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Qualified Business Income: A Summary of the Provision in the Tax Cuts and Jobs Act

As part of the Tax Cuts and Jobs Act signed into law on December 22, 2017 a new deduction is made available to taxpayers other than corporations that is based on passthrough income.  In this case, passthrough includes not only income from a partnership or S corporation, but also income from any unincorporated trade or business operated by the taxpayer.

The deduction is the total of:

  • The “combined qualified business income amount” of the taxpayer (subject to an adjusted taxable income limit) plus
  • 20% of the aggregate amount of qualified cooperate dividends (subject to a separate adjusted taxable income limit)

The qualified business income deduction is not adjusted for preferences and adjustments in the computation of alternative minimum taxable income. [IRC §199(f)(2)]

The deduction is not used in calculating adjusting gross income, nor is it an itemized deduction.  The deduction, available whether or not a taxpayer itemizes, serves to simply reduce taxable income directly.  [Act Section 11011(b)]

The calculation is made at the shareholder or partner level for a business conducted as a partnership or S corporation. [IRC §199A(f)(1)]

Computation of Qualified Business Income

For a tax year, “qualified business income” is defined as “the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer.” [IRC §199A(c)(1)]  Qualified business income does not include any qualified REIT dividends, qualified cooperative dividends or qualified publicly traded partnership income.

If the net amount above results in a loss, this loss must be taken into account in the following tax year as a loss when computing qualified business income (but not taxable income) for the succeeding tax year. [IRC §199A(c)(2)]

The items taken into account are items of gain, deduction and loss to the extent such items are:

  • Effectively connected with the conduct of a trade or business within the United States and
  • Included or allowed in determining taxable income for the taxable year. [IRC §199A(c)(3)(A)]

The following items are excluded from the calculation of qualified business income:

  • Any item of short-term capital gain, short-term capital loss, long-term capital gain, or long-term capital loss.
  • Any dividend, income equivalent to a dividend, or payment in lieu of dividends.
  • Any interest income other than interest income which is properly allocable to a trade or business.
  • Commodities transactions.
  • Foreign currency gains.
  • Notional principal contracts (other than items attributable to notional principal contracts entered into in transactions qualifying as a hedging transaction under section 1221(a)(7)).
  • Any amount received from an annuity which is not received in connection with the trade or business.
  • Any item of deduction or loss properly allocable to an amount described in any of the preceding bulleted items. [IRC §199A(c)(3)(B)]

Qualified business income also does not include:

  • Reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business,
  • Any guaranteed payment described in section 707(c) paid to a partner for services rendered with respect to the trade or business, and
  • To the extent provided in regulations, any payment described in section 707(a) to a partner for services rendered with respect to the trade or business.

Finally, qualified business income does not include income from the trade or business of providing services as an employee.  [IRC §199A(d)(1)(B)]

Combined Qualified Business Income Amount

The amount of deduction is computed separately for each trade or business.  The businesses that have positive qualified business income have that amount multiplied by 20%. [IRC §199A(b)(2)(A)].

The deduction is phased out for income from a “specified service trade or business” and is also subject to a limit based on W-2 wages and invested capital for each business.  These two limitations are phased-in once a taxpayer’s taxable income exceeds a threshold amount, discussed later.  These limits are applied on a business by business basis for the taxpayer.

After the final deduction is computed for each business, the deductions are added together to form an initial deduction amount [IRC §199A(b)(1)]  To this is added 20% of the aggregate amount of qualified REIT dividends and qualified publicly traded partnership income of the taxpayer. [IRC §199A(b)(2)] This total is defined as the “combined qualified business income amount.”

