The recent federal tax reform measures included a new deduction offering possibly the greatest tax benefit to pass-through businesses in more than 60 years.
The Qualified Business Income Deduction – or QBI – allows qualified small business owners to simply not pay income taxes on 20% of their income in tax years 2018 through 2026.
Like many provisions in the federal tax code, there are of course stipulations. Restrictions kick in to reduce the benefit when a taxpayer’s income rises and there are a different set of qualifications for Specified Service Trades or Businesses (SSTB).
Late this summer, the IRS released new proposed regulations intended to clear up some of the QBI deduction rules. These regulations provided guidance how owners of multiple businesses can use aggregation to affect their deduction and the definition of SSTBs, which face deduction limitations.
Specified Service Trades or Business Definition
QBI deductions based on specified service trades or businesses begin to phase out after a taxpayer’s income exceeds $315,000 for a married joint filer, or $157,500 for all others. The Tax Cuts and Jobs Act defined SSTB as businesses in the following fields: health, law, accounting, actuarial science, consulting, financial, brokerage, investing or investment management, trading, performing arts, and athletics.
The act also said a SSTB is any business “where the principal asset is the reputation or skill of one or more of its employees or owners.” That provision left many business owners scratching their heads, as the skills and reputations of business owners and their employees are important assets to many businesses.
The new regulations clarified the previously vague provision. The regulations limit the SSTB definition to businesses that meet one or more of the following descriptions:
- One where a person receives fees, compensation or other income for endorsing products or services,
- One that licenses or receives fees, compensation or income for the use of an individual’s image, likeness, name, signature, voice, trademark or any symbol associated with that individual’s identity, or
- One that receives fees, compensation or income for appearing at an event, on radio, television or another media format.
For instance, celebrity chef Emeril Lagasse could qualify for QBI from his restaurants, but not his name branded cookware and food products.
Business Aggregation Rules
Under the new regulations, owners of multiple qualifying trades or businesses can aggregate their businesses to potentially claim a larger QBI deduction. Aggregation is optional, but if elected it must be used to:
- Calculate QBI and
- Calculate the QBI limitation based on the greater of a) 50% of W-2 wages paid by the business or b) 25% of W-2 wages paid by the business plus 2.5% of the unadjusted basis immediately after acquisition of qualified property used to generate QBI.
If a taxpayer 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 greater QBI deduction. Keeping them separate could result in a lower deduction or maybe no deduction at all.
Here’s an example involving a person with ownership interest in three qualifying businesses:
- Business 1 has $1,000,000 of income & $500,000 of wages
- Business 2 has $1,000,000 of income & no wages
- Business 3 has $2,000 of income & $500,000 of wages.
Without aggregation, each business limit is determined separately:
- Business 1: $200,000 (the lesser of 20% of $1,000,000 or 50% of $500,000)
- Business 2: $0 (the lesser of 20% of $1,000,000 or 50% of $0)
- Business 3: $400 (the lesser of 20% of $2,000 or 50% of $500,000)
With aggregation, the same business owner could get a $400,400 deduction, based on the lesser of 20% of $2,002,000 or 50% of $1,000,000.
As you can see, the rules for the QBI deduction are complex. We can help you sort through the details to get the best QBI deduction results in your specific circumstances. Contact us for personalized assistance.