Qualified business income

I realize that the last post began with “This is the fourth and final in a series of posts reviewing the recently proposed regulations (‘PR’) under Sec. 199A of the Code” – strictly speaking, it was. Yes, I know that the title of this post begins with “The Section 199A Deduction.” Its emphasis, however, is not upon the proposed regulations, as such; rather, today’s post will consider whether the recently enacted deduction, and the regulations proposed thereunder last month, will play a role in determining a taxpayer’s net economic gain from the sale of the taxpayer’s business.

 It has often been stated in this blog that the less a seller pays in taxes as a result of selling their business – or, stated differently, the more that a seller can reduce their resulting tax liability – the greater will be the seller’s economic return on the sale.[i]

 M&A and the TCJA – In General

The Tax Cuts and Jobs Act (“TCJA”)[ii] included a number of provisions that will likely have an impact upon the purchase and sale a business. Among these are the following:

  • the reduced C corporation income tax rate,
  • the exclusion of self-created intangibles from the definition of “capital asset,”
  • the elimination of the 20-year carryforward period for NOLs,
  • the limitation on a buyer’s ability to deduct the interest on indebtedness incurred to acquire a target company, and
  • the extension of the first-year bonus depreciation deduction to “used” property.

Code Section 199A

As we have seen over the last couple of weeks, Sec. 199A generally allows a non-corporate taxpayer a deduction for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such taxable year.

The QBI of a QTB means, for any taxable year, the net income with respect to such trade or business of the taxpayer for the year, provided it is effectively connected with the conduct of a trade or business in the U.S.

Investment income is not included in determining QBI. Thus, if a taxpayer’s rental activity with respect to a real property owned by the taxpayer does not rise to the level of a trade or business, the taxpayer’s rental income therefrom will be treated as investment income and will not be treated as QBI.

In addition, the trade or business of performing services as an employee is not treated as a QTB; thus, the taxpayer’s compensation in exchange for such services is not QBI.

Limitations

If an individual taxpayer-owner’s taxable income for a taxable year exceeds a threshold amount, a special limitation will apply to limit that individual’s Section 199A deduction. Assuming the limitation rule is fully applicable[iii], the amount of the Section 199A deduction may not exceed the greater of:

  • 50% of the W-2 wages with respect to the QTB that are allocable to QBI, or
  • 25% of such W-2 wages, plus 2.50% of the “unadjusted basis” (“UB”)[iv] of all depreciable tangible property held by the QTB at the close of the taxable year, which is used at any point in the year in the production of QBI, and the depreciable period for which has not ended before the close of the taxable year (“qualified property”).

In addition, the amount of a taxpayer’s Section 199A deduction for a taxable year, determined under the foregoing rules, may not exceed 20% of the excess of:

  1. the taxpayer’s taxable income for the taxable year, over
  2. the taxpayer’s net capital gain for such year.

Pass-Through Entities

If the non-corporate taxpayer carries on the QTB indirectly, through a partnership or S corporation (a pass-through entity, or “PTE”), the Section 199A rules are applied at the partner or shareholder level, with each partner or shareholder taking into account their allocable share of the PTE’s QBI, as well as their allocable share of the PTE’s W-2 wages and UB (for purposes of applying the above limitations).

Because some individual owners of a PTE may have personal taxable income at a level that triggers application of the above limitations, while others may not, it is possible for some owners of a QTB to enjoy a smaller Section 199A deduction than other owners of the same QTB, even where they have the same percentage equity interest in the QTB (or in the PTE that holds the business). Stated differently, one taxpayer may have a different after-tax outcome with respect to the QBI allocated to them than would another taxpayer to whom the same amount of QBI is allocated, notwithstanding that they may have identical tax attributes[v] and have identical levels of participation in the conduct of the QTB.

Income or Gain from the Sale of a PTE’s Business

Although the sale of a business may be effected through various means as a matter of state law[vi], there are basically two kinds of sale transactions for tax purposes:

  1. the owners’ sale of their stock or partnership interests (“equity”) in the PTE that owns the business, and
  2. the sale by such PTE of the assets it uses to conduct the business, which is typically followed by the liquidation of such entity.

The character of the gain realized on the sale – i.e., capital or ordinary – will depend, in part, upon whether the PTE is an S corporation or a partnership, and whether the sale is treated as a sale of equity or a sale of assets.

Sale of Assets

If the PTE sells its assets, or is treated as selling its assets[vii], the nature and amount of the gain realized on the sale will depend upon the kind of assets being sold and the allocation of the purchase price among those assets. After all, the character of any item of income or gain included in a partner’s or a shareholder’s allocable share of partnership or S corporation income is determined as if it were realized directly from the source from which realized by the PTE, or incurred in the same manner as incurred by the PTE.[viii]

Thus, any income realized on the sale of accounts receivable or inventory will be treated as ordinary income.

The gain realized on the sale of property used in the trade or business, of a character that may be depreciable, or on the sale of real property used in the trade or business, is generally treated as capital gain.[ix]

However, some of the gain realized on the sale of property in respect of which the seller has claimed accelerated depreciation will be “recaptured” (to the extent of such depreciation) and treated as ordinary income.[x]

Sale of Equity

If the shareholders of an S corporation sell their shares of stock in the corporation, the gain realized will be treated as gain from the sale of a capital asset.[xi]

When the partners of a partnership sell their partnership interests, the gain will generally be treated as capital gain from the sale of a capital asset, except to the extent that the purchase price for such interests is attributable to the unrealized receivables or inventory items (so-called “hot assets”) of the partnership, in which case part of the gain will be treated as ordinary.[xii]

Related Transactions

Aside from the sale of the business, the former owners of a PTE may also engage in other, closely-related, transactions with the buyer.

For example, one or more of the former owners may become employees of, or consultants to, the buyer; in that case, the consideration paid to them will be treated as compensation received in exchange for services.
One of more of the former owners may enter into non-competition agreements with the buyer; the consideration received in exchange may be characterized as compensation for “negative” services.

If one or more of the former owners continue to own the real property on which the business will be operated, they may enter into lease arrangements with the buyer that provide for the payment of rental income.

Tax Rates

If any of the gain from the sale of the PTE’s business is treated as capital gain, each individual owner will be taxed on their allocable share thereof at the federal capital gain rate of 20%.

If any of such gain is treated as ordinary income, each individual owner will be subject to federal income tax on their allocable share thereof at the ordinary income rate of 37%.

If an owner did not materially participate in the business, the 3.8% federal surtax on net investment income may also be applicable to their allocable share of the above gain and ordinary income.[xiii]

Of course, any compensation for services (or “non-services”) would be taxable as ordinary income, and would be subject to employment taxes.

Any rental income would also be subject to tax as ordinary income, and may also be subject to the 3.8% surtax.[xiv]

Based on the foregoing, one may conclude, generally, that it would be in the best interest of the PTE’s owners to minimize the amount of ordinary income, and to maximize the amount of capital gain, to be realized on the sale of the PTE’s business.[xv]

Of course, the selling PTE and its owners cannot unilaterally, or even reasonably expect to, direct this result. The buyer has its own preferences and imperatives[xvi]; moreover, one simply cannot avoid ordinary income treatment in many circumstances.

