualified Business Income or QBI) and which service businesses do not (Specified Service Trades or Businesses or SSTB). Part 2 will take a little deeper dive into what will make or break the deduction.
The computation of the new deduction is simple enough on its face. Taxpayers who have income from a qualified business are entitled to deduct the lower of 20 percent of the income allocated to them or 50 percent of their share of wages paid to all employees of the business. For businesses that are capital intensive with low payroll (think real estate) an alternative to the 50 percent test can be used, where that limit is replaced with a limitation based on a combination of 25 percent of wages plus 2.5 percent of the original cost of most property used in the trade or business. For taxpayers with multiple business interests, each business stands on its own for purposes of the limitation computations and the resulting separate computations are combined in determining the deduction. Losses from one business will reduce the overall benefit from profitable businesses.
For a married couple filing a joint return, the 50% percent wage test (as well as the alternative test) is not applicable for any year in which their taxable income is $315,000 or less. In addition, at that income level, the 20 percent deduction is available to all flow-through businesses, regardless of whether or not they are an SSTB. This special set of rules phases out over the next $100,000 of income and is completely phased out when taxable income reaches $415,000. For all other taxpayers, the income limits are $157,500 and $207,500, respectively.
Wages for these purposes are defined as wages paid and reported by the employer on W-2s to employees of the trade or business. It also includes wages paid to employees by a professional employer organization or another organization that is paying the payroll to a business’ common law employees. In short, wages count for the entity that is the common law employer. Wages do not include guaranteed payments made to partners, nor payments to a sole proprietor from their business. Of note is the compliance rule that says wages will not count unless W-2s are actually prepared and filed annually.
These rules put many S corporations at an advantage over the same business that is operated through a partnership, since wages paid to the owner of an S corporation will qualify for the 50 percent test. For example, assuming the phase-in rules do not apply, if an S corporation shows a $100,000 profit and has only paid $45,000 of wages, all of which were paid to the owners, the deduction will be the lower of 20 percent of $100,000 ($20,000) or 50 percent of $45,000 ($22,500), resulting in a reduction of taxable income of $20,000. If the same business was operated as a partnership and $45,000 of guaranteed payments were paid to the partners, the guaranteed payments would not count as wages and therefore there would be no deduction available.
Without regulatory relief, a taxpayer with multiple businesses, where one has large payroll and the other has a large profit, would be at a disadvantage since the wage base of one could not be used in the testing for the other. The regulations provide an optional way for taxpayers to elect to aggregate qualifying businesses into one, for purposes of computing the deduction. Eligible businesses include those that are 50 percent or more owned by the same person or group of persons, and satisfy two of the following tests: provide services or products that are the same or customarily offered together, share facilities or share significant centralized business elements, or operate in coordination with or in reliance on each other. Once the 50 percent ownership test is met, any owner may elect to aggregate business interests on their return. For example, if A owns 50 percent of partnerships X, Y and Z and B owns 10 percent of X and Y, B can elect to aggregate his interests in X and Y since someone in the group owns at least 50 percent of them.
Once the aggregation election is made, both the 20 percent and 50 percent tests are computed at the combined level and must be handled that way going forward.
The test of whether a trade or business is a QBI or an SSTB is not an all-or-nothing test. If a trade or business has less than $25 million in gross receipts for the year, it will not be treated as an SSTB if less than 10 percent of the business receipts are attributable to the performance of services in one of the disqualified fields listed earlier. If gross receipts exceed $25 million, the test is reduced to 5 percent.
This de minimus rule presents an opportunity for certain businesses wherein the services provided are a mixture of both disqualified and qualified services. Take, for example, a company with $20 million of annual revenue that derives $18.5 million from the sale of manufacturing equipment and $1.5 million from consulting, installation and training services. Since the company derives less than 10 percent of its income from consulting services, these services will not be counted as an SSTB.
FINAL PLANNING THOUGHTS
Early on, many practitioners thought that an SSTB (such as a law firm or accounting firm) could form a related entity and transfer all of the non-SSTB back office operations (billing, payroll, human resources, maintenance, etc.) to it. By segregating these services into a new entity and providing them at a profit, the thought was that some of the otherwise nonqualifying profits could be shifted to a QBI entity to create an eligible deduction. The regulations prohibit that, in whole or in part, for any two entities that are 50 percent or more owned by the same individuals. This model would still work to the extent the management company is providing services to noncontrolled businesses.
Earlier we pointed outthat wages paid to an S corporation owner would be counted toward the 50 percent of wages test. Keep in mind that paying wages to an owner of an S corporation can be used to increase the value of the deduction, even though it serves to reduce QBI. As long as the 50 percent wage test limit is lower than the 20 percent of net income limit, paying wages will increase the available deduction.
While these regulations are in the proposed stage, the Treasury department is holding public hearings in mid-October and plans to issue final rules before next filing season begins.
While the intent of the provision was to give a tax benefit to flow-through business owners, to provide a break similar to the corporate rate cut, the simple concept has become extremely complicated and will be years before all the issues are resolved.
Ronald B. Hegt is a tax partner at Citrin Cooperman with more than 40 years of experience in accounting and taxation. His area of expertise is in serving as the entrepreneurial tax and business adviser to middle-market entrepreneurs, their businesses and their families. He can be reached at 914-949-2990 or at email@example.com. Citrin Cooperman is a full-service accounting and consulting firm with 10 locations on the East Coast. More at citrincooperman.com.