CLOSELY HELD BUSINESS: TAX PLANNING & COMPLIANCE STRATEGIES AFTER THE TAX CUTS AND JOBS ACT OF 2017: 2018 EDITION

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1 CLOSELY HELD BUSINESS: TAX PLANNING & COMPLIANCE STRATEGIES AFTER THE TAX CUTS AND JOBS ACT OF 2017: 2018 EDITION 12. QUALIFIED BUSINESS INCOME Copyright Robert W. Jamison QUALIFIED BUSINESS INCOME 1201 Introduction 1202 General Rules 1203 Framework for Inclusions, Exclusions, Limits and Phase Ins Based on Taxable Income 1204 Domestic Source Rule 1205 Separate Computation for each Trade or Business 1206 Specified Service Trade or Business Rules 1207 Businesses Other Than Specified Service Trade or Businesses 1208 Effect of Qualified Business Loss 1209 Rules for S Corporations and Partnerships 1210 Stringent Procedural Rules for the QBI Deduction Copyright Robert W. Jamison 2 1

2 1201 Introduction Background Qualified Business Income Copyright Robert W. Jamison Introduction Beginning in 2018, taxpayers other than corporations are allowed a deduction for qualified business income. This deduction requires no outlay of cash or property and may be as high as 20% of the income from proprietorships, farms, S corporations and partnerships. On December 22, 2017 the U.S. president signed the Tax Cuts and Jobs Act of 2017 (TCJA) into law. The principal purposes of this legislation were twofold: To change the U.S. corporate tax system from a worldwide approach to a territorial model; and, To reduce the corporate tax rates. Copyright Robert W. Jamison 4 2

3 1201 Introduction The TCJA accomplished both principal objectives, at least to a degree. The rates of tax on C corporations were changed from a graduated scale of 15% to 35% in 2017 to a flat 21% in Copyright Robert W. Jamison Introduction (Cont.) In August 2018 the IRS issued proposed regulations to implement this deduction. The operative proposed regulations are: 1.199A 1 Operational rules A 2 Determination of W 2 Wages and unadjusted basis immediately after acquisition of qualified property A 3 Qualified business income, qualified REIT dividends, and qualified PTP income A 4 Aggregation A 5 Specified service trades or businesses and the trade or business of performing services as an employee A 6 Relevant passthrough entities (RPEs), publicly traded partnerships (PTPs), trusts, and estates. Copyright Robert W. Jamison 6 3

4 Background The American Jobs Creation Act of 2004 added a deduction for Income Attributable to Domestic Production Activities. This rule allowed a deduction for certain income of various domestic production activities, up to 9% of taxable income. To allay some concerns about exportation of jobs, this deduction was limited to 50% of the W 2 wages paid in a taxable year. The Tax Cuts and Jobs Act repealed this deduction and replaced it with the C corporation rate reduction and the QBI deduction. Copyright Robert W. Jamison Background (Cont.) Some analysts have compiled the estimates of compliance time to be as high as 25 million hours. Whether or not this estimate is accurate, the implications are clear. Tax professionals with business clients will need to spend considerably more time, and charge significantly higher fees, for preparation of 2018 returns than was the case for Copyright Robert W. Jamison 8 4

5 Qualified Business Income Code Section 199A, Qualified Business Income, is the provision authorizing the deduction. In general, the rule permits a deduction for 20% of income from partnerships, proprietorships and S corporations. It also applies to dividends from real estate investment trusts (REITs), income from publicly traded partnerships (PTPs) and certain payments from cooperatives (COOPs) to their patrons. The rules for income from REITs and PTPs are reasonably straightforward. However, the rules for proprietorships, farms, partnerships and S corporations have several complicating factors. Copyright Robert W. Jamison Qualified Business Income (Cont.) Commercial businesses, professional service businesses and farms are subject to the most complex rules. The rules require separate computations for each separate trade or business Income and other items must be effectively connected with a U.S. trade or business. There are also special rules based on the taxpayer s taxable income (before the 199A deduction). The IRS has specific and broad regulatory authority to interpret Section 199A. Therefore, its interpretations will have substantial weight of authority and will not be easy to challenge successfully. Copyright Robert W. Jamison 10 5

6 Separate Income Components The proposed regulations separate the Section 199A deduction into component groups of income: The REIT/PTP component. The QBI component. The REIT/PTP component applies only to income and losses received from these entities. The QBI component applies to all other businesses, farms and rental activities in which the individual taxpayer owns an interest. A person who has income or loss from both of these components combines the sources within each component before computing the final deduction. Copyright Robert W. Jamison General Rules The deduction for qualified business income (QBI deduction, or Section 199A deduction) has a rate of 20%. This rate is measured by the lesser of the QBI or the taxpayer s taxable income, before the QBI deduction. However, taxable income is reduced by any portion of the income taxable as a capital gain, including any long term capital gain. It requires no cash outlay and is a pure paper allowance. No material participation is necessary to claim this deduction. Thus, some trade or business, rental or royalty income may be subject to both the Section 199A deduction and net investment income tax. This also applies to income from publicly traded partnerships and real estate investment trusts. Copyright Robert W. Jamison 12 6

