Wealthy clients who own businesses may qualify for a big tax deduction: The IRS estimates that nearly 24 million taxpayers may be eligible to claim the new 20 percent deduction for qualified business income (QBI).
The trick is figuring out if and how a business qualifies.
“QBI is potentially available for anyone with a small business, a Schedule C, a rental property, a farm operation, any type of business operation,” said Chris Wittich, a CPA and senior manager with Boyum & Barenscheer in Bloomington, Minn. "Two out of three clients are aware of the QBI deduction, but almost none understands how it works and what types of limitations apply. It’s far more complex than most of the tax changes in the past 15 years or so.”
QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, according to the IRS. Only items included in taxable income are counted. In addition, the items must be connected with a U.S. trade or business. Capital gains and losses, certain dividends and interest income are excluded.
The deduction can be limited by a range of factors based on taxable income, the amount of W-2 wages paid by the business and the unadjusted basis immediately after acquisition of qualified property held by the trade or business. Taxable income limits are $315,000 for a married couple filing a joint return and $157,000 for all other taxpayers.
Wittich said two other limitations apply to the deduction, starting with the definition of a specified service trade or business (SSTB). “SSTBs are service businesses such as doctors, lawyers, accountants, consultants, entertainers and so on,” Wittich said. “The second limitation for taxpayers over the income threshold is that the QBI is limited to either 50 percent of wages from the business or 25 percent of wages plus 2.5 percent of the unadjusted cost basis of property. For most operating businesses that employ people, the 50 percent of wage limitation is better and it often doesn’t limit the business.”
Wittich sees additional areas in the deduction’s definitions that need guidance. “One is the definition of ‘consulting,’” he said. “Many businesses have a core operating business but then also do some consulting with their clients. How do you measure that consulting? What is ‘consulting’ versus what is ‘education’ or ‘training’ for clients? What if the consulting is ancillary to the operating business versus being a separate line of business operations?”
Real estate is another unclear area of the deduction, according to Nathan Smith, director in the CBIZ MHM national tax office in Clearwater, Fla. “The deduction applies only to the financial activity of a business,” he said. “Whether a rental operation rises to the level of a trade or business is often difficult to determine given the ambiguity of the law.
“A landlord who merely waits for the rent checks each month and does nothing more to sustain the rental operation is clearly not engaged in a business,” Smith added. “A landlord with a multiunit apartment building who frequently tends to repairs and maintenance, procures insurance for the property and vets the integrity of tenants is likely engaged in a rental business. There are obviously many situations that fall somewhere in between.”
The IRS does offer a safe harbor to determine whether a rental real estate enterprise rises to the level of a trade or business but the terms may be impractical, “particularly ... where contemporaneous logs of time must be maintained to substantiate the taxpayer’s involvement in the rental activity,” Smith said.