The qualified business income deduction, or QBI, was one of the most popular changes to the tax code in 2017. Stephen J. Slade, CPA, tax director of Wouch Maloney & Co. LLP in Horsham, Pa., dives into the restrictions and exceptions and what they
really mean for your clients. Slade also addressed this topic for CPA Now.
By: Jim DeLuccia, PICPA Communications Manager
The section 199A qualified business income deduction or QBI is one of the most popular changes to the tax code since the sweeping reform of 2017. The deduction has many restrictions and exceptions that CPAs need to communicate to their clients and here to help clarify those today is Stephen J. Slade, CPA tax director with Wouch, Maloney and Company LLP in Horsham. Steve, thanks for joining me on the phone to discuss this popular issue today.[Slade]
Thank you, Jim.Before we get into our discussion, I want to be sure the listeners are aware that you blogged about this topic in July and that can be found on www.picpa.org, by just searching for “qualified business income deductions, big impact on your clients.” Steve, thank you for doing that for us as well.[Slade]
Sure, sure. No problem.Where are we currently with newer updated guidance regarding the section 199A qualified business income deduction? Members often tell me they have questions about how to properly comply with this new regulation.[Slade]
Sure, Jim. Basically, the final IRS regulations for the 20% 199A deduction were released in late January of 2019. There's been some minor updates and tweaks since then, but pretty much the majority of the information is contained
in those final regulations, which are several hundred pages. They do provide a lot of thorough examples and they do basically go through what the IRS was thinking in terms of when they issue proposed regulations back in the summer of ‘18 and
some of the changes that they arrive to in ‘19. I would definitely suggest that CPAs and other tax practitioners really can consult the 2019 final regulation. And also most tax software companies, at this point have really updated their portfolios
so that if you're doing research now in 2019 for the 2018 tax returns, the software is going to be a little bit more robust as they've also had time to issue, create their products.Great. I guess the more time that passes between when the new law actually passed, up until now, I guess there's always going to be some additional resources and it's a little bit easier to catch up I suppose. Right?[Slade]
Yeah, exactly. For us, with the regs coming out in January of 2019 we're normally starting to actually do business tax returns, at that point. It really did throw a monkey wrench in tax season for us. And I'm sure most CPAs
and with the tax software companies and the tax research companies, everybody was really scrambling to really digest what was in the regulations and just make sure that they were putting out accurate information to kind of help support us.I certainly heard that you tax practitioners had a challenging and an interesting tax season, I guess, when filing those 2018 returns.[Slade]
Yeah, it was definitely, definitely an interesting tax season. Glad we got to,
have had the chance to experience it but, certainly looking forward to next year now that we'll have really more time to really sit back and digest all the sweeping changes.There you go. Why do CPAs need to be cognizant of taxable income and the QBI restrictions their clients may face?[Slade]
That's really a great question. And it really is the taxable income determines whether or not you will actually face the QBI limitation. For example, basically a married filing joint taxpayer or a married filing separate taxpayer,
they're actually going to have separate limitations based on taxable income. There could be instances where perhaps it's actually better for taxpayers to file separately. I still think in the majority of cases it's going to be better to file jointly.
But just knowing and understanding that your QBI deduction can be limited because it's actually tied into your taxable income, it's really important. The limitations really are, if you're a service business, a specified service business, once you
exceed a certain taxable income number, you no longer actually get to qualify for the deduction at all.
And if you're a really any other type of business, a non-specified service business, once you exceed the similar taxable income thresholds,
you have to be able to justify that you have enough W2 wages paid to employees or enough unadjusted basis in real estate assets that you hold. Really understanding where your client's taxable income is going to be, really can help you better plan
for your taxpayer. If it's somebody who maybe is normally under the taxable income limitation, but in this year or they have the potential to go over that limitation, that may impact the tax planning strategies you have. Maybe you want to decide to
section 179 more property to get them below this threshold so that they qualify. Really looking at and understanding your taxable income, really will help you plan better for your clients and allow them to potentially maximize the deduction and the
fear of potentially losing deductions.Can you explain a few of the blocking rules the IRS has created and how CPAs should work with them?[Slade]
Sure. This was actually pretty funny to me. There was a lot of articles
right after the law was passed in the end of 2017 where a lot of people came up with the idea, is well, if you're a specified service business, perhaps you set up a related entity and put all of your administrative support in that entity and then
have that entity build a related specified service. And then because it's not a specified service business, it would actually qualify. What we definitely learned, I think, is that the IRS actually reads a lot of these trade articles because what they
really did was come up with a rule and says basically that, any commonly owned businesses that were, that you share 50% or more ownership, if one of the businesses is basically gaining revenue by performing services for a related specified service
business, they won't get to actually claim the 20% deduction on that one that basically shared revenue.
