Under the 2017 Tax Cuts and Jobs Act, Congress enacted the new Section 199A 20% profit deduction for owners of pass-through businesses, and which include Subchapter S corporations, LLCs, sole proprietorships, and even certain trusts. Section 199A is intended to provide a deduction to owners of these pass-through business entities who do not otherwise benefit from the new 21% flat tax Congress has given to corporations under the new tax law.
The 20% pass-through deduction is not applicable generally to certain businesses that provide services, such as doctors, lawyers, accountants, athletes, stock brokers, and others, except where the service provider has taxable income of less than $315,000 (married) or $157,500 (individual). The benefit to these service providers is phased out over these income thresholds (another $100,000 for married filers and $50,000 for individuals), so that where a married filer has over $415,000 in taxable income or an individual filer has over $217,500 in taxable income, the 20% deduction is lost for the service provider’s business.
For non-service providers with higher income levels, the deduction is the lesser of (1) the “combined qualified business income” of the taxpayer, or (2) 20% of the excess of taxable income over the sum of any net capital gain. The term “combined qualified business income” is then defined as the lesser of (1) 20% of the business owner’s “qualified business income” (QBI) or (2) the greater of (A) 50% of the W-2 wages of the business allocable to the owner or (B) 25% of the W-2 wages of the business plus 2.5% of the unadjusted tax basis in property of the business (generally the original cost of certain depreciable assets) allocable to the business owner.
For pass-thru business owners with higher income having W-2 employees is a must, unless the business has substantial depreciable assets in the alternative, because the deduction is essentially “capped” for most businesses by 50% of the W-2 wages the business pays. If the business has no W-2 employees, then the business may not even receive the deduction.
An individual can have an ownership interest in more than one pass-thru business. Multiple and often different trades or businesses can also be conducted in the same pass-thru entity. The general rule under Section 199A is that each business “stands on its own” for purposes of evaluating whether sufficient W-2 wages or depreciable assets exist in order to qualify for the deduction.
However, the IRS adopted final regulations under Section 199A that permit an individual to “aggregate” or combine multiple trades or businesses for purposes of applying the W-2 wages and depreciable property limits for the deduction. The aggregation rules are intended to allow combination of what is commonly thought of as a single trade or business where the business is spread across multiple pass-thru business entities. The final IRS regulations do not permit a “Specified Service Trade or Business” (the service-providers identified above) to be aggregated with another business.
To determine whether trades or businesses may be aggregated, the IRS regulations provide that multiple trades or businesses must, among other requirements, satisfy a minimum ownership interest in each entity to be aggregated (generally at least 50% held individually or through a common group of individuals) and two of three listed factors, which demonstrate that the businesses are part of a larger, integrated trade or business. These factors include: (1) the businesses provide products and services that are the same (for example, a restaurant and a food truck) or customarily provided together (for example, a gas station and a car wash); (2) the businesses share facilities or share significant centralized business elements (for example, common personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources); or (3) the businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (for example, supply chain interdependencies).
If businesses qualify for aggregation, IRS regulations allow an election to be made for this purpose. Once an individual chooses to aggregate two or more trades or businesses, the individual must consistently report the aggregated trades or businesses in all subsequent taxable years unless a significant change in facts and circumstances causes the prior aggregation to no longer qualify. For example, an individual should be able to add a newly created or newly acquired trade or business to an existing aggregated trade or business if the business is otherwise eligible to be aggregated.
To make an aggregation election, an individual must attach a statement to his return identifying each business that has been aggregated and include information identifying any trade or business that was formed, ceased operations, was acquired, or was disposed of during the taxable year. The election must generally be made on a timely-filed return, and cannot be made on an amended return; however, and as a limited exception to this rule, an aggregation election can be made on amended return for the 2018 tax year.
Once an individual chooses to aggregate businesses through an aggregation election, these businesses must remain aggregated. New businesses can later be added, but the IRS regulations infer that businesses existing in the year of an aggregation election cannot later be added. Also, once businesses are aggregated together, businesses cannot generally be “dropped-off” the election, unless there has been a significant change in facts and circumstances which causes the prior aggregation to no longer qualify. It may be inferred that where an aggregated business is sold or otherwise disposed, this presents the required “significant change in facts” justifying the removal of this business from the election.
For individuals with multiple businesses, and where one or more of the businesses may not have W-2 employees or significant depreciable assets, an election to aggregate these businesses can be very important and can maximize the potential 20% profit deduction under Section 199A. Even where a 2018 tax return may have already been filed, aggregation is still permitted by the IRS through an election on an amended 2018 return now, but only for 2018 and not through amended returns for later tax years.
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