Monday, January 15, 2018
If tax simplicity was the goal of the recently enacted “Tax Cuts and Jobs Act” (not the official title), it’s hard to claim that the goal was met, at least as to the entirety of the bill. Perhaps a number of the individual income tax provisions were streamlined by virtue of the elimination of some itemized deductions and the near doubling of the standard deduction. Likewise, the corporate tax rate structure was simplified by moving to a single 21 percent rate. But that single lower rate doesn’t necessarily mean that there will be a stampede to form C corporations or convert existing businesses to C corporate status. There are other issues that work against converting a business to the C corporate form.
For sole proprietorships and pass-through businesses, a new deduction makes tax planning and preparation more complex - much more complex. Today’s post takes a brief look at this new deduction – a 20 percent deduction for qualified business income (QBI) that is available to businesses other than C corporations. There are many issues associated with the QBI, and those issues will be left for future posts. But, a couple of implications are addressed in this post.
The QBI Deduction
The complexity of the QBI deduction Code section (I.R.C. §199A) is difficult to overstate. The new QBI provision is 23 pages in length, at least when counting pages of the text of the provision in the final bill version that the President signed. If my count is correct, there are over 20 definitions in §199A, more than two dozen cross references to other parts of the Code, and just as many cross-references to other parts of §199A. The QBI deduction computation contains several formulas with “lesser than” or “greater than” language, and some of the computations are embedded inside each other. In addition, those computations involve addition, subtraction and multiplication (remember the ordering rules from grade school math class?). The QBI deduction also includes exemption amounts, formulas that phase-out those exemptions, and an international tax provision that applies to domestic pass-through entities.
The basics. The genesis for the §199A deduction dates at least to 2009. Before he became House Majority Leader in 2011, Rep. Eric Cantor, proposed a 20 percent deduction for small businesses. That proposal came up again a couple of times in later years, but nothing was formally introduced until the tax legislative discussions started to take shape in the summer of 2016, and the legislative process unfolded in 2017. The 20 percent deduction found its life in newly created I.R.C. §199A as part of the recently enacted tax bill.
Like the original proposal years ago, the QBI deduction is a deduction against business income for non-C corporations that aren’t specified service businesses. Some of the other basic points about the QBI deduction include: 1) for income above a threshold a W-2 wage limitation applies; 2) the deduction is claimed at the partner or shareholder level; 3) trusts and estates are eligible, as are agricultural and horticultural cooperatives; 4) the deduction applies only for income tax purposes, and is determined without regard to alternative minimum tax (AMT) adjustments; and 5) the accuracy-related penalty for substantial understatement of tax for a tax return claiming the QBI deduction applies if the understatement if five percent, rather than the normal 10 percent.
The formulas. The QBI deduction equals the sum of the lesser of the “combined qualified business income” of the taxpayer, or 20 percent of the excess of taxable income over the sum of any net capital gains and qualified cooperative dividends, plus the lesser of 20 percent of qualified cooperative dividends or taxable income less net capital gain. What is “combined qualified business income”? It’s not really income. Instead, it’s a deduction. It’s 20 percent of the taxpayer’s “qualified business income” from each of the taxpayer’s qualified trade or business; limited to the greater of 50 percent of W-2 wages with respect to the business or 25 percent of the W-2 wages with respect to the business, plus 2.5 percent of the unadjusted basis (immediately after acquisition of all qualified property). Plus, 20 percent of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership income.
Definitions. As noted the definition of terms for purpose of the deduction are many. “Qualified property” is defined as tangible property that is subject to I.R.C. §167 depreciation. Likewise, “qualified business income” is the taxpayer’s ordinary income (less ordinary deductions) from the taxpayer’s non-C corporate business. Not included are any wages earned as an employee. Thus, for independent contractors, self-employment income is QBI that is potentially eligible for the 20 percent deduction. Conversely, for employees, wages earned are not eligible for the 20 percent deduction. Also, the definition of QBI does not include short or long-term capital gain or loss, dividend income or interest income. In addition, QBI does not include any wages or guaranteed payments received from a flow-through business, and any income that is not “effectively connected with the conduct of a U.S. trade or business.”
QBI might also include rental income. Clearly, the QBI must be earned in a “qualified trade or business.” But, what definition is going to be used to determine “trade or business”? My guess is it will be the I.R.C. §162 definition. If so, certain rental activities may not meet the definition, such as a triple-net lease where the owner has practically no regular involvement. Also, not satisfying the test would be cash rentals and non-material participation crop-share or livestock-share leases.
As noted above, the formula applies a W-2 wage limitation to pass-through businesses and sole proprietorships. However, the limitation does not apply to taxpayers below $315,000 (MFJ) – half of that for all other filers. Once taxable income exceeds the threshold, the W-2 limitations are phased-in over the next $100,000 of taxable income (MFJ) - $50,000 for all other taxpayers. But, what are W-2 wages? They must be wages subject to withholding. So, by definition, that excludes payments a business makes to an independent contractor, management fees that are paid, and ag wages paid in-kind.
