IRC 199A Deduction for Qualified Business Income

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2 IRC 199A Deduction for Qualified Business Income

3 What is it? 20% deduction against qualified business income Designed to provide a tax break to owners of pass through entities, in light of substantial cut of C corporation rates from 35% to 21% Applies to owners of sole proprietorships, individually owned real estate, S corporations, and partnerships Regulations to be issued on application to tiered entities Deduction allowed to trusts and estates holding an interest in a pass through entity

4 What is it? Effective for tax years beginning after 12/31/2017 and before 1/1/2026 Double taxation issue still a concern, even with TCJA: Previous: 50.47% C Corp; 40.8% all others TCJA: 39.8% C Corp; 29.6% all others

5 What is Qualified Business Income? 199A(c) defines QBI as the ordinary income less ordinary deductions earned from a sole proprietorship, individually owned real estate, S corporation or partnership Does not include any wages or guaranteed payments received Excludes certain investment income: Short and long term capital gain/loss Dividend income Interest income

6 What is Qualified Business Income? 199A(d) requires QBI to be earned in a qualified trade or business Trade or business has many interpretations in tax law 469, 1411, 162 Currently defined as any trade or business other than: Trade or business of performing services as an employee A specified service trade or business

7 What is a Specified Service Business? Trade or business involving the performance of services in fields of: Health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services and brokerage services Any trade or business where principal asset of such trade or business is the reputation or skill of its employees or owners Any business which involves investing and investing management, trading, or dealing in securities, partnership interests, or commodities

8 Mechanics of the Deduction Simply put, the deduction is equal to: LESSER of: 20% of QBI or The GREATER of: 50% of W2 wages paid or 25% of W2 wages paid plus 2.5% of basis of all qualified property

9 Mechanics of the Deduction BUT, there is an overall limitation! The deduction is limited to the LESSER of 20% of the combined QBI of the taxpayer or 20% of the excess of taxable income over any net capital gain Why the limit? To match the deduction with income taxed at ordinary rates, not income with a favorable long term capital gain rate

10 Mechanics of the Deduction Example of overall limit: A has $100,000 of QBI. In addition, A has $200,000 of long term capital gains, $20,000 of wages, and $50,000 of itemized deductions, for taxable income of $270,000. A's deduction is limited to the lesser of: 20% of QBI of $100,000, or $20,000, or 20% of ($270,000 $200,000), or $14,000.

11 W 2 Limitation Typical operating business 50% of allocable share of W2 wages paid by the business Real estate business 25% of allocable share of W2 wages plus 2.5% of basis of qualified property (more on this later) Cannot be management fees or payments to independent contractor The amount paid must be reportable on a payroll tax return

12 Allocable Share of W2 Wages S corporation shareholder Piece of cake! Pro rata, based on stock ownership Partnership partner A bit more tricky, due to potential special allocations 199A(f)(1) states a partner s share is determined in same manner as share of partnership s wage deduction

13 Example A has a 20% capital stake in ABC, LLC. Under the terms of the agreement, however, A is allocated 80% of any depreciation, but only 30% of Schedule K 1, Line 1 ordinary income Since A is being allocated 30% of the wage deduction via the Line 1 deduction, A receives 30% of the partnership s W2 wage expense for the limitation purposes

14 Basis of Qualified Property Any tangible property, subject to depreciation, held by the business at yearend Land and inventory do not count! Goodwill is also not eligible Used at any point during the year in the production of QBI Depreciable period of the asset must not have ended prior to the last day of the year in which basis is claimed for deduction Basis is not reduced by any depreciation

15 Depreciable Period of Qualified Property Starts on date the property is placed in service Ends on the later of: 10 years The last day of the last full year in the asset s regular depreciation period Any asset fully depreciated prior to 2018 will not count toward basis, unless placed in service after 2008

16 Example XYZ Co. purchases a piece of machinery on November 18, 2014 The machinery is used in the business, and is depreciated over 5 years Even though the depreciable life of the asset is only 5 years, the owners of XYZ Co. will be able to take the unadjusted basis of $10,000 into consideration for purposes of this adjusted basis limitation for ten full years, from , because the qualifying period runs for the longer of the useful life (5 years) or 10 years

17 Example Consider the same facts, only the asset is a non residential rental building that is depreciated over 39 years The shareholders of XYZ Co. will be able to take their share of the building's basis into consideration from , the last full year of the asset's depreciation schedule

18 Allocable Share of Qualified Basis Like the allocation of W2 wages, S corporations and partnerships have different nuances S shareholder: basis allocated pro rata based on stock ownership Partner: basis allocated in same manner in which depreciation expense is allocated to the respective partner

19 Exceptions! Taxable income of less than $315,000 MFJ removes the following limitations: W2 wage limit Property based limit Specified Service Businesses In other words, if an individual s taxable income, not including the 199A deduction, is less than these amounts: Any business can claim the deduction, regardless of the industry The deduction is simply 20% of the lesser of QBI or taxable income over capital gains

