The dust is clearing after the first spring tax season under the most recent federal tax overhaul. Taxpayers and tax professionals alike have now had a chance to see how new rules played out in reality – especially those governing the qualified business income deduction.
Many tax experts, including us, did their best to understand and explain these rules in advance. We knew that taxpayers who owned pass-through entities like partnerships and S corporations would want to secure the new 20% deduction on qualified business income (QBI). We also knew that taxpayers would have to pass a variety of tests and income thresholds to do so. And we knew that taxpayers whose total income fell below $157,500 (for single taxpayers) or $315,000 (for married taxpayers filing jointly) would receive the 20% deduction on QBI regardless of other factors. That much was fairly straightforward.
For taxpayers above those income thresholds, though, the picture was less clear. Rules about “specified service businesses” came into play, which created a variety of gray areas for many taxpayers. Higher-income taxpayers who were not disqualified by the service business rules would need to determine whether they qualified for the deduction based on wages they paid to employees, or a combination of wages and the cost basis of business assets. And even taxpayers who qualified would be subject to overall deduction limits based on taxable income adjusted for capital gains. Taxpayers with rental real estate also faced questions about whether the new QBI deduction would provide any benefit.
Now that we have made it through the first application of the new rules, some aspects of the law have become clearer and some remain murky. The good news is that, as this rule becomes more familiar, certain taxpayers can more confidently take advantage of planning opportunities to make the most of it. Let’s examine a few specific topics confronted during this first tax season with the new QBI rules.
Being a landlord got more complicated under the new tax law, especially when it comes to the QBI deduction rules for rental properties. To be eligible for the 20% deduction, an entity must rise to the level of a “Section 162 trade or business.” This does not mean much to most taxpayers – even those who own and operate a rental property don’t stay up at night thinking about Internal Revenue Code Section 162. Unfortunately for tax professionals, this term is also not clearly defined within the law or the tax code.
Complex rules have always limited taxpayers’ ability to deduct losses from some rental activities depending on the facts and circumstances, but those are separate rules from the new QBI deduction. For taxpayers who consistency experience rental losses, there is no positive QBI to deduct. However, even with losses, taxpayers are required to carry forward any QBI losses to be used to offset future positive QBI. The new deduction and the “trade or business” requirement are therefore major considerations for all rental property owners.
Rental real estate is more of a gray area, because it is generally considered a passive activity. The IRS does not consider taxpayers automatically “in business” just because they own and rent out some real estate. In Revenue Procedure 2019-7, the Service offered safe harbor provisions for some rental owners. However, the rules are fairly strict and many taxpayers may not satisfy all of the requirements. For example, the owner must maintain separate books and records for each rental, unless he or she opts to treat several rentals as a combined enterprise. (In the latter case, commercial rentals cannot be grouped with residential properties.)
The taxpayer must also spend 250 hours or more carrying out “rental services” per year, which can include activities such as managing real estate, supervising employees or contractors, collecting rent, and performing daily operation and maintenance. Many taxpayers whose main career is unrelated to their rental properties may struggle to meet this 250 hour requirement – or, at a minimum, they may not have thought much about exactly how much time they spend on their rental in the past. Taxpayers who rent properties must now ask whether they spend about 5 hours per week year-round managing those properties. Despite busy individual weeks or months, many landlords may not spend significant time managing a rental during an off-season, or for long-term tenants who don’t require much attention. Few owners likely took care to carefully document and log all of their time spent on such rental activities before the new QBI deduction rules, but they may now want to start. The safe harbor rules also require such documents, because they require the taxpayer’s records to include specific information including when the services were performed, for how long and by whom.
Some other key provisions of the new safe harbor rules state that if a taxpayer has any personal use of a rental property during the year, the rental will not be considered a business for purposes of the QBI deduction. In addition, real estate rented on a “triple net” basis will not qualify under the safe harbor rules. A triple net lease is one in which the landlord passes the responsibility of paying property tax, insurance and maintenance costs to the tenant.
Keep in mind that just because a property is not eligible under the safe harbor rules does not mean the taxpayer cannot claim a rental property constitutes an eligible business. But the taxpayer will need to take more care to satisfy close scrutiny if the IRS challenges the rental’s status as a business, and thus the owner’s ability to claim the 20% QBI deduction. Several of Palisades Hudson’s tax clients have rental properties, and this season our staff needed to carefully consider all of the facts and circumstances of each client’s situation to correctly report the activity under the new rules.
Perhaps the largest headache associated with the QBI deduction rules is determining precisely what qualifies as a “specified service trade or business.” The stakes are high, because individual taxpayers with incomes over the threshold can only partially deduct income from a service business. Once the taxpayer’s income hits $207,500 (or $415,000 for married couples), the deduction disappears entirely.