Enter Section 199A

No, not astride a horse, but on tip toes, wearing sneakers.[xvii]

The tax treatment of M&A transactions was certainly not what Congress was focused on when Section 199A was conceived. PTEs already enjoyed a significant advantage in the taxation of M&A transactions in that capital gains are taxed to the individual owners of a PTE at a very favorable federal rate of 20%.

Rather, Congress sought to provide a tax benefit to the individual owners of PTEs in response to complaints from the PTE community that the tax bill which eventually became the TCJA was heavily biased in favor of C corporations, especially with the reduction in the federal corporate income tax rate from a maximum graduated rate of 35% to a flat rate of 21%.

It order to redress the perceived unfairness, Congress gave individual business owners the Section 199A deduction as a way to reduce their tax liability with respect to the ordinary net operating income of their PTEs.

Sale of a Business

This is borne out by the exclusion from the definition of QBI of dividends and interest, and by the exclusion of capital gains[xviii], regardless of whether such gains arise from the sale of a capital asset; thus, the capital gain from the sale of a property used in the PTE’s trade or business, and of a character which is subject to the allowance for depreciation, is excluded from QBI.

Does that mean that Section 199A has no role to play in the taxation of M&A transactions? Not quite.

Simply put, a number of the business assets disposed of as part of an M&A transaction represent items of ordinary income that would have been realized by the business and its owners in the ordinary course of business had the business not been sold; the sale of these assets accelerates recognition of this ordinary income.

Ordinary Income Items

For example, the ordinary income realized on the sale, or deemed sale[xix], of accounts receivable and inventory by a PTE as part of an M&A deal should qualify as QBI, and should be taken into account in determining the Section 199A deduction for the individual owners of the PTE.

Unfortunately, neither the Code nor the proposed regulations explicitly state that this is the case, though the latter clearly provide that any ordinary income arising from the disposition of a partnership interest that is attributable to the partnership’s hot assets – i.e., inventory and unrealized receivables – will be considered attributable to the trade or business conducted by the partnership and taken into account for purposes of computing QBI.[xx]

Of course, the partnership rules[xxi] define the term “unrealized receivables” expansively, so they include other items in addition to receivables; for example, the ordinary income – i.e., depreciation recapture – realized on the sale of tangible personal property used in the business, the cost of which has been depreciated on an accelerated basis, or for which a bonus depreciation deduction or Section 179 deduction has been claimed.

In light of the foregoing, the same result should obtain where the inventories and receivables are sold as part of an actual or deemed asset sale, though the proposed regulations do not speak directly to this situation. These assets are not of a kind that appreciate in value, or that generate income, as in the case of investment property. Rather, they represent “ordinary income in-waiting” and should be treated as QBI.

Similarly in the case of tangible personal property used in a business and subject to an allowance for depreciation; taxpayers are allowed to recover the cost of acquiring such assets on an accelerated basis so as to reduce the net cost thereof, and thereby to incentivize taxpayers to make such investments.; i.e., they are allowed to reduce the ordinary income that otherwise would have been realized (and taxed) in the ordinary course of business. The “recapture” of this depreciation benefit upon the sale of such property should, likewise, be treated as QBI.

Compensation

As stated above, a taxpayer’s QBI does not include any amount of compensation paid to the individual taxpayer in their capacity as an employee. In other words, if a former owner of the PTE-operated business is employed by the new owner of the business (for example, as an officer), the compensation paid to the former owner will not be treated as QBI.

If the former owner is not employed by the new owner, but is retained to provide other services as an independent contractor, the payments made to them in exchange for such services may constitute QBI, provided the service provider is properly characterized as a non-employee and the service is not a “specified service trade or business.”[xxii] Query whether the “consulting” services often provided by a former owner to the buyer are the equivalent of providing the kind of “advice and counsel” that the proposed regulations treat as a specified service trade or business, the income from which is not QBI.

Rental

As was mentioned above, it is not unusual for the owners of a PTE to sell their operating business while retaining ownership of the real property on which the business may continue to operate – hopefully, it has been residing in an entity separate from the one holding the business. Under these circumstances, the owners may ensure themselves of a continued stream of revenue, a portion of which may be sheltered by depreciation deductions.

Whether such rental activity will rise to the level of a trade or business for purposes of Section 199A will depend upon the facts and circumstances. However, if the property is wholly-occupied by one tenant – i.e., by the business that was sold, as is often the case – it is unlikely that the rental activity will represent a QTB and, so, the net rental income will not be QBI.

Don’t Forget the Limitations

Even assuming that a goodly portion of the income arising from the sale of a QTB will be treated as QBI, the individual taxpayer must bear in mind the “W-2-based” and “taxable-income-based” limitations described above.

This Time, I Promise

Well, that’s it for Section 199A – at least until the proposed regulations are finalized.

“I’m so glad we had this time together . . .”[xxiii] I know, “Lou, keep you day job.”


[i] The flip-side may be stated as follows: the faster a buyer can recover their investment – i.e., the purchase price – for the acquisition of a business, the greater is the buyer’s return on its investment in the business. See, e.g.

[ii] P.L. 115-97.

[iii] Meaning that the taxpayer’s taxable income for the taxable year exceeds the threshold amount ($315,000 in the case of married taxpayers filed jointly) plus a phase-in range (between the threshold amount and $415,000).

[iv] The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased by or contributed to the PTE.

[v] Other than taxable income.

[vi] For example, a sale of assets may be accomplished through a merger of two business entities; a stock sale may be accomplished through a reverse subsidiary merger in which the target is the surviving entity.

[vii] In the case of an S corporation, where the shareholders make an election under Sec. 336(e), or where the shareholders and the buyer make a joint election under Sec. 338(h)(10), to treat the stock sale as a sale of assets by the corporation followed by the liquidation of the corporation.

In the case of a partnership, a buyer who acquires all of the partnership interests is treated, from the buyer’s perspective, as acquiring the assets of the partnership. Rev. Rul. 99-6.

[viii] Sec. 702 and Sec. 1366.

[ix] Sec. 1231. Specifically, if the “section 1231 gains” for a taxable year exceed the “section 1231 losses” for such year, such gains and losses shall be treated as long-term capital gains or losses, as the case may be.

[x] Sec. 1245.

[xi] Sec. 1221.

[xii] Sec. 741 and Sec. 751.

[xiii] Sec. 1411. The tax is imposed on the lesser of (a) the amount of the taxpayer’ net investment income for the taxable year, or (b) the excess of (i) the taxpayer’s modified adjusted gross income, over (ii) a threshold amount ($250,000 in the case of a married taxpayer filed a joint return).

[xiv] Assuming it is a passive activity. See Reg. Sec. 1.1411-5.

[xv] In the case of a PTE that is an S corporation that is subject to the built-in gains tax, the shareholders may also be interested in allocating consideration away from those corporate assets to which the tax would apply.