7 Limit to Income Tax and AMT Section 199A specifically states that the deduction is limited to this chapter. UNITED STATES CODE TITLE 26 INTERNAL REVENUE CODE SUBTITLE A INCOME TAXES Chapter 1 Normal Taxes and Surtaxes Chapter 1, which includes the income tax and the alternative minimum tax, does not contain the self employment tax, which is in Chapter 2 or the net investment income tax, which is in Chapter 3. The deduction is below AGI, although it is available in full for taxpayers who itemize, or those who use the standard deduction. Copyright Robert W. Jamison Framework for Inclusions, Exclusions, Limits and Phase Ins Based on Taxable Income Always QBI Never QBI Sometimes QBI Copyright Robert W. Jamison 14 7

8 1203 Framework for Inclusions, Exclusions, Limits and Phase Ins Based on Taxable Income There are several sub categories of QBI. Some are conditional on other limits, whereas some are not. There are also types of income that can never be treated as QBI. Copyright Robert W. Jamison Always QBI Some items are always parts of qualified business income, regardless of the source of income or the taxpayer s level of income. These include: Dividends from REITs, other than those treated as qualified dividends. Income from publicly traded partnerships, unless the publicly traded partnership is treated as a corporation. This rule extends to the gain on disposition of an interest in a publiclytraded partnership, to the extent the gain is treated as ordinary income by Code Section 751(a). Copyright Robert W. Jamison 16 8

9 Never QBI Some categories of income and deductions are never components of QBI, including: Wage, salary and retirement income. Dividends, including qualified dividends. Interest, unless it is properly allocable to a trade or business. Capital gains and losses (short or long term). Gains and losses from transactions of foreign personal holding companies. Income from annuities, unless received in connection with a trade or business. Any income that is not effectively connected with a U.S. trade or business cannot be QBI. Copyright Robert W. Jamison Sometimes QBI The third general category of income is that which may or may not be QBI, depending upon the taxpayer s taxable income before computing the QBI deduction. Figure 12-1 Thresholds and Phaseouts for Qualified Business Income All except Married Filing Joint Married Filing Joint Filing status Threshold $157,500 $315,000 Phaseout for wage and property limit and specified service business income 50, ,000 End of phaseout $207,500 $415,000 Copyright Robert W. Jamison 18 9

10 1204 Domestic Source Rule QBI must be effectively connected with the conduct of a trade or business within the United States. This rule borrows from Code Section 864(c), which is used to characterize U.S. source income for purposes of the allocation rules applicable to non U.S. persons and corporations. The principal test is based on having an office or other fixed place of business within the U.S., if the place is a material factor in the realization of the income, gain, or loss, and if the income, gain, or loss is realized in the ordinary course of the trade or business carried on through that office or other fixed place of business. Copyright Robert W. Jamison Domestic Source Rule The U.S. place of business is a material factor if it is used for management of U.S. sales, rents or royalties Copyright Robert W. Jamison 20 10

11 1205 Separate Computation for each Trade or Business Ultimately, each taxpayer is allowed one Section 199A deduction on his or her (or their) tax return for the year. However, if a taxpayer has interests in more than one separate trade or business, there must be a separate computation of QBI for each. The major significance of this rule is that the taxpayer may not comingle the income and limits of two or more businesses in computing the Section 199A deduction for each separate activity. Copyright Robert W. Jamison Aggregation Rules: Separate and Combined Activities When an individual is engaged in more than one trade or business each is treated as separate unless one of the aggregation rules applies. Aggregation is not required. Aggregation is permitted only if it meets certain conditions. Figure 12 2 depicts the aggregation rules applicable to Section 199A Copyright Robert W. Jamison 22 11

12 Figure 12 2: Aggregation Rules for Section 199A Business #1 SSTB? Yes No Business #2 SSTB? Yes No Same or complementary products or services. Same person(s) own > 50% of each? Yes No Shared facilities or resources Ownership majority of year? No Interdependen cy Yes Yes Report on same tax year? No May elect to aggregate Yes 2 of the 3 factors? No Cannot aggregate Copyright Robert W. Jamison [a]The Common Ownership Rule In order to aggregate, a person, or group of persons, must own at least 50% of each trade or business: Stock in an S corporation. Capital or profits interest in a partnership. There must be this common ownership for a majority of the taxable year in question. All of the businesses must use the same taxable year. There are limited attribution rules. An individual is considered to own the interests held by his or her spouse, children, grandchildren and parents. The aggregation eligibility extends to all owners. Copyright Robert W. Jamison 24 12

13 Example 12 1 Dan owns 80% and Sue owns 20% of the outstanding shares of DS1, Inc. an S corporation. Dan owns 90% and Sue owns 10% of the capital and profits interests in DS2, LLC, taxed as a partnership. Dan owns 2% and Sue owns 98% of DS3, Inc. an S corporation. These three entities are under control of the same persons. Therefore, under the common ownership rule, Dan can combine the income and other attributes of any two, or of all three of these entities for purposes of Section 199A. Sue can also combine any two, or all three, as she chooses. Dan s election is not relevant to Sue s choice. The three entities must meet the other tests. Copyright Robert W. Jamison [b]The Specified Service Trade or Business (SSTB) Rule A taxpayer cannot aggregate an income from an SSTB with any other enterprise. However, certain businesses that provide property or services to an SSTB may be classifies as SSTBs. Copyright Robert W. Jamison 26 13