The combined qualified business income amount is subject to an overall limitation.  The deduction cannot be more than 20% of adjusted taxable income.  For this purpose the adjusted taxable income is the excess of:

  • The taxable income of the taxpayer (before any qualified business income related deduction [IRC §199A(e)(1)]) over
  • The sum of
    • Any net capital gains of the taxpayer plus
    • The total of any qualified cooperative dividends of the taxpayer [IRC §199A(a)(1)(B)]

Threshold Amount

The threshold amount, above which both the W-2 wages and capital limitation and the restrictions on the deduction for a specified trade or business applies, is set at $315,000 for a married couple filing a joint return and $157,500 for all other taxpayers. The threshold amounts will be adjusted for inflation in future years. [IRC §199(e)(2)]

In both cases, the limitation phases in over $100,000 for a married couple filing a joint return and $50,000 for all other taxpayers. [IRC §199A(b)(3)(B)]

Specified Trade or Business

Taxpayers in certain trades or businesses will find that if they have taxable income in excess of the threshold amount, they will face a reduced qualified business income deduction that eventually is phased out entirely as their income increases over the threshold amount.

The businesses included as a “specified trade or business” are:

  • Health,
  • Law,
  • Accounting,
  • Actuarial science,
  • Performing arts,
  • Consulting,
  • Athletics,
  • Financial services,
  • Brokerage services,
  • Any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners, or
  • Performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities. [IRC §199A(d)(2)]

Note that the above list, aside from the last bullet point, is taken from the list of businesses that do not qualify for IRC §1202 treatment per the provisions of §1202(e)(3)(A), but omitting architectural and engineering business—those two service businesses are not subject to the loss of the benefit once taxable income exceeds the threshold amount.

Although much of this was borrowed from IRC §1202, there has been little guidance nor litigation to help determine the limits of these categories.  In all the years that IRC §1202 has been in the law the IRS has never published regulations defining these businesses.

Using this list for limiting the availability of the qualified business income deduction will greatly increase the number of taxpayers affected by these definitions, so additional guidance will likely be needed to clarify these terms, as well as litigation to test those boundaries.

That said, when Congress created the list found in §1202, the first part of the list represented business areas that had been part of the definition of “qualified personal service corporation” under IRC §448(d).

Specified Service Business Definitions and IRC §448(d)

The business categories for which definitions exist under IRC §448(d) and which are included in the list of “specified service businesses” are:

  • Health,
  • Law,
  • Accounting,
  • Actuarial science,
  • Performing arts, and
  • Consulting,

Note that unlike the requirements to be a qualified personal service corporation, there is no requirement for “substantially all” of the services to be in this area for the business to be a specified service business.  Presumably businesses that fail the “substantially all” test of IRC §488(d) (and thus would not have been qualified personal service corporations if taxed as a C corporation) may nonetheless be deemed to be a specified service business. 

The IRS may address the question of “how much” an business must do in these areas to be treated as specified service businesses.

Below we look at the definitions we have under IRC §448, its regulations and case law for the six categories that exist also as specified service businesses.

Health

Reg. §1.448-1T(e)(4)(ii) provides the following definition of health services:

… the performance of services in the field of health means the provision of medical services by physicians, nurses, dentists, and other similar healthcare professionals. The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient. For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers.

In Rev. Rul. 91-30 the IRS concluded that veterinarians were also included in the category of health services for this purpose.  The IRS has also issued private letter rulings including physical therapists in the health category [PLR 9222004} as well as emergency medical ambulance technician employees [PLR 9309004].

However, in one of few rulings based on IRC §1202’s list, the IRS found that a laboratory that performed tests and provided results to healthcare providers, but did not discuss either diagnosis or treatment was not engaged in a health business.  [PLR 201717010]

Law

The regulations do not directly address what constitutes the practice of law.  However, attorney’s offices have generally been held to be personal service corporations under IRC §448.

Accounting

Accounting is also not directly addressed in the regulations defining activities for qualified personal service corporations. 

In Rainbow Tax Services, 128 TC 42 (2007) the Tax Court found that accounting services included tax return preparation and bookkeeping services.  As well, the fact that neither the corporation nor the individuals working in the organization were licensed either as a CPA firm or as CPAs themselves was not relevant—the work they were doing was accounting work and the licensing did not matter.

