When it was announced that the Tax Cuts and Jobs Act included a new 20% deduction for qualified business income (“QBI”) of pass-through businesses, many business owners started planning for huge tax savings. Hopefully, their exuberance was not misplaced and was based on a thorough review of the new tax law. Aside from many types of businesses that are subject to a categorical exclusion from this tax benefit (i.e., specified service trades or businesses), many mechanical rules significantly limit the deduction for qualified business income. Of particular importance, the wage and property thresholds under I.R.C. § 199A(b)(2)(B) limit the amount of the deduction for QBI. Business owners should analyze these limitations in tandem with their business’ financial outlook in order to effectively plan and maximize the deduction.
Pursuant to I.R.C. § 199A(b)(2)(B), for those with taxable income exceeding a statutorily-defined amount, the amount of the QBI deduction is limited to the lesser of (A) 20% of qualified business income with respect to the trade or business or (B) the greater of (i) 50% of the W-2 wages with respect to the trade or business or (ii) the sum of 25% percent of the W-2 wages with respect to the trade or business plus 2.5% of the unadjusted basis immediately after acquisition (“UBIA”) of qualified property. In other words, while individuals cannot obtain more than a 20% deduction from QBI, their deduction may be further limited if insufficient wages are paid or if insufficient property is owed by the business generating the QBI in a given tax year.
Given these potentially significant limitations, taxpayers and their advisors should carefully review the recently finalized regulations promulgated under I.R.C. § 199A. These clarify that taxpayers will be required to affirmatively establish an amount of W-2 wages and UBIA in order to avoid limitation of the deduction. The determination of W-2 wages must be made for each trade or business and is presumed to be zero if not determined and reported. Treas. Reg. § 1.199A-2(a)(2). Similarly, the determination of the UBIA of qualified property must be made for each trade or business and is presumed to be zero if not determined and reported. Treas. Reg. § 1.199A-2(a)(3). That means that taxpayers will be required to track these amounts should they want to claim the deduction. (These amounts should already be tracked anyway.)
As far as UBIA for business owners, a determination of the amount may vary based on the tax classification of the business (i.e., partnership, S corporation, or sole proprietorship). Further, the regulations provide a few examples of how UBIA computations may be affected by basis adjustments arising out of subsequent transfers. Treas. Reg. § 1.199A-2(a)(3)(iv)(D). For instance, one example shows that adjustments under I.R.C. § 743 and Treas. Reg. § 1.755-1 must be incorporated to determine this limitation on the QBI deduction. Another regulation provides that property cannot be acquired and disposed of for the principal purpose of inflating UBIA. Treas. Reg. § 1.199A-2(c)(1)(iv). Still another provides for adjustments that could be manipulated through the transfer of property by involuntary conversion, tax-free exchange, or inheritance. Treas. Reg. § 1.199A-2(c)(3). All told, these interpretations of UBIA show that one cannot simply conjure up a series of meaningless property transactions to bolster their QBI deduction. If a business is not wage-intensive and may rely on UBIA to maximize the QBI deduction, capital planning is paramount.
As far as W-2 wages, taxpayers must determine the total amount of wages allocable to a particular trade or business to compute the limitation. W-2 wages include any amounts paid to an employee, including elective deferrals, certain deferred compensation, and Roth contributions. Treas. Reg. § 1.199A-2(b)(2). Generally, this can be determined from totaling the amounts reported on any Form W-2 issued to officers or employees of a business. (Businesses may still claim W-2 wages for this purpose if they are the common law employer and another entity merely issues this information or delivers payment on their behalf.) Importantly, W-2 wages are limited to the amount reported on returns filed with the Social Security Administration within 60 days of their due date with extensions. Treas. Reg. § 1.199A-2(b)(2)(iii). In the event that a business acquires another business mid-year, the W-2 wages must be allocated amongst the businesses. Treas. Reg. § 1.199A-2(b)(2)(iv)(B). With respect to employees performing services for multiple trades or businesses, these must be allocated in a manner similar to the allocation of expenses for QBI purposes. Treas. Reg. § 1.199A-2(b)(3). For service-oriented businesses or those where human capital is significant, it is perhaps more important than ever that payroll reporting be performed on a timely basis. Those with multiple businesses under the same umbrella may want to re-visit personnel titles and responsibilities to ensure that their W-2 wages are allocable to the business deriving the greatest benefit for QBI purposes. Finally, in some instances, business dispositions may be structured in such a way as to maximize availability of W-2 wages and, corresponding, increase the amount of the QBI deduction.
As with determinations in the context of specified service trades or businesses, careful planning can help to maximize the available QBI deduction by minimizing the impact of the W-2 wages and UBIA limitations on the deduction through. While one size does not fit all, this may be accomplished through proper segregation of businesses, elections to aggregate business for QBI purposes, proper capitalization of businesses, and effective compensation planning.