14 [c] The Business Relationship Rule Each of the businesses must share at least two of these attributes with the others: 1. The products or services must be the same or complementary. 2. The businesses must share the same facilities or business functions such as accounting and payroll. 3. There must be interdependence between (or among) the businesses. Copyright Robert W. Jamison [d]The Consistency Rule Once an individual elects to aggregate he or she cannot disaggregate the activities in the future, unless the businesses no longer qualify for aggregation. An individual may (but is not required to) add a newly acquired businesses to a group if it meets the criteria. The individual must disclose the aggregation on a statement with each year s tax return. Copyright Robert W. Jamison 28 14

15 Business with Multiple Activities When a single entity conducts more than one line of business, some of the activities may be QBI and others may not. In other situations, separate operations may produce QBI, but either cannot be aggregated, or the taxpayer does not elect to aggregate them. Similarly, a single owner, or identifiable group of owners may conduct different business activities through multiple entities. In these situations, there may be some overlap of costs, including the wages of employees. Copyright Robert W. Jamison Business with Multiple Activities (Cont.) Proposed Regulations Section 199A 3(b)(5) prescribes allocation of expenses among different activities. It is based on ordinary cost accounting principles of tracing expenses and costs to the income they produce. Proposed Regulation Section 1.199A 2(b)(2)(iv)(D) refers to this rule for allocation of W 2 among various activities. Copyright Robert W. Jamison 30 15

16 1206 Specified Service Trade or Business Rules Specified Service Business: Taxpayer Below Threshold Specified Service Business: Taxpayer Above Threshold Plus Phaseout Specified Service Business: Taxpayer Above Threshold but Within Phaseout Applicability of Other Limits to Specified Service Businesses Copyright Robert W. Jamison Specified Service Trade or Business Rules Any taxpayer whose taxable income exceeds the threshold plus phaseout is not able to claim a deduction for income from a specified service trade or business. This rule starts with the service rules from Code Section 1202, dealing with the exclusion for sale on small business stock. Code Section 1202(e)(3)(A) defines trade or business activities that render a corporation ineligible for the exclusion by its shareholders. Copyright Robert W. Jamison 32 16

17 1206 Specified Service Trade or Business Rules Health Law Engineering (but not for Section 199A) Architecture (but not for Section 199A) Accounting Actuarial science Performing arts Consulting Athletics Financial services Brokerage services Any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees. Copyright Robert W. Jamison Specified Service Trade or Business Rules Section 199A adds investing and investment management, trading, or dealing in securities, partnership interests, or commodities to the list of specified services. However, Section 199A specifically excludes engineering and architecture from the specified service business rules. Copyright Robert W. Jamison 34 17

18 Specified Service Business: Taxpayer Below Threshold For many taxpayers engaged in professional services, the QBI deduction will provide significant tax savings. If the taxpayer s taxable income, that is to say AGI less the standard deduction or itemized deductions, but before the Section 199A deduction, does not exceed the threshold, the professional service income qualifies as QBI, in its entirety. Copyright Robert W. Jamison Taxpayer Below Threshold (Cont.) Example 12 1 (2) Lanny Gant, a single individual, is the sole owner of LGU, LLC, a licensed accounting practice. All of LGU s income is from the practice of accounting and is thus a specified service business. LGU has not elected out of its default tax status as a disregarded entity. LG reports all of the income from the accounting practice on his Schedule C. He does not itemize deductions. Copyright Robert W. Jamison 36 18

19 Example 12 1 (2) (Cont.) Lanny s 2018 Form 1040 shows the following: Income from accounting practice, sole practitioner $125,000 Other ordinary income, not from trade or business, rent or royalty 30,000 SE Tax deduction (8,831) AGI $146,169 Standard deduction (12,000) Taxable Income before 199A deduction $134,169 Copyright Robert W. Jamison 37 Example 12 1 (2) (Cont.) Lanny s income from LGU is subject to the specified service rules. He must determine whether or not his taxable income (before the Section 199A deduction) is under the threshold. The threshold for a single individual is $157,500. Since his income is less than the threshold he may treat all of his accounting practice income as QBI. Copyright Robert W. Jamison 38 19

20 Example 12 1 (2) (Cont.) Lanny calculates his base for the QBI deduction as the lesser of: Income from LGU $125,000 Tentative deduction 20% $25,000 Taxable income: $134,169 Taxable income limitation $134,169 Tentative deduction 20% $26,834 Deduction $25,000 Copyright Robert W. Jamison 39 Example 12 1 (2) (Cont.) Lanny s taxable income and income tax are: Adjusted gross income $146,169 Standard deduction (12,000) QBI deduction (25,000) Income $109,169 Tax, at 2018 rates Income Tax $20,490 SE tax 17,662 Total Tax $38,152 Copyright Robert W. Jamison 40 20

