One of the most valuable tax breaks in the Tax Cuts and Jobs Act (TCJA) is the new deduction for up to 20% of qualified business income (QBI) from pass-through entities. The IRS recently issued proposed regulations that help clarify who can benefit from the deduction. One of the issues the recently issued proposed regulations clarify is how taxpayers can elect to aggregate, or combine or group, their trades or businesses for purposes of the QBI deduction (also called the pass-through or Section 199A deduction).
Aggregating businesses for QBI deduction purposes
QBI is the net amount of qualified items of income, gain, deduction and loss with respect to any “pass-through entity.” While the term “pass-through entity” has traditionally referred to partnerships and S corporations, for purposes of the new QBI deduction, such term also includes sole proprietorships taxed on Schedule C (but the term does not include C corporations). If a taxpayer owns interests in several qualifying trades or 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
For 2018, the QBI deduction limitations begin to phase in when a taxpayer’s taxable income exceeds the threshold of $157,500 per return ($315,000 for married joint filer returns). Taxable income for this purpose is calculated before any QBI deduction.
When the limitations are fully phased in, the QBI deduction is limited to the greater of: 1) the taxpayer’s share of 50% of W-2 wages paid to employees and properly allocable to QBI during the tax year or 2) 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 limitations are separately applied to each qualified trade or business.
The UBIA of qualified property generally equals the original cost of the property. “Qualified property” means depreciable tangible property (including real estate) that: 1) is 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) hasn’t reached the end of its depreciable period as of the tax year-end. Once again, the QBI rules provide a special definition – “depreciable period” is the period over which the depreciation deduction is eligible to be claimed, but is at least 10 years after the date the tangible property was originally placed in service.
Aggregating trades or businesses can allow a taxpayer with high taxable income to claim a higher QBI deduction when the limitations based on W-2 wages and the UBIA of qualified property would otherwise preclude a larger deduction.
A taxpayer can potentially aggregate qualified trades or businesses that are operated directly, such as through a sole proprietorship or a single-member limited liability company (LLC), which are both taxed on Schedule C. The taxpayer must calculate the QBI, W-2 wages and UBIA of qualified property for each trade or business separately and then aggregate those amounts to calculate QBI for the aggregated trades or businesses and apply the QBI deduction limitations for the aggregated trades or businesses.
Similarly, a taxpayer can potentially aggregate trades or businesses that are operated via pass-through entities, such as S corporations, partnerships or multi-member LLCs (whether the LLC is taxed as an S corporation or a partnership). All owners of pass-through entities need not aggregate in the same fashion.
5 aggregation requirements
Bear in mind that the aggregation privilege isn’t automatic. In general, a taxpayer can aggregate trades or businesses only if the five aggregation requirements listed below are satisfied:
- The same person or group of persons directly or indirectly owns 50% or more of each trade or business to be aggregated. For trades or businesses operated by an S corporation, that means owning 50% or more of the issued and outstanding shares, and in the case of an LLC taxed as an S corporation, 50% or more of the issued and outstanding membership units. 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 trade or business that’s owned directly or indirectly by his or her spouse, children, grandchildren or parents.
- The preceding 50% ownership picture exists for a majority of the tax year in which the items for each trade or business to be aggregated are included in the taxpayer’s income.
- All the tax items attributable to each trade or business to be aggregated are reported on returns with the same tax year-end.
- None of the trades or businesses to be aggregated is a “specified service trade or business” (SSTB). Income from an SSTB generally doesn’t count as QBI for purposes of the aggregation regulations. The SSTB disallowance rule is phased in over the same taxable income ranges that apply to the limitations based on W-2 wages and the UBIA of qualified property, but is considered a separately applied limitation before the W-2 wages and the UBIA of qualified property limitation.
- The trades or businesses to be aggregated must satisfy at least two of the following three requirements:
- The trades or businesses provide products and services that are the same or customarily offered together (for example, a gas station and a car wash).
- The trades or businesses share facilities or significant centralized business elements (such as personnel, accounting, legal, manufacturing, purchasing, human resources or information technology).
- The trades or businesses are operated in coordination with or in reliance on each other. (For example, they have supply chain interdependencies).
Options for aggregating
A taxpayer can choose to aggregate some trades or businesses for which aggregation is allowed while not aggregating others for which aggregation isn’t.