[xvi] See endnote “i”, supra.

[xvii] I wish I could recall the name of the presidential scholar who coined the phrase, that I am trying to paraphrase, to describe how presidents get things done. It may have been Prof. Richard Pious of Columbia University.

[xviii] Sec. 199A(c)(3)(B); Prop. Reg. Sec. 1.199A-3(b)(2).

[xix] For example, upon the filing of a Sec. 338(h)(10) election.

[xx] Prop. Reg. Sec. 1.199A-3(b).

[xxi] Sec. 751(c).

[xxii] Prop. Reg. Sec. 1.199A-5.

[xxiii] Remember Carol Burnett’s sign-off song?

This is the fourth[i] and final in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction/

Earlier posts considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one , the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A, https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ , and the meaning of “qualified business income.” https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-three/. Today, we turn to the calculation of the deduction, the limitations on the amount of the deduction, and some special rules.

 Threshold and Phase-In Amounts

Let’s assume for the moment that our taxpayer (“Taxpayer”) is a married individual, files a joint return with their spouse, and owns an equity interest in a qualified trade or business (“QTB”) that is conducted through a pass-through entity (“PTE”), such as a sole proprietorship,[ii] a partnership, or an S corporation.

At this point, Taxpayer must determine their joint taxable income for the taxable year.[iii]

There are three categories of taxpayers for purposes of Section 199A – those whose joint taxable income[iv]:

  • does not exceed $315,000 (the “threshold”),
  • exceeds $315,000 but does not exceed $415,000 (the “phase-in range”),[v] and
  • exceeds $415,000.[vi]

 

 

 

Below the Threshold

If Taxpayer falls within the first category – joint taxable income that does not exceed $315,000 – they determine their Section 199A deduction by first calculating 20% of their QBI with respect to their QTB (Taxpayer’s “combined QBI amount”).[vii] For this first category of taxpayer, their share of income from a specified service trade or business (“SSTB”) qualifies as QBI.

Taxpayer must then compare their

  • combined QBI amount (determined above) with
  • an amount equal to 20% of the excess of:
    • their taxable income for the taxable year, over
    • their net capital gain for the year.

The lesser of these two amounts is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain. Taxpayer’s Section 199A deduction is equal to the lesser of these two amounts.

Thus, if Taxpayer’s only source of income was their QTB, Taxpayer would be entitled to claim the full “20% of QBI” deduction, with the result that their QBI would be subject to an effective top federal income tax rate of 29.6%[viii]

Above the Threshold and Phase-In

If Taxpayer falls within the third category – joint taxable income for the taxable year in excess of $415,000 – they face several additional hurdles in determining their Section 199A deduction.[ix] It is with respect to these taxpayers that the application of the Section 199A rules becomes even more challenging, both for the taxpayers and their advisers.

To start, no SSTB in which Taxpayer has an equity interest will qualify as a QTB as to Taxpayer.

Moreover, there are other limitations, in addition to the ones described above, that must be considered in determining the amount of Taxpayer’s Section 199A deduction.

N.B.

Before turning to these limitations, it is important to note the following:

  • the application of the threshold and phase-in amounts is determined at the level of the individual owner of the QTB[x], which may not be where the trade or business is operated; and
  • taxpayers with identical interests in, and identical levels of activity with respect to, the same trade or business may be treated differently if one taxpayer has more taxable income from sources outside the trade or business than does the other;
    • for example, a senior partner of a law firm, who has had years to develop an income-producing investment portfolio, vs a junior partner at the same firm, whose share of partnership income represents their only source of income.[xi]

Limitations

The additional limitations referred to above are applied in determining Taxpayer’s “combined QBI amount.”

Specifically, the amount equal to 20% of Taxpayer’s QBI with respect to the QTB must be compared to the greater of:

  • 50% of the “W-2 wages” with respect to the QTB, or
  • The sum of (i) 25% of the W-2 wages plus (ii) 2.5% of the unadjusted basis (“UB”) of qualified property immediately after the acquisition of all qualified property (“a” and “b” being the “alternative limitations”).

The lesser of Taxpayer’s “20% of QBI” figure and the above “W-2 wages-based” figure may be characterized as Taxpayer’s “tentative” Section 199A deduction; it is subject to being further reduced in accordance with the following caps:

  • The Section 199A deduction cannot be greater than 20% of the excess (if any) of:
    • Taxpayer’s taxable income for the taxable year, over
    • Taxpayer’s net capital gain for the year.
  • The resulting amount – i.e., the tentative deduction reduced in accordance with “a” – is then compared to Taxpayer’s entire taxable income for the taxable year, reduced by their net capital gain.

Taxpayer’s Section 199A deduction is equal to the lesser of the two amounts described in “b”, above.

Applied to Each QTB

Under the PR, an individual taxpayer must determine the W-2 wages and the UB of qualified property attributable to each QTB contributing to the individual’s combined QBI. The W-2 wages and the UB of qualified property amounts are compared to QBI in order to determine the individual’s QBI component for each QTB.

After determining the QBI for each QTB, the individual taxpayer must compare 20% of that trade or business’s QBI to the alternative limitations for that trade or business.

If 20% of the QBI of the trade or business is greater than the relevant alternative limitation, the QBI component is limited to the amount of the alternative limitation, and the deduction is reduced.

The PR also provide that, if an individual has QBI of less than zero (a loss) from one trade or business, but has overall QBI greater than zero when all of the individual’s trades or businesses are taken together, then the individual must offset the net income in each trade or business that produced net income with the net loss from each trade or business that produced net loss before the individual applies the limitations based on W-2 wages and UB of qualified property.

The individual must apportion the net loss among the trades or businesses with positive QBI in proportion to the relative amounts of QBI in such trades or businesses. Then, for purposes of applying the limitation based on W-2 wages and UB of qualified property, the net income with respect to each trade or business (as offset by the apportioned losses) is the taxpayer’s QBI with respect to that trade or business.

The W-2 wages and UB of qualified property from the trades or businesses which produced negative QBI for the taxable year are not carried over into the subsequent year.

W-2 Wages

The PR provide that, in determining W-2 wages, the common law employer (such as a PTE) may take into account any W-2 wages paid by another person – such as a professional employer organization – and reported by such other person on Forms W-2 with the reporting person as the employer listed on the Forms W-2, provided that the W-2 wages were paid to common law employees of the common law employer for employment by the latter.[xii]

Under this rule, persons who otherwise qualify for the deduction are not limited in applying the deduction merely because they use a third party payor to pay and report wages to their employees.

The W-2 wage limitation applies separately for each trade or business. Accordingly, the PR provides that, in the case of W-2 wages that are allocable to more than one trade or business, the portion of the W-2 wages allocable to each trade or business is determined to be in the same proportion to total W-2 wages as the ordinary business deductions associated with those wages are allocated among the particular trades or businesses.

W-2 wages must be properly allocable to QBI (rather than, for example, to activity that produces investment income). W-2 wages are properly allocable to QBI if the associated wage expense is taken into account in computing QBI.