20 Exceptions! Once taxable income exceeds $415,000 MFJ, all limitations and exclusions fully apply Taxable income between the two? Ratable phase in of the wage and basis limitation Owners of specified service trade or businesses allowed a partial deduction

21 Other Considerations The 199A deduction is a below the line deduction No impact on various AGI thresholds Potential adverse state tax considerations Deduction cannot be taken in a loss year Negative QBI will be carried over and reduces QBI in following years calculations 199A deduction in a year with a Net Operating Loss NOL does not include the deduction

22 Title Text Non Real Estate Trade or Business Impact of Tax Cuts and Jobs Act Previous Law 20% Rule S Corporation Income $4,000,000 $4,000,000 Domestic Production Activities Deduction $(360,000) 0 Pass Through Deduction 0 $(800,000) Taxable Income $3,640,000 $3,200,000 Income Tax (highest marginal rate 39.6% in 2017; 37% in 2018) $1,441,440 $1,184,000 Net Investment Income Tax $ $ Federal Tax Savings from State and local income tax deduction $(64,865) $ State Tax on income (assumed 4.5% rate for all states combined) $163,800 $180,000 Total Tax under 2018 Tax Law $1,364,000 Total Tax under 2017 Tax Law $1,540,375 Savings under new tax law $176,375

23 Title Text Real Estate Business With Income Impact of Tax Cuts and Jobs Act Previous Law 20% Rule Partnership Income $750,000 $750,000 Pass Through Deduction 0 $(150,000) Taxable Income $750,000 $600,000 Income Tax (highest marginal rate 39.6% in 2017; 37% in 2018) $297,000 $222,000 Net Investment Income Tax $ $ Federal Tax Savings from State and local income tax deduction $(13,365) $ State Tax on income (assumed 4.5% rate for all states combined) $33,750 $33,750 Total Tax under 2018 Tax Law $255,750 Total Tax under 2017 Tax Law $317,385 Savings under new tax law $61,635

24 Title Impact of Tax Cuts and Jobs Act Text Real Estate Business With Loss Previous Law 20% Rule Partnership Income $(500,000) $(500,000) Pass Through Deduction 0 $ Taxable Income $(500,000) $(500,000) Income Tax (highest marginal rate 39.6% in 2017; 37% in 2018) $(198,000) $(185,000) Net Investment Income Tax $ $ Federal Tax Savings from State and local income tax deduction $8,910 $ State Tax on income (assumed 4.5% rate for all states combined) $(22,500) $(22,500) Total Tax under 2018 Tax Law $(207,500) Total Tax under 2017 Tax Law $(211,590) Savings (cost) under new tax law $(4,090)

25 IRC 163(j) Limitation on Business Interest Deduction

26 What is it? Limitation on the amount of interest expense businesses can deduct Effective for tax years beginning after 12/31/2017 Net business interest will be limited to 30% of adjusted taxable income

27 Adjusted Taxable Income Taxable income, without taking into account: EBITDA Non business income (e.g. gain from sale of assets held for investment) Business interest expense or business interest income Net operating loss deductions 20% QBI deduction Depreciation, amortization, or depletion Only through 2021 EBIT after

28 Exceptions to the Limitation Small businesses Average annual gross receipts of $25M or less the last three years Related taxpayers must be combined for this test (see 52, 414, and 1563) Electing real property business Those engaged in real estate development, construction, rental, management, or brokerage may elect out of rule Election is irrevocable Consequence? Those making the election are required to use the ADS lives for any nonresidential real property, residential real property and qualified improvement property

29 Summary of ADS Differences

30 Application to Pass Through Entities Interest limitation is applied at the entity level If 30% of ATI + interest income > interest expense incurred, excess passes through to owner as excess ATI and is taken into account to determine amount of business interest deducted by owner If 30% of ATI + interest income < interest expense: S corporation entity level carryover until enough income generated to absorb Partnership excess allocated to partners and carried over at the individual level until allocated income from that entity

31 Example X Co. has taxable income of $300,000 Included in that amount is $20,000 of interest income, $150,000 of interest expense, $200,000 of depreciation, and $20,000 of amortization X Co. computes its ATI as follows: $300,000 $20,000 + $150,000 + $200,000 + $20,000 = $650,000 The ATI is multiplied by 30%, resulting in a limitation of $195,000 The total limitation, however, is $195,000 plus interest income of $20,000, or $215,000 Since the interest expense of $150,000 is less than the limitation of $215,000, the interest is deductible in full

32 Example Assume the same facts, except taxable income was only $25,000 ATI is: $25,000 $20,000 + $150, ,000 +$20,000 = $375,000 30% limitation of $112,500 before adding interest income of $20,000 Total limitation is $132,500, so X Co. can deduct $132,500 of the $150,000 of interest expense

33 IRC 461(l) Excess Business Loss Rules

34 What is it? Yet another loss disallowance provision in the IRC, operating after: Basis limitations ( 1366, 704) At Risk limits ( 465) Passive activity limits ( 469) Simply, a taxpayer can only deduct net business losses up to $500,000 MFJ, regardless of how much nonbusiness income they may have

35 Mechanics Losses in excess of $500,000 are disallowed in the current year Carried forward Becomes a Net Operating Loss in the following year TCJA change to NOL rules! Can only carryforward (indefinite) 80% limitation on utilization MUCH unknown with this provision What to include in EBL calculation Essentially, what constitutes business income and loss?