Actuarial Science

Actuarial science is also not directly addressed in the regulations.  However, it would seem likely that the definition, along with that of accounting services, would cause many third party administration firms for qualified retirement plans to fall into the category of specified service businesses.

Performing Arts

Another category not directly addressed in the qualified personal service corporation regulations.  Presumably the IRS believed the common definition of this term should be adequate to address the category.

Consulting

This category had always been the most difficult one to deal with in the area of qualified personal service corporations.  Reg. §1.448-1T(e)(4)(iv)(A) provides the following definition of consulting:

the performance of services in the field of consulting means the provision of advice and counsel. The performance of services in the field of consulting does not include the performance of services other than advice and counsel, such as sales or brokerage services, or economically similar services. For purposes of the preceding sentence, the determination of whether a person's services are sales or brokerage services, or economically similar services, shall be based on all the facts and circumstances of that person's business. Such facts and circumstances include, for example, the manner in which the taxpayer is compensated for the services provided (e.g., whether the compensation for the services is contingent upon the consummation of the transaction that the services were intended to effect).

The IRS provides a series of ten examples to attempt to differentiate between what constitutes consulting and what does not. [Treas. Reg. §1.448-1T(e)(4)(iv)(B)]

Example 1.

A taxpayer is in the business of providing economic analyses and forecasts of business prospects for its clients. Based on these analyses and forecasts, the taxpayer advises its clients on their business activities. For example, the taxpayer may analyze the economic conditions and outlook for a particular industry which a client is considering entering. The taxpayer will then make recommendations and advise the client on the prospects of entering the industry, as well as on other matters regarding the client's activities in such industry. The taxpayer provides similar services to other clients, involving, for example, economic analyses and evaluations of business prospects in different areas of the United States or in other countries, or economic analyses of overall economic trends and the provision of advice based on these analyses and evaluations. The taxpayer is considered to be engaged in the performance of services in the field of consulting.

Example 2.

A taxpayer is in the business of providing services that consist of determining a client's electronic data processing needs. The taxpayer will study and examine the client's business, focusing on the types of data and information relevant to the client and the needs of the client's employees for access to this information. The taxpayer will then make recommendations regarding the design and implementation of data processing systems intended to meet the needs of the client. The taxpayer does not, however, provide the client with additional computer programming services distinct from the recommendations made by the taxpayer with respect to the design and implementation of the client's data processing systems. The taxpayer is considered to be engaged in the performance of services in the field of consulting.

Example 3.

A taxpayer is in the business of providing services that consist of determining a client's management and business structure needs. The taxpayer will study the client's organization, including, for example, the departments assigned to perform specific functions, lines of authority in the managerial hierarchy, personnel hiring, job responsibility, and personnel evaluations and compensation. Based on the study, the taxpayer will then advise the client on changes in the client's management and business structure, including, for example, the restructuring of the client's departmental systems or its lines of managerial authority. The taxpayer is considered to be engaged in the performance of services in the field of consulting.

Example 4.

A taxpayer is in the business of providing financial planning services. The taxpayer will study a particular client's financial situation, including, for example, the client's present income, savings and investments, and anticipated future economic and financial needs. Based on this study, the taxpayer will then assist the client in making decisions and plans regarding the client's financial activities. Such financial planning includes the design of a personal budget to assist the client in monitoring the client's financial situation, the adoption of investment strategies tailored to the client's needs, and other similar services. The taxpayer is considered to be engaged in the performance of services in the field of consulting.

Example 5.

A taxpayer is in the business of executing transactions for customers involving various types of securities or commodities generally traded through organized exchanges or other similar networks. The taxpayer provides its clients with economic analyses and forecasts of conditions in various industries and businesses. Based on these analyses, the taxpayer makes recommendations regarding transactions in securities and commodities. Clients place orders with the taxpayer to trade securities or commodities based on the taxpayer's recommendations. The taxpayer's compensation for its services is typically based on the trade orders. The taxpayer is not considered to be engaged in the performance of services in the field of consulting. The taxpayer is engaged in brokerage services. Relevant to this determination is the fact that the compensation of the taxpayer for its services is contingent upon the consummation of the transaction the services were intended to effect (i.e., the execution of trade orders for its clients).

