Tax Reform - The New Pass-Through DeductionAugust 28, 2018
Richard C. Parmelee, CPA
Section 199A Qualified Business Income Deduction (20% Deduction)
One of the most significant aspects of the Tax Cuts and Jobs Act for dealerships organized as pass-through entities was the enactment of the Section 199A Qualified Business Income (QBI) Deduction. The basic concept behind the QBI provision was that taxpayers with income from qualified trades or businesses would be entitled to a deduction of 20% taxable income. The 20% deduction is substantial, lowering the effective tax rate of a taxpayer in the top tax bracket from 37% to 29.6%. The deduction contained several limitations:
- income must be domestic “qualified business income” from a trade or business
- the deduction is limited to the greater of 50% of W-2 wages paid with respect to the qualified trade or business or 25% of W-2 wages paid by the qualified trade or business, plus 2.5% of the unadjusted basis of qualified property
During 2018 we have held discussions with our dealership clients about questions arising from Section 199A. On August 8 the Treasury Department and the IRS released proposed regulations that answer a number of those questions.
What is a Qualified Trade or Business?
For our dealership clients selling automobiles, trucks, motorcycles, equipment or recreational vehicles there was no doubt that the income from those trades or businesses qualified for the deduction. For many of our clients a typical arrangement would be for the dealership to be owned by one entity and the real estate to be owned by a separate entity, with the real estate being self-rented by the dealership under a triple net lease arrangement where the ownership of those entities is common.
The Internal Revenue Code contains several definitions of what is considered a trade or business. For purposes of IRC Code Section 162 an activity conducted with continuity and regularity is considered to meet the threshold of being considered a trade or business. Triple net leases are problematic under this definition, which creates a problem for client dealership real estate activities operated under triple net leases. The proposed regulations attempt to address this issue by permitting taxpayers to aggregate single trades or businesses operated across multiple legal entities to be treated as a single trade or business. The IRS requires that several factors be met, however in our earlier example where the dealership and real estate are owned in separate entities by common owners it appears clear that taxpayers can elect to aggregate those activities, allowing the self-rented real estate to qualify for the Qualified Business Income deduction.
Many dealerships initially assumed that the wage limitations would not impact them. However, a strict reading of Section 199A led many to believe that only wages reported under the federal employment identification number (FEIN) for the dealership entity could be used in computing the wage limitation. This is particularly problematic for dealers who have an employee paid by one dealership entity, whose wages may be allocated to several other commonly owned dealership entities. The allocated wages would not be eligible when calculating the wage limitation. This situation is further complicated for dealerships that use professional employer organizations (PEO) where all W-2 wages are reported under the PEO’s FEIN.
The proposed regulations resolve this issue by allowing W-2 wages paid by another dealership entity to a common law employee of the dealership entity expensing the wages to use the wages paid to the common law employee in calculating the wage limitation. The proposed regulations also allow wages paid by a PEO to be used in calculating the wage limitation. Taxpayers are not allowed to double count these wages in computing the limitation, so care should be taken in situations where wages reported on one W-2 are allocated amongst multiple entities.
Confusion existed for taxpayers with business entities generating losses. In particular, questions arose with taxpayers who owned multiple entities where some entities were profitable and others had losses. In a simplistic example let’s assume that a taxpayer owns two dealerships. Dealership A has QBI of $1,000,000 and dealership B has a loss of $350,000. In this situation the question is if the QBI deduction $1,000,000 x 20% = $200,000 with no deduction for dealership B or $1,000,000 - $350,000 = $650,000 x 20% = $130,000. The proposed regulations clarify that the deduction in this scenario would be $130,000.
If the combination of all positive and negative QBI amounts resulted in a net loss the taxpayer is required to carry forward the loss to the following tax year. The W-2 wages and basis amounts do not carry forward.
The proposed regulations issued by the Department of Treasury and the IRS answer a number of significant questions for dealerships and their owners.
Richard C. Parmelee, CPA, is a partner at BlumShapiro, the largest regional business advisory firm based in New England, with offices in Connecticut, Massachusetts and Rhode Island. The firm, with a team of over 500, offers a diversity of services, which include auditing, accounting, tax and business advisory services. Blum serves a wide range of privately held companies, government and non-profit organizations and provides non-audit services for publicly traded companies. To learn more visit us at blumshapiro.com.