36 Carried Interest Long term capital gains from an applicable partnership interest held less than three years recharacterized as short term capital gains Applicable partnership interest must be received in exchange for services Applies to tax years beginning after December 31, 2017

37 Q & A

38 Bonus Depreciation Now 100% for both new and used property Type of property eligible Tax life of < 20 years Must be placed in service after 9/27/17

39 Cost Segregation Impact The process is the same breakdown of assets into various tax categories (i.e. 5, 7 or 15 years) Bonus depreciation now applies to acquired properties, not just new construction! Impact example: $1,000,000 property acquisition

40 Qualified Property Rules Old Law Qualified Leasehold Improvements Qualified Restaurant Property Qualified Retail Improvements Qualified Improvement Property (39 year life) Only interior improvements to commercial buildings New Law Qualified Improvement Property (15 year life?) Impact Example: $500,000 renovation (assuming 15 year life)

41 Changes to 179 Deduction Old Law Could deduct up to $500,000 Phase out began at $2,000,000 Eligible property included: Tangible personal property (real property was not eligible) Software Qualified leasehold, restaurant or retail improvements New Law Can deduct up to $1,000,000 Phase out begins at $2,500,000 Eligible property includes: Tangible personal property and software Qualified Improvement Property Certain improvements to commercial property (i.e. roofs, HVAC, fire and alarm systems, security systems) Must be placed in service after 12/31/17

42 Q & A

43 Like Kind Exchanges Like Kind Exchanges have a long history. Have been around since 1921 Benefits Include: They allow you to deploy more cash into future deals Provides ability to diversify location and type of assets in your portfolio No limit to the number of exchanges you can do

44 General Rules of a Like Kind Exchange To qualify for non recognition of gain under 1031, relinquished property must be exchanged for replacement property of like kind for investment or use in trade or business In other words, three requirements must be met: 1. The exchanged properties must be of like kind to each other 2. The property must be held for investment, or use in a trade or business 3. There must be an exchange of properties

45 TCJA changes For exchanges completed after December 31, 2017 All real property other than real property held by the taxpayer as inventory is eligible Ancillary Personal Property may include taxable boot Washers, dryers, dishwashers, stoves, office equipment Courts have held that state law is generally followed to determine whether property is real or personal

46 Digging Deeper Related Party Exchanges o Generally, gain in a like kind exchange with a related party (related directly or indirectly) is triggered if either person disposes of exchanged property within two years Taking cash out of an exchange o Triggering Partial Gain o Cash Out Refinance post replacement purchase o Using Tenants in Common

47 Opportunity Zones

48 Opportunity Zones What s In it for Us? Capital Gain Deferral Gains from the sale of assets can be deferred until December 31, 2026 or the sale of the new investment, whichever is earlier Step up In Basis After a 5 year hold we get to exclude 10% of the original capital gain After a 7 year hold we exclude an additional 5% ~ 15% total Permanent Gain Elimination After 10 year hold, investors get to permanently exclude any capital gains tax on the post acquisition gains No dollar limitation on the amount of gain that can be deferred 1031 difference All asset classes are eligible Only have to reinvest gain No QI Losses given favorable treatment (Step Up on original deferral and get to take advantage of the loss upon disposition or )

49 Tax Deferral Timeline How do you achieve the 10 year holding period if gains are taxed on 12/31/2026?

50 Numerical Example

51 The Mechanics Invest the gain realized from the sale of an asset into an Opportunity Fund (OF) within 180 day limit Opportunity Fund must invest in QO Business Property QO Business Property is defined as: QO Zone stock QO Zone partnership interest QO Zone business property Original use commences with the QO Fund or the QO Fund substantially improves the property QO Zone Business

52 Anti Abuse/Limitations Must invest opportunity Fund to take advantage of: 15% gain exclusion by % gain exclusion by 2021 Appreciated gain excluded by 2026 Substantially Improved in a 30 month period Some think it may be difficult to do anything other than development or heavy repositioning Can t sell to related party The following trade or business will not qualify as an QOZ business Golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or a liquor store. Depreciation recapture current language uses the word gain. Recapture isn t normally considered gain therefore the conservative position is to plan on recapturing.

53 Other Issues Mixed Funds When mixing funds where only a portion of which is gain from the sale of an asset: Such investment shall be treated as 2 separate investments Only the rolled over gain is eligible for deferral & the step up Debt financing is available No depreciation allowed on initial investment on the reinvested gain Losses may be limited to investors due to basis

54 Resources Federal Resources IRS FAQ frequently asked questions CDFI Interactive Map Zones.aspx Each state has its own web resource guide Indiana Kentucky 144 sites in 84 counties Michigan _85624,00.html Ohio 320 census tracts in 73 counties

55 Q & A