The IRS is true to their word when they said they’d issue regulations on the Qualified Business Income Deduction, otherwise known as QBI, by the end of summer. In the past week proposed regulations were published, coming in at 184 pages. Remember these are “proposed” regulations. Final regulations come after guys like me pick it apart. Most of what you see probably survives so it is a good time to start the planning process.
Accountants who wanted to get a jump-start advising clients on ways to maximize the deduction are in for a rude surprise. Most schemes are out. At the end of this post I will outline what can be done to maximize the deduction.
The 184 pages of proposed regs cover more than just QBI. We will discuss the most relevant here. Consider consulting with a tax professional to review how your personal situation is affected by these proposed regulations.
If I find any other juicy tidbits, I’ll publish. If not, I’ll wait until the final regs are issued.
First, let’s clarify what the QBI deduction is. The QBI deduction is a 20% non-cash deduction for qualified business income (generally profits) for small businesses (sole proprietors, LLCs, S corporations, partnerships and some trusts) and income property investors.
The IRS confirmed what I suspected when they said QBI applies to self-employed persons, along with pass-through entities (S corps, partnerships, LLCs) and certain trusts. I think there is room for debate of the sole proprietor issues, but if the IRS gives the green light I’m happy to oblige. QBI is also available for income property owners with somewhat different rules.
Some issues the IRS clarified are pretty straight forward from H.R. 1. Phase out of the deduction starts at $315,000 for joint returns and $157,500 for the rest of the crowd if the business is in a listed field. The deduction is reduced to zero for that business once income exceeds $415,000 for joint returns; $207,500 for other returns.
The fields restricted by the above phase out are:
- Performing Arts
- Actuarial Science
- Financial/Brokerage/Investment Management/Securities Trading/Securities Dealers
One issue worth pointing out is the phase out is applied per business! This opens a potential planning opportunity where you break a larger company into parts to fall under the limits. Except the IRS knows this trick already and nixed it.
This doesn’t mean you can’t have multiple businesses. QBI is calculated separately for each business, but if the same owner/s has two or more similar businesses they are combined in many cases! The “bust the company into a bunch of littler companies” idea doesn’t work.
And talking about wages: enterprising tax professionals may have advised you to fire employees and hire them back as independent contractors. This way the old employees are really business owners and get a 20% deduction on their wages. The IRS has made clear this will NOT be allowed. This and similar schemes will be pursued and denied by Revenue. Penalties and interest will apply. You’ve been warned.
Investors in Real Estate Investment Trusts (REITs) have clarity with the proposed regs when claiming QBI. I’ll discuss this in a future post closer to tax season as the planning opportunities are limited for most taxpayers.
S corporations exclude reasonable compensation to owners when calculating QBI. The same applies to guaranteed payments to partners. Every idea I’ve seen to game the system involving owner’s compensation is clarified in the proposed regs and not allowed. But there are legal ways to maximize QBI.
Legal Ways to Increase QBI
Fancy footwork may seem the way to go when dealing with the new tax rules, but the old reliable methods of reducing income have a better chance having stood the test of time.
Lowering your income if you are already below the phase out has less benefit than in the past as business deductions are technically only worth 80 cents on the dollar. (You get a 20% deduction anyway if you don’t invest in the expense.) Below the phase out you need to consider the long-term effects on your tax situation. Additional equipment purchases or promotional expenses may not be the best choice when you consider the reduced profits mean a reduced QBI deduction. Example: You elect to spend an additional $10,000 on advertising. The additional deduction is only $8,000 since you would have received a $2,000 QBI deduction anyway.
The phase out is where things really get interesting. If you’re reasonably close to the phase out threshold, a modest amount of planning could make the difference between the full QBI deduction and no deduction at all. Remember, you can’t just increase your paycheck (assuming you are an owner receiving reasonable compensation) to reduce the company profits since reasonable compensation isn’t considered when calculating QBI. Let’s start with some small things and work up to large deductions you can take to qualify for the QBI deduction.
Office in the home: Sole proprietors can deduction a regular and exclusive office in the home using actual expenses or the safe harbor of $5 per square foot, up to 300 square feet. This is more valuable than in the part with the standard deduction much higher and state and local taxes (SALT) deductions limited on Schedule A.
Missing deductions: It might sound strange, but many business owners forget to take all their deductions. Business miles are deductible. Keep a log book in your vehicle so every mile is counted. Small cash payments for business expenses add up. Track them all. Any expense related to the business should be included. The IRS used “ordinary and necessary” as their term for what is allowed as a business expense. This is a wide road.
Section 1.263(a)-1(f) de minimis election: The de minimis election allows you to deduct all items that would normally be depreciated under $2,500. This is per item! For businesses this doesn’t mean much as bonus depreciation (more on this later) allows much larger deductions. But income property owners benefit mightily! Most stoves and refrigerators are under $2,500. Expensing anything connected to real estate under Section 179 isn’t allowed, even stoves and refrigerators. For most taxpayers this is a moot point as bonus depreciation counts for all assets with a class life of 20 years or less. But, many states limit Section 179 depreciation or don’t exactly follow federal tax rules for bonus depreciation. To my knowledge, all states follow this de minimis election, thereby bypassing Section 179 and bonus depreciation issues. Note: you can clean your depreciation schedule, too. Previous items under $2,500 can be currently expensed if the election is made. This could be a sizable deduction if you have a lot of small items on your depreciation schedule from prior years.
Repair Regs: Section 1.263(a)-3(h) election: This election allows for a deduction of up to $10,000 for an improvement as a repair. Property improvements do not fall under the bonus depreciation rules. Example: a bathroom or kitchen in an office or income property is probably an improvement by most measures and therefore depreciated over 27.5 or 39 years. If the remodel is $10,000 or less (per remodel or improvement) you can elect to treat the improvement as a repair and expense the entire amount. This is important. You might have a deck on a property replaced for $3,000, a roof for $9,000 and a minor bathroom remodel for $6,000. Each is a separate event. Each is under $10,000. You can elect for each improvement (you make multiple elections for multiple improvements) to deduct the amount as a repair expense. In this case the total repair expense deducted is $18,000.
Bonus depreciation: Bonus depreciation is back at 100% for assets with a class life of 20 years or less. This is by far the easiest way to chew huge chunks of reportable profit from a business. The decision for a machine shop to purchase a new piece of equipment this year or next for $200,000 will require a review of the current circumstances. If this year’s profits are too high for the QBI deduction, it might be advantageous to purchase the equipment this year. If not, you can save the purchase for next year. Facts and circumstances will prevail. If there is one area to get creative, it’s here. One caveat: restaurant, retail and leasehold improvements (qualified improvement property) acquired and placed in service between September 28, 2017 and December 31, 2017 get the 100% bonus depreciation, but not afterwards unless the tax law glitch is fixed. Don’t hold your breath.
I don’t want to get any longer on such a technical post. I just want you to understand there are many ways to take advantage of the current tax environment. The proposed regulations cover a wide variety of material. When the regs finalize I’ll publish more.
Until then, feel free to leave questions in the comments. I’ll answer the best I can with the limited information you provide me and as time permits. As previously noted, the proposed regs run 184 pages. I focused on the issues affecting my clients most. There are lesser issues that also affect clients I didn’t touch on. For example, I didn’t touch on the “reputation or skill” clause as it relates to QBI.
To keep this blog readable I’ll break up the technical tax posts with plenty of entertaining and useful wealth building, early retirement, side hustle and frugal living posts. It’s always good to have a family friendly blog.
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