Lions, Tigers, and Pass-Through Deductions, Oh My!

Background

Why was this rule created? Under the TCJA, C corporation rates were lowered to a flat 21 percent from a tiered rate that went up to 35 percent for taxable income over $10 million. This is a great change for C corporations, but what about all those pass-through entities—S corporations, partnerships, sole proprietorships, and some LLCs? These entities were set up to have the income “pass through” to the owner and then be taxed at the owner’s level of individual tax. The TCJA reduced individual rates, but these reductions were not of the same magnitude as corporate changes. Therefore, legislators opted to add the pass-through deduction, which is applied on the individual owner’s return as a “below the line” deduction, meaning it reduces adjusted gross income (AGI) to get to taxable income for the individual.

The amount of the deduction is related to the business’s QBI, which is generally defined as the business’s net income, but the deduction excludes reasonable compensation paid to an S corporation owner (which the IRS makes mandatory), guaranteed payments in partnerships, and investment income. If the maximum deduction is allowed, lawmakers estimate that the top rate on pass-throughs would be 29.6 percent (which they calculated as 37 percent [the top individual rate] × 80 percent remaining after the deduction).

The Rule and Limitations

The rule and formula, along with the limitations, are very overwhelming when you try to take them all in at once. There is one overarching rule, and then additional limitations address, among other things, certain types of income, levels of higher earnings, and maximum overall income. The general pass-through rule is that qualified taxpayers receive a deduction of 20 percent of QBI. However, the formula for the rule goes on to say the allowed deduction is the lesser of:

• 20 percent of QBI, or
• the greater of
  • 50 percent of W-2 wages with respect to the qualified trade or business, or
  • the sum of 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the unadjusted basis immediately after acquisition of all qualified property (QP).

The second part of the formula, with regard to W-2 wages and QP, is applied to limit the deduction, and the QP section was added to ensure that those businesses without many employees would still receive a benefit.

What is QP? It is tangible property subject to depreciation; however, QP is not just the assets on the business’s depreciation schedule and therefore must be looked at more closely. The basis of the property used to determine the limitation is the unadjusted basis of the property determined “immediately after acquisition” and therefore not reduced for any depreciation. A taxpayer may take into consideration the unadjusted basis of property only when the “depreciable period” of the property has not ended before the close of the tax year. The depreciable period begins on the date the property is placed in service and ends on the later of:

• ten years after the date placed in service, or
• the last day of the last full year in the applicable recovery period that would apply to the property under I.R.C. § 168 (ignoring the alternative depreciation system).

What that means is that the maximum number of years of depreciation is ten, while the minimum number of years is the actual number of years, if less than ten. As part of a pass-through’s Schedule K-1, the W-2 and QP information needs to be reported on the K-1 by the entity’s accountant; for a sole proprietor, this information needs to be requested from the personal accountant.

Does Your Profession Affect the Deduction?

Section 199A states that certain types of businesses face additional limits that may result in their not receiving a deduction at all. It divides businesses into two categories: specified service business (SSB) or other qualified trade or business (QTB). SSBs are limited when income hits a certain level, so it is very important to understand who falls into that category. I.R.C. § 1202(e)(3)(A) defines SSBs as

any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners . . . or any business which involves the performance of services that consist of investing and investing management, trading, or dealing in securities, partnership interests, or commodities.

However, two groups of professionals are purposely excluded: engineers and architects. They were probably not included in this group because the domestic production activities deduction was eliminated, and they likely had already lost a significant tax benefit. The catchall line in the definition of SSBs of “any trade or business where the principal asset . . . is the reputation or skill of one or more of its employees or owners” caused a big stir until the regulations were finalized in January 2019. The regulations narrowed this part of the definition to mean:

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

Therefore, this section of the SSB definition now refers only to activities where a person’s name and likeness is used because of who they are. A perfect example is a restaurant owner who employs a famous chef. The restaurant is not part of the SSB definition now, even if most people go the restaurant because of the reputation of the chef. However, if the chef sells a line of cutlery because of her reputation, then that income is part of an SSB.

