IRS issues proposed regulations on the pass-through business income deduction

The IRS recently released highly anticipated regulations addressing the deduction for up to 20% of qualified business income (QBI) from pass-through entities. The deduction was a major component of the Tax Cuts and Jobs Act, which became law late last year. It has also been referred to as the pass-through deduction, the QBI deduction or the Section 199A deduction. 

Defining the deduction

For tax years beginning in 2018 and ending in 2025, the QBI deduction can be up to 20% of a pass-through entity owner’s QBI, subject to restrictions that can apply at higher income levels and another restriction based on the owner’s taxable income. 

For QBI deduction purposes, pass-through entities are defined as sole proprietorships, single-member (one owner) LLCs that are treated as sole proprietorships for tax purposes, S corporations, partnerships, and LLCs that are treated as partnerships for tax purposes. 

The QBI deduction is available only to individuals, estates and trusts. The newly proposed regulations refer to all three as “individuals.” For the purposes of this article, let’s follow that terminology to be consistent with the language used in the proposed regs. 

This deduction is scheduled to sunset after 2025 unless Congress extends it. Even though the new QBI deduction regs are in proposed form, you can rely on them until final regs are issued. 

Operational rules and definitions

The proposed regs supply operational rules for determining allowable QBI deductions, including how to apply the phaseout rules that can reduce or eliminate QBI deductions for individuals with taxable income (calculated before any QBI deduction) that exceeds the phaseout threshold of $157,500 ($315,000 for married joint filers). Phaseout is complete when an owner’s taxable income reaches $207,500 ($415,000 for married joint filers). At that point: 1) QBI deductions for a nonservice business must be based on the business’s W-2 wages or its W-2 wages plus the basis of qualified property used in the business, and 2) no QBI deduction can be claimed based on income from a specified service trade or business (SSTB), as defined below.

Definitions of new terms used to apply the QBI deduction rules are also included in the proposed regs, including the definition of QBI and of specified service trades or businesses (SSTBs). 

In defining what constitutes an eligible business for QBI deduction purposes, the IRS decided to go with the Internal Revenue Code Section 162 definition of a trade or business, because that definition is derived from longstanding case law and IRS guidance dealing with a broad range of industries.

Deduction limitations and when businesses can be “aggregated”
When an individual owns interests in several qualifying non-SSTB businesses, the individual can potentially choose to aggregate and treat them as a single business for purposes of: 

  • Calculating QBI and

  • Calculating the QBI deduction limitation based on 50% of W-2 wages paid by a business to generate QBI or the limitation based on 25% of such W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property used to generate QBI.

The limitation involving the UBIA of qualified property is for the benefit of capital-intensive businesses.

These QBI deduction limitations kick in when an individual’s (the pass-through business owner’s) taxable income (calculated before any QBI deduction) exceeds $157,500 ($315,000 for a married joint filer). When the limitations are fully phased in, the QBI deduction is limited to the greater of: 1) the individual’s share of 50% of W-2 wages paid to employees and properly allocable to QBI during the tax year or 2) the sum of the individual’s share of 25% of W-2 wages plus the individual’s share of 2.5% of the UBIA of qualified property. 

In any case, the deduction can’t exceed 20% of QBI, and it can’t exceed 20% of the individual’s taxable income calculated before: 1) any QBI deduction and 2) any net capital gain amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends). The proposed regs explain how to calculate a business’s W-2 wages for purposes of applying the QBI deduction limitations. 

A business’s UBIA of qualified property generally equals the original cost of the property. Qualified property is defined as depreciable tangible property (including real estate) that: 

1. Is owned by a qualified business as of the tax year end,
2. Is used by the business at any point during the tax year for the production of QBI, and 
3. Hasn’t reached the end of its depreciable period as of the tax year end. 

Why aggregating businesses could pay off

Aggregating businesses can allow an individual with higher taxable income to claim a larger QBI deduction when the limitations based on W-2 wages and the UBIA of qualified property would otherwise reduce or eliminate the allowable deduction. For instance, if a high-income individual owns an interest in one business with high QBI but little or no W-2 wages and an interest in another business with minimal QBI but significant W-2 wages, aggregating the two could result in a healthy QBI deduction. Keeping them separate could result in a lower deduction or maybe no deduction at all. However, certain tests set forth in the proposed regs must be passed for businesses to be aggregated. Also, it’s important to remember that an SSTB cannot be aggregated with any other business, including another SSTB. 