21 Example 12 2 (3) Specified Service Business: Taxable Income Does Not Exceed Threshold, Taxable Income Limitation Applies When a portion of the taxable income is composed of long term capital gains and qualified dividends, the individual must reduce the taxable income limitation for these amounts. Same facts as Example 12 1 except that $12,000 of LG s income was from qualified dividends, and $18,000 was income that did not qualify for either the QBI deduction or capital gain rates. Copyright Robert W. Jamison 41 Example 12 2 (3) (Cont.) Lanny s 2018 Form 1040 shows the following: Qualified dividends $ 12,000 Income from accounting practice, sole practitioner 125,000 Other ordinary income, not from trade or business, rent or royalty 18,000 SE Tax deduction (8,831) AGI 146,169 Standard deduction (12,000) Taxable Income before 199A deduction 134,169 Copyright Robert W. Jamison 42 21

22 Example 12 2 (3) (Cont.) His income from LGU is subject to the specified service rules. He must determine whether or not his taxable income (before the Section 199A deduction) is under the threshold. The threshold for a single individual is $157,500. Since his income is less than the threshold, he may treat all of his accounting practice income as QBI. However, his taxable income after reduction for the qualified dividends, is less than his income from his accounting practice. Copyright Robert W. Jamison 43 Example 12 2 (3) (Cont.) He calculates his base for the QBI deduction as the lesser of: Income from LGU $125,000 Tentative deduction 20% $25,000 Taxable income: 134,169 Less net capital gain (12,000) Taxable income limitation 122,169 Tentative deduction 20% 24,434 Deduction $24,434 Copyright Robert W. Jamison 44 22

23 Example 12 2 (3) (Cont.) Lanny s taxable income and income tax are: Adjusted gross income $145,438 Standard deduction (12,000) QBI deduction (24,434) Income $109,735 Tax, at 2018 rates Income Tax $19,546 SE tax 17,662 Total Tax $37,208 Copyright Robert W. Jamison Specified Service Business: Taxpayer Above Threshold Plus Phaseout When the individual s taxable income (before the Section 199A deduction) exceeds the threshold plus the phaseout, none of the specified service business income is qualified business income. For single individuals the threshold is $157,500 and the phaseout is $50,000. Therefore, when taxable income exceeds $207,500 the prohibition applies in full. Taxable income is not reduced for any capital gain or qualified dividend. Copyright Robert W. Jamison 46 23

24 Example 12 3 (4) Specified Service Business: Taxable Income Exceeds Threshold Same facts as Example 12 2 except income was $205,000. Lanny s 2018 Form 1040: Qualified dividends $ 12,000 Income from accounting practice, sole practitioner 205,000 Other ordinary income, not from trade or business, rent or royalty 18,000 SE Tax deduction (10,706) AGI 224,294 Standard deduction (12,000) Taxable Income before 199A deduction $212,294 Copyright Robert W. Jamison 47 Example 12 3 (4) (Cont.) Lanny s income is subject to the specified service rules. Since his income exceeds the threshold plus the phaseout, none of his specified service business income is QBI. Taxable Income $212,294 Tax, at 2018 rates Income Tax $47,592 SE tax 21,412 Total Tax $69,004 Copyright Robert W. Jamison 48 24

25 Specified Service Business: Taxpayer Above Threshold but Within Phaseout When a person s taxable income exceeds the threshold limit of $157,000 ($315,000 for married filing joint return), but within the phaseout range of $50,000 ($100,000 for married filing joint return), a portion of the income from a specified service business is QBI. To determine the percentage allowed as QBI, the taxpayer must back in from the amount disallowed. Copyright Robert W. Jamison Specified Service Business: Taxpayer Above Threshold but Within Phaseout (Cont.) The amount disallowed is: (Taxable income less threshold) / (phaseout range) For single taxpayers, heads of household and married persons filing separate returns, the calculation is: (Taxable income $157,500) / $50,000 For married taxpayer filing jointly, the formula is: (Taxable income $315,000) / $100,000 Copyright Robert W. Jamison 50 25

26 Inapplicability of Other Limits to Specified Service Businesses Other businesses are subject to limitations based on W 2 wages paid by the business, and qualified property held by the business. However, these limits are subject to the same threshold and phaseout limits as specified service business income. Therefore, it is mathematically impossible for these limits to affect the QBI status of specified service business income, since specified service business income cannot be QBI in any situation in which those rules are a limiting factor. Copyright Robert W. Jamison Applicability of Other Limits to Specified Service Businesses Other businesses are subject to limitations based on W 2 wages paid by the business, and qualified property held by the business. However, these limits are subject to the same threshold and phaseout limits as specified service business income. Therefore, it is mathematically impossible for these limits to affect the QBI status of specified service business income, if the taxpayer s income is below the threshold. Moreover, the wage and qualified property of an SSTB have no impact on the taxable income of a person whose income exceeds the threshold plus phaseout range. However, when a taxpayer within the phaseout range has income from an SSTB, all of the QBI limits apply to the portion of the SSTB income treated as QBI. Copyright Robert W. Jamison 52 26