Example 6.

A taxpayer is in the business of studying a client's needs regarding its data processing facilities and making recommendations to the client regarding the design and implementation of data processing systems. The client will then order computers and other data processing equipment through the taxpayer based on the taxpayer's recommendations. The taxpayer's compensation for its services is typically based on the equipment orders made by the clients. The taxpayer is not considered to be engaged in the performance of services in the field of consulting. The taxpayer is engaged in the performance of sales services. Relevant to this determination is the fact that the compensation of the taxpayer for its services it contingent upon the consummation of the transaction the services were intended to effect (i.e., the execution of equipment orders for its clients).

Example 7.

A taxpayer is in the business of assisting businesses in meeting their personnel requirements by referring job applicants to employers with hiring needs in a particular area. The taxpayer may be informed by potential employers of their need for job applicants, or, alternatively, the taxpayer may become aware of the client's personnel requirements after the taxpayer studies and examines the client's management and business structure. The taxpayer's compensation for its services is typically based on the job applicants, referred by the taxpayer to the clients, who accept employment positions with the clients. The taxpayer is not considered to be engaged in the performance of services in the field of consulting. The taxpayer is involved in the performance of services economically similar to brokerage services. Relevant to this determination is the fact that the compensation of the taxpayer for its services is contingent upon the consummation of the transaction the services were intended to effect (i.e., the hiring of a job applicant by the client).

Example 8.

The facts are the same as in Example 7, except that the taxpayer's clients are individuals who use the services of the taxpayer to obtain employment positions. The taxpayer is typically compensated by its clients who obtain employment as a result of the taxpayer's services. For the reasons set forth in Example 7, the taxpayer is not considered to be engaged in the performance of services in the field of consulting.

Example 9.

A taxpayer is in the business of assisting clients in placing advertisements for their goods and services. The taxpayer analyzes the conditions and trends in the client's particular industry, and then makes recommendations to the client regarding the types of advertisements which should be placed by the client and the various types of advertising media (e.g., radio, television, magazines, etc.) which should be used by the client. The client will then purchase, through the taxpayer, advertisements in various media based on the taxpayer's recommendations. The taxpayer's compensation for its services is typically based on the particular orders for advertisements which the client makes. The taxpayer is not considered to be engaged in the performance of services in the field of consulting. The taxpayer is engaged in the performance of services economically similar to brokerage services. Relevant to this determination is the fact that the compensation of the taxpayer for its services is contingent upon the consummation of the transaction the services were intended to effect (i.e., the placing of advertisements by clients).

Example 10.

A taxpayer is in the business of selling insurance (including life and casualty insurance), annuities, and other similar insurance products to various individual and business clients. The taxpayer will study the particular client's financial situation, including, for example, the client's present income, savings and investments, business and personal insurance risks, and anticipated future economic and financial needs. Based on this study, the taxpayer will then make recommendations to the client regarding the desirability of various insurance products. The client will then purchase these various insurance products through the taxpayer. The taxpayer's compensation for its services is typically based on the purchases made by the clients. The taxpayer is not considered to be engaged in the performance of services in the field of consulting. The taxpayer is engaged in the performance of brokerage or sales services. Relevant to this determination is the fact that the compensation of the taxpayer for its services is contingent upon the consummation of the transaction the services were intended to effect (i.e., the purchase of insurance products by its clients).

Specified Service Businesses in §1202 But Not Listed in §448

The following business types are found also in IRC §1202, but were not businesses that were treated as qualified personal service corporations:

  • Athletics,
  • Financial services,
  • Brokerage services, or
  • Any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners.

As was noted earlier, the IRS has not released regulations defining the reach of these categories.  Particularly the last one raised concerns in the context of §1202 since Congress had never previously established a “reputation based” category in taxes.

