QBI Deduction: The Impact of Proposed Regulations on Government Contractors
December 13, 2018
Recently, the U.S. Department of the Treasury and Internal Revenue Service (IRS) issued much-anticipated proposed regulations on the potential 20% qualified business income (QBI) deduction for owners of pass-through entities and sole proprietorships. This proposed guidance provides clarity to certain areas where the statute was vague, but it has also left tax practitioners with some significant unresolved questions. It is important to understand that proposed regulations are not effective as law and are still subject to change.
Ever since the Tax Cuts and Jobs Act (TCJA) was signed into law back on December 22, 2017, clients have been asking if they qualify for the 20% qualified business income deduction. Some of the questions that have been posed include:
- Will I be able to take the 20% deduction on all my business income?
- Is my business considered a specified service trade or business (SSTB)?
- How does the IRS define “consulting” as a SSTB?
- Do we need to restructure our business to be in the most tax-efficient structure in order to maximize the QBI deduction?
- I have a great reputation in my field. Is my company considered a SSTB?
- We use a professional employer organization (PEO) to manage our company’s payroll. How does that impact our ability to take the QBI deduction when factoring in the wage limitation?
Brief Recap of QBI Deduction
For tax years beginning after January 1, 2018, taxpayers (other than a C corporation) are allowed a deduction of 20% on qualified business income from each qualified trade or business carried on by the taxpayer. However, there are limitations on that 20% deduction, including:
- Limited to 20% of overall taxable income (reduced by net capital gain), and 50% of allocable qualified business wages attributable to the qualifying business income, or
- 25% of allocable qualified business wages attributable to the qualifying business income, plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of all qualified property.
Qualified business income (QBI) is generally defined as the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business of the taxpayer that is effectively conducted within the United States.
The statute also provides exceptions to the general definition of qualified business income, including:
- Investing, investment management, trading or dealing in securities, partnership interests or commodities
- The trade or business of performing services as an employee
- Capital gains and losses
- Dividend income (and dividend equivalents)
- Portfolio interest income
- Gain or loss from controlled foreign corporation
- Guaranteed payments received by partners (also not includible in the W-2 wage base limitation)
A SSTB is identified utilizing the definition provided for qualifying small business stock, with the statute excluding architecture and engineering. That leaves the following SSTBs, which would not be considered as a qualified trade or business and would (generally) not have the benefit of the 20% deduction:
- Health services
- Law services
- Actuarial services
- Performing arts
- Financial services
- Brokerage services
- Any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees
However, the statute did provide exceptions to both the W-2 wage limitation and the definition of an SSTB for taxpayers who fall below certain taxable income thresholds:
- For taxpayers who have taxable income below $315,000 (joint filers) and $157,500 (other filers), the SSTB and wage limitations are ignored and the full 20% deduction is available.
- Taxpayers with taxable income above those threshold figures, but below $415,000 (joint filers) and $207,500 (other filers) have an ability to take the qualified business income deduction, based on the applicable percentage of its activities above the original threshold amounts.
The statute left a number of unresolved issues and questions for taxpayers.
The single greatest concern for most of our government contracting clients is how the “consulting” work they perform impacts their ability to maximize the QBI deduction. The proposed regulations address that concern in part but also leaves some significant questions.
Consulting is defined in the regulations as: …“performance of services in the field of consulting” means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems. Consulting includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such. The performance of services in the field of consulting does not include the performance of services other than advice and counsel.
The real concern for our clients will be whether their contracts specify services or deliverables that meet the “advice and counsel” requirement In our view, if there are no recommendations required by the contract and it is merely recording historical data or assisting with the implementation of an already determined strategy, it would not be considered consulting, and therefore, excluded as an SSTB for QBI purposes.
For those taxpayers that do provide clients with “advice and counsel,” they may fall under the regulations’ new de minimis rule, which states that a trade or business with $25 million of gross receipts or less in a taxable year is not an SSTB if less than 10% of those gross receipts are attributable to the performance of services in a specified service activity (i.e. consulting). This rule was intended to reduce taxpayers’ administrative costs in tracking consulting and SSTB activities that integrated into their business model. That is a huge benefit to taxpayers who can factually meet the de minimis test.
For trades or businesses with greater than $25 million, the threshold percent is dropped to less than 5%. It is important to note that the $25 million gross receipts threshold appears to be gross receipts for the tax year that is being tested. As opposed to other areas of the Internal Revenue Code where the $25 million gross receipts benchmark is based on a three year average gross receipts. If a business that sells or manufactures goods provides any ancillary consulting services that are not separately purchased by or billed to customers, then such business is not considered to be in the field of consulting.
However, what if you review your activities as a whole and find that consulting and SSTB activities are above those arbitrary threshold percentages (5% or 10% based on your gross receipts)? Does that mean that it is an “all or nothing” proposition and you lose out on the QBI deduction, if that SSTB threshold is exceeded? As these are proposed regulations, we are hoping that Treasury clarifies that point in the final regulations—or better yet, provides a more equitable resolution by possibly prorating the deduction based on QBI in relation to all business income.
As the proposed regulations stand, the failure of the de minimis test, based on the activities as a whole, may cause taxpayers to take a deeper dive into whether they truly conduct a single trade or business or multiple trades and businesses. The statute and proposed regulation is driven by the underlying trades or businesses. So it may be incumbent upon those businesses who fail the de minimis test to analyze their business activities and see if they are conducting multiple businesses that happen to be operating in a single entity. They can then try to isolate the SSTB from the qualifying trades or businesses, provided that the SSTB activity is not an integrated activity of a trade or business as a whole, which would necessitate separately accounting and allocation of overhead (unattributable) expenses among the multiple trades or businesses. These are the administrative costs that the de minimis test was trying to avoid, but for some taxpayers who want to properly take advantage of the QBI deduction, these are unavoidable.
