Nearly everyone has heard about the reduction in the C corporation tax rate from 35% to 21%, but very few businesses actually operate as C Corporations. The large majority of businesses operate as sole proprietorships, partnerships, or S Corporations for tax purposes. Congress quickly realized that a reduction of C corporation tax rates without a similar benefit for these other business types would generate a huge outcry from the business community. And thus was born this new highly beneficial, and highly complex, tax deduction.
Due to the complexity of this new deduction, we will address the qualified business income deduction in four articles:
- Who Qualifies
- How to Compute the Deduction
- Limitations and Exceptions
- Maximizing the Deduction
In this article, we will address which businesses qualify for the new deduction.
Types of Entities That Qualify
The TCJA states that the 20% deduction is available to all business entities other than C corporations. So, we can assume that businesses taxed as sole proprietorships, partnerships, and S Corporations all qualify. In fact, Congress even decided to allow the deduction for businesses owned by trusts and estates. Adding an element of surprise, Real Estate Investment Trust dividends and publicly traded partnership income can qualify as well.
That makes it sound like ALL businesses of this type are eligible for the deduction, but that is not the case. The 20% deduction is only applicable to QBI earned in a “qualified trade or business.” However, there is no definition of “trade or business” in the tax law. This has been a thorny issue with the IRS for many years and the TCJA does not define it. We believe that in order to achieve this standard, the business must be regular, continuous, and substantial. This would exclude a hobby or one time transaction. The provisions in the TCJA also indicate that many rentals will qualify for the deduction. However, it is not clear when rental activities do rise to the level of a trade or business. Over 100 years of court cases only tell us what some of the criteria might be, such as triple net or gross leases, types of property rented, and the level of services provided by the lessor.
Compensation as QBI
What if you happen to provide personal efforts to operate the business, does your compensation qualify as QBI? The answer to that is a bit tricky as well. Wages in the form of a W-2 from your S Corporation are not considered QBI. S Corporations are required to pay reasonable compensation to shareholders providing services to their corporation.
For a partner in a partnership, compensation for services take the form of guaranteed payments, which do not qualify as QBI either. However, there is no comparable requirement that a partnership pay guaranteed payments, which would seem to indicate that a partnership could simply characterize all income as QBI and not pay guaranteed payments. This could be considered a loophole in the new law that could make entities taxed as partnerships more attractive. However, this may be addressed over the next year by Congress or the IRS as more guidance is issued on this new deduction.
For a sole proprietor, compensation cannot be paid to the owner. The TCJA does not mention anything about compensation for these entities, so we could assume that 100% of sole proprietor’s income is considered QBI.
Furthermore, there does not appear to be any provision in the law to determine what reasonable compensation should be. Without guidance on these issues, taxpayers may be operating with lots of uncertainty and we could see many court cases covering this issue.
Finally, there is one additional factor limiting QBI. The deduction does not apply to a “specified service trade or business” (SSTB) if the taxpayer’s taxable income exceeds the phase-out amount. The tax law states that an SSTB is "any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, OR ANY trade or business where the principal asset of such trade or business is the reputation or skill of its employees.” However, Congress removed architects and engineers from the list and added a couple more - investment managers and traders. The last section of the definition referring to the reputation or skill of its employees does not have a specific definition either and could be subject to interpretation. Income from a SSTB is only excluded if it exceeds the phase-out amount. We’ll cover this phase-out and more information about how to calculate the deduction next week.