A specified service trade or business is broadly defined as “any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.” This is a wide category that can include doctors, lawyers, consultants, musicians, financial planners and many other professionals. (Notably, the tax reform law ultimately removed engineering and architecture from the list of specified service businesses, though they were originally included.) While the law’s definition includes many professions specifically, it leaves some room for ambiguity.
Taxpayers who receive business income from multiple sources may find that similar work could end up categorized differently depending on the circumstances. For example, a freelance author working as a sole proprietor may be able to argue in most cases that her business does not fall into the “specified service trade or business” category. But if she writes a play, she may fall afoul of the IRS’ specific inclusion of the “performing arts” category. Even if the author avoids writing for the performing arts, she could also run into trouble if she is so successful that she becomes an in-demand speaker or receives money for an endorsement deal – a circumstance specifically mentioned in the catch-all provision of the specified service trade or business rules.
Some businesses may provide services that fall within the rules and other services or products that do not. The law provides an exception for businesses with gross receipts of less than $25 million when 10% or less of those receipts are attributable to performing services. In these cases, owners can treat the entire business as a nonservice enterprise. For businesses with gross receipts over $25 million, service-related receipts must be less than 5% of the total to qualify for the exception.
As with any brand-new tax law, there is no existing case law to examine for clear guidance on how tax courts may judge applications of the QBI rules, or the classification of what exactly is and is not a service business. I am sure many tax professionals had detailed discussions with their clients this tax season, with the same essential topic: “To be a service, or not to be a service, that is the question.”
The tax reform package is a federal law, which means it applies nationwide. Yet Americans in different states had different experiences where the law’s effect on state taxes came into play. The QBI deduction is “below the line,” which means it is taken after the taxpayer calculates adjusted gross income.
States can choose how they tax income relative to the federal tax system. A few directly conform to the Internal Revenue Code without exceptions. But most conform in more limited or specific ways. Some determine a starting point for state tax computations tied to a particular line item in the federal return. In many cases, including New York and California, this starting point is federal adjusted gross income – which means state taxes may leave out QBI deductions entirely. As with all state tax planning, the specifics will vary depending on your home state. In many states, however, the QBI deduction will not affect your taxable income at the state level unless the state specifically adopts it via legislation.
The differences between states’ approach to taxation means that the benefits of the QBI deduction may be greater or lower depending on where you live. And of course, some states do not levy an income tax at all, rendering the question moot.
So much for a postcard-sized tax return. Much of the tax reform process focused on simplifying the tax code and the process of filing a return. Yet in many cases, the final rules are anything but simple. This article only scratches the surface of the QBI deduction’s complexities, and that deduction was just one aspect of a collection of tax law changes. Each of these changes involved some new or added complexities.
But with tax complexity comes tax planning opportunities.
For rental property owners, the safest bet is to take steps to qualify for the safe harbor – or at least to get as close as possible. This may mean limiting or stopping all personal use of a rental property that you may have otherwise visited for a couple of weeks during the year. Taxpayers who have used triple net leases in the past may want to renegotiate with tenants in order to modify the terms. Rental owners should remember to keep good records and logs to track their time for the 250-hour test, too.
Businesses that provide both service and nonservice offerings by the IRS’ definition may find it useful to reorganize if the service component represents more than 5% or 10% of gross receipts. Based on the existing regulations, at a minimum, an owner would need to keep separate books and records for each business line if he planned to treat one as a service business and one as a nonservice business. Depending on the facts and circumstances, the separation may need to be even more pronounced.
Business owners should note that the final regulations specify that for businesses renting property to a commonly controlled service business, the rental income is treated as service business income too. So a service business that owns its office building cannot simply create a separate entity to own the building and collect rent from the operating business in order for that rent to qualify as nonservice qualified business income. Some lawyers suggested this idea early on after the tax law passed, but the IRS sniffed this strategy out and put an end to it before anyone could try it.
The state you live in is the state you live in, so there is not much to do about state conformity rules in most cases. However, if you have previously considered relocating from a high-tax state to a more tax-friendly climate, this may be one more factor in your calculation.
Taxpayers should bear in mind that, like much of the 2017 tax reform package, the 20% QBI deduction will expire at the end of 2025 if Congress does not elect to extend it. Therefore, in some cases, the difficulty and expense of making major structural changes to a business or implementing new planning opportunities may not be worth the temporary gains involved. The possibility of a shift in political power in Washington also could lead to major tax reforms as soon as 2021.
This tax season involved many new components, and sometimes surprises. Tax software and human tax preparers alike had to adjust to a variety of new considerations, QBI deductions among the rest. But the first year of a new tax rule is always the hardest; in time, even a complex system like this one will simply become the new normal.