27 Example 12 4 (5) Specified Service Business: Taxable Income Exceeds Threshold but not Phaseout Range Assume the same facts in Example 12 3 except that Lanny s income was $180,000. Lanny s 2018 Form 1040: Qualified dividends $ 12,000 Income from accounting practice, sole practitioner 180,000 Other ordinary income, not from trade or business, rent or royalty 18,000 SE Tax deduction (10,371) AGI $199,629 Standard deduction (12,000) Taxable Income before 199A deduction $187,629 Copyright Robert W. Jamison 53 Example 12 4 (5) (Cont.) Since Lanny s income exceeds the threshold but not the phaseout, he must determine the amount allowed and the amount disallowed. He must determine the excess of his taxable income over the threshold, and then divide that excess by the phaseout range. Taxable income before 199A $187,629 Threshold (157,500) Excess $30,129 Phaseout range 50,000 Excess as % of phaseout range % Percent of deduction allowed % Copyright Robert W. Jamison 54 27

28 Example 12 4 (5) (Cont.) Thus, Lanny must treat % of his accounting income as qualified business income. He must also threat the same percentage of wages paid by his firm as wages attributable to QBI. Finally, if 20% of the QBI exceeds 50% of the wages, he will be able to include % of the excess amount as part of his QBI deduction. Total Percentage QBI Income 180, % 71,536 W 2 wage 40, % 15,897 Copyright Robert W. Jamison 55 Example 12 4 (5) (Cont.) QBI 71,536 20% of QBI 14,307 50% of W 2 wage 7,948 Excess of 20% QBI over 50% W 2 wage 6,359 Percent excess allowed % Excess allowed 2,527 QBI deduction 10,476 Limit to 20% of taxable income less capital gain Taxable income 177,153 Less capital gain and qualified dividend (12,000) 165,153 33,030 QBI deduction $10,476 Copyright Robert W. Jamison 56 28

29 Example 12 4 (5) (Cont.) Lanny s taxable income and income tax are: Adjusted gross income $199,429 Standard deduction (12,000) QBI deduction ($10,476) Income $177,153 Tax, at 2018 rates Income Tax $36,339 SE tax 20,742 Total Tax $57,081 Copyright Robert W. Jamison Businesses Other Than Specified Service Trade or Businesses W 2 Wage Limitation Wage and Property Limitation Phase in of W2 and Qualified Property Limits Copyright Robert W. Jamison 58 29

30 1207 Businesses Other Than Specified Service Trade or Businesses Income other than specified service business income is subject to the QBI deduction. It must not be one of the excluded categories such as capital gain or foreign source income. One major distinction between specified service business income and other eligible business income: the deduction applies to taxpayers whose income exceeds the threshold and phaseout ranges. These sources of income may be limited to a percentage of W 2 wages paid by the business, or by a combination of W 2 wages and basis of qualified property held by the business. Copyright Robert W. Jamison W 2 Wage Limitation The QBI deduction is limited to 50% of W 2 wages paid by an activity other than a specified service business. There are two exceptions to this rule: If the taxpayer s taxable income, before the Section 199A deduction, does not exceed the threshold plus the phaseout, the W 2 limit is relaxed, in full or in part. If the taxpayer owns substantial depreciable property, a limit of 25% of the W 2 wages plus 2.5 percent of the depreciable property s basis applies. Copyright Robert W. Jamison 60 30

31 [a] W 2 Wages Allowed for the Limit W 2 wages include any payment subject to either FICA or withholding. Items included on Form W 2, such as health insurance for employees, including shareholder employees of S corporations, constitute part of the W 2 base. Wages paid in Puerto Rico also qualify as part of this base. Guaranteed payments to partners are not reported on Form W 2. These payments are reported on Form 1065 Schedule K 1. Therefore, guaranteed payments are not part of the W 2 base. Copyright Robert W. Jamison 61 Example 12 5 (6) Partnership and S Corporation Contrasted Tom and Chris are 50/50 owners of TSI, LLC, a professional education firm. TSI provides several seminars each year on computer software applications. Tom speaks at several of these sessions, but others are conducted by outside speakers. TSI treats the outside speakers as independent contractors. In 2018, TSI s net income is $200,000. Tom and Chris both have other full time businesses, with sufficient taxable income to be above the threshold plus phaseout range. Therefore, each is concerned with the W 2 limit. Copyright Robert W. Jamison 62 31

32 Example 12 5 (6) (Cont.) If Tom and Chris operate TSI as a partnership, neither owner will be able to claim a Section 199A deduction for the income from TSI. There are some options they can consider: Pay the outside speakers W 2 wages instead of independent contractor compensation. Elect S corporation status and pay themselves W 2 wages, being mindful of the employer FICA taxes, which will erode part of the tax savings. Elect C corporation status and pay themselves dividends. Tom and Chris need to determine the costs and benefits of the Section 199A deduction in light of other alternatives. Copyright Robert W. Jamison 63 Example 12 5 (6) (Cont.) The W 2 wages are only those applicable to a qualified trade or business. Wages allocable to foreign source income or to investment income that does not constitute trade or business income, would not be taken into account for this limit. Moreover, the W 2 wages for one trade or business may not be combined with the income or qualified property from another trade or business. Therefore, when a grouping alternative is viable, taxpayers may want to consider combining separate entities or activities into a single trade or business. Copyright Robert W. Jamison 64 32