Where the QTB is conducted by a PTE, a partner’s or a shareholder’s allocable share of wages must be determined in the same manner as their share of wage expenses.

Finally, the PR provide that, in the case of an acquisition or disposition of (i) a trade or business, (ii) the major portion of a trade or business, or (iii) the major portion of a separate unit of a trade or business, that causes more than one individual or entity to be an employer of the employees of the acquired or disposed of trade or business during the calendar year, the W-2 wages of the individual or entity for the calendar year of the acquisition or disposition are allocated between each individual or entity based on the period during which the employees of the acquired or disposed of trade or business were employed by the individual or entity.

 UB of Qualified Property

The PR provides that “qualified property” means (i) tangible property of a character subject to depreciation that is held by, and available for use in, a trade or business at the close of the taxable year, (ii) which is used in the production of QBI, and (iii) for which the depreciable period has not ended before the close of the taxable year.

“Depreciable period” means the period beginning on the date the property is first placed in service by the taxpayer and ending on the later of (a) the date 10 years after that date, or (b) the last day of the last full year in the applicable recovery period that would apply to the property without regard to whether any bonus depreciation was claimed with respect to the property. Thus, it is possible for a property to be treated as qualified property even where it is no longer being depreciated for tax purposes.

The term “UB” means the initial basis of the qualified property in the hands of the individual or PTE, depending upon whether it was purchased or contributed.

UB is determined without regard to any adjustments for any portion of the basis for which the taxpayer has elected to treat as an expense (for example, under Sec. 179 of the Code). Therefore, for purchased or produced qualified property, UB generally will be its cost as of the date the property is placed in service.

For qualified property contributed to a partnership in a “tax-free” exchange for a partnership interest and immediately placed in service, UB generally will be its basis in the hands of the contributing partner, and will not be changed by subsequent “elective” basis adjustments.

For qualified property contributed to an S corporation in a “tax-free” exchange for stock and immediately placed in service, UB generally will be its basis in the hands of the contributing shareholder.[xiii]

Further, for property inherited from a decedent and immediately placed in service by the heir, the UB generally will be its fair market value at the time of the decedent’s death.

In order to prevent trades or businesses from transferring or acquiring property at the end of the year merely to manipulate the UB of qualified property attributable to the trade or business, the PR provides that property is not qualified property if the property is acquired within 60 days of the end of the taxable year and disposed of within 120 days without having been used in a trade or business for at least 45 days prior to disposition, unless the taxpayer demonstrates that the principal purpose of the acquisition and disposition was a purpose other than increasing the deduction.

For purposes of determining the depreciable period of qualified property, the PR provide that, if a PTE acquires qualified property in a non-recognition exchange, the qualified property’s “placed-in-service” date is determined as follows: (i) for the portion of the transferee-PTE’s UB of the qualified property that does not exceed the transferor’s UB of such property, the date such portion was first placed in service by the transferee-PTE is the date on which the transferor first placed the qualified property in service; (ii) for the portion of the transferee’s UB of the qualified property that exceeds the transferor’s UB of such property, if any, such portion is treated as separate qualified property that the transferee first placed in service on the date of the transfer.

Thus, qualified property acquired in these non-recognition transactions will have two separate placed in service dates under the PR: for purposes of determining the UB of the property, the relevant placed in service date will be the date the acquired property is placed in service by the transferee-PTE (for instance, the date the partnership places in service property received as a capital contribution); for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the transferor first placed the property in service (for instance, the date the partner placed the property in service in their sole proprietorship).

The PR also provide guidance on the treatment of subsequent improvements to qualified property.[xiv]

Finally, in the case of a trade or business conducted by a PTE, the PR provide that, in the case of qualified property held by a PTE, each partner’s or shareholder’s share of the UB of qualified property is an amount that bears the same proportion to the total UB of qualified property as the partner’s or shareholder’s share of tax depreciation bears to the entity’s total tax depreciation attributable to the property for the year.[xv]

Computational Steps for PTEs

The PR also provide additional guidance on the determination of QBI for a QTB conducted by a PTE.

A PTE conducting an SSTB may not know whether the taxable income of any of its equity owners is below the threshold amount. However, the PTE is best positioned to make the determination as to whether its trade or business is an SSTB.

Therefore, reporting rules require each PTE to determine whether it conducts an SSTB, and to disclose that information to its partners, shareholders, or owners.

In addition, notwithstanding that PTEs cannot take the Section 199A deduction at the entity level, each PTE must determine and report the information necessary for its direct and indirect individual owners to determine their own Section 199A deduction.

Thus, the PR direct PTEs to determine what amounts and information to report to their owners and the IRS, including QBI, W-2 wages, and the UB of qualified property for each trade or business directly engaged in.

The PR also require each PTE to report this information on or with the Schedules K-1 issued to the owners. PTEs must report this information regardless of whether a taxpayer is below the threshold amount.

“That’s All Folks!”[xvi]

With the series of posts ending today, we’ve covered most aspects of the new Section 199A rule, as elaborated by the PR, though the following points are also worth mentioning:

  • the Section 199A deduction has no effect on the adjusted basis of a partner’s interest in a partnership;
  • the deduction has no effect on the adjusted basis of a shareholder’s stock in an S corporation or the S corporation’s accumulated adjustments account;
  • the deduction does not reduce (i) net earnings from self-employment for purposes of the employment tax (for example, a partner’s share of a partnership’s operating income), or (ii) net investment income for purposes of the surtax on net investment income (for example, a shareholder’s share of an S corporation’s business in which the shareholder does not materially participate); and
  • for purposes of determining an individual’s alternative minimum taxable income for a taxable year, the entire deduction is allowed, without adjustment.

Stay tuned. Although taxpayers may rely upon the PR, they are not yet final. A public hearing on the PR is scheduled for October 16; the Republicans recently proposed to make the deduction “permanent” (whatever that means); midterm elections are scheduled for November 6; we have a presidential election in 2020; the deduction is scheduled to disappear after 2025. Oh, bother.

—————————————————————————————————-

[i] Yes, I know – where has time gone? The fourth already? Seems like just yesterday, I was reading the first. Alternatively: Oh no, not another! It’s like reading . . . the Code? Where are those definitions of SSTB covered? The first or the second installment?

[ii] Including a single-member LLC that is disregarded for tax purposes.

[iii] Of course, we are only considering taxable years beginning after December 31, 2017, the effective date for Section 199A of the Code.

[iv] Regardless of the source or type of the income.

[v] See EN ix, below.

[vi] For our purposes, it is assumed that Taxpayer has no “qualified cooperative dividends,” no “qualified REIT dividends,” and no “qualified publicly traded partnership income.”

[vii] If Taxpayer has more than one QTB, this amount is determined for each such QTB, and these amounts are then added together.

[viii] I.e., 80% of the regular 37% rate.

[ix] Yes, we skipped the second category – taxpayers with taxable income in excess of the threshold amount but within the phase-in range amount.