Specified service trades or businesses

The proposed regs define specified SSTBs. The status as an SSTB is important, because QBI deductions based on SSTB income begin to be phased out after an individual’s taxable income (calculated before any QBI deduction) exceeds $157,500 ($315,000 for a married joint filer). 
The proposed regs also include an antiabuse rule intended to prevent service business owners from separating out parts of what otherwise would be an integrated SSTB, such as an optometrist practice’s sales of vision care items, in an attempt to qualify the separated part for the QBI deduction. 

Defining SSTBs

In general, an SSTB is a trade or business that performs services in one or more of the following fields:

  • Health,

  • Law,

  • Accounting,

  • Actuarial science,

  • Consulting,

  • Financial, brokerage, investing or investment management,

  • Trading,

  • Performing arts, and

  • Athletics.

In addition, an SSTB can be any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. 

You may ask: What’s a trade or business where the principal asset is the reputation or skill of an owner or employee? Good question. Before the proposed regs were released, there was concern that this SSTB definition could snare unsuspecting businesses, such as a restaurant with a well-regarded chef. 

Thankfully, the proposed regs limit this definition to trades or businesses that meet one or more of the following descriptions:

  • One in which a person receives fees, compensation or other income for endorsing products or services,

  • One that licenses or receives fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark or any other symbol associated with that individual’s identity, or

  • One that receives fees, compensation or other income for appearing at an event or on radio, television or another media format.

Other QBI deduction issues

The proposed regs supply guidance on when QBI deductions can be claimed based on qualified income from publicly traded partnerships (PTPs) and qualified dividends from real estate investment trusts (REITs).

Finally, the proposed regs include special computational and reporting rules that pass-through entities, PTPs, trusts and estates may need to follow to provide their owners and beneficiaries with the information necessary to calculate allowable QBI deductions at the owner or beneficiary level.

Getting the best results

The proposed QBI deduction regs are lengthy and complex. This article only scratches the surface of the proposed rules. We can help you sort through the details to get the best QBI deduction.

Home equity borrowers get good news from the IRS

Passage of the Tax Cuts and Jobs Act (TCJA) in December 2017 has led to confusion over some of the changes to longstanding deductions, including the deduction for interest on home equity loans. In response, the IRS has issued a statement clarifying that the interest on home equity loans, home equity lines of credit and second mortgages will, in many cases, remain deductible under the TCJA — regardless of how the loan is labeled.

Previous provisions

Under prior tax law, taxpayers could deduct “qualified residence interest” on a loan of up to $1 million secured by a qualified residence, plus interest on a home equity loan (other than debt used to acquire a home) up to $100,000. The home equity debt couldn’t exceed the fair market value (FMV) of the home reduced by the debt used to acquire the home.

For tax purposes, a qualified residence is the taxpayer’s principal residence and a second residence, which can be a house, condominium, cooperative, mobile home, house trailer or boat. The principal residence is where the taxpayer resides most of the time; the second residence is any other residence the taxpayer owns and treats as a second home. Taxpayers aren’t required to use the second home during the year to claim the deduction. If the second home is rented to others, though, the taxpayer also must use it as a home during the year for the greater of 14 days or 10% of the number of days it’s rented.

In the past, interest on qualifying home equity debt was deductible regardless of how the loan proceeds were used. A taxpayer could, for example, use the proceeds to pay for medical bills, tuition, vacations, vehicles and other personal expenses and still claim the itemized interest deduction.

The TCJA rules

The TCJA limits the amount of the mortgage interest deduction for taxpayers who itemize through 2025. Beginning in 2018, a taxpayer can deduct interest only on mortgage debt of $750,000. The congressional conference report on the law stated that it also suspends the deduction for interest on home equity debt. And the actual bill includes the section caption “DISALLOWANCE OF HOME EQUITY INDEBTEDNESS INTEREST.” As a result, many people believed the TCJA eliminates the home equity loan interest deduction.

On February 21, the IRS issued a release (IR 2018-32) explaining that the law suspends the deduction only for interest on home equity loans and lines of credit that aren’t used to buy, build or substantially improve the taxpayer’s home that secures the loan. In other words, the interest isn’t deductible if the loan proceeds are used for certain personal expenses, but it is if the proceeds go toward, for example, a new roof on the home that secures the loan. The IRS further stated that the deduction limits apply to the combined amount of mortgage and home equity acquisition loans — home equity debt is no longer capped at $100,000 for purposes of the deduction.