33 Example 12 5 (6) (Cont.) If they are confident that TSI can avoid specified service business categorization, they should set W 2 wages to themselves based on the following formula:.5 W 2 wage =.2 (Income W 2 wage+.5 W 2 wage =.2 Income.2 W 2 wage W 2 wage =.4 Income.4 W 2 wage 1.4 W 2 wage =.4 Income (1.4 W 2 wage) /.4 = Income 3.5 wage = Income Wage = Income / 3.5 Wage = Income Copyright Robert W. Jamison 65 Example 12 5 (6) (Cont.) To be more concise: 50% * 2/7 = 20% * 5/7 Copyright Robert W. Jamison 66 33

34 [b] Limit Per Trade or Business Example 12 6 (7) Separate Businesses, W 2 Wage Limitation Applies in Full. Magnus and Evelyn James file a joint return in They each own a business that is not a specified service business. Magnus s business reported $260,000 net income and paid $24,000 in W 2 wages this year. Evelyn s business had net income of $310,000 and her business paid $1,500,000 in W 2 wages. Neither spouse is subject to self employment tax. Copyright Robert W. Jamison 67 Example 12 6 (7) (Cont.) Their combined income items are: Wage and salary income $320,000 Capital gains & qualified dividends 10,000 Qualified Business Income 570,000 AGI $900,000 Itemized deductions (86,000) Taxable Income before 199A deduction 814,000 Copyright Robert W. Jamison 68 34

35 Example 12 6 (7) (Cont.) Magnus and Evelyn cannot combine their incomes and W 2 wage limits. They compute each QBI deduction separately and then combine the two. Magnus Evelyn Total 1. Net income $260,000 $310, % QBI 52,000 62, W 2 wages 24,000 1,500, W 2 limit (50%) 12, ,000 Lesser amount, 2 or 4 $12,000 $62,000 $74, Taxable income limitation (less capital gain) 804,000 20% 160, Section 199A deduction $74,000 Copyright Robert W. Jamison 69 Example 12 6 (Cont.) Their itemized deductions are $86,000. Their taxable income and tax: AGI $900,000 Itemized deductions (86,000) Taxable Income before 199A deduction 814, A deduction (74,000) Taxable income 740,000 Total Income Tax $211,479 Copyright Robert W. Jamison 70 35

36 [c] Business with Multiple Activities When a single entity conducts more than one line of business, some of the activities may be QBI and others may not. Similarly, a single owner, or identifiable group of owners may conduct different business activities through multiple entities. In either of these situations, there may be some overlap of costs, including the wages of employees. Until and unless there is specific guidance on these problems within the context of Section 199A, some regulations issued under prior Section 199 and under Section 861 may be useful. Regulations Section 199 2(e) shows an allocation of wages between two different activities. It is based on ordinary cost accounting principles of tracing expenses and costs to the income they produce. Copyright Robert W. Jamison Wage and Property Limitation For real estate businesses and other enterprises that do not pay substantial wages, Congress enacted an alternative to the W 2 wage limit. A taxpayer may claim a limit based on W 2 wages plus a percentage of basis of certain property. The first component is 25 percent of the W 2 wage base, as defined above for purposes of the 50% limit. The second component is based on the unadjusted basis of certain qualified property held at the end of the year. Only tangible and depreciable property qualifies for this purpose. Copyright Robert W. Jamison 72 36

37 Wage and Property Limitation (Cont.) Since land is not depreciable it does not constitute qualified property. Businesses with significant investments in patents and other intangible property, including goodwill, are not able to include these assets in their qualified property base. The property must be held and available for use at the end of the year. Any assets sold before the end of the year are not part of this base The depreciable period of the property must not have ended at the close of the year. This period generally corresponds to the MACRS rules. If the property s MACRS life exceeds 10 years, the depreciable period is the last full year of its MACRS life. Buildings, 39 or 27.5 Qualified improvement property 15 Copyright Robert W. Jamison Wage and Property Limitation (Cont.) If a real estate trade or business (or other business operation with substantial depreciable property) has a rate of return of 12.5% or less on its depreciable assets, payment of W 2 wages will not result in any increase in the QBI deduction. Proof: Income x 20% = Basis x 2.5% Income x 100% = Basis x 12.5% Or Basis = 8 x Income Copyright Robert W. Jamison 74 37

