ALBUQUERQUE, N.M. — In the horror film “Poltergeist,” the trailer showed a scene in which a little girl at the end of a bed informs her family “they’re here.” They being here was not a good thing and no one in the family asked them to come.
Tax practitioners and business owners can now say “they’re here.” They are the proposed regulations explaining the operating rules of the new qualified business income deduction. Some parts of them are frightening, others docile, still others helpful.
Proposed regulations are not (yet) authoritative. But they often become final regulations, which are authoritative. So they provide an early indication (warning?) of where the rules are heading. And they can be relied upon if the taxpayer likes them.
A brief recap of the QBID. Beginning this year, taxpayers may deduct as much as 20 percent of their qualified business income. If the taxpayer’s income exceeds a threshold ($315,000 if married and half of that otherwise), the QBID may be limited.
The deduction limit is generally based on the W-2 wages paid in the business and the basis of depreciable property used in the business. For a specified service trade or business (SSTB), the deduction can become zero. Again, these limits apply only to high-income taxpayers.The regulations were released last Wednesday. The purpose of this column is to provide an early overview of the rules. Some are good, some are bad, some expected, some unexpected. The next step is for interested parties to comment on the regulations before they are tweaked and become final.
Each business must separately report its income or loss and its wages and property. Many practitioners thought Treasury would define the scope of a business by reference to “activity” rules already in use for two other tax law provisions (passive losses and net investment income tax).
Treasury said the QBID was unique enough that it was not appropriate to use the existing activity definition. So the regulations provide four factors to use in defining the scope of a business (that is, to what extent separate operations may be aggregated as a single business).
Reinventing the (scope of business) wheel is going to create more work for taxpayers and their advisers. Recognizing this, Treasury suggested in the preamble to the regulations that the QBID aggregation rules may eventually also be used for passive loss and net investment income tax purposes. That would be a major change to tax reporting.
Confusion reigns about the SSTBs, which is bad because they may get zero deduction for high-income taxpayers. Tax advisers have discussed the ability to segregate activities that are not service-related to still obtain a QBID.
For example, a veterinarian who also sells products or has income from boarding animals might be able to obtain the QBID for the non-veterinary services even if he or she is high income. Similarly, an optician who sells lenses and frames might segregate the product and service income.
Treasury says, probably not. If the two activities have common (>50 percent) ownership, and no more than 5 percent of the gross receipts of the combined activity come from non-service income, then the non-service income is incidental and must be aggregated as part of the SSTB, perhaps leading to no QBID even for the non-service income.
The example provided in the regulations is a dermatologist who earns 5 percent or less of total gross receipts from selling skin-care products. The example would also apply to many optical or veterinary practices.
The same problem arises if the SSTB owner leases a building to the SSTB. Tax advisers thought the rental income would qualify for the “regular” (non-service) QBID. The regulations say the rental income must be aggregated as SSTB income if 80 percent or more of the rental income comes from a lease to the SSTB.
Practitioners have had concerns about how broadly an SSTB would be defined, as it includes a business for which skill and reputation are principal assets. On this point, the regulations provide good news. Treasury will not adopt a broad view, instead listing three fairly limited examples of skill and reputation (endorsements, licensing and appearance fees).
The SSTB good news is that if a business is primarily non-service, but has some elements of SSTB income, the SSTB income can be ignored if it is small in relation to the total business income.
For taxpayers with no more than $25 million of gross receipts for the year, service income can be ignored if it is no more than 10 percent of the total gross receipts. If total gross receipts exceed $25 million, the service income can be ignored if it is not more than 5 percent of the total.
Other good news: W2 wages paid by a professional employer organization (such as ADP) on behalf of a business will count as paid by the business in which the employees work.
Section 179 expense elections and bonus depreciation do not reduce the basis of property eligible to compute the QBID for threshold income taxpayers. This is also good.
Bad news for certain partners: Special basis adjustments under Sections 734 or 743 of the tax Code do not count as depreciable basis for the QBID limit. Guaranteed payments for both services and capital do not count as QBI.
These rules will be tweaked. But we finally have some guidance to advise clients on strategies. Treasury has unleashed the poltergeist.
Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at firstname.lastname@example.org.