The 2018 tax preparation season is upon us and Labenz & Associates will need more information than ever before from our clients to file certain tax returns.
One of the new tax benefits for 2018 tax returns is the 20% Qualified Business Income (QBI) tax deduction. This is a great tax benefit for those clients who qualify. But as discussed below, the new deduction will require us to obtain additional information from our clients to assess qualification and to determine the amount of the deduction.
In certain instances, these will be difficult assessments. The better the information clients can provide to us, the better we will be able to determine the eligibility to claim the new tax benefits.
For noncorporate taxpayers – individuals, estates and trusts who own a business activity – the key question for their 2018 tax returns is: Will you qualify for the 20% QBI deduction? The analysis will apply to individuals, estates and trusts with:
- One or more rental properties,
- Ownership interest in an LLC, partnership or S corporation, and
- Businesses operated as a sole proprietorship.
A simple example: Mary and Bob own a hardware store through an S corporation. The business earned a $100,000 profit in 2018. Will Mary and Bob qualify for a $20,000 deduction on their 2018 tax return?
The purpose of this Alert is to provide an overview of the 20% QBI deduction, including some recently issued IRS guidance, so our clients can help us assess their ability to claim the deduction. If a client does qualify, we may need more information to quantify the deduction when we prepare the 2018 tax return.
The 20% QBI deduction is determined differently for taxpayers above or below certain taxable income threshold amounts. Taxpayers below the threshold amount must satisfy one requirement whereas taxpayers above the threshold must satisfy three requirements.
TAXABLE INCOME UNDER $157,500 SINGLE AND $315,000 JOINT
Single individuals, estates and trusts with 2018 taxable income at or under $157,500 and married filing jointly with taxable income at or under $315,000 (the threshold amount) can qualify for the 20% QBI deduction by satisfying one requirement – their business activity must be classified as a “trade or business activity”.
A trade or business activity is not a defined term, but prior Court cases and the recently released IRS guidance shed some light on activities that will be considered a trade or business. Examples:
- Taxpayer, employees of the business activity or their agents must be involved in the activity with continuity and regularity.
- A hobby or amusement type activity does not qualify.
- Operating five days a week as a plumbing business, hardware store, dental practice or law practice are clear examples of a trade or business.
- Farmland and rental properties are the most difficult business activities to determine whether they rise to the IRS requirement of a trade or business activity. Examples are below:
- An individual owns farmland which is cash rented or crop shared with a tenant. The farm owner pays certain bills and is involved in certain decisions.
- An individual owns two or three duplexes and collects rents, pays bills and arranges maintenance.
- Do either of these business activities rise to being defined as a “trade or business activity”?
To address rental situations, the IRS offered a safe harbor. The rental activity (or multiple activities, if the taxpayer chooses to treat them as a combined enterprise) can be classified as a trade or business activity if all the requirements below are met.
- Separate books and records are maintained for each rental activity (or the combined enterprise, if grouped together).
- There are at least 250 hours or more of rental services performed per year for the activity.
- Starting January 1, 2019, taxpayer maintains contemporaneous records, including time reports or similar documents, which support the 250 hours of rental service activities.
- The taxpayer includes a statement on their tax return, under penalties of perjury, verifying the rental enterprise meets the above requirements.
- Note: Commercial and residential rental properties cannot be combined for the above requirements.
Triple net leases and vacation homes do not qualify as a trade or business activity under the safe harbor even if the 250 hours requirement can be documented. Self-rentals do qualify even if the 250 hours requirement is not met if the self-rental is combined with a trade or business activity that is commonly owned by the taxpayer that is not a C corporation.
TAXABLE INCOME OVER $157,500 SINGLE AND $315,000 JOINT
Taxpayers with taxable income over the threshold amounts who have business activities that satisfy the trade or business requirement outlined above either by itself or on a combined enterprise basis must satisfy two additional requirements to claim the 20% QBI deduction:
Requirement #1 – THE TRADE OR BUSINESS CANNOT BE A SPECIFIED SERVICE TRADE OR BUSINESS.
For whatever reason, when Congress created the new 20% QBI deduction, certain trades or businesses were specifically excluded from claiming the deduction if the taxpayer’s income is above the threshold amount. These trades or businesses are defined as Specified Service Trade or Businesses (SSTB) and include the following:
- Trade or business of performing services as an employee, or
- Trade or business of performing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.
IRS guidance tried to address questions about who is and who is not an SSTB. For example, with the right facts, surgery centers could fall outside the health field, as well as research, testing and the sale of pharmaceuticals and medical devices.
If your taxable income is above the threshold amount and your business activity includes an SSTB, a decision will need to be made if your business activity qualifies when we prepare your 2018 tax return.
The IRS provided a de minimis exception to address situations where a business activity with multiple trades or businesses, of which one or more is an SSTB, could still qualify for the 20% QBI deduction.
For business entities with gross receipts less than $25 million for a taxable year:
- The business qualifies for the deduction if less than 10% (lowered to 5% if gross receipts greater than $25 million) of gross receipts are from SSTB activities.
- If the 10% de minimis exception is not met, but taxpayer has separate books and records, it may be possible to split the business between SSTB and non-SSTB activities. If the qualifications are met, some portion of the business activity may still qualify for the 20% QBI deduction.
Requirement #2 – THE TRADE OR BUSINESS MUST HAVE WAGES OR INVESTMENT IN DEPRECIABLE ASSETS.
For taxpayers above the threshold amount, the 20% QBI deduction for non-SSTB business activities are limited to the greater of the following:
- 50% of wages paid to employees during the taxable year and reported on Form W-2, or
- 25% of the wages paid to employees during the taxable year plus 2.5% of the original cost of depreciable tangible property owned at the end of the taxable year.
- Note: Wages paid to owners only qualify if paid by an S corporation.
How this limitation impacts taxpayers above the threshold will vary greatly by taxpayer and by type of business activity. For example:
We have found most banks have sufficient wages, whereas real estate investors will generally rely on the 25% of wages and 2.5% of depreciable tangible property to cover their 20% QBI deduction.
Taxpayers who own farmland that is either crop share or custom farmed and have no wages and limited tangible property will have a significantly reduced 20% QBI deduction due to these limitations.
ALL IS NOT LOST
Remember – even if your business activity does not qualify for the 20% QBI deduction, all is not lost.
Early planning in 2019 may enable the business activity to qualify in 2019. For example:
- Triple net leases could be converted to a more active type lease;
- Partnerships or LLC’s could be converted to S corporations and wages paid to owners;
- Business structures or ownerships can be adjusted; or
- Taxpayers close to the threshold amounts can utilize planning techniques to insure their 2019 taxable income is below the threshold, making qualification simpler.
Please discuss your qualification for the 20% QBI Deduction with your Labenz & Associates tax advisor. We are here to help.