Restaurateurs, Hoteliers See Boon in 20% Tax Reform Pass-Through Deduction
November 6, 2018
The owners of restaurants, hotels and other franchise and hospitality businesses will soon be more flush thanks to the 20% income deduction provision of the new tax reform law.
Congress hopes that will spur creation of new jobs and capital expenditures, especially in the restaurant, hotel and hospitality industry, where the wages typically paid by hospitality companies works in their favor for the deduction.
While owners of law firms, doctor groups and other professional services struggle to understand complex income caps and phase-outs in Section 199Athat limit their ability to deduct income from pass-through business entities, the hospitality industry enjoys a straightforward boon of being able to deduct the full 20% of qualified business income (QBI) on their tax returns.
Although the 199A deduction may be limited to 50% of W-2 wages paid by a trade or business, the vast majority of restaurants pay wages that are roughly equivalent to a third of revenue or less. That means it’s almost impossible for restaurant owners to have 20% of taxable margins exceed 50% of wages because of the natural economics of the industry.
With a new lower tax rate on ordinary income for individuals, which is now 37% compared with 39.6% previously, the section 199A pass-through deduction can effectively reduce the rate on QBI for pass-through owners to 29.6%.
As theInternal Revenue Service confirmed in a 184-page proposed regulation in August, there are relatively few limitations and exceptions for owners of restaurants, hotels, franchises and other hospitality businesses under the tax reform law.
“Applying the deduction broadly helps put Main Street businesses on a more level playing field,” Chris Smith, executive director of a lobbying group formed by small business and pass-through entity associates called Parity for Main Street Employers, said in a post on the organization’s website when the IRS guidance came out.
In addition to limited liability companies and S corporations that are common in the hospitality industry, the owners of other pass-through entities such as sole proprietorships, partnerships, trusts and other structures can also qualify for the deduction.
PEOs Don’t Affect Eligibility
One question some business owners had was around the use of professional employer organizations (PEOs), which are separate business entities that serve as the employer of record for tax purposes. PEOs can help franchisees and other restaurant and hospitality businesses get better prices on benefits and services such as healthcare, training and workers’ compensation.
Some users of PEOs were worried that ambiguous language in the Tax Cuts and Jobs Act that President Donald J. Trump signed into law last year might preclude them from taking the 20% deduction, which could have cost many business owners who use PEOs thousands and thousands of dollars in additional taxes.
The IRS guidelines released on Aug. 8 affirmed that a relevant pass-through entity (RPE) with employees paid through PEOs are indeed eligible for the deduction, and that wages paid to those employees will be matched up to where their services are being provided.
“The guidance released today by Treasury and IRS provides much needed clarity for PEOs and their clients, and represents a huge victory for the PEO industry,” Thom Stohler, vice president of federal government affairs for the National Association of Professional Employer Organizations (NAPEO), said in a news release on the day the IRS regulations were issued.
The IRS regulations underscore the importance of separately tracking wages for certain employees who may work at or support multiple locations that are ultimately part of the same ownership group.
For example, if a franchisee with a dozen restaurants has two trainers and four regional managers who all split their time among multiple restaurant locations throughout the year, the portion of their pay associated with each individual restaurant location must be apportioned out to the individual limited liability company (LLC) or other pass-through entity that owns that specific location.
This is important for accurately calculating startup costs for new restaurants, and also for capturing accurate unit-level economics.
How to Calculate It
To calculate the 20% deduction, business owners must first determine their qualified business income, which is calculated separately for each of the taxpayer’s qualified businesses.
To calculate the QBI deduction, business owners must first determine their share of qualified business income, wages and adjusted basis of tangible depreciable property. Items excluded from QBI calculations include capital gains or losses, dividends, investment income and guaranteed payments to name a few.
If a taxpayer has more than one qualified trade or business, the deductible amount of QBI is calculated separately and then added up.
The 199A deduction is limited to the larger amount of 50% of W-2 wages paid, or the sum of 25% of the W-2 wages plus 2.5% of tangible depreciable property on an adjusted basis. That means pass-throughs with high employee wages can take larger deductions than those that pay smaller wages, according to Forbes.
There is a second set of limitations equal to the excess of taxable income for the year over the sum of net capital gain plus the total amount of qualified dividends. The tax law was written that way to disallow the 20% deduction for income that’s already taxed at preferential rates.
If a taxpayer has negative QBI, he or she must carry forward that loss to offset positive QBI in future years.
Another wrinkle for pass-through business owners is that the 199A pass-through deduction will sunset in 2025, making longer-term tax planning more challenging unless the deduction is made permanent.
To Aggregate, Or Not to Aggregate
There are also new guidelines for 199A for grouping businesses to satisfy wage and asset tests that must be taken into consideration.
For example, businesses owned by a spouse or children will fall under the family attribution rule for voluntary aggregation. Likewise, a taxpayer who owns 50% or more of stock in a S corporation or 50% or more of the capital or profits in a partnership or LLC can aggregate those businesses. The business must have the same taxable year, such as a calendar year or a fiscal year ending on the last day of a certain month.
Businesses that are aggregated can’t be SSTBs, and they must provide products and services that are similar or normally provided together. They must also share centralized administrative elements such as human resources and purchasing, and rely on sister companies in the aggregated group.
Taken together, the grouping rules mean that the owner of several restaurant franchises can probably aggregate them along with a parent company that handles operational tasks such as payroll and bookkeeping. But if that person also owns a car wash or a hotel, those unrelated businesses would have to be treated separately for 199A deduction purposes.
$75,000 Per Day
Although the 199A deduction can be taken by most restaurant owners even if they are celebrity chefs, some other activities may fall under the “specified service trade or business” (SSTB) limitations that cap how much income can be deducted for business owners in professions such as health care, law, sports and product endorsements.
For example, if a celebrity chef gets paid to make appearances at food festivals or cooking shows, income from those ventures is considered to be an SSTB activity because it’s tied to their “skill and reputation” as a chef and is subject to the limitations.
Chefs with shows on Food Network command upward of $75,000 per day for cooking demonstrations and other appearances, while “untouchables” like Emeril Lagasse and Rachael Ray are paid far more, according to The New York Times.
President Trump’s tax reform law included a new section 199A that lets the owners of pass-through entities such as LLCs and S corporations deduct as much as 20% of their qualified business income (QBI) on their personal tax returns.
While certain professions such as attorneys, health care practitioners and athletes face limitations under the SSTB rules, the owners of restaurants, hotels, franchisees and many other businesses in the hospitality industry will be able to take the full 20% deduction.
The IRS proposed guidelines in August that clarified some confusion about how to interpret section 199A, such as confirming that wages paid through a PEO don’t disqualify business owners from taking the deduction.