The proposed regulations also addressed some commentary suggesting that taxpayers try to restructure/create entities to maximize (or inflate) the QBI deduction. The guidance now taints a trade or business as an SSTB, if it has 50% or more common ownership (directly or indirectly) and provides 80% or more of its property or services to an SSTB.
The proposed regulation provided an example of a law firm that conducts its business utilizing three partnership entities. The law firm conducts legal services in one entity (Partnership 1) and owns the office building in another (Partnership 2), which rents the entire building to Partnership 1. It then employs the administrative staff in another entity (Partnership 3), which has a contract with Partnership 1 where it exchanges the administrative services for fees. All three of the partnerships are owned by the same people. The common ownership collapses the three entities and the trade or business would be considered one SSTB.
Once again, since the QBI calculations and determinations are essentially at the trade or business level, reshuffling the entities becomes superfluous. Treasury has created a “built-in” anti-abuse measure.
Treasury created a new methodology for aggregating trades of businesses in applying the wage and UBIA limitations. Aggregation will be allowed if the following conditions are met:
- At least 50% of the individual ownership group (direct or indirect) is the same.
- Attribution rules apply, which include spouses, children, grandchildren and parents
- At least 50% ownership existed for a majority of the year.
- The tax year reported by the group is consistent.
- SSTBs are excluded
- At least two of the following factors are met:
- The businesses offer the same product or service or customarily provided together,
- The businesses share facilities or share significant centralized business elements (i.e. accounting, legal, manufacturing , human resources, or IT resources), or
- The businesses are operated in coordination with or reliance on other businesses in the aggregated group.
- Once multiple trades or businesses are aggregated into a single aggregated trade or business, individuals must consistently report the aggregated group in subsequent tax years.
Aggregation of multiple trades or businesses is optional when allowed and can be an effective way of maximizing the QBI deduction given the right facts and circumstances. The converse can also be true, in that it could negatively impact the QBI deduction. It is important for our clients to understand the availability and application of the aggregation rules, and we would recommend clients do this analysis where multiple trades or business exist.
Reputation or Skill of Owners/Employees
Fortunately, the proposed regulations have taken a very narrow approach in defining business activities as SSTBs, where the principal asset of the business is the reputation or skill of one or more employees or owners. That definition narrowly pertains to any of the following characteristics:
- Trade or business that receives fees, compensation, or other income for endorsing products or services.
- Trade or business in which a person licenses or receives fees, compensation. or other income for the use of an individual’s image, likeness, name signature, voice, trademark, or any other symbols associated with his/her identity.
- Trade or business receives fees, compensation, or other income for appearing at an event or on radio, television, or another media format.
The proposed regulations also defined income component to include the receipt of partnership interests/S corporation stock and corresponding activities from those underlying entities.
Treatment of PEOs and Wage Allocation
Another area of concern for our clients is the use of third party payroll companies that issue W-2s to their employees. The original statute left taxpayers wondering if the use of those companies negatively impacted the W-2 wage base calculation. There is now clarity around the treatment for wages paid through a professional employer organization (PEO) and a certified professional employer organization. The wages paid by third parties would be included in the QBI W-2 wage base of the taxpayer, if the employees are common law employees of the taxpayer and/or officers of that corporate taxpayer.
The proposed regulation also creates a three step process for determining the W-2 wages base allocable to QBI in the following order:
- Each individual and relevant passthrough entity determines its total W-2 wages paid for the tax year, then
- Each individual and relevant passthrough entity allocates its W-2 wages among the one or more trades or businesses, then
- If wages are allocable to more than one trade or business, the allocation of those wages should be in the same proportion as the deduction of those wages among the trades or business.
- Each individual and relevant passthrough entity determines the amount of the W-2 wages above that are allocable to QBI.
This determination and process provides clarity for trades or businesses who administer payroll in a single entity (usually for administrative ease), but whose employees collectively provide the support for those trades or businesses conducted in more than one entity. This is the mechanism that allows taxpayers to allocate the W-2 wages (as appropriate) for the purpose of calculating the W-2 wage limitations.
The following are some of the general highlights of the proposed regulations:
- The QBI deduction has no effect on the adjusted basis of a the partner’s interest in the partnership or shareholder’s basis in an S corporation stock, nor does it have an impact on an S corporation’s accumulated adjustments account.
- The QBI deduction does not reduce the net earnings from self-employment nor net investment income when calculating self-employment and net investment income tax liabilities.
- The Treasury clarified that any gain attributable to partnership assets that gives rise to ordinary income under IRC Section 751 (“hot assets”) would be considered to be eligible QBI provided that it is from an underlying trade or business.
- If gains or losses are treated as capital gain or loss under IRC Section 1231, it is not included in QBI. But conversely, if IRC Section 1231 provides that gains or losses are not treated as gains or losses from the sale or exchange of capital assets, the gain or loss must be included in QBI.
Observation: Since IRC Section 1231 applies to property used in a trade or business, there was some uncertainty prior to the issuance of the proposed regulations whether IRC Section 1231 gains or losses would be factored into QBI. IRC Section 1231 gains can be treated as capital gains and IRC Section 1231 losses can be treated as ordinary losses depending on the result of how those gains net out. With the new guidance it appears that the only qualifying IRC 1231 gain for QBI purposes would be the amount recaptured depreciation under IRC Section 1245, which is taxed as ordinary income. To the extent that the IRC Section 1231 loss is ordinary loss, it will reduce QBI for purposes of calculating the deduction.
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