Beginning with the 2018 taxable year, owners of pass-through entities engaged in qualified businesses can claim a U.S. federal income tax deduction up to 20 percent on their qualified business income. This QBI deduction could possibly bring a taxpayer’s effective tax rate on such income down from 37 percent (without the deduction) to 29.6 percent (with the deduction). Planning for this deduction can yield significant tax savings for investors and business owners. Here are some questions and answers about the qualified business income deduction:
Can investments funds pass along QBI to their investors?
QBI means income from a qualified trade or business, and certain income from real estate investment trusts and publicly traded partnerships, or PTPs, may also give rise to QBI.
A private investment fund that invests in REITs and master limited partnerships can generally pass-through to its investors its distributive share of QBI from qualified REIT dividends and qualified PTP income. QBI from qualified REIT dividends and qualified PTP income is not subject to the W-2 wage limitation or the basis limitation. Investment funds that rely on the qualifying income exception from the PTP rules do not generate qualified PTP income because investment and trading activities are a specified services trade or business.
A mutual fund may pass through qualified REIT dividends to its shareholders. The IRS is continuing to study whether QBI received by a mutual fund from a PTP may be passed through to the mutual fund’s shareholders.
Can real estate investment funds pass QBI to their investors?
Income from real estate will generally qualify for the QBI deduction if the real estate activities qualify as a trade or business. Therefore, the fund must be engaged in a real estate trade or business to pass QBI to investors. As there is no participation requirement, passive investors in real estate funds that are engaged in a trade or business for U.S. federal income tax purposes may be able to claim a QBI deduction.
Whether a real estate enterprise constitutes a trade or business is determined under general income tax principles. However, conflicting authorities have created uncertainty as to when rental real estate activities rise to the level of a trade or business. Recognizing this uncertainty, the IRS proposed a safe harbor to allow taxpayers that own rental real estate businesses to claim this deduction.
Generally, the safe harbor imposes record-keeping requirements on the business and also requires that 250 hours of rental services are performed annually by the business’s employees, owners or agents. The safe harbor must be met separately with respect to residential and commercial rental activities. Triple net leases are excluded from the safe harbor. If a rental real estate enterprise does not meet the safe harbor, the rental real estate activities may still constitute a trade or business under section 162 of the tax code. Taxpayers should be made aware of these requirements prospectively so they can endeavor to come within the safe harbor.
Who else can claim the QBI deduction?
Owners of pass-through entities and sole proprietors that have QBI may claim this deduction, even if they do not actively participate in the business. Recently finalized regulations define pass-through entities as partnerships (other than PTPs) or S corporations owned, directly or indirectly, by at least one individual, estate or trust. Certain trusts or estates may also be a pass-through entity for this purpose.
The definition of “qualified trade or business” excludes a “specified service trade or business.” Income in excess of the phase-in amounts from a specified service trade or business is not eligible for the QBI deduction. (Taxpayers with taxable income below $157,500, or $315,000 if married, can claim the QBI without regard to the wage or UBIA — unadjusted basis immediately after acquisition — limitations and with respect to income from a specified service trade or business.) Businesses that constitute a specified services trade or business include investment managers other than financial services businesses, brokerages, medical, accounting and consulting practices, performing arts businesses, athletic businesses (including professional sports clubs) and any trade or business that relies principally on the skill or reputation of its employees.
Recently finalized Treasury regulations contain an anti-abuse provision preventing the segregation of QBI from non-QBI activities. Where an entity conducts both a specified services trade or business and also other qualified business activities, the entity’s owners generally cannot spin out the QBI activities into a new entity, charge a fee or rent to the original entity and claim a QBI deduction with respect to the QBI from the new entity.
How is QBI calculated?
The determination of QBI is made at the level of the trade or business. An entity or sole proprietor must be engaged in a trade or business (other than a specified services trade or business) to have QBI. Taxpayers claiming this deduction do not need to satisfy any participation requirement or be themselves engaged in a trade or business. QBI is the net income from such trade or business.
The maximum deduction allowed is 20 percent of QBI. Generally, the amount of QBI from a qualified trade or business eligible for deduction is limited to the lesser of:
(1) 20 percent of the taxpayer’s QBI with respect to the qualified trade or business, and
(2) the greater of:
(A) 50 percent of the W-2 wages with respect to the qualified trade or business, and
(B) the sum of 25 percent of the W-2 wages with respect to the qualified trade or business plus 2.5 percent of the unadjusted basis immediately after acquisition (UBIA) of all qualified property.
Like QBI, the determination of the W-2 wage and UBIA limitations is also made at the level of the trade or business. These limitations do not apply to QBI from qualified REIT dividends or qualified PTP income. The partners’ share of QBI from a partnership or S corporation will be reflected on their Schedule K-1. The deduction for QBI may be further limited at the partner level.
In situations where one or more trades or businesses are operated across multiple entities for legal, economic or other non-tax reasons, taxpayers may aggregate income, expenses (including wage expenses) and UBIA across entities. Taxpayers may choose to aggregate entities that have QBI where there is common ownership for more than half the year, the businesses or entities to be aggregated generally relate to each other to be viewed as a single enterprise, and certain other requirements are met. Aggregating QBI across entities may help taxpayers optimize the amount of the QBI deduction.
Given the wage and basis limitations, trade or business rules, the requirements to meet the real estate safe harbor and certain other aspects of 199A and the proposed and final Treasury regulations and other IRS guidance, tax planning can result in significant tax benefits to investors and business owners.
