The QBI deduction
QBI is the net amount of qualified items of income, gain, deduction and loss with respect to any pass-through business. If a taxpayer owns interests in several qualifying businesses, he or she can potentially choose to aggregate them and treat them as a single business for purposes of:
- Calculating QBI; and
- Calculating the QBI deduction limitations.
The QBI deduction limitations begin to phase in when a taxpayer’s taxable income (before the QBI deduction) exceeds the threshold amount of $157,500 ($315,000 for married joint filers).
When the limitations are fully phased in, the QBI deduction is limited to the greater of:
- The taxpayer’s share of 50% of W-2 wages paid to employees and properly allocable to QBI during the tax year; or
- The sum of the taxpayer’s share of 25% of W-2 wages plus the taxpayer’s share of 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property.
The UBIA of qualified property generally equals the original cost of the property. Qualified property generally means depreciable tangible property (including real estate) that is: 1) owned by a qualified business as of the tax year end; 2) is used by that business at any point during the tax year for the production of QBI; and 3) has not reached the end of its depreciable period as of the tax year end.
The deduction after application of the limitations is call the QBI amount. Unless there is aggregation, it must be calculated separately for each business.
See our previous client alerts, 1. “New Pass-Through Tax Provisions: The Devil is in the Details” and 2. “IRS Proposes Pass-Through Deduction Regulations” for more information on the basic calculation of the QBI deduction.
Netting of negative and positive QBI amounts
If a taxpayer has at least one business that produces negative QBI, then the QBI from each business that has positive QBI proportionally reduces positive QBI to account for the loss. Losses reduce the positive QBI before the wage and property limitations are applied.
Importantly, this netting occurs regardless of whether the taxpayer elects to aggregate the businesses. Without aggregation, the positive QBI of a business can be reduced by losses from another business, without getting any benefit of the W-2 wages and qualified property from the business that generates the loss.
If, after netting the positive and negative QBI from all businesses, a taxpayer has overall negative QBI for the tax year, the negative amount is treated as a loss from a separate qualified business in the following tax year. This carryover rule does not affect the deductibility of losses under any other tax law provisions.
Aggregating businesses can allow a taxpayer subject to the wage and property limitations to claim a higher QBI deduction by aggregating a business subject to the limitations with a business that has more than enough wages and/or property. However, under the proposed regulations, only certain businesses may be aggregated with each other.
Five aggregation requirements
Aggregation is not automatic. A taxpayer can aggregate businesses only if the five aggregation requirements listed below are satisfied:
- Common Ownership
The same person or group of persons directly or indirectly own 50% or more of each business to be aggregated. For businesses operated by an S corporation, that means owning 50% or more of the issued and outstanding shares. For businesses operated by partnerships (including LLCs treated as partnerships for tax purposes), that means owning 50% or more of the capital or profits interests. For purposes of applying the 50% ownership rule, a taxpayer is also considered to own the interest in each business that is owned directly or indirectly by his or her spouse, children, grandchildren or parents.
- Length of Ownership
The preceding 50% ownership picture exists for a majority of the tax year in which the items for each business to be aggregated are included in the taxpayer’s income.
- Same Tax Year
All the tax items attributable to each business to be aggregated are reported on returns with the same tax year end.
- No SSTB
None of the businesses to be aggregated are a specified service trade or business (SSTB). Income from a specified service trade or business generally does not count as QBI when a taxpayer’s income is over the threshold. The service business disallowance rule is phased in over the same taxable income ranges that apply to the limitations based on W-2 wages and qualified property.
- Two of Three Integration Factors
The businesses to be aggregated must satisfy at least two of the following three requirements:
- The businesses provide products and services that are the same or customarily offered together (for example, a gas station and a car wash);
- The businesses share facilities or significant centralized business elements (such as personnel, accounting, legal, manufacturing, purchasing, human resources or information technology); or
- The businesses are operated in coordination with or in reliance on each other, for example, they have supply chain interdependencies.