The regulations also clarified that a few of the other professions in the following fields are not disqualified.

• Health: those who provide services for health improvement to the recipient, such as the operator of a health club or spa, or the research, testing, and sale of pharmaceuticals or medical devices
• Law: individuals who provide services not exclusively related to law like printing, stenography, or delivery service
• Performing arts: those who publicly broadcast or disseminate video or audio and those who operate or maintain equipment or facilities used in performance arts
• Consulting: those who train or provide educational courses and salespeople
• Actuarial science: individuals who do not analyze or assess the financial costs of risk or uncertainty
• Athletics: broadcasters and individuals who maintain or operate equipment used in athletic events
• Financial services: banking
• Brokerage services: real estate brokers
• Investment management: real estate management services

What Are the Taxable Income Limitations?

Regardless of the type of business, individuals are then subject to a second limitation equal to 20 percent of the excess of taxable income on the taxpayer’s return less net capital gains. The purpose of this limitation is to keep the deduction at a certain level relative to the taxpayer’s taxable income and to ensure that the deduction is not taken against preferential income. In addition, SSBs and QTBs are treated differently at certain levels of income, depending on what kind of business it is. A pass-through owner with total taxable income of less than $315,000 for married joint filers (or $157,500 for single filers) is eligible to receive a deduction equal to 20 percent of his or her QBI, regardless of the type of business. However, if the taxable income reaches or exceeds $415,000 (for a married couple filing jointly or half as much for single filers), an owner of an SSB receives no deduction. Other QTBs must follow the full rule for determining the QBI deduction, which may be the lesser of the deductions. If the income is between $315,000 and $415,000 (for married filing jointly or half for single filers), then owners of SSBs receive a partial deduction, while other QTBs receive a phase-in calculation of the original deduction and limitation. The following is a list of how the limitation is computed.

• Is taxable income < $315,000 (MFJ) or $157,000 (Single)? If yes,
  • both SSB and QTB have full deduction of QBI × 20 percent.
• Is taxable income between $315,000 and $415,000 (MFJ) or $157,500 and $207,500 (Single)? If yes and
  • if SSB, then partial deduction;
  • if QTB, then partial deduction and partial limitation.
• Is taxable income > $415,000 (MFJ) or $207,500 (Single)? If yes and
  • if SSB, then no deduction;
  • if QTB, then full limitation for the deduction.

An Example

The side-by-side analysis presented in the chart below shows SSB versus QTB with different levels of taxable income. By going through the example, you will see that the calculations are simple for taxable income under $315,000 (MFJ) and over $415,000 (MFJ). It’s the phase-out area between $315,000 and $415,000 (MFJ) where it gets complicated. If you are able to follow along, you are well on your way to understanding this deduction. The next couple of topics are implementation techniques that provide other levels of complication.

De Minimis Rule

What happens if only a small portion of the business is an SSB activity? Does that make the whole business ineligible? As soon as the pass-through rules were released, CPAs scrambled to find out how to move service income to other businesses. This technique, referred to as “cracking,” moved the SSB portion of income to another entity. There were many recommendations for moving rental properties owned by the business out of the SSB into its own entity. However, the new January 2019 regulations stopped this work-around by stating that if the two businesses share 50 percent or more common ownership and the business provides 80 percent or more of its product or services to an SSB, then it is treated as an SSB.

On the plus side, the new regulations provide a “de minimis” exception for a business that sells products with limited services. If a business with gross receipts of $25 million or less in a tax year derives less than 10 percent of its gross receipts from services, it is not treated as an SSB. If gross receipts are over $25 million, the de minimis rule is instead set at 5 percent of gross receipts. These rules strongly suggest that if you exceed the de minimis amounts, the activities would be divided into two separate lines of businesses. Note that in each business all the facts and circumstances would need to be weighed in making a determination. However, in the examples provided by the regulations, the most common thread was that if there are multiple business lines in one entity, separate books and records for each line should be kept in order to make the argument.