What the IRS really did was is they put a squash to companies who, say, were law firms who were going to perhaps create a related administrative
firm where 90% of their revenue was just going to be billing the related law firm. They really eliminated that. This also works perhaps for self-rentals where if you're a dentist office and you are considered to be a specified service and you also,
say, own a building that you pay related rent, well that related real estate entity collecting rents from the dentist office, that'll be considered a specified service rental entity as well. Those were really the blocking rules where they wanted basically
businesses who were specified service businesses, they didn't want them to just create a separate entity that had no real business purpose and be able to then qualify some of their income for the deduction.
I guess the other big thing as
well is that there was a rule where you can't be in the trade or business of being an employee. There's a lot out there now where companies are deciding perhaps that instead of paying somebody as a W2 employee, they're going to pay that individual
now on a 1099 contract basis. Well, the IRS puts some safe harbors in where they're going to automatically look to disallow that relationship and that 1099 contractor, in theory, is not going to be able to take the 20% deduction unless they can really
affirmatively show that they pass the 20 point independent contractor test, which is really hard to determine, to surpass. Those are some of the blocking strategies where the IRS definitely realize that CPAs and attorneys could come up with some real
cute tactics perhaps to ultimately maximize this deduction and the IRS was really on top of that, I would say.Interesting. What are a few noteworthy items that apply to business owners who own real estate properties? I recall on your blog that you mentioned that the IRS made an unexpected move of not permitting aggregation of commercial and residential rental businesses. Can you explain a little bit of that as well?[Slade]
Sure. A lot of the actual regulations were really focused heavily on real estate businesses and the IRS, I'll touch on briefly, put out a safe harbor actually to help real estate businesses. I guess the first and most important
thing is to determine whether or not your real estate enterprise actually qualifies as trade or business. And unfortunately, the IRS doesn't define exactly what a trade or business is. They tell you that you have to consult basically various case
law that's out there. Right away you're kind of off and wondering, do I even have a trade or business? And the IRS would look at certain things like what's the extent of the operation? Do you own just one small rental property that's residential or
do you have 10 commercial buildings? They're going to really look at the facts and circumstances.
One thing that the IRS did do was they released notice 2019-07 which created a safe harbor for real estate enterprise. And if you can determine
and document that through all of your real estate enterprises, you spent 250 hours basically in that enterprise, not including things like bookkeeping, you could potentially qualify under the safe harbor. And the other rules are you have to keep separate
books and records and then the property that you rent cannot be leased under a triple net lease where it can't be part of, say, a self-rental or related party rental. What the IRS did was, is they basically came up with this safe harbor where, an
individual who say, meets, feels that they meet these safe harbors can attach this to their return and then they will be deemed to qualify.
Really step one is determining whether or not you actually meet the definition of being a trade
or business. From my perspective, if you own a condominium and you also have a W2 day job, you're probably not going to rise to the level of a trade or business. But if you're somebody who maybe owns eight commercial buildings and four residential
buildings, you most likely will rise to the level of a trade or business because of the amount of property you have and the amount of time that most likely goes into managing those properties.
Next, what the IRS and I guess the Congress
did, was they created the concept of, they understand that real estate businesses might not have a lot of payroll. If you are over the taxable income thresholds, you basically are faced with the QBI limitation. The first limitation is based on W2
wages. Well, a lot of commercial landlords and residential landlords, they might not pay any W2 wages or pay very low W2 wages. What they created was the concept of you can look at the unadjusted basis of your real estate property and take two and
a half percent of that number and use that to potentially pass the QBI limitation. That's something that's unique and a lot of our real estate clients rely on that limitation to pass it.
One of the other interesting things was that the
proposed reg was not going to allow a certain 754 step up depreciation to be included in that unadjusted basis calc. But the final regs did allow for a somewhat complicated calculation but you can potentially pull in prior stepped up 754 assets and
potentially include that in your unadjusted basis and potentially allow you to maybe maximize the 20% deduction. The IRS did address their ideas on 754 and 734B. Also, to double back on the aggregation rules, what was a little unexpected to me was,
we just assumed under aggregation that if you have a real estate enterprise, and like a lot of our clients, they might have several commercial properties and several residential properties and they don't really anywhere in their head, really distinguish
all that much between the two.