38 Example 12 7 (8) Separate Businesses, W 2 Wage Plus Qualified Property Limitation Applies in Full Assume the same facts in Example 12 6 except that Magnus s business owned qualified property with an unadjusted basis of $600,000 at the end of the year. Evelyn s unadjusted basis in her qualified property at the end of the year was $1,000,000. Their AGI and itemized deductions are the same as those shown in Example They determine the effects of the W 2 wage plus qualified property limit on their Section 199A deduction. Copyright Robert W. Jamison 75 Example 12 7 (8) (Cont.) Magnus Evelyn Total Net income 260, ,000 Wages paid 24,000 1,500,000 W 2 limit (50%) 12, ,000 W 2 + property limit Qualified property 600,000 1,000, % 15,000 25,000 25% W 2 wages 6, ,000 W 2 + property limit 21, ,000 Limit, > of W 2 or W 2 + QP 21, ,000 20% QBI 52,000 62,000 20% of Taxable income (less capital gain) before 199A 160, A 21,000 62,000 $83,000 Copyright Robert W. Jamison 76 38

39 Example 12 7 (8) (Cont.) Their itemized deductions are $86,000, as they were in Example Their taxable income and tax: AGI $900,000 Itemized deductions (86,000) Taxable Income before 199A deduction 814, A deduction (83,000) Taxable income 731,000 Total Income Tax $208,149 NII tax ($10,000 x. 38) 380 Total $208,529 Copyright Robert W. Jamison Phase in of W2 and Qualified Property Limits The limits related to W 2 wages and qualified property do not apply to taxpayers whose taxable income does not exceed the threshold amount, described in Figure 2 1. When taxable income exceeds the threshold, but is still within the phaseout range, the limits apply proportionately. Copyright Robert W. Jamison 78 39

40 Example 12 8 (9) Separate Businesses, W 2 Wage Plus Qualified Property Limitation Applies in Part Assume the same facts in Example 12 7, except that they also incur a loss from an interest in a Jamaican resort in which they materially participate. The loss is $425,000. Since this business is not located in the U.S., it has no effect on QBI, per se. Copyright Robert W. Jamison 79 Example 12 8 (9) (Cont.) Their combined income items: Wage and salary income $320,000 Capital gains & qualified dividends 10,000 Qualified Business Income 570,000 Resort loss (425,000) AGI $475,000 Itemized deductions (86,000) Taxable Income before 199A deduction $389,000 Copyright Robert W. Jamison 80 40

41 Example 12 8 (9) (Cont.) Since their taxable income is now between $315,000 (the threshold for married filing jointly) and $415,000 (the end of the phaseout range for married filing jointly) they are allowed a partial relaxation of the limit to W 2 wages and qualified property. The excess of 20% of QBI over the limit is the following percentage: Taxable income $389,000 Less threshold (315,000) Excess $74,000 Excess as percent of $100,000 phaseout 74% Percent of excess QBI disallowed 74% Percent of excess QBI allowed 26% Copyright Robert W. Jamison 81 BS21 Example 12 8 (9) (Cont.) Magnus Evelyn Total Net income $260,000 $310,000 Wages paid 24,000 1,500,000 W 2 limit (50%) 12, ,000 W 2 + property limit Qualified property 600,000 1,000, % 15,000 25,000 25% W 2 wages 6, ,000 W 2 + property limit 21, ,000 Limit, > of W 2 or W 2 + QP 21, ,000 20% QBI 52,000 62,000 Excess 20% QBI over limit 31,000 0 Disallowance percent 74% Disallowed QBI > limit 22,940 Allowed QBI > limit 8,060 QBI deduction before taxable income limitation $29,060 $62,000 $91,060 Copyright Robert W. Jamison 82 41

42 Slide 82 Cornell Tax School S Corporation 2018 Updated Ch. 12 slides BS21 This table has nothing in the text to describe it. Barbara Stayton, 5/13/2018

43 Example 12 8 (9) (Cont.) Their decrease in taxable income due to the Jamaican loss allows a relaxation of the W 2 wage and qualified property limit. They must also consider the effect that this loss has on their taxable income and the taxable income limitation on the QBI deduction. QBI deduction before taxable income limitation $91,060 Taxable income before QBI deduction $389,000 Less capital gain and qualified dividend (10,000) Subtotal $379,000 20% of Taxable income (less capital gain) before 199A 75,800 Section 199A deduction $75,800 Copyright Robert W. Jamison 83 Example 12 8 (Cont.) Their itemized deductions are $86,000, same as Example Their taxable income and tax: AGI $475,000 Itemized deductions (86,000) Taxable Income before 199A deduction $389, A deduction (75,800) Taxable income $313,200 Total Income Tax $62,847 NII tax ($10,000 x. 38) 380 Total $63,227 Copyright Robert W. Jamison 84 42

44 1208 Effect of Qualified Business Loss The effect of a loss from a qualified business is to offset income from other qualified businesses. If the overall QBI is still positive, it reduces the QBI from each other business proportionately. If the overall QBI is negative the result is a negative deduction. This negative deduction does not directly create taxable income, but it offsets the Section 199A deduction that would otherwise be available. Copyright Robert W. Jamison 85 Example 12 9 (10) Separate Activities Including Loss from Qualified Business Assume the same facts in Example 12 8, except that the resort was in Puerto Rico, rather than Jamaica. Since Puerto Rico is considered to be part of the U.S. for purposes of the QBI deduction, this loss is an item of negative QBI. Their joint taxable income, before the Section 199A deduction is unchanged in total, but the composition is different. Copyright Robert W. Jamison 86 43