If a trade or business provides less than 80 percent of its products or services to a commonly controlled SSB, the business won’t be treated as an SSB, but instead it will have that portion of its income treated as though it were earned from a related SSB, and the income will be ineligible for the QBI deduction. If there are multiple business lines of businesses in one entity, the taxpayer should keep separate books and records for each line.

Aggregation

Each individual owner of each company will need to do his or her own calculation for this deduction, and some owners may be able to receive the deduction, while others may receive no deduction or the deduction will be limited. However, if one individual has several companies, he or she may be able to aggregate the calculations, while other owners may choose not to aggregate. Aggregation is purely elective and must be disclosed to the IRS. If it is not disclosed, the IRS may not allow the election. Once a business owner has elected to aggregate the businesses, he or she cannot revoke the election, but a new business may be added to the aggregation. Aggregation under § 199A is allowed only when the following is true:

• the same person or group of persons, directly or indirectly, owns 50 percent or more of each business to be aggregated (S corps based on outstanding stock, while partnerships based on capital or profits) for the majority of the tax year (which includes the last day of the tax year);
• the businesses share the same tax year;
• none of the businesses are SSBs;
• the businesses to be aggregated satisfy two of the following three factors:
• they must provide products or services that are the same or customarily offered together;
• they must share facilities or significant centralized business elements (such as personnel, accounting, legal, manufacturing, purchasing, human resources, or technology resources); or
• the businesses are operated in coordination with, or reliance upon, one or more of the businesses in the aggregated group.

Qualified REIT Dividends and PTP Income

There is also a deduction for 20 percent of the taxpayer’s qualified Real Estate Investment Trust (REIT) dividends and publicly traded partnerships (PTP) income for the year. These are not typical business investments but are instead part of investment portfolios. This is a separate computation from the pass-through deduction. Note that if the pass-through were a loss, it would not offset the potential for the REIT/PTP deduction, and vice versa. However, once both deductions are calculated, they are combined and subjected to the overall taxable income limitation discussed above.

S Corp versus C Corp

Will companies rush to become C corps? This remains unclear, as the facts of each situation will determine the best type of entity. One must also remember that C corps potentially face double taxation. The C corp tax rate is now 21 percent, but then any dividends issued to the owners are also taxed at a 15-percent or 20-percent rate plus 3.8 percent net investment income (Medicare) tax rate. The cumulative total of these taxes is higher than the highest individual marginal rate of 37 percent. If the funds are kept in the company and not issued as a dividend, it may be an advantage to be a C corp. Manufacturers purchasing equipment and those just starting out are most likely to want to keep cash in the business and not issue dividends, so for these companies, it may make sense to be a C corp. Also, companies would want to look at state corporate rates as well. For instance, an individual is taxed at 3.07 percent in Pennsylvania, but all corporations in Pennsylvania are taxed at 9.99 percent. Those switching from S corp to C corp must also remember they cannot switch back to an S corp for five years, so a company needs to be sure that becoming a C corp makes sense.

Conclusion

There are still many gaps with this rule, but the regulations did help to clarify many of the open issues. Family lawyers needing to make these calculations to help their clients will require additional information from the business. Any Schedule K-1s received will need to have QBI information provided, while sole practitioners will need to have their accountant do the calculations. This is going to take additional time, and some calculations will not be able to be determined until after year end. Many more individuals will be on extension, especially for the 2018 tax year, as CPAs work to master this calculation. As family lawyers take stock of what they need to request to assist their clients, they will want to ask for more information than they have in the past. The year 2018 is going to be a very hard year to calculate as we continue to navigate the rules and have no prior year’s results to follow as guidelines. In addition, the IRS has already noted that for 2019, the taxable income thresholds will be adjusted—but that’s a subject for another day.