But the IRS is not going to allow you to aggregate a commercial rental enterprise with a residential. And where that can be bad is, is in the sense that if you have a low basis property and a high basis property,
it really might be beneficial to aggregate them because you get to combined the basis and maximize the two and a half percent for your 20% deduction. Typically, the residential real estate might have a much lower basis and you could potentially lose
some of the 20% deduction because the basis is low and not being able to aggregate it with a typically high basis commercial property. I did see that on a client where they lost out on a couple thousand dollars because their rental real estate was
actually limited because we couldn't aggregate it, the residential with the commercial. That was definitely an area.
I guess another issue to keep in mind that the IRS addressed, one of the things that some people forget is, is that hey,
you could be a passive investor in a real estate, possibly in a real estate enterprise, but that doesn't mean that it doesn't qualify for the 20% deduction. Any pre-2018 passive loss carryovers that are released in 2018 or beyond, that they will not
reduce the current year QBI deduction. Let's say you have a K1 with $50,000 of rental real estate income, but you end up paying zero tax because you had 50,000 in pass up loss carryovers. That doesn't mean just because you had zero taxable income
on that property that you won't actually be able to potentially qualify for the 20% deduction because the pre-2018 passive loss carryover will not actually reduce the 2018 QBI income even though it actually reduces your 2018 taxable income.
And then lastly, the IRS in the regulations address 1231 income. Basically, if it ends up on schedule D then it's not going to be part of QBI. If any of your 1231 or 1245 income ends up as ordinary, it could potentially be included in QBI so that
might be bad potentially for your 1231 losses. If you take them as ordinary, you may have to consider pulling that into as a reduction of your QBI income.Well, Steve, you mentioned a lot so far about tests and what sorts of things actually qualify for the deduction. And I wanted to transition to a specified service business. How does the QBI affect that?[Slade]
I guess the thing to keep in mind is that a specified service business is bad. If you're a health professional, an attorney, an accountant, a consultant, things of those nature, an investment advisor, what happens is once you
exceed those income limitations, you no longer qualify for the deduction at all. And that's really where the issue comes in. if you're a CPA and a partner in a CPA firm, and if, let's say you make $415,000 of taxable income, that's basically the cutoff
where you actually no longer can qualify for the 20% deduction. Whereas, if you're a construction company with the same taxable income, as long as you can demonstrate you satisfy and have enough W2 wages, you can continue to take the QBI deduction.
We had some clients who had potentially, five to 10 million of income and because they had sufficient W2 wages, they were able to get a significant QBI deduction.
Whereas, the CPA or the attorney or the doctor who owns their own business,
once they exceed either the 415,000 married filing joint taxable income threshold, they actually no longer qualify for the deduction at all. Really, if you're a borderline gray area, or am I really a specified service business? That's where you want
to have those conversations with your client because once you kind of put them in that category of specified service, if they're earning significant income, you could be costing them on the QBI deduction.Finally, Steve, the premise of your blog is to encourage CPAs to have the section 199A conversation with their clients. Do you have any advice on how they should go about that conversation and make the subject matter more easily digestible?[Slade]
Yes. I think the biggest thing is to explain to your clients that this deduction really can only help save them money. The more as a CPA you understand about your client's circumstances, really the better you are to help them
determine how you can help maximize that deduction. And this really can come into play, specifically with those businesses who are really borderline service type businesses. For example, your consulting type clients. I know we have a lot of clients
that might have the word “consulting” in their legal name, but by scratching past the surface and having an in depth conversation, you might learn that while they think that they're doing consulting services, it doesn't necessarily meet
the IRS definition for QBI purposes of what they think a consultant does.
Are they providing advice and counsel? There are several examples that they provide that really go into detail. I would definitely urge you to talk to your clients
about this and really let them know that, what they're doing is, by having these conversations now we're setting them up to potentially maximize a 20% deduction on their business income for the next eight years during tax reform. Really, it's an educational
thing that we can learn more as accountants and advisers about our clients and really set them up to save a lot of money. And I think most clients will be appreciative and be happy that we're trying to do something in their best interests.
I would say that would be my advice on really how to go about the subject matter with your clients. Overall, there's heavy technical things in these regulations, which are many, many pages. But, just starting it off and letting them know that we're
going to spend some time here to go over this, but just doing your best to make it easy and asking the right questions.Great. Well thanks again Steve for sharing this insight with our listeners today. I know it's such a complex issue and there's so many nuances just regarding it, so again, I appreciate you spending some time with us today on that.[Slade]
Great, well thanks a lot. I appreciate you giving me the opportunity to speak and we'd be happy to answer any questions regarding QBI in the future.