The exclusion of QBI (for SSTBs), W-2 wages, and UB of qualified property from the computation of the Section 199A deduction is subject to a phase-in for individuals with taxable income within the phase-in range.

[x] Thus, we look at the taxable income of the individual member of the LLC or shareholder of the S corporation – not at the taxable income of the entity.

[xi] Compare to the passive activity loss rules (material participant or not?), and the net investment income surtax rules (modified adjusted gross income in excess of threshold; material participant?).

[xii] In such cases, the person paying the W-2 wages and reporting the W-2 wages on Forms W-2 is precluded from taking into account such wages for purposes of determining W-2 wages with respect to that person.

[xiii] The PR also provide special rules for determining the UB and the depreciable period for property acquired in a “tax-free” exchange.

Specifically, for purposes of determining the depreciable period, the date the exchanged basis in the replacement qualified property is first placed in service by the trade or business is the date on which the relinquished property was first placed in service by the individual or PTE, and the date the excess basis in the replacement qualified property is first placed in service by the individual or PTE is the date on which the replacement qualified property was first placed in service by the individual or PTE. As a result, the depreciable period for the exchanged basis of the replacement qualified property will end before the depreciable period for the excess basis of the replacement qualified property ends.

Thus, qualified property acquired in a like-kind exchange will have two separate placed in service dates under the PR: for purposes of determining the UBIA of the property, the relevant placed in service date will be the date the acquired property is actually placed in service; for purposes of determining the depreciable period of the property, the relevant placed in service date generally will be the date the relinquished property was first placed in service.

[xiv] Rather than treat them as a separate item of property, the PR provides that, in the case of any addition to, or improvement of, qualified property that is already placed in service by the taxpayer, such addition or improvement is treated as separate qualified property that the taxpayer first placed in service on the date such addition or improvement is placed in service by the taxpayer for purposes of determining the depreciable period of the qualified property. For example, if a taxpayer acquired and placed in service a machine on March 26, 2018, and then incurs additional capital expenditures to improve the machine in May 2020, and places such improvements in service on May 27, 2020, the taxpayer has two qualified properties: The machine acquired and placed in service on March 26, 2018, and the improvements to the machine incurred in May 2020 and placed in service on May 27, 2020.

[xv] In the case of qualified property of a partnership that does not produce tax depreciation during the year (for example, property that has been held for less than 10 years but whose recovery period has ended), each partner’s share of the UB of qualified property is based on how gain would be allocated to the partners if the qualified property were sold in a hypothetical transaction for cash equal to the fair market value of the qualified property. In the case of qualified property of an S corporation that does not produce tax depreciation during the year, each shareholder’s share of the UB of the qualified property is a share of the UB proportionate to the ratio of shares in the S corporation held by the shareholder over the total shares of the S corporation.

[xvi] And so ended every episode of Looney Tunes. Thank you Mel Blanc.

This is the third in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

So far, we’ve considered the elements of a “qualified trade or business” under Section 199A https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/, and the related issue of what constitutes a “specified service trade or business,” the owners of which may be denied the benefit of Section 199A. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-two/ Today we’ll turn to the meaning of “qualified business income.”

Qualified Business Income – In General

In general, under Section 199A of the Code, a non-corporate taxpayer is allowed a deduction (the “Section 199A deduction”) for a taxable year equal to 20% of the taxpayer’s qualified business income (“QBI”) with respect to a qualified trade or business (“QTB”) for such year.

The term “QBI” means, for any taxable year, the net amount of “qualified items of income, gain, deduction, and loss” attributable to any QTB of the taxpayer, which in turn means those items of income, gain, deduction, and loss to the extent they are (i) “effectively connected with” the conduct of a trade or business within the U.S., and (ii) included or allowed in determining taxable income for the taxable year.

QBI items must be determined for each QTB by the individual or pass-through entity (“PTE”) that directly conducts the trade or business before applying the aggregation rules. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/

Exclusion from QBI for Certain Items

The PR provide a list of items that are not taken into account as qualified items of income, gain, deduction, and loss, including capital gain or loss, dividends, interest income other than interest income properly allocable to a trade or business, and certain other items; similarly, items of deduction or loss attributable to these items of income or gain are also not taken into account in determining a taxpayer’s QBI.

Compensation for Services

In general, S corporations must pay their shareholder-employees “reasonable compensation” for services rendered before making “dividend” distributions with respect to shareholder-employees’ stock in the S corporation.

The PR provide that QBI does not include the amount of reasonable compensation paid to the shareholder-employee of an S corporation that operates a QTB for services rendered by the shareholder-employee with respect to such trade or business.

However, the S corporation’s deduction for such reasonable compensation reduces QBI if such deduction is properly allocable to the trade or business and is otherwise deductible.

Guaranteed Payments

Similarly, the PR provide that QBI does not include any guaranteed payment – one determined without regard to the income of the partnership – made by a partnership to a partner for services rendered with respect to the partnership’s trade or business.

However, the partnership’s related expense deduction for making the guaranteed payment may constitute an item of QBI. [i]

The PR clarify that QBI does not include any guaranteed payment paid to a partner for services rendered, regardless of whether the partner is an individual or a PTE. Therefore, a guaranteed payment paid by a lower-tier partnership to an upper-tier partnership retains its character as a guaranteed payment and is not included in QBI of a partner of the upper-tier partnership regardless of whether it is guaranteed to the ultimate recipient.

Other Payments to “Partners”

QBI does not include any payment to a partner, regardless of whether the partner is an individual or a PTE, for services rendered with respect to the partnership’s trade or business where the partner engages with the partnership other than in their capacity as a partner. Thus, it is treated similarly to guaranteed payments, reasonable compensation, and wages, none of which is includable in QBI.

Guaranteed Payments for the Use of Capital

Because guaranteed payments for the use of capital are determined without regard to the income of the partnership, the PR provide that such payments are not considered attributable to a trade or business, and thus do not constitute QBI.

However, the partnership’s related expense for making the guaranteed payments may constitute an item of QBI.

Interest Income

QBI does not include any interest income other than interest income that is properly allocable to a trade or business.

According to the PR, interest income received on working capital, reserves, and similar accounts is income from assets held for investment and is not properly allocable to a trade or business.

In contrast, interest income received on accounts or notes receivable for services or goods provided by the trade or business is not income from assets held for investment, but income received on assets acquired in the ordinary course of the trade or business.

QBI – Special Rules

In addition to the foregoing exclusions, the PR clarify the treatment of certain items that may be of interest to taxpayers that are disposing of their interest in a trade or business.

“Hot Asset” Gain

Under the partnership rules, the gain realized by a partner on the exchange of all or part of their interest in a partnership is treated as ordinary income to the extent it is attributable to the unrealized receivables or inventory items (“hot assets”) of the partnership. These are items that eventually would have been recognized by the partnership and allocated to the partner in the ordinary course; the exchange by the partner of their partnership interest merely accelerates this recognition and allocation.