Some examples from the IRS help show how the TCJA rules work:

Example 1: A taxpayer took out a $500,000 mortgage to buy a principal residence with an FMV of $800,000 in January 2018. The loan is secured by the residence. In February, he takes out a $250,000 home equity loan to pay for an addition to the home. Both loans are secured by the principal residence, and the total doesn’t exceed the value of the home.

The taxpayer can deduct all of the interest on both loans because the total loan amount doesn’t exceed $750,000. If he used the home equity loan proceeds to pay off student loans and credit card bills, though, the interest on that loan wouldn’t be deductible.

Example 2: The taxpayer from the previous example takes out the same mortgage in January. In February, he also takes out a $250,000 loan to buy a vacation home, securing the loan with that home. Because the total amount of both mortgages doesn’t exceed $750,000, he can deduct all of the interest paid on both mortgages. But, if he took out a $250,000 home equity loan on the principal home to buy the second home, the interest on the home equity loan wouldn’t be deductible.

Example 3: In January 2018, a taxpayer took out a $500,000 mortgage to buy a principal home, secured by the home. In February, she takes out a $500,000 loan to buy a vacation home, securing the loan with that home. Because the total amount of both mortgages exceeds $750,000, she can deduct only a percentage of the total interest she pays on them.

Stay tuned

The new IRS announcement highlights the fact that the nuances of the TCJA will take some time to shake out completely. We’ll keep you updated on the most significant new rules and guidance as they emerge.

© 2018

There’s still time to get substantiation for 2018 donations


To claim an itemized deduction for a donation of more than $250, generally you need a contemporaneous written acknowledgment from the charity. “Contemporaneous” means the earlier of

1) the date you file your income tax return, or

2) the extended due date of your return.

If you made a donation in 2018 but haven’t received substantiation and you’d like to deduct it, consider requesting a written acknowledgment from the charity and waiting to file your 2018 return until you receive it. Additional rules apply to certain types of donations.

Contact us to learn more.

3 big TCJA changes affecting 2018 individual tax returns and beyond

When you file your 2018 income tax return, you’ll likely find that some big tax law changes affect you — besides the much-discussed tax rate cuts and reduced itemized deductions. For 2018 through 2025, the Tax Cuts and Jobs Act (TCJA) makes significant changes to personal exemptions, standard deductions and the child credit. The degree to which these changes will affect you depends on whether you have dependents and, if so, how many. It also depends on whether you typically itemize deductions.

1. No more personal exemptions

For 2017, taxpayers could claim a personal exemption of $4,050 each for themselves, their spouses and any dependents. For families with children and/or other dependents, such as elderly parents, these exemptions could really add up. 

For 2018 through 2025, the TCJA suspends personal exemptions. This will substantially increase taxable income for large families. However, enhancements to the standard deduction and child credit, combined with lower tax rates and other changes, might mitigate this increase.

2. Nearly doubled standard deduction

Taxpayers can choose to itemize certain deductions or take the standard deduction based on their filing status. Itemizing deductions when the total will be larger than the standard deduction saves tax, but it makes filing more complicated.   

For 2017, the standard deductions were $6,350 for singles and separate filers, $9,350 for head of household filers, and $12,700 for married couples filing jointly.

The TCJA nearly doubles the standard deductions for 2018 to $12,000 for singles and separate filers, $18,000 for heads of households, and $24,000 for joint filers. For 2019, they’re $12,200, $18,350 and $24,400, respectively. (These amounts will continue to be adjusted for inflation annually through 2025.)

For some taxpayers, the increased standard deduction could compensate for the elimination of the exemptions, and perhaps provide some additional tax savings. But for those with many dependents or who itemize deductions, these changes might result in a higher tax bill — depending in part on the extent to which they can benefit from enhancements to the child credit.

3. Enhanced child credit

Credits can be more powerful than exemptions and deductions because they reduce taxes dollar-for-dollar, rather than just reducing the amount of income subject to tax. For 2018 through 2025, the TCJA doubles the child credit to $2,000 per child under age 17. 

The TCJA also makes the child credit available to more families. For 2018 through 2025, the credit doesn’t begin to phase out until adjusted gross income exceeds $400,000 for joint filers or $200,000 for all other filers, compared with the 2017 phaseout thresholds of $110,000 and $75,000, respectively. 

The TCJA also includes, for 2018 through 2025, a $500 credit for qualifying dependents other than qualifying children. 

Maximize your tax savings

These are just some of the TCJA changes that may affect you when you file your 2018 tax return and for the next several years. We can help ensure you claim all of the breaks available to you on your 2018 return and implement TCJA-smart tax-saving strategies for 2019. 

© 2019