On August 8, 2018, the IRS released proposed regulations providing additional guidance on the 20% qualified business income (QBI) deduction created by tax reform—commonly known as the Tax Cuts and Jobs Act—under Internal Revenue Code (IRC) Section 199A.
The QBI deduction became effective beginning in 2018. It’s taken against taxable income and applies to most owners of dealership and real-estate-entity structures. There are a number of requirements businesses must fulfill to qualify for the deduction, which are addressed below.
Before the proposed regulations were issued, it was understood the QBI deduction generally couldn’t exceed the greater of an owner’s share of one of the following:
- 50% of the amount of W-2 wages paid by the business
- 25% of the W-2 wages paid by the business plus 2.5% of the cost of qualified property
This left three key issues unanswered, which have since been addressed by the proposed regulations:
- Calculating the QBI deduction
- Applying the new law to multiple business entities
- Handling varying ownership percentages
Below are the main items clarified by the IRS proposed regulations that are important for dealers.
Netting of Income from Related Entities
The proposed regulations create an opportunity for the owners of dealerships with related dealership real-estate entities to aggregate those related businesses when computing the 20% QBI deduction. It also provides dealers with a management company structure or centralized payroll with a similar opportunity. It’s worth noting that while this aggregation is generally allowed, it’s not mandatory.
To qualify, a person or group of people must have common ownership, income from different aggregated entities must be reported on returns within the same tax year, and the aggregated businesses must meet two of the following tests:
- Provide products and services that are the same or customarily offered together
- Share facilities or share significant business elements
- Operate in coordination with, or reliance upon, one or more of the businesses in the aggregated group
The principal benefit of aggregation is that the entire aggregated automotive group’s wages and qualifying property can then be used to determine the deduction limitation. This matters because generally, the greater the qualifying wages and property included in determining the deduction limitation, the greater the anticipated 20% QBI deduction.
Scenario One: Related Companies
Bob owns 80% of the shares of Company A—a dealership S corporation—and 80% of the LLC units of Company B, which owns and leases real property to Company D. The proposed regulations provide that Companies A and B qualify to be aggregated for purposes of calculating the qualifying wages and property used to compute the amount of Bob’s QBI deduction.
Scenario Two: Dealer-Management Company
Dealer-management companies may also be aggregated if they meet certain tests. Let’s say Bob owns 80% of the shares of a management company that’s an S corporation as well as 80% of the shares of 10 dealership S corporations. The management company provides standard management services and pays the wages for all the dealerships in exchange for a management fee.
Bob can elect on his individual tax return to aggregate the management company and dealerships into one group for the purpose of calculating the wage and property limitations, which are used to determine the overall QBI deduction.
The aggregation rules used in both examples allowed for the biggest possible benefit from the 20% QBI deduction. However, aggregation should be analyzed in each unique situation before being deployed because there are specific rules related to common ownership and family attribution that need to be considered.
Once the election to aggregate for the determining the QBI deduction is made, it applies to all future tax years. This means careful tax planning is required to provide the largest QBI deduction in the current year as well as future tax years.
Netting of Income from Unrelated Businesses
The proposed regulations clarify how to combine business income at the owner level when owners have multiple unrelated businesses.
For example, Company A has qualified business income of $1 million while unrelated qualifying Company B has a QBI loss of $1 million. Under the proposed regulations, the taxable income of these two trades or businesses must be netted together to determine overall QBI. In this example, that results in net zero with no qualifying QBI deduction at the individual level.
While some unknowns remain, the proposed regulations appear to be positive for dealers, taking a step in the right direction to provide tax relief in 2018.
When reviewing and planning ways to increase an owner’s QBI deduction, keep in mind any final regulations may contain significant modifications. Regardless, the proposed regulations can be relied upon for tax planning and filing purposes until further guidance is issued.
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For more information about how the new QBI deduction may affect your business, contact your Moss Adams professional.