Similarly, a distribution of property by a partnership to a partner in exchange for the partner’s interest in the “hot assets” of the partnership may be treated as sale or exchange of such hot assets between the partner and the partnership, thereby generating ordinary income.

According to the PR, any gain that is attributable to the hot assets of a partnership – thereby giving rise to ordinary income in the circumstances described above – is considered attributable to the trade or business conducted by the partnership, and therefore, may constitute QBI to the partner.

Of course, the term “unrealized receivables” is defined to include not only receivables, but other items as well; for example, depreciation recapture. This may be significant in the sale of a business by a PTE where the gain arising from the sale would otherwise be excluded from QBI.

Change in Accounting Adjustments

If a taxpayer changes their method of accounting, the Code requires that certain adjustments be made in computing the taxpayer’s taxable income in order to prevent amounts of income or deduction from being duplicated or omitted. In general, these adjustments are taken into account by the taxpayer over a three-year period.

The PR provide that when such adjustments (whether positive or negative) are attributable to a QTB, and arise in a taxable year ending after December 31, 2017, they will be treated as attributable to that trade or business. Accordingly, such adjustments may constitute QBI.

Previously Suspended Losses

Several sections of the Code provide for the disallowance of losses and deductions to a taxpayer in certain cases; for example, the “at risk” rules and the “passive activity loss” rules. Generally, the disallowed amounts are suspended and carried forward to the following year, at which point they are re-tested and may become allowable; of course, when the taxpayer disposes of their interest in the business to an unrelated party in a fully taxable transaction, the loss will cease to be suspended.

Likewise, losses may be suspended because an individual shareholder of an S corporation does not have sufficient stock or debt basis to utilize them; however, the actual or deemed sale of the assets of the S corporation’s business may generate enough gain to increase such basis and enable the shareholder to use the suspended losses.

The PR provide that, to the extent that any previously disallowed losses or deductions, attributable to a QTB, are allowed in the taxable year, they are treated as items attributable to the trade or business. Thus, losses that cease to be suspended under one of the above “disposition rules” may be treated as QBI. However, losses or deductions that were disallowed for taxable years beginning before January 1, 2018 are not taken into account for purposes of computing QBI in a later taxable year.

Net Operating Losses

Generally, items giving rise to a net operating loss (“NOL”) are allowed in computing taxable income in the year incurred. Because those items would have been taken into account in computing QBI in the year incurred, the NOL should not be treated as QBI in subsequent years.

However, to the extent the NOL is comprised of amounts attributable to a QTB that were disallowed under the new “excess business loss” rule – which are not allowed in computing taxable income for the taxable year but which are, instead, carried forward and treated as part of the taxpayer’s net operating loss carryforward in subsequent taxable years – the NOL is considered attributable to that trade or business, and may constitute QBI. https://www.taxlawforchb.com/2018/01/the-real-property-business-and-the-tax-cuts-jobs-act/

Property Used in the Trade or Business

QBI does not include any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss.

The Code provides rules under which gains and losses from the sale or exchange of certain property used in a trade or business are either treated as long-term capital gains or long-term capital losses, or are not treated as gains and losses from sales or exchanges of capital assets.[ii]

The PR clarify that QBI excludes short-term and long-term capital gains or losses, regardless of whether those items arise from the sale or exchange of a capital asset, including any item treated as one of such items taken into account in determining net long-term capital gain or net long-term capital loss.

Conversely, if the gains or losses are not treated as gains and losses from sales or exchanges of capital assets, the gains or losses may be included in QBI.

Effectively Connected With a U.S. Trade or Business

Section 199A applies to all non-corporate taxpayers, whether such taxpayers are domestic or foreign. Accordingly, Section 199A applies to both U.S. citizens and resident aliens, as well as nonresident aliens (“NRA”) that have QBI.

QBI includes items of income, gain, deduction, and loss to the extent such items are (i) included or allowed in determining the U.S. person’s or NRA’s taxable income for the taxable year, and (ii) effectively connected with the conduct of a trade or business within the U.S.

Determining Effectively Connected Income

In general, whether a QTB is engaged in a trade or business within the U.S., partially within the U.S., or solely outside the U.S., is based upon all the facts and circumstances.[iii]

If a trade or business is not engaged in a U.S. trade or business, items of income, gain, deduction, or loss from that trade or business will not be included in QBI because such items would not be effectively connected with the conduct of a U.S. trade or business.

Thus, a shareholder of an S corporation, or a U.S. partner of a partnership, that is engaged in a trade or business in both the U.S. and overseas would only take into account the items of income, deduction, gain, and loss that would be effectively connected with the business conducted by the S corporation, or partnership, in the U.S.

In determining whether income or gain from U.S. sources is effectively connected with the conduct of a trade or business within the U.S., a number of factors have to be considered, including whether the income, gain or loss is derived from assets used in or held for use in the conduct of such trade or business, or the activities of such trade or business were a material factor in the realization of the income, gain or loss.

If an NRA’s QTB is determined to be conducted in the U.S., the Code generally treats all non-investment income of the NRA from sources within the U.S. as effectively connected with the conduct of a U.S. trade or business.[iv]

Income from sources without the U.S. is generally not treated as effectively connected with the NRA’s conduct of a U.S. trade or business. Thus, a trade or business’s foreign source income, gain, or loss, (and any deductions effectively connected with such foreign source income, gain, or loss) would generally not be included in QBI.[v]

However, this rule does not mean that any item of income or deduction that is treated as effectively connected with an NRA’s conduct of a trade or business with the U.S. is necessarily QBI. Indeed, certain provisions of the Code allow items to be treated as effectively connected, even though they are not “items” with respect to a trade or business. For example, the Code allows an NRA to elect to treat income from rental real property in the U.S. that would not otherwise be treated as effectively connected with the conduct of a trade or business within the U.S. as effectively connected. However, if items are not attributable to a QTB, they do not constitute QBI.

Allocation of QBI Items

The PR provides that, if an individual or a PTE directly conducts multiple trades or businesses, and has items of QBI that are properly attributable to more than one trade or business, the taxpayer or entity must allocate those items among the several trades or businesses to which they are attributable using a reasonable method that is consistent with the purposes of Section 199A.

The chosen reasonable method for each item must be consistently applied from one taxable year to another, and must clearly reflect the income of each trade or business.

There are several different ways to allocate expenses, such as direct tracing, allocating based on gross income, or some other method, but whether these are reasonable depends on the facts and circumstances of each trade or business.

Next week, we’ll bring together the basic elements of Section 199A, which we covered in the last three posts, to see how the “20% deduction” is determined.

———————————————————————————

[i] The PR provides that QBI does not include reasonable compensation paid by an S corporation but does not extend this rule to partnerships. Because the trade or business of performing services as an employee is not a QTB, wage income received by an employee is never QBI.

The rule for reasonable compensation is merely a clarification that, even if an S corporation fails to pay a reasonable wage to its shareholder-employees, the shareholder-employees are nonetheless prevented from including an amount equal to reasonable compensation in QBI.

[ii] IRC Sec. 1231.

