One of the most valuable tax breaks in the Tax Cuts and Jobs Act (TCJA) is the new deduction for up to 20% of qualified business income (QBI) from pass-through entities. The IRS recently issued proposed regulations that help clarify who can benefit from the deduction. One of the issues the regs clarify is how taxpayers can elect to aggregate, or combine, their trades or businesses for purposes of the QBI deduction (also called the pass-through or Section 199A deduction).
Aggregating businesses for QBI deduction purposes
QBI is the net amount of qualified items of income, gain, deduction and loss with respect to any pass-through entity. If a taxpayer owns interests in several qualifying businesses, he or she can potentially choose to aggregate them and treat them as a single business for purposes of:
• Calculating QBI, and
• Calculating the QBI deduction limitations.
The QBI deduction limitations begin to phase in when a taxpayer’s taxable income exceeds the threshold of $157,500 ($315,000 for married joint filers). This is calculated before any QBI deduction.
When the limitations are fully phased in, the QBI deduction is limited to the greater of: 1) the taxpayer’s share of 50% of W-2 wages paid to employees and properly allocable to QBI during the tax year or 2) the sum of the taxpayer’s share of 25% of W-2 wages plus the taxpayer’s share of 2.5% of the unadjusted basis immediately after acquisition (UBIA) of qualified property.
The UBIA of qualified property generally equals the original cost of the property. “Qualified property” means depreciable tangible property (including real estate) that: 1) is owned by a qualified business as of the tax year end, 2) is used by that business at any point during the tax year for the production of QBI, and 3) hasn’t reached the end of its depreciable period as of the tax year end or is less than 10 years old for property with depreciable lives less than 10 years.
Aggregating businesses can allow a taxpayer with high taxable income to claim a higher QBI deduction when the limitations based on W-2 wages and the UBIA of qualified property would otherwise preclude a larger deduction.
A taxpayer can potentially aggregate qualified businesses that are operated directly, such as through a sole proprietorship or a single-member limited liability company (LLC). The taxpayer must calculate the QBI, W-2 wages and UBIA of qualified property for each business and then aggregate those amounts to calculate QBI for the aggregated businesses and apply the QBI deduction limitations for the aggregated businesses.
Similarly, a taxpayer can potentially aggregate businesses that are operated via pass-through entities, such as S corporations, partnerships or LLCs. All owners of pass-through entities need not aggregate in the same fashion.
5 aggregation requirements
Bear in mind that the aggregation privilege isn’t automatic. In general, a taxpayer can aggregate businesses only if the five aggregation requirements listed below are satisfied:
1. The same person or group of persons directly or indirectly owns 50% or more of each business to be aggregated. For businesses operated by an S corporation, that means owning 50% or more of the issued and outstanding shares. For businesses operated by partnerships (including LLCs treated as partnerships for tax purposes), that means owning 50% or more of the capital or profits interests. For purposes of applying the 50% ownership rule, a taxpayer is also considered to own the interest in each business that’s owned directly or indirectly by his or her spouse, children, grandchildren or parents.
2. The preceding 50% ownership picture exists for a majority of the tax year in which the items for each business to be aggregated are included in the taxpayer’s income.
3. All the tax items attributable to each business to be aggregated are reported on returns with the same tax year end.
4. None of the businesses to be aggregated is a specified service business. The service business disallowance rule is phased in over the same taxable income ranges that apply to the limitations based on W-2 wages and the UBIA of qualified property.
5. The businesses to be aggregated must satisfy at least two of the following three requirements:
- The businesses provide products and services that are the same or customarily offered together (for example, a gas station and a car wash).
- The businesses share facilities or significant centralized business elements (such as personnel, accounting, legal, manufacturing, purchasing, human resources or information technology).
- The businesses are operated in coordination with or in reliance on each other. (For example, they have supply chain interdependencies.)
Options for aggregating
A taxpayer can choose to aggregate some businesses for which aggregation is allowed while not aggregating others for which aggregation isn’t.
How a taxpayer groups or doesn’t group businesses for purposes of applying the passive activity loss (PAL) rules doesn’t affect how the taxpayer can aggregate or not aggregate businesses for purposes of applying the QBI deduction rules. In other words, PAL groupings or nongroupings are irrelevant for purposes of the QBI deduction rules.
Netting of negative and positive QBI amounts
If a taxpayer has at least one business that produces negative QBI (including aggregated businesses that are treated as a single business), he or she must offset the QBI from each business that has positive QBI (including aggregated businesses that are treated as a single business) with an amount of negative QBI in proportion to the relative amount of positive QBI of each business that has positive QBI. However, the W-2 wages and UBIA of qualified property from a business that produces negative QBI aren’t taken into account in calculating W-2 wages and the UBIA of qualified property when applying the QBI deduction limitations.
