There may be errors in spelling, grammar, and accuracy in this machine-generated transcript]
Jeremy Wells: The Tax Cuts and Jobs Act of 2017, slashed the corporate tax rate from a top rate of 35% to a flat rate of 21%. When you factor in the taxation of dividends. C corporations double [00:00:30] taxation. The individual effective tax rate for income from a C corporation dropped from 48% to 36.8%. Congress decided when it was drafting the Tax Cuts and Jobs Act that it wasn't fair to have that benefit only go to shareholders of C corporations. They needed to have a benefit that went to small business owners as well. So Congress added section [00:01:00] 199 cap A otherwise known as the Qualified Business Income Deduction. In order to maintain the tax advantage of pass through entity income earners with an up to 20% deduction from income for sole proprietorships, partnerships and S corporations for the owners of those pass through entities. Combining that with the reduction in the top [00:01:30] individual tax rates from 39.6% to 37%, results in an effective tax rate of 29.6% for those pass through entity owners. So for C Corporation owners, their effective rates dropped from 48% to 36.8%. For pass through entity owners, their effective rates dropped from 39.6% to 29.6%. The qualified business income deduction has become [00:02:00] a powerful planning tool and tax reduction strategy for small business owners. But it's complicated. It's an entire system of limitations exceptions, phase ins, phase outs and calculations that result in the deduction. So in this episode I want to clear up how we actually calculate the qualified business income deduction.
Jeremy Wells: What goes into it. So in this episode [00:02:30] we're going to look at the key statutory elements that determine eligibility for that. Section 199 cap a qualified business income deduction. I'm going to explain how taxable income thresholds and specified service trade or business rules affect the availability and the amount of the deduction. We're going to interpret the wage and the qualified property limitations used to compute the deduction for those [00:03:00] higher income taxpayers. And then we're going to look at how that section 1099 A deduction actually gets calculated on forms 8995 and 8995. A. So let's jump into it. What for the purposes of qualified business income deduction is a qualified trade or business. Well section 199. Cap AD1 tells us that a qualified trade or business means any trade or business [00:03:30] other than a specified service, trade or business, or the trade or business of performing services as an employee. So there are essentially three ways that an activity would not qualify for this qualified business income deduction. The first one is if you're in the trade or business of being an employee. Essentially, if you're a wage earner, you don't qualify for. The second way is if it's a specified service, trade or business. I'll talk about [00:04:00] what that means later on and talk about how in section 189 cap A, even though a specified service, trade or business is not a qualified trade or business, there's actually an exception.
Jeremy Wells: And this gets back into that taxable income limitation that we will talk about. And then the third way is for the activity to just not be a trade or business. Now, what does it mean in general for tax law to be a trade or business? We're essentially looking at whether section 162 [00:04:30] applies. So is this a trade or business. And that's a topic