Pass-Through Deduction Details Clarified by IRS/Treasury
Recently, the IRS and Treasury Department issued proposed regulations for a new provision which allows pass-through businesses to benefit from a 20 percent deduction of their qualified business income. Pass-throughs, which have their income taxed through the individual tax code via their owners, include limited liability companies, partnerships, S corporations and trusts/estates.
The deduction is the result of last year’s Tax Cuts and Jobs Act and is available for tax years beginning after December 31, 2017. The pass-through deduction provision is currently set to expire after 2025.
Eligible taxpayers include those whose taxable incomes fall below $315,000 for joint filers or $157,000 for individual filers. Those with higher incomes will see limits and phase-outs apply to the deduction.
- Eligible: Qualified trades or businesses such as Real Estate, Insurance & Engineering
- Not eligible: Specified service trades or businesses including: Accounting, Healthcare, Consulting, Financial Services, Law, Performing Arts, Athletics
Qualified business income (QBI) is considered domestic income from a trade or business. Excluded from that definition are employee wages, capital gain, interest and dividend income.
The IRS is accepting comments on the proposal for 45 days; until then, taxpayers may rely on these proposed regulations for guidance.
While the proposed regulations provide much-needed guidance, taxpayers will face a number of important considerations and decisions as they calculate their QBI deductions. Significant analysis will likely be needed to ensure an accurate calculation of the QBI deduction as well as meeting the potentially cumbersome reporting obligations. Key areas of consideration and expected analysis addressed within the proposed regulations include:
- General Computational Rules: The proposed regulations provide extensive computational rules that will greatly assist taxpayers in determining their QBI deduction. These rules, however, also highlight the importance of ensuring proper identification and calculation of QBI, W-2 wages, and UBIA of qualified property. It will also be important for a relevant pass-through entity to ensure the accuracy of the allocation of this information among partners.
- Determination of Wages Allocable to QBI: These rules are generally taxpayer-favorable and should not result in the need for restructuring of business operations in order to maximize the QBI deduction. However, complexities may arise where common paymaster structures are used in connection with multiple trades or businesses.
- Determination of UBIA of Qualified Property Allocable to QBI: These rules appear to be relatively straightforward and taxpayers should have readily available information to determine the amounts in total. The rules of Section 704(c) may come into play requiring partnerships to ensure accurate tracking of partner’s capital accounts. Additionally, special rules apply with respect to property acquired in a like-kind exchange.
- Definition & Determination of QBI: The proposed regulations generally provide clarification around the meaning of the term QBI. However, the importance of determining each separate trade or business, as defined under Section 162, may create complexity in ensuring compliance with the rules.
- Allocation of Items Among Directly-Conducted Trades or Businesses: Where multiple trades or business are operated, taxpayers are likely to be faced with the need to allocate certain items, e.g., income, expense, and property, among the separate trades or business. The proposed regulations provide taxpayers with flexibility to determine these allocations. However, documentation and implementation of a selected reasonable method will be important.
- Aggregation of Trades or Businesses: The proposed regulations create an opportunity for taxpayers to aggregate multiple trades or businesses. Taxpayers will not be required to apply grouping methods similar to passive active rules. Rather, the proposed regulations provide flexibility allowing taxpayers to determine an appropriate aggregation method for purposes of the QBI deduction. While this will be of significant benefit where the QBI deduction would otherwise be limited, the aggregation rules may create a significant record-keeping and reporting obligation.
- Definition of SSTB: One of the most anticipated parts of the proposed regulations, the IRS has provided definitions and examples illustrating the meaning of a specialized service trade or business (SSTB). While these rules are helpful, taxpayers will need to carefully review these definitions in the context of their particular trade or business to ensure compliance with the rules. Additionally, the proposed regulations contain a de minimis rule and rules regarding activities incidental to an SSTB. The ultimate determination of an SSTB will continue to require careful analysis.
- Reporting Obligations of an SSTB: Because the QBI generated from an SSTB may not be subject to exclusion at the individual level, all SSTBs will be required to determine and report to each owner their share of QBI, W-2 wages, and UBIA of qualified property. Consequently, even pass-through entities that operate an SSTB will be faced with similar reporting obligations as non-SSTB pass-through businesses.
- Other Reporting Rules: The proposed regulations provide detailed reporting rules that must be followed by certain pass-through entities. These rules will require reporting entities to maintain specific details and ensure the necessary information is accurately reported to its owners.
- Electing Small Business Trusts: The proposed regulations clarify that an electing small business trust (ESBT) is entitled to the QBI deduction. The “S portion” of the ESBT may take into account only items from any S corporation owned by the ESBT properly allocated to the S portion. Thus, an ESBT may also take into account items relevant to the QBI deduction in a grantor portion or a non-S portion.
- Fiscal-Year Passthrough Entities: The proposed regulations clarify that for purposes of determining QBI, W-2 wages, and UBIA of qualified property, if an individual receives any of these items from a passthrough entity having a fiscal year beginning in 2016 and ending before December 31, 2017, such items are treated as having been incurred by the individual during the individual’s 2017 taxable year, Conversely, if an individual receives any of these items from a passthrough entity having a fiscal year beginning in 2017 and ending in 2018, such items are treated as having been incurred by the individual during the individual’s 2018 taxable year and may be taken into account in determining the individual’s QBI deduction.
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