If a taxpayer has overall negative QBI for the tax year, the negative amount is treated as a loss from a qualified business in the following tax year. This carryover rule doesn’t affect the deductibility of losses under any other tax law provisions.
An aggregation example
The aggregation rules are confusing stuff, so here’s an example to help provide clarification.
Alexandra is a single, calendar-year small business owner with taxable income of $300,000 before any QBI deduction. She’s subject to the QBI deduction limitations based on W-2 wages and the UBIA of qualified property.
She owns and operates a catering business and a restaurant via separate single-member LLCs (SMLLCs) that are treated as sole proprietorships owned by her for tax purposes. The two operations share centralized purchasing and accounting, all done by Alexandra. She also maintains a website and does print advertising for both operations. The restaurant kitchen is used to prepare food for the catering business, but the catering business employs its own staff and owns equipment and trucks that aren’t used by the restaurant.
The catering business has QBI of $300,000, but no W-2 wages because all the work is done by independent contractors hired job-by-job. The restaurant business has QBI of only $50,000, but it has regular employees with $200,000 of W-2 wages.
If Alexandra keeps the two businesses separate for QBI deduction purposes, her deduction from the catering business is $0 (50% × W-2 wages of $0), and her deduction from the restaurant is $10,000 (20% × QBI of $50,000), for a total deduction of only $10,000.
But if Alexandra is allowed to aggregate the two businesses, her deduction is $70,000 — the lesser of $70,000 (20% × aggregated QBI of $350,000) or $100,000 (50% × aggregated W-2 wages of $200,000). The deduction is further limited to 20% of taxable income, so her deduction is $60,000. If she can aggregate the businesses, her QBI deduction would be $50,000 higher. But is she allowed to aggregate them?
Because the restaurant and catering businesses are held in SMLLCs that are treated as sole proprietorships owned by Alexandra, she’s treated as directly owning and operating both businesses. Because common ownership of the businesses (100% by Alexandra) exists for the entire tax year, and because all the tax items attributable to both businesses are reported on Alexandra’s calendar-year return, aggregation requirements 1, 2 and 3 are satisfied.
Neither business is a specified service business, so aggregation requirement 4 is also satisfied. Because both businesses offer prepared food to customers and share the same kitchen facilities, and also because they both share centralized purchasing, accounting and marketing functions, aggregation requirement 5 is satisfied.
Therefore, Alexandra can aggregate the catering and restaurant businesses for purposes of calculating her QBI and for purposes of applying the QBI deduction limitations based on W-2 wages and the UBIA of qualified property. Thus, she can claim a QBI deduction of $60,000.
Variation: Let’s say Alexandra’s taxable income (before any QBI deduction) is $157,500 or less. In that case, she’s unaffected by QBI deduction limitations based on W-2 wages and the UBIA of qualified property. Thus, there’s no advantage to aggregating the catering and restaurant businesses. Her QBI deduction from the catering business would be $60,000 (20% × QBI of $300,000), and her QBI deduction from the restaurant business would be $10,000 (20% × QBI of $50,000) totaling $70,000. However, the deduction is still limited to 20% of taxable income for a total deduction of $31,500 ($157,500 x 20%).
Bottom line: As the example and its variation illustrate, aggregation is advantageous only when the taxpayer’s taxable income is high enough to be affected by the QBI deduction limitations based on W-2 wages and the UBIA of qualified property.
Aggregation consistency requirement
After a taxpayer chooses to aggregate two or more businesses for QBI deduction purposes, he or she must continue to aggregate the businesses in all subsequent tax years. However, a taxpayer can add a newly created or newly acquired business to an existing aggregated group of businesses if the five aggregation requirements are met.
If there’s a change in facts and circumstances so that a taxpayer’s prior aggregation of businesses no longer qualifies for aggregation, the taxpayer must reapply the requirements to determine a new permissible aggregation (if any).
Required annual disclosure of aggregation
For each tax year, a taxpayer must attach a statement to his or her federal income tax return for that year identifying each business that’s been aggregated. The statement must include, among other things, the name and employer identification number of each entity. If a taxpayer fails to attach the required statement, the IRS can disaggregate the businesses.
Use the QBI deduction to your advantage
The aggregation rules for the QBI deduction are complex, but they may allow certain businesses to achieve more favorable tax results. We can help you get the most out of this provision and all other tax breaks in the TCJA.