IRS issues proposed regulations on the pass-through business income deduction

The IRS recently released highly anticipated regulations addressing the deduction for up to 20% of qualified business income (QBI) from pass-through entities. The deduction was a major component of the Tax Cuts and Jobs Act, which became law late last year. It has also been referred to as the pass-through deduction, the QBI deduction or the Section 199A deduction.

Defining the deduction

For tax years beginning in 2018 and ending in 2025, the QBI deduction can be up to 20% of a pass-through entity owner’s QBI, subject to restrictions that can apply at higher income levels and another restriction based on the owner’s taxable income.

For QBI deduction purposes, pass-through entities are defined as sole proprietorships, single-member (one owner) LLCs that are treated as sole proprietorships for tax purposes, S corporations, partnerships, and LLCs that are treated as partnerships for tax purposes.

The QBI deduction is available only to individuals, estates and trusts. The newly proposed regulations refer to all three as “individuals.” For the purposes of this article, let’s follow that terminology to be consistent with the language used in the proposed regs.

This deduction is scheduled to sunset after 2025 unless Congress extends it. Even though the new QBI deduction regs are in proposed form, you can rely on them until final regs are issued.

Operational rules and definitions

The proposed regs supply operational rules for determining allowable QBI deductions, including how to apply the phaseout rules that can reduce or eliminate QBI deductions for individuals with taxable income (calculated before any QBI deduction) that exceeds the phaseout threshold of $157,500 ($315,000 for married joint filers). Phaseout is complete when an owner’s taxable income reaches $207,500 ($415,000 for married joint filers). At that point: 1) QBI deductions for a nonservice business must be based on the business’s W-2 wages or its W-2 wages plus the basis of qualified property used in the business, and 2) no QBI deduction can be claimed based on income from a specified service trade or business (SSTB), as defined below.

Definitions of new terms used to apply the QBI deduction rules are also included in the proposed regs, including the definition of QBI and of specified service trades or businesses (SSTBs).

In defining what constitutes an eligible business for QBI deduction purposes, the IRS decided to go with the Internal Revenue Code Section 162 definition of a trade or business, because that definition is derived from longstanding case law and IRS guidance dealing with a broad range of industries.

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 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.

The limitation involving the UBIA of qualified property is for the benefit of capital-intensive businesses.

These QBI deduction limitations kick in when an individual’s (the pass-through business owner’s) taxable income (calculated before any QBI deduction) exceeds $157,500 ($315,000 for a married joint filer). When the limitations are fully phased in, the QBI deduction is limited to the greater of: 1) the individual’s share of 50% of W-2 wages paid to employees and properly allocable to QBI during the tax year or 2) the sum of the individual’s share of 25% of W-2 wages plus the individual’s share of 2.5% of the UBIA of qualified property.

In any case, the deduction can’t exceed 20% of QBI, and it can’t exceed 20% of the individual’s taxable income calculated before: 1) any QBI deduction and 2) any net capital gain amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends). The proposed regs explain how to calculate a business’s W-2 wages for purposes of applying the QBI deduction limitations.

A business’s UBIA of qualified property generally equals the original cost of the property. Qualified property is defined as depreciable tangible property (including real estate) that:

1. Is owned by a qualified business as of the tax year end,
2. Is used by the business at any point during the tax year for the production of QBI, and
3. Hasn’t reached the end of its depreciable period as of the tax year end.

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 instance, 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. However, certain tests set forth in the proposed regs must be passed for businesses to be aggregated. Also, it’s important to remember that an SSTB cannot be aggregated with any other business, including another SSTB.

Specified service trades or businesses

The proposed regs 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 regs also include an anti-abuse rule 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, in an attempt to qualify the separated part for the QBI deduction.

Defining SSTBs

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.

You may ask: 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 regs 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 regs 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.

Other QBI deduction issues

The proposed regs supply guidance on when QBI deductions can be claimed based on qualified income from publicly traded partnerships (PTPs) and qualified dividends from real estate investment trusts (REITs).

Finally, the proposed regs include special computational and reporting rules that pass-through entities, PTPs, trusts and estates may need to follow to provide their owners and beneficiaries with the information necessary to calculate allowable QBI deductions at the owner or beneficiary level.

Getting the best results

The proposed QBI deduction regs are lengthy and complex. This article only scratches the surface of the proposed rules. We can help you sort through the details to get the best QBI deduction results in your specific circumstances.