However, wages paid to children under age 18 by parents count as qualified wages. How so? I.R.C. Sec. 199A(b)(4)(A) references I.R.C. Sec. 6501(a) for the definition of W-2 wages. In particular, I.R.C. Sec. 6051(a)(3) specifies that the total wages are defined in I.R.C. Sec. 3401(a) which is the definition of wages for withholding purposes. The I.R.C. §3401(a) definition comprises all wages, including wages paid in a medium other than cash, except wages paid for agricultural labor unless the wages are for payroll tax purposes under I.R.C. §3401(a)(2). Wages paid to children under age 18 by their parents are not included as an exception in IRC §3401(a). Such wages are subject to withholding but are often exempt because the amount is less than the standard deduction. However, under IRC §3401(a)(2), commodity wages are not included because they are not “wages” under IRC §3121(a). Therefore, wages paid to children under age 18 by their parents count as wages for QBI purposes, but agricultural wages paid in-kind do not.
In addition, the wages must be paid for amounts that are properly allocable to producing QBI.
Net Operating Losses. As for net operating losses (NOLs), if a taxpayer claims the QBI deduction in the same year as an NOL, the deduction does not add to the NOL.
Agricultural and horticultural cooperatives. One issue that Senators Thune (R-SD) and Hoeven (R-ND) (among others) are presently working on is a technical correction that would balance out how the QBI deduction works with respect to agricultural products sold to a cooperative by a patron and those sold to a non-cooperative. A cooperative is eligible for the QBI deduction in accordance with a formula (of course). That is not in controversy. A cooperative’s deduction is 20 percent of the cooperative’s excess gross income over qualified cooperative dividends, or the greater of 50 percent of the cooperative’s W-2 wages, or the sum of 25 percent of the cooperative’s W-2 wages relating to the cooperative’s business plus 2.5 percent of the unadjusted basis immediately after acquisition of the cooperative’s qualified property. The deduction is then limited to the cooperative’s taxable income for the tax year.
What is controversial is that the QBI deduction is essentially 20 percent of taxable income (less capital gains) in the hands of a taxpayer that is a patron of a cooperative that sells to the cooperative. For a taxpayer in the 35 percent bracket, the deduction would reduce the effective rate by seven percentage points. However, for a taxpayer that doesn’t sell the ag products to a cooperative (say, for example) to a private elevator, the deduction is 20 percent of net farm income. That will often result in a lower deduction, but whether a sale should be made to a cooperative or a non-cooperative will depend on various economic factors as well as the tax factors.
The discrepancy could cause some farm landlords to switch from a cash lease to a crop-share lease if doing so will allow the landlord to claim the QBI deduction. Sales to a non-cooperative require that the taxpayer be engaged in a “trade or business” to qualify for the deduction. That means that a cash rent landlord will not qualify for the deduction. On the other hand, sales to a cooperative do not require the existence of a trade or business. Thus, the tenant under a cash lease gets the entire deduction. The landlord under a crop-share lease would be entitled to the landlord’s share.
Form 4797 and the QBI Deduction
Even though the new tax bill bars personal property trades, farmers will undoubtedly continue “trading” equipment. The “trade-in” value will be listed as the “selling price” of the “traded” equipment. A key question is whether the gain reported on Form 4797 will be QBI. As noted, the QBI deduction does not apply to capital gain income. I.R.C. §199A refers to “capital gain.” It does not refer to “gain on capital assets.” Thus, income taxed as “capital gain,” even though it is from an I.R.C. §1231 asset, is included in the definition of “capital gain” that is not eligible for the QBI deduction.
Form 4797 separates out the I.R.C. §1231 gain, the ordinary income and the gain attributable to recapture from sales or exchanges of business property. Specifically, Form 4797 Part I property is includible as LTCG property (taxed at a favorable rate), and is not QBI. Form 4797 Part II property is not considered STCG property, which is specifically excluded from the calculation. Gain or loss reported on Part II is QBI. The same is true for income reported on Part III of Form 4797.
The Form 4797 issue is not restricted just to personal property trades. It will also arise, for example, with respect to dairy operations. Dairies that are not C corporations, can be eligible for the QBI deduction. However, without careful planning, the deduction could be of limited value. Dairies typically have two sources of income – Schedule F income from milk sales (which is likely minimal due to offsetting expenses); and Form 4797 where sales of culled dairy cows are reported. The gain attributable to the dairy cow sales is not eligible for the QBI deduction.
I will get into more of the QBI-related issues at the law school’s January 24 seminar/webinar. Our first one on January 10 sold-out, and available spots for the January 24 event are filling up fast. Information on registration is available here: http://washburnlaw.edu/employers/cle/taxlandscape2.html.
By the time we get to January 24, there may be additional developments concerning the QBI deduction, especially with respect to its application to cooperatives and patrons. In addition, Paul Neiffer and I will delve deeply into these issues at our summer seminar in Shippensburg, PA on June 7-8. Plan now to attend. Be watching http://washburnlaw.edu/practicalexperience/agriculturallaw/waltr/index.html for information concerning the seminar in the next few days. If you would like to be put on a list to be notified of the June seminar, please send an email to [email protected].