Recently proposed IRS regulations provide aggregation rules that allow eligible individuals to "aggregate" their businesses in order to maximize the new qualified business income (QBI) deduction. Specifically, they may be able to combine income, W-2 wages and the unadjusted basis immediately after acquisition (UBIA) of qualified assets from qualified businesses conducted as pass-through entities. Here's some background material, along with examples, on how this aggregation strategy can work.
Important note: While new QBI deduction regulations are in proposed form, taxpayers can rely on them until final regulations are issued.
The new QBI deduction is part of the Tax Cuts and Jobs Act, which was passed in December 2017. By now, you probably know some of the basics. But you may not know that individuals who own interests in several qualified businesses may be eligible to aggregate (combine) them for purposes of taking the QBI deduction.
Aggregating businesses can allow an individual with higher taxable income to claim a bigger QBI deduction when the QBI deduction limitations based on W-2 wages and the UBIA of qualified property would otherwise produce a smaller deduction or maybe even no deduction at all. See "Limitations Based on W-2 wages and the Basis of Qualified Assets" at right.
When an individual owns interests in several qualifying businesses, the individual can potentially choose to aggregate them and treat them as a single business for purposes of calculating 1) the amount of QBI, and 2) the QBI deduction limitation based on 50% of W-2 wages or the limitation based on 25% of W-2 wages plus 2.5% of the UBIA of qualified property.
An individual can potentially aggregate qualified businesses that are operated directly, such as via a sole proprietorship or a single-member limited liability company (SMLLC) that's treated as a sole proprietorship for tax purposes. The individual must first calculate the QBI, W-2 wages and UBIA of qualified property for each business. Then those amounts can be combined to calculate QBI for the aggregated businesses and to apply the QBI deduction limitations based on W-2 wages and the UBIA of qualified property for the aggregated businesses.
Similarly, an individual can potentially aggregate businesses that are operated via pass-through entities, such as partnerships, LLCs that are treated as partnerships for tax purposes and S corporations. Other owners of a pass-through entity need not aggregate in the same fashion as the individual.
The aggregation privilege isn't automatic. In general, an individual can aggregate businesses only if the following five requirements are satisfied:
1. The same individual or group of individuals directly or indirectly owns 50% or more of each business to be aggregated.
2. The preceding 50% ownership picture exists for a majority of the tax year in which the tax items for each business to be aggregated are included in the individual's income.
3. All the tax items attributable to each business to be aggregated are reported on tax returns with the same tax year end.
4. None of the businesses is a specified service business. A special QBI deduction disallowance rule applies to income from specified service businesses, and they cannot be aggregated with any other businesses to minimize or avoid the rule. Your tax adviser can explain exactly what constitutes a specified service business for purposes of the disallowance rule.
5. The businesses to be aggregated must satisfy at least two of these requirements to demonstrate that they're part of a larger integrated business:
An individual can choose to aggregate some businesses for which aggregation is allowed while not aggregating others for which aggregation would be allowed.
Important note: An individual's decision about combining businesses for purposes of applying other tax law provisions — such as the passive loss rules — does not affect his or her decision to aggregate businesses for purposes of applying the QBI deduction rules (and vice versa).
How can aggregation be advantageous? Basically, aggregation can sometimes result in higher QBI deductions for higher-income taxpayers who are affected by the deduction limitations based on W-2 wages and the UBIA of qualified property. For instance, the aggregation rules would benefit a higher-income individual who owns 1) an interest in one business with substantial QBI but no W-2 wages (or UBIA of qualified assets), and 2) an interest in another business with minimal QBI but significant W-2 wages (or UBIA of qualified assets). Aggregating these two businesses could result in a larger QBI deduction than if they were treated separately.
For example, John is an unmarried calendar-year taxpayer and small business owner with taxable income of $300,000 before any QBI deduction. Since his taxable income exceeds $207,500, he is fully subject to the QBI deduction limitations based on W-2 wages and the UBIA of qualified property.
John owns and operates a catering family business and a restaurant business through separate single-member LLCs that are treated as sole proprietorships for tax purposes. The two operations share centralized purchasing and human resources functions, which are performed by John. He also maintains a website and does print advertising for both businesses. The restaurant kitchen is used to prepare food for the catering business, but the catering business employs its own staff and leases 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 that John hires on a job-by-job basis. The restaurant business has QBI of only $50,000, but it has regular employees who are paid $200,000 of W-2 wages for the year.
If John keeps the two businesses separate for QBI deduction purposes, his deduction from the catering business is zero (50% of no W-2 wages). His QBI deduction from the restaurant is $10,000 (20% x $50,000). So, his total QBI deduction for the year is only $10,000.
However, if John aggregates the two businesses, his aggregated QBI would be $350,000 ($300,000 + $50,000) and his aggregated W-2 wages would be $200,000 ($0 + $200,000). So, his aggregated QBI deduction is equal to the lesser of:
Under the facts in this example, John is allowed to aggregate the businesses. Therefore, his allowable QBI deduction is $70,000.
When an individual's taxable income is below the threshold for the QBI deduction limitations based on W-2 wages and the UBIA of qualified property, there's no advantage to aggregating businesses.
For example, let's assume the same facts, except now John's taxable income before any QBI deduction is only $150,000. So, he's unaffected by the QBI deduction limitations, and there's no advantage to aggregating the businesses.
His QBI deduction is simply computed as the sum of 20% of QBI from the two businesses. The deduction from the catering business is $60,000 (20% x $300,000), and the deduction from the restaurant business is $10,000 (20% x $50,000) for a total of $70,000.
The proposed QBI deduction regulations are lengthy and complex. This article only covers one specific issue, and many details have necessarily been omitted. Your tax advisor can sort through the regulations to help you maximize the QBI deduction based on your specific circumstances.
Limitations Based on W-2 Wages and the Basis of Qualified Assets
Limitations on the deduction for qualified business income (QBI) begin to phase in when an individual's taxable income (calculated before any QBI deduction) exceeds the threshold of $157,500 or $315,000 for a married couple who files jointly. The limitations are phased in over a $50,000 taxable income range or a $100,000 taxable income range for a married couple who files jointly. They're fully phased in when taxable income exceeds $207,500 or $415,000 for a married couple who files jointly.
When the limitations are fully phased in, the QBI deduction is limited to the greater of:
The limitation involving the UBIA of qualified property is for the benefit of capital-intensive businesses. The UBIA of qualified property generally equals the original cost of the property.
In addition, an individual's deduction can't exceed the lessor of: 1) 20% of QBI plus 20% of qualified income from REITs and publicly traded partnerships (PTPs) or 2) 20% of the individual's taxable income calculated before any QBI deduction and before any net capital gain (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).
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