Last December’s tax reform was billed as the Tax Cuts and Jobs Act, and to that end, small businesses received a valuable deduction with the idea that the tax savings would translate into new jobs. The Section 199A qualified business income deduction allows business owners to deduct up to 20% of their net income from pass-through entities or sole proprietorships.
However, high-earning businesses that operate in one of the categories of a specified service trade or business (SSTB) start losing that deduction if the business owner’s income is greater than $315,000 for joint filers and $157,500 for all other filers. The deduction is completely gone when taxable income hits $415,000 for joint filers and $207,500 for all others. These SSTBs include trades or businesses in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management.
You may have seen articles earlier this year with a strategy for business owners who are in one of those SSTBs and who also own the building in which their business operates. By putting the building in a separate entity, and having their SSTB pay rent to that business, tax strategists hoped that high-earning business owners would be able to shield some of their income from the thresholds that limit the qualified business income deduction, and be eligible for the Section 199A deduction on at least a portion of their income.
However, proposed regulations released by the IRS put an end to that strategy. Under the proposed regulations, if the SSTB and the non-SSTB rental entity have at least 50% common ownership and at least 80% of the rental entity’s space is occupied by that related SSTB, then all of the rental income will be considered part of the SSTB and subject to the income limitations on the deduction. If less than 80% of the space is used by the related SSTB, a pro-rated amount of the rental income will be added to the SSTB income.
Here’s an Example:
Albert is an unmarried attorney who operates his business out of a small building. His solo law practice, which is an S-corporation, pays rent to the LLC that owns the building. He is the sole owner of that LLC. All of his income from both his law firm and his rental business will be treated as a specified service trade or business and will be subject to the income limitations. If his taxable income is greater than $157,500, his 20% qualified business deduction will be phased out, and if his taxable income is greater than $207,500, the deduction will be completely gone.
Note that it still may be a good idea to keep real estate in a separate LLC from your operating business. It just won’t necessarily help salvage the Section 199A Deduction.
Confused about how the 2017 tax reform will impact your taxes this year? Contact us to discuss strategies that will save tax deductions this year and in the future. With the complexity of the qualified business income deduction, careful planning is more important than ever.