To date we still have limited guidance on this category.  One case where the Tax Court rejected an IRS assertion that there was a reputation based business was the case of Owen v. Commissioner, TC Memo 2012-21.

That case suggested the required “reputation asset” must be more than just a general relationship with the entity’s success.  The Court held:

Although respondent argues that FFAEP is not qualified because one of the principal assets is the skill of Mr. Owen, the Court disagrees. While we have no doubt that the success of the Family First Companies is properly attributable to Mr. Owen and Mr. Michaels, the principal asset of the companies was the training and organizational structure; after all, it was the independent contractors, including Mr. Owen and Mr. Michaels in their commission sales hats, who sold the policies that earned the premiums, not Mr. Owen in his personal capacity.

Businesses Not Found in §1202

The final category are businesses note found in §1202 at all.  IRS guidance on just how broadly these categories would apply to a business would be helpful, as would that for the other covered businesses.

These additional businesses involve performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

W-2 Wages and Capital Limit

Taxpayers with taxable income over the threshold will begin to be subject to another limitation on their qualified business income deduction—the W-2 wages and capital limit.  The limit is phased in over $100,000 (for a married couple filing a joint return) and $50,000 (for all other taxpayers) as the taxpayer’s income exceeds the threshold amount.

For affected taxpayers, the qualified business income deduction is limited to the greater of the following:

  • 50% of W-2 wages related to the qualified business or
  • The total of
    • 25% of W-2 wages related to the qualified business plus
    • 2.5% of the unadjusted basis of qualified property used in the qualified business. [IRC §199A(b)(2)(B)]

Qualified property is tangible property used in the qualified business which is subject to depreciation and

  • Which is held by, and available for use in, the qualified trade or business at the close of the taxable year,
  • Which is used at any point during the taxable year in the production of qualified business income, and
  • Either
    • The property had not been acquired more than 10 years before the end of the taxable year or
    • The last day of the recovery period for the property had not passed by the end of the taxable year.

Qualified REIT Dividend

The law defines a qualified REIT dividend that will be available for the 20% deduction as any dividend received from a real estate investment trust that:

  • Is not a capital gain dividend and
  • Is not qualified dividend income (subject to tax at the long term capital gain rates) [IRC §199A(e)(3)]

Qualified Publicly Traded Partnership Income

Qualified publicly traded partnership income means, with respect to any qualified trade or business of the taxpayer, the total of:

  • The net amount of the taxpayer’s allocable share of each item of qualified item of income, gain, deduction or loss from a publicly traded partnership not treated as a corporation plus
  • Any hot asset gain not treated as gain from the sale of a capital asset under IRC §751(a) recognized from the sale of such a partnership interest.  [IRC §199A(e)(5)]

Qualified Cooperative Dividend

A qualified cooperative dividend is any patronage dividend received (as defined at IRC §1388(a)), any per unit allocation (as defined in IRC §1388(f)) and any qualified written notice of allocation (as defined in IRC §1388(c)) received from a qualified cooperative which is includable in the taxpayer’s gross income.  [IRC §199A(e)(4)]

Penalty for Substantial Understatement of Tax Related to Qualified Business Income Deduction

Anticipating that taxpayers may try to “push the envelope” for what qualifies for the qualified business income deduction, Congress lowered the percentage of income test for a substantial understatement of taxes for the 20% accuracy related penalty from 10% of the proper tax to 5% of the proper tax.  [IRC §6662(d)(1)(C)]

For a substantial understatement penalty, a taxpayer can only escape the penalty if

  • The position had substantial authority;
  • The position had a reasonable basis and the position was properly disclosed on the return; or
  • The taxpayer has a reasonable basis for the erroneous reporting.

As a practical matter, the IRS is unlikely to concede a taxpayer’s position has substantial authority if the position is not disclosed.  In such a case of a nondisclosed position, taxpayers will likely attempt to escape the penalty through showing reasonable reliance on the preparer.  If the taxpayer is successful in that showing, the preparer then would be at risk of facing a preparer penalty under IRC §6694.