Options for aggregating
If the taxpayer qualifies, aggregation is optional. The taxpayer can choose to aggregate some, all, or none of the eligible businesses. The aggregation election of one owner does not impact the election for another owner. Also, the grouping for purposes of applying the passive activity loss (PAL) rules does not affect how the taxpayer aggregates for purposes of applying the QBI deduction rules.
An aggregation example
Alexandra is a single, calendar-year small business owner with taxable income of $300,000 before any QBI deduction. She is subject to the QBI deduction limitations based on W-2 wages and the UBIA of qualified property.
She owns and operates a catering business and restaurant via separate single-member LLCs (SMLLCs) that are treated as sole proprietorships owned by her for tax purposes. The two operations share centralized purchasing and accounting, all done by Alexandra. She also maintains a website and does print advertising for both operations. The restaurant kitchen is used to prepare food for the catering business, but the catering business employs its own staff and owns equipment and trucks that are not used by the restaurant.
The catering business has QBI of $300,000, but no W-2 wages because all the work is done by independent contractors hired job-by-job. The restaurant business has QBI of only $50,000, but it has regular employees with $200,000 of W-2 wages.
If Alexandra keeps the two businesses separate for QBI deduction purposes, her deduction from the catering business is $0 (50% × W-2 wages of $0), and her deduction from the restaurant is $10,000 (20% × QBI of $50,000), for a total deduction of only $10,000.
But, if Alexandra is allowed to aggregate the two businesses, her deduction is $70,000 — the lesser of $70,000 (20% × aggregated QBI of $350,000) or $100,000 (50% × aggregated W-2 wages of $200,000). If she can aggregate the businesses, her QBI deduction would be $60,000 higher. But, is she allowed to aggregate them?
Because both businesses are held in SMLLCs that are treated as sole proprietorships owned by Alexandra, they have common ownership for a majority of the year. They also have the same tax year and neither of the businesses are a SSTB. The aggregation requirements one, two, three and four are satisfied.
Because both businesses offer prepared food to customers and share the same kitchen facilities. Additionally, because they both share centralized purchasing, accounting and marketing functions, aggregation requirement five is also satisfied.
Since the businesses satisfy all five requirements, Alexandra can aggregate them and claim the higher QBI deduction of $70,000.
Let’s say Alexandra’s taxable income (before any QBI deduction) is $157,500, including $7,500 of capital gains. In that case, she is not subject to the limitations based on wages and property. Without the limitations, there is no advantage to aggregating the catering and restaurant businesses.
Her potential QBI deduction from the catering business would be $60,000 (20% × QBI of $300,000), and her potential QBI deduction from the restaurant business would be $10,000 (20% × QBI of $50,000) for a total of $70,000.
However, the total QBI deduction is always limited to 20% of her taxable income net of capital gains. In this case, that is 20% of $150,000, or $30,000.
An election to aggregate cannot be revoked
After a taxpayer chooses to aggregate two or more businesses for QBI deduction purposes, he or she must continue to aggregate the businesses in all subsequent tax years. A taxpayer can add a newly created or newly acquired business to an existing aggregated group of businesses if the five aggregation requirements are met.
The aggregation must continue until the facts change, such that a taxpayer’s prior aggregation of businesses no longer qualifies. At that point, the taxpayer must reapply the requirements to determine if there is any new permissible aggregation.
Note that aggregating can impact which businesses will first absorb losses from other businesses. Determining the benefits of aggregation may require projections of future income and loss from each business that might be aggregated.
Required annual disclosure of aggregation
A taxpayer must attach a statement to his or her federal income tax return for the year an election to aggregate is made and then for every subsequent year to report the aggregation. If a taxpayer fails to attach the required statement, the IRS can disaggregate the businesses.
Use the QBI deduction to your advantage
Reduced tax expenses can free up money to reward owners and make room in the budget for investments in your business. The aggregation rules for the QBI deduction are complex, but they can provide big benefits. We can help you get the most out of Section 199A and other tax breaks.