The dawn of the first filing season with the new Qualified Business Income (QBI) deduction has arrived. Business owners and their tax advisors now seek the payoff from extensive planning during the prior year to maximize this deduction. Amidst planning for the QBI deduction under Section 199A, some important questions lingered. Luckily for everyone, final regulations on the QBI deduction resolve some of these lingering issues. These answers are generally positive and may afford certain taxpayers a deduction where none was anticipated. All pass-through owners can benefit from a familiarity with QBI deduction information coming their way, but first we will explore some important changes made under the final regulations.
Rental Real Estate
The final regulations (together with other proposed guidance) made a significant and beneficial clarification in the rental real estate area. Previously, the IRS provided that it would use existing judicial and administrative guidance to determine when a rental activity rose to the level of a trade or business, but the existing tests do not provide a definitive answer and were often unevenly applied. Remember, an activity is not eligible for the QBI deduction unless it is classified as a trade or business. The new guidance provides two ways to aid in determining whether a rental activity is a trade or business. First, it lays out five nonexclusive criteria that are relevant to the trade or business analysis:
- The type of rented property (commercial real property versus residential property),
- The number of properties rented,
- The owner’s or the owner’s agents day-to-day involvement,
- The types and significance of any ancillary services provided under the lease, and
- The terms of the lease (for example, a net lease versus a traditional lease and a short-term lease versus a long-term lease).
The other assist that the IRS provided in this analysis is a new safe harbor under which a rental activity will be considered a trade or business for purposes of the QBI deduction. This safe harbor only has three criteria:
- At least 250 hours of services are performed each taxable year with respect to the enterprise;
- Separate books and records and separate bank accounts are maintained for the rental real estate enterprise; and
- The property is not leased under a triple net lease or used by the taxpayer (including an owner or beneficiary of a relevant pass-through entity) as a residence for any part of the year.
While these are relatively easy to understand, they may not be so easy to follow. For instance, contemporaneous logs are necessary to substantiate the 250 hour test for each real estate enterprise, and triple net leases are commonplace in many rental arrangements. Nevertheless, business owners in the rental sector now have a clearer path to use in determining that they qualify for this deduction. Also it should be noted that for all businesses, the final regulations make it clear that meeting a material participation standard is not required for an activity to be considered a trade or business.
Specified Services Trades or Businesses
Another concern for business owners was getting tagged with the dreaded Specified Services Trade or Business (SSTB) designation. A business with this designation could see its QBI deduction reduced or even eliminated, depending on the owner’s taxable income. Here the news is mostly good as well, unless you’re a writer or a sports team owner.
Unfortunately for those two professions the final regulations provide that they are SSTBs in many cases. For writers, the test is whether the writer was paid for material that is integral to the creation of a performing art (screenwriters for a movie or songwriters for music). And for sports team owners, the IRS clarified that it does not matter whether they are athletes; rather, the test looks at where the income arises from a trade or business involving the performance of services in a specified service category — in this case the athletes and entertainers category.
But for other categories the news is much better. Franchisors will not be classified as SSTBs even if they sell franchises that are considered SSTBs. For example, if a person were in the business of selling dental practice franchises, the income from the franchise sales would not cause the franchisor’s business to be an SSTB. Professional staffing firms (businesses who assist other firms by referring job applicants) also benefit from the new regulations. These firms are not in the field of consulting (an SSTB) as long as compensation is based on whether the applicants accept employment with the business to which they are referred.
Also, excluded from the SSTB designation are businesses consisting of retail pharmaceutical sales, such as a pharmacy. So a pharmacy that only sells prescription and over-the-counter medications would not be an SSTB. However, a pharmacy that also provided medical services through a pharmacist might be designated an SSTB if such services are not de minimis. Assisted living facilities, which also could have fallen into the health category of SSTBs, are not necessarily SSTBs under the final regulations. We discussed the possibility that they could be SSTBs and some arguments against that classification in a prior article.
Get to Know the QBI Data on Your Schedule K-1
Schedules K-1 from partnerships and S corporations will contain copious amounts of new data for 2018, but taxpayers should not be daunted. QBI deduction information will appear on partnership schedules K-1 under Box 20, and for S corporations under Box 17. This data consists of many items, but three are key:
- Qualified business income – the amount upon which the 20 percent deduction is based;
- W-2 wages – a measure that may limit the potential 20 percent deduction; and
- Unadjusted basis immediately after acquisition (UBIA) in property – an alternative measure that may limit the potential 20 percent deduction.
The 20 percent QBI deduction depends on adequate levels of W-2 wages and UBIA, so the more the better. Also, the QBI deduction generally is computed separately for each business (i.e., each Schedule K-1). The IRS provided the potential for a special election to aggregate multiple businesses for QBI deduction purposes. When eligible, this election is beneficial so that W-2 wages and/or UBIA can be pooled between multiple businesses in order to keep the 20 percent deduction from being limited. Be on the lookout for these items and be sure to discuss this idea with your tax advisor.
The final regulations for the QBI deduction provide some last minute clarity for taxpayers, especially in regards to rental real estate activities and the rules regarding SSTBs. They also provide more detail on some of the calculation rules that your tax professional will be applying to calculate the amount of your QBI deduction. If you have any questions about the QBI deduction, and to discuss ways to help maximize it, please contact us.
Elizabeth Whitney is a Director in the Tax Department in New England. She can be reached at 617.761.0636 or EWhitney0@cbiz.com.
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