45 Example 12 9 (10) (Cont.) Wage and salary income $320,000 Capital gains & qualified dividends 10,000 Qualified Business Income (260, , ,000) 145,000 AGI $475,000 Itemized deductions (86,000) Taxable Income before 199A deduction $389,000 Copyright Robert W. Jamison 87 Example 12 9 (Cont.) They would compute the QBI deductions for their two other businesses as they did in Example 12 8, but would reduce this by 20% of the loss from the resort: Copyright Robert W. Jamison 88 44

46 Example 12 9 (10) (cont.) Magnus Evelyn Resort Net income $260,000 $310,000 ($425,000) Loss from resort (193,860) (231,140) 425,000 Net income before limits 66,140 78,860 Wages paid 24,000 1,500,000 W 2 limit (50%) 12, ,000 W 2 + property limit Qualified property 600,000 1,000, % 15,000 25,000 25% W 2 wages 6, ,000 W 2 + property limit 21,000 21,000 Limit, > of W 2 or W 2 + QP 21, ,000 20% QBI 13,228 15,772 QBI deduction before taxable income limitation 13,228 15,772 Total of 3 activities 29,000 20% of Taxable income (less capital gain) before 199A 75,800 Section 199A deduction $29,000 Copyright Robert W. Jamison 89 Example 12 9 (10) (cont.) AGI $475,000 Itemized deductions (86,000) Taxable Income before 199A $389,000 deduction 199A deduction (29,000) Taxable income 360,000 Total Income Tax 77,879 NII tax ($10,000 x. 38) 380 Total 78,259 Copyright Robert W. Jamison 90 45

47 Overall Loss from QBI Activities When the overall result of the QBI rules is a negative deduction, there is no current addition to taxable income. The negative amount carries forward and offsets future QBI deductions. Copyright Robert W. Jamison 91 Example (11) Separate Activities: Loss from Qualified Business Exceeds Qualified Business Income Assume the same facts as Example 12 9, except the Puerto Rico resort loss was $600,000, exceeding the combined income from the other qualified businesses. Their joint taxable income, before considering Section 199A: Wage and salary income $320,000 Capital gains & qualified dividends 10,000 Qualified Business Income ($260,000 + $310, ,000) (30,000) AGI $300,000 Itemized deductions (86,000) Taxable Income before 199A deduction $214,000 Copyright Robert W. Jamison 92 46

48 Example (11) (Cont.) Since there is no qualified business income, there can be no QBI deduction this year. They must make a complete calculation of all of the qualified business income and loss, as well as the limits. As a result of this loss, Magnus and Evelyn s taxable income is below the $315,000 threshold for married persons filing joint returns. Therefore, none of the W 2 wage or qualified property limits apply. Copyright Robert W. Jamison 93 Example (11) (Cont.) The qualified business income calculations are: Source Income or (loss) 20% Magnus s business $260,000 $52,000 Evelyn s business 310,000 $62,000 Puerto Rico resort (600,000) (120,000) Total ($30,000) ($6,000) Copyright Robert W. Jamison 94 47

49 Example (11) (Cont.) The $6,000 negative deduction has no effect on their 2018 income. They will need to carry it forward, and reduce any QBI deduction in 2019 by $6,000. This reduction would apply to the deductions generated by Magnus s business, Evelyn s business, positive income from the Puerto Rico resort, any new business they might acquire, but not to any REIT dividend or income from publicly traded partnerships that they receive in Copyright Robert W. Jamison Rules for S Corporations and Partnerships When the entity that actually conducts the business is not an individual, there are some special rules that apply: If the entity is a C corporation, there is no Section 199A deduction. If the entity is a partnership or S corporation, the deduction is claimed by the owner. However, the partnership or S corporation must report the appropriate income and other items to each owner. Income and loss items from the qualifying business. W 2 wages paid by the qualifying business. Qualified property owned by the business at the end of the taxable year. Copyright Robert W. Jamison 96 48

50 1210 Stringent Procedural Rules for the QBI Deduction Taxpayers who claim, or intend to claim, the QBI deduction need to observe some extra caution. At a minimum, they should be prompt in filing payroll tax returns. To qualify for the Section 199A deduction, W 2 wages must be reported on Federal payroll tax returns. This return, if not filed timely, must be filed no later than 60 days following the due date of the return. Copyright Robert W. Jamison Stringent Procedural Rules for the QBI Deduction (Cont.) There are special rules for penalties for negligence or understatement of tax liability that apply to persons claiming the QBI deduction. For individuals in general, there is a substantial understatement when the understatement exceeds the greater of $5,000 of 10 percent of the correct tax for the year. For any taxpayer claiming the Section 199A deduction, the 10 percent threshold is reduced to 5 percent. The penalty rate is 20% of the underpayment related to the offending item. Copyright Robert W. Jamison 98 49