Treasury Unveils New 20% QBI “Pass-Through” Regulations
Treasury Unveils New 20% QBI “Pass-Through” Regulations
On Wed. Aug. 8, 2018, the IRS released new “proposed” rules and regulations which give guidance on how the small business deduction will work for various business entities (S-Corp., LLC, partnership & sole proprietorships).
The new corporate tax rate is 21%, down from 35%. I.R.C. § 199A confers a similar tax break to small business owners operating outside of corporate solution, via a variety of entities that are taxes as pass-throughs.
One area the rules and regulations clarify is how business-owners with multiple business entities will be treated under the new tax rules. The regulations contain “aggregation” rules for adding income from these entities together before applying the tax deductions provided for under I.R.C. § 199A.
“The pass-through deduction is an important tax cut for small and mid-size businesses, reducing their effective tax rates to their lowest levels since the 1930s,” said Secretary Steven T. Mnuchin. “Pass-through businesses play a critical role in our economy. This 20-percent deduction will lead to more investment in U.S. companies and higher wages for hardworking Americans.”
Logic Behind the QBI 20% Deduction – What is This All About?
The QBI deduction is a part of the Tax Cuts & Jobs Act (“TCJA”) which is supposed to put small businesses on an even playing field with larger corporations. Traditionally, the lack of a “corporate level” tax for smaller, less sophisticated pass-through entities managed directly by one-or-more owners has been at least 15-20% lower than the combined corporate tax rate.
An article by Michale Kitces explains, “Through 2017, the top corporate tax rate was 35%, and the top dividend and capital gains tax rate was 23.8% (including the 3.8% Medicare surtax), for a total of 58.8% (although technically corporate taxes paid reduce subsequent dividend/capital gains taxation). By contrast, the top individual rate was “only” 39.6%.” https://www.kitces.com/blog/pass-through-business-deduction-rules-qualified-business-income-qbi-limits/
“Since the corporate tax rate is being reduced to 21%, this brings the combined top corporate tax rate down to “just” 21% + 23.8% = 44.8%, which is on par with the top individual rate, and would have substantially eroded the tax preferences otherwise associated with pass-through businesses.” Id.
“The TCJA QBI deduction reduces the top marginal tax rate on pass-through business entities from a new top tax rate of 37%, down to a reduced rate of 37% x 80% = 29.6%, better preserving the “gap” between pass-through and corporate taxation, for what are still predominantly a wide swath of small-to-mid-sized business owners who employ the majority of Americans.” Id.
Small businesses come in many shapes and sizes. The drafters of the TCJA wanted to distinguish between supposedly high-income white-collar Wall Street businesses (i.e., lawyers/doctors/finance professionals) and more traditional blue-collar Main Street businesses. For that reason, they’ve limited the upper ranges of professional services, reducing their benefit, in an effort to prevent abuse.
The QBI deduction is also designed to confer a greater benefit on those who create jobs and put productive labor and state-of-the-art technology to work at scale. This is the conceptual framework the “wage and property” formulas under the rule derive from. Businesses are rewarded for scale and for undertaking complex labor-intensive tasks through technological advancements, versus remaining lean and favoring elbow grease over mechanical advantage.
QBI Not Available to “Professional Service” Income Exceeding Thresholds
A pass-through, under the rule, includes a broad range of businesses engaged in for profit (as discussed below), but the benefits are expressly limited for businesses where “the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners.” I.R.C. § 199A(d)(2)(A).
Doctors, lawyers, accountants, actuaries, performing artists, consultants, professional athletes, financial analysts, and brokers all fall under the umbrella of professions for which “reputation or skill” disqualifies the business from the unlimited benefit for the QBI pass-through deduction. Architects and engineers have special dispensation and can benefit from the rule if set up as pass-through entities, regardless of how much income they make.
The law provides that the following are ineligible for the benefit of the QBI deduction above the income limitations: “Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services… or any trade or business which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.”
So how does the deduction operate under the new regulations?
How Does the “Professional Service” Limitation Work?
These specified businesses may still take advantage of the 20% deduction up to income of $315,000 married / $157,500 single.
Once you exceed the threshold, the law imposes a formula and limits your total deduction to the GREATER OF: (1) 50% of your allocable share of the firm’s W-2 wages; OR (2) 25% of your share of the firm’s W-2 wages PLUS 2.5% of your share of the firm’s unadjusted basis (i.e. cost) of all qualified property.
So what does all that mean? Let’s say you are a financial analyst in an LLC owned 50/50 with a partner. Your firm has a payroll of $200,000 per year. Your share of the firm’s W-2 wages is $100,000. You own 1/2 of the firm and ½ of the wages, so you multiply 50% * $100,000 to get your limitation figure of $50,000. That is the max QBI deduction you qualify for.
Take the same example, but instead of a financial analyst you are a Doctor that just does MRIs and the basis in your MRI equipment is $4,000,000. You’ve purchased the latest fully-loaded model of the 3T Tesla Magnetom Treo MRI machine at a whopping total cost of $3,000,000 plus have some legacy technology. 25% of your share of the firm’s wages here would be 25% * 100,000 or $25,000. 2.5% of the $4MM of cost basis in qualified property comes out to $100,000. Adding those up, you get your limitation figure of $125,000 versus the $50,000 limitation above.
What About Other Businesses?
Trade or business for Sec. 199A purposes will utilize the Sec. 162(a) formulation. While that provision does not give a “dictionary definition” it has been interpreted that to carry on a “trade or business” is a regular, continuous activity engaged in for profit. The Supreme Court has interpreted “trade or business” for purposes of IRC § 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making profit. Comm’r v. Groetzinger, 480 U.S. 23, 35 (1987).
In that case, Rob Groetzinger spent 60 to 80 hours a week placing bets on dog races! On the question of whether gambling on dog races constituted a “trade or business,” Justice Blackmun wrote for the Court in a 6-3 decision determining that – Yes. – “Trade or Business” under the Internal Revenue Code is a broad definition and any activity one takes on regularly and continuously, devoting a substantial portion of their time to it, with an eye to making a profit, is a “trade or business.” While a hobby does not qualify, activities engaged in primarily for profit do qualify.
However, passive activity (such as managing a portfolio of stocks and bonds on one’s own account) does not constitute a “trade or business” even though it is engaged in for profit. Higgins v. Comm’r, 312 U.S. 212 (1941). The taxpayer, who "merely kept records and collected interest and dividends from his securities, through managerial attention for his investments" was not engaged in carrying on a “trade or business.” Id. at 218.
The tax code further distinguishes between investors, traders, and dealers. Investors “are not eligible for IRC section 162’s trade or business deductions and . . . will deduct most of their investment expenses under IRC section 212 as ‘below the line’ itemized deductions.” Shu-Yi Oei, “A Structural Critique of Trader Taxation,” 8 FLA. TAX REV. 1013, 1020 (2008). In contrast, traders and brokers can deduct, “under IRC section 162 for ‘all the ordinary and necessary expenses.’”
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