How a taxpayer aggregates or doesn’t aggregate trades or businesses for purposes of applying the passive activity loss (PAL) rules doesn’t affect how the taxpayer can aggregate or decline to aggregate trades or businesses for purposes of applying the QBI deduction rules. In other words, PAL groupings or nongroupings are irrelevant for purposes of the QBI deduction rules.
Netting of negative and positive QBI amounts
If a taxpayer has at least one trade or business that produces negative QBI (including aggregated trades or businesses that are treated as a single trade or business), he or she must offset the QBI from each trade or business that has positive QBI (including aggregated trades or businesses that are treated as a single trade or business) with an amount of negative QBI in proportion to the relative amount of positive QBI of each trade or business that has positive QBI. However, the W-2 wages and UBIA of qualified property from a trade or business that produces negative QBI aren’t taken into account in calculating W-2 wages and the UBIA of qualified property when applying the QBI deduction limitations.
If a taxpayer has overall negative QBI for the tax year, the negative amount is treated as a loss from a separate qualified trade or business in the following tax year. This carryover rule doesn’t affect the deductibility of losses under any other tax law provisions.
It is important to note that while a taxpayer can elect to aggregate or group trades or businesses, a taxpayer is required to apply the netting rules. The netting rules are applied regardless of the taxpayer’s wishes.
An aggregation example
The aggregation rules are complicated in the abstract, so here’s an example to help provide clarification.
Alexandra is a single, calendar year small business owner with taxable income of $300,000 before any QBI deduction. She’s 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 a 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 aren’t 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 elects 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 elects to aggregate the businesses, her QBI deduction would be $60,000 higher. A further review of the facts is required to ensure that she is eligible to make the aggregation election.
Because the restaurant and catering businesses are held in SMLLCs that are treated as sole proprietorships owned by Alexandra, she’s treated as directly owning and operating both businesses. Because common ownership of the businesses (100% by Alexandra) exists for the entire tax year, and because all the tax items attributable to both businesses are reported on Alexandra’s calendar year return, aggregation requirement numbers 1, 2 and 3 as listed above are satisfied.
Neither business is an SSTB, so aggregation requirement number 4 is also satisfied. Because both businesses offer prepared food to customers and share the same kitchen facilities, and because they both share centralized purchasing, accounting and marketing functions, aggregation requirement number 5 is satisfied.
Therefore, Alexandra can aggregate the catering and restaurant businesses for purposes of calculating her QBI and for purposes of applying the QBI deduction limitations based on W-2 wages and the UBIA of qualified property. Thus, she can claim a QBI deduction of $70,000.
Variation: Let’s say Alexandra’s taxable income (before any QBI deduction) is $157,500 or less. In that case, she’s unaffected by QBI deduction limitations based on W-2 wages and the UBIA of qualified property. Thus, there’s no advantage to aggregating the catering and restaurant businesses. Her QBI deduction from the catering business would be $60,000 (20% × QBI of $300,000), and her QBI deduction from the restaurant business would be $10,000 (20% × QBI of $50,000) for a total deduction of $70,000.
Bottom line: As the example and its variation illustrate, aggregation is advantageous only when the taxpayer’s taxable income is high enough to be affected by the QBI deduction limitations based on W-2 wages and the UBIA of qualified property. While these examples illustrate the facts surrounding the decision of whether to elect to aggregate in a single taxable year, it is also important to consider events occurring in future tax years as well.
Aggregation consistency requirement
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. However, 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.
If there’s a change in facts and circumstances so that a taxpayer’s prior aggregation of businesses no longer qualifies for aggregation, the taxpayer must reapply the requirements to determine a new permissible aggregation (if any).
Required annual disclosure of aggregation
For each tax year, a taxpayer must attach a statement to his or her federal income tax return for that year identifying each business that’s been aggregated. The statement must include, among other things, the name and employer identification number of each entity. If a taxpayer fails to attach the required statement, the IRS can disaggregate the businesses and disallow the claimed benefits of aggregation.
Use the QBI deduction to your advantage
The aggregation rules for the QBI deduction are complex, but they may allow certain businesses to achieve more favorable tax results. We can help you get the most out of this provision and all other tax breaks in the TCJA. For assistance in planning to maximize your QBI, contact Brett Bissonnette, JD, CPA, or any of the other tax professionals at Clark Schaefer Hackett to discuss your options.