On Aug. 8, 2018, the IRS issued much-anticipated guidance on the 20 percent qualified business income (QBI) deduction in the form of 184 pages of proposed regulations and explanatory information. In addition, the IRS issued Notice 2018-64 providing specific information on the calculation of wages for purposes of the QBI deduction. The information is extremely detailed, and an initial review tells us that the regulations provide some much-needed answers to questions considered since the passing of the Tax Cuts and Jobs Act (TCJA) in late December of 2017. On balance, the proposed regulations are favorable to taxpayers and will aid in the implementation of strategies to maximize the QBI deduction and minimize the taxes that result.
The TCJA enacted a series of tax law changes that were intended to incentivize business growth through a set of targeted provisions, and many of those provisions are first effective in 2018. One provision is new Sec. 199A which creates a new 20 percent QBI deduction. Under this provision, certain business income taxed to individuals (and to certain trusts and estates) will be offset by 20 percent of that income. Since the highest individual tax rate was reduced to 37 percent, the 20 percent reduction will effectively draw down that top individual tax rate on qualifying business income to 29.6 percent.
Note that this deduction is not available to C-corporations. Under the TCJA, C-corporations have been allowed a 21 percent federal income tax rate. This 20 percent QBI deduction is intended to provide somewhat similar tax benefit to income taxed to individuals.
With the passage of the new law, we knew the 20 percent deduction did not apply to broad classes of income such as wages, investment income and retirement plan distributions. The 20 percent QBI deduction is also phased out between taxable income of $315,000 to $415,000 of individuals filing joint return for business income in certain ‘specified service trades or businesses’ (SSTB) and for businesses that had insufficient wage expense. The QBI deduction for high income taxpayers is limited to 50 percent of wage expense of the business (or if greater, to the sum of 25 percent of wage expense plus 2.5 percent of original cost of depreciable assets). We find that the interplay of these rules is best illustrated by the following chart:
What you need to know now
Perhaps the most important item of the proposed regulations was the detail provided on which industries are specified service trades or businesses or SSTBs. These industries are less favored as the 20 percent QBI deduction is phased out for higher income taxpayers in these industries. We note four items of interest to specific industries:
- The regulations provide that commercial banking, the taking of deposits and making loans, is not within the concept of financial services and is not an SSTB.
- While brokerage services are SSTBs, this concept is limited to investment brokers. Insurance agents and brokers and real estate agents and brokers are excluded from brokerage services and are not SSTBs. As such, the income of insurance agents and brokers and real estate agents and brokers is eligible for the 20 percent QBI deduction for high income taxpayers.
- Sec 199A includes in the definition of SSTBs ‘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 owners.’ This provision caused much concern as the breadth of the language could include many businesses. The guidance clarified that the proposed regulations would limit this provision to:
1.) The business of personal endorsement of products and services, and
2.) The licensing or receiving of income for the use of an individual’s image, likeness, name, signature, voice, trademark or other symbols associated with an individual’s identity, and
3.) The business of receiving appearance fees or similar items of income.
- Services in the field of ‘health’ are SSTBs under the statute and the proposed regulation and are defined as ‘the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.’ The proposed regulations go on to exclude from the definition of ‘health’ services ‘the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient.’ Examples excluded from ‘health’ include health clubs or spas, payment processing, and the pharmaceuticals or medical device industries.
An additional, and potentially unfavorable, item to note is that rental income is not defined as a trade or business eligible for the 20 percent QBI deduction. Where the rental is to another trade or business of the taxpayer, the rules may allow the rental income to be combined with the other trade or business for purposes of the deduction. This may be the most controversial and debatable conclusion of the proposed regulations. We expect this conclusion to receive the most negative comment from taxpayers and tax advisors and have some hope that this decision will be reversed.
Each business or activity is analyzed separately regarding wage and other limitations. The regulations provide for a limited ability to aggregate or combine activities for purposes of the limitation. Prior to the issuance of the proposed regulations, there had been the suggestion from many tax advisors that one trade business could be allocated into several businesses. While it is clear that one entity may have several businesses, some that are SSTBs and some that are not, the proposed regulations provide rules to prevent a single business to be allocated into several solely for purposes of qualifying one or more for the deduction.
We have begun the process of calculating the effect of these proposed regulations on our clients’ tax situation. While the proposed regulation does not answer all of the questions in this area, there are a potential series of strategies to employ to maximize tax benefits. Namely, the effect of the 20 percent QBI deduction, which applies to pass-through income taxed to individuals, is a factor in the analysis of whether certain taxpayers should pursue taxation as C-corporations. A full understanding of the effect of this new tax regime and its interplay with the business objectives will be key factors in future tax planning goals.
To learn more about how this will affect you or to get tax planning advice, call 888-556-0123 or fill out our form.