[iii] Because an NRA cannot be a shareholder on an S corporation, the NRA’s effectively connected income must arise from the NRA’s direct conduct of a trade or business in the U.S. (including through a disregarded entity; if the NRA is a resident of a treaty country, the NRA’s business profits will not be subject to U.S. tax unless the NRA operates the business through a permanent establishment in the U.S.); in addition, an NRA is considered engaged in a trade or business within the U.S. if the partnership of which such individual is a member is so engaged.

[iv] However, any “FDAP” income or “portfolio interest” income from sources within the U.S., and any gain or loss from the sale of capital assets, may be effectively connected only if the income meets certain requirements.

[v] There are exceptions.

In the weeks preceding the introduction of the bill that was just enacted as the Tax Cuts and Jobs Act (the “Act”), my colleagues teased me, “Lou, what are you going to do when Congress simplifies the Code?”

“Simplify?” I responded as I reached for the Merriam-Webster’s Dictionary that I have used since 1980 – it resides next to the HP scientific calculator that I have used since 1987 – change is not always a good thing – “Congress is incapable of simplifying anything.”

Tax Cuts and Jobs Act

“The word ‘simplify’,” I continued, “is defined as follows: to make simple or simpler; to reduce to basic essentials; to diminish in scope or complexity; to make more intelligible.”

After reviewing the final version of the legislation, two thoughts came to mind: first, Congress must not have a dictionary and, second, the most influential lobbying organization in Washington must be comprised entirely of tax professionals.

In order to better appreciate – if not fully understand – the changes wrought by the Act regarding the Federal taxation of trade or business income that is recognized, “directly or indirectly,” by non-corporate taxpayers, the reader should be reminded of the existing rules, and should also be made aware of the policy underlying the changes.

Pre-2018

A business that is conducted by an individual as a sole proprietorship (whether directly or through a single-member LLC that is disregarded for tax purposes) is not treated as an entity separate from its owner. Rather, the owner is taxed directly on the income of the business.

A business that is conducted by two or more individuals as a general partnership, a state law limited partnership, or a state law limited liability company, is treated as a pass-through entity for tax purposes – a partnership. The partnership is not itself taxable on the income of the business. Rather, each partner/member is taxed on their distributive share of the partnership’s business income.

A corporation that is formed under state law to conduct a business is not itself taxable on the income of the business if it is a “small business corporation” and its shareholders elect to treat it as an S corporation. In that case, the corporation is treated as a pass-through entity for tax purposes. In general, it is not taxable on its business income; rather, its shareholders are taxed on their pro rata share of the S corporation’s business income.

In each of the foregoing situations, the business income of an individual owner of a sole proprietorship, a partnership, or an S corporation (each a “Pass-Through Entity” or “PTE”) is treated for tax purposes as though the owner had realized such income directly from the source from which it was realized by the PTE.

In determining the taxable business income generated by a PTE, the Code allows certain deductions that are “related” to the production of such income, including a deduction for the ordinary and necessary expenses that are paid or incurred by the PTE in carrying on the business.

Because business income is treated as ordinary income (as opposed to capital gain) for tax purposes, the taxable business income of the PTE is taxed to its individual owner(s) at the regular income tax rates.[1]

What’s Behind the Change?

The vast majority of closely-held businesses are organized as PTEs, and the vast majority of newly-formed closely-held businesses are organized as limited liability companies that are treated as partnerships or that are disregarded for tax purposes.[2]

In light of this reality, Congress sought to bestow some unique economic benefit or incentive upon the non-corporate owners of PTEs in the form of a new deduction, and reduced taxes.[3]

However, Congress restricted this benefit or incentive in several ways that reflect a bias in favor of businesses that invest in machinery, equipment, and other tangible assets:[4]

  • in general, it is limited to PTEs that do not involve only the performance of services;
  • it benefits only the net business income of the PTE that flows through to the taxpayer; it does not apply to any amount paid by the PTE to the taxpayer in respect of any services rendered by the taxpayer to the PTE;
  • it does not apply to the PTE’s investment income; it is limited to the PTE’s business income; and
  • the benefit is capped, based upon how much the PTE pays in wages or invests in machinery, equipment, and other tangible property.

Beginning in 2018: New Sec. 199A of the Code

For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer[5] (a “Taxpayer”) who owns an equity interest in a PTE that is engaged in a qualified trade or business may deduct up to 20% of the qualified business income allocated to him from the PTE.

Qualified Trade or Business

Taxpayer’s qualified business income (“QBI”) is determined by each qualified trade or business (“QTB”) in which Taxpayer is an owner.[6] A QTB includes any trade or business conducted by a PTE other than a specified service trade or business.[7]

A “specified service trade or business” means any trade or business involving the performance of services in the fields of health, law, accounting, consulting, 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 which involves the performance of services that consist of investing and investment management, or trading or dealing in securities.[8] However, a trade or business that involves the performance of engineering or architectural services is not a “specified service.”

Qualified Business Income

Taxpayer’s QBI from a QTB for a taxable year means Taxpayer’s share of the net amount of qualified items of income, gain, deduction, and loss that are taken into account in determining the taxable income of the QTB for that year.[9]

Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the PTE’s conduct of a QTB within the U.S.[10]

“Qualified items” do not include specified investment-related income, gain, deductions, or loss; for example, items of gain taken into account in determining net long-term capital gain, dividends, and interest income (other than that which is properly allocable to a trade or business) are not included[11]; nor are items of deduction or loss allocable to such income.

Taxpayer’s QBI also does not include any amount paid to Taxpayer by an S corporation that is treated as reasonable compensation for services rendered by Taxpayer. Similarly, Taxpayer’s QBI does not include any “guaranteed payment” made by a partnership to Taxpayer for services rendered by Taxpayer.[12]

The Deduction

In general, Taxpayer is allowed a deduction for any taxable year of an amount equal to the lesser of:

(a) Taxpayer’s “combined QBI amount” for the taxable year, or

(b) an amount equal to 20% of the excess (if any) of

(i) Taxpayer’s taxable income for the taxable year, over

(ii) any net capital gain for the taxable year.

The combined QBI amount for the taxable year is equal to the sum of the “deductible amounts” determined for each QTB “carried on” by Taxpayer through a PTE.[13]

Taxpayer’s deductible amount for each QTB is the lesser of:

(a) 20% of the Taxpayer’s share of QBI with respect to the QTB, or

(b) the greater of:

(i) 50% of the “W-2 wages” with respect to the QTB, or

(ii) the sum of:

(A) 25% of the W-2 wages with respect to the QTB, plus

(B) 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”.[14]

In general, the W-2 wages with respect to a QTB for a taxable year are the total wages subject to wage withholding, plus any elective deferrals, plus any deferred compensation paid by the QTB with respect to the employment of its employees during the calendar year ending during the taxable year of Taxpayer.[15]

“Qualified property” means, with respect to any QTB for a taxable year, tangible property of a character subject to depreciation that is held by, and available for use in, the QTB at the close of the taxable year, which is used at any point during the taxable year in the production of QBI, and for which the depreciable period[16] has not ended before the close of the taxable year.

Example

The taxpayer is single. She is a member of an LLC (“Company”) that is treated as a partnership for tax purposes (a PTE). The company is engaged in a QTB that is not a specified service trade or business.

Taxpayer’s taxable income for 2018 is $500,000 (i.e., gross income of $520,000 less itemized deductions of $20,000), which includes a guaranteed payment from Company of $120,000, for services rendered to Company during 2018, and her allocable share of QBI from Company for 2018 of $400,000. She has no investment income for 2018.

Her allocable share of W-2 wages with respect to Company’s business for 2018 is $300,000.

During 2018, Company purchases machinery and immediately places it into service in its QTB (the machinery is “qualified property”). Taxpayer’s allocable share of the purchase price is $750,000.

The taxpayer is allowed a deduction for the taxable year of an amount equal to the lesser of:

(a) her “combined QBI amount” for the taxable year (the guaranteed payment of $120,000 is not included in QBI), or

(b) 20% of her taxable income of $500,000 for the taxable year, or $100,000.

Taxpayer’s combined QBI amount for 2018 is equal to her “deductible amount” with respect to Company. The deductible amount is the lesser of:

(a) 20% of Taxpayer’s QBI (20% of $400,000 = $80,000), or

(b) the greater of:

(i) 50% of the W-2 wages with respect to the QTB (50% of $300,000 = $150,000), or

(ii) the sum of: 25% of the W-2 wages with respect to the QTB ($75,000), plus (B) 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (2.5% of $750,000 = $18,750): $75,000 + $18,750 = $93,750.

Thus, Taxpayer’s deductible amount is $80,000. Because this amount is less than $100,000 (20% of her taxable income of $500,000 for the taxable year), Taxpayer will be allowed to deduct $80,000 in determining her taxable income for 2018.

Looking Ahead

It remains to be seen whether the “20% deduction” based upon the QBI of a PTE will be a “game changer” for the individual owners of the PTE.

After all, the deduction is subject to several limitations that may dampen its effect. For example, QBI does not include the amount paid by the PTE to Taxpayer in respect of services rendered by Taxpayer. In addition, the losses realized in one QTB may offset the income realized in another, thereby reducing the amount of the deduction. Finally, the deduction is subject to limits based upon the wages paid and the capital investments made by the QTB.

Maximizing the Deduction?

Might an S corporation shareholder or a partner in a partnership reduce the amount paid to them by the entity for their services so as to increase the amount of their QBI and, so the amount of the deduction? In the case of an S corporation, this may result in the IRS’s questioning the reasonableness (i.e., insufficiency) of the compensation paid to the shareholder-employee.[17]

Or might a PTE decide to invest in more tangible property than it otherwise would have in order to set a greater cap on the deduction?

In any case, the business must first be guided by what makes the most sense from a business perspective.

Becoming a Pass-Through?

What if a business is already organized as a C corporation? Should the QBI-based deduction tip the scales toward PTE status?

Before taking any action with respect to changing its status for tax purposes, a C corporation will have to consider much more than the effect of the deduction for PTEs.

For example, does it even qualify as a small business corporation? If not, what must it do to qualify? Must it redeem the stock owned by an ineligible shareholder, or must it recapitalize so as to eliminate the second class of stock? Either option may prove to be economically expensive for the corporation and the remaining shareholders.

If the corporation does qualify, what assurances are there that all of its shareholders will elect to treat the corporation as an S corporation? Even if the election is made, will the presence of earnings and profits from “C” taxable years implicate the “excess passive income” rules?

In any case, a C corporation that is not otherwise contemplating a change in its tax status, should probably not become an S corporation solely because of the PTE-related changes under the Act, especially if the corporation does not contemplate a sale of its business in the foreseeable future.

Wait and See?

The deduction based on the QBI of a PTE will expire at the end of 2025 unless it is extended before then. It is also possible that it may be eliminated by Congress after 2020.

An existing PTE and its owners should continue to operate in accordance with good business practice while they and their tax advisers determine the economic effect resulting from the application of the new deduction to the PTE.

They should also await the release of additional guidance from the IRS regarding “abusive” situations, tiered entities, and other items.[18]


*This post is the first of several that will be dedicated to those portions of the Tax Cuts and Jobs Act of 2017 (H.R. 1) that are most relevant to the closely-held business and it owners.

[1] The Act reduces the highest income tax rate applicable to the individual owner of a PTE to 37% (from 39.6%) for taxable years beginning after December 31, 2017 and before January 1, 2026. Note that the 3.8% surtax continues to apply to the distributive or pro rata share of an individual partnership or shareholder who does not materially participate in the trade or business conducted by the PTE.

[2] Though occasionally, the owner(s) will elect to treat the LLC as a corporation for tax purposes; for example, to reduce employment taxes.

[3] The Act includes a number of business-related benefits that are applicable to both corporate and non-corporate taxpayers. It also includes some that are unique to corporations, such as the reduction of the corporate income tax rate from a maximum of 35% to a flat 21%.

[4] As we will see in the coming weeks, that Act contains a number of such provisions.

[5] More accurately, the benefit is available to non-corporate owners; basically, individual taxpayers, though trusts and estates are also eligible for the deduction.

[6] A PTE may conduct more than one QTB – different lines of business – or Taxpayer may own equity is more than one PTE.

[7] Also excluded is the trade or business of being an employee.

[8] The exclusion from the definition of a qualified business for specified service trades or businesses is phased in for a taxpayer with taxable income in excess of a “threshold amount” of $157,500 ($315,000 in the case of a joint return). The exclusion is fully phased in for a taxpayer with taxable income at least equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[9] If the net amount of the QBI is a loss (negative), it is treated as a loss from a QTB in the succeeding taxable year.

[10] Generally, when a person engages in a trade or business in the U.S., all income from sources within the U.S. connected with the conduct of that trade or business is considered to be effectively connected income.

[11] Qualified items should include the gain recognized on the sale of business assets.

[12] The IRS is authorized to issue regulations that would exclude any amount paid or incurred by the partnership to Taxpayer for services provided by Taxpayer to the partnership other than in his capacity as a partner.

[13] Taxpayer does not need to be active in the business in order to qualify for the deduction.

[14] This “wage limit” is phased in for a taxpayer with taxable income in excess of the threshold amount. The limit is fully applicable for a taxpayer with taxable income equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[15] In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner or shareholder, as the case may be, takes into account his allocable or pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages and unadjusted basis for the taxable year equal to his allocable or pro rata share of the W-2 wages and unadjusted basis of the partnership or S corporation, as the case may be.

[16] The “depreciable period” is the period beginning with the date the qualified property is first placed in service and ending on the later of the date that is 10 years after such date, or the last day of the last full year in the applicable recovery period for the property.

[17] State and local taxes also need to be considered; for example, NYC’s unincorporated business income tax and its general corporation tax.

[18] “What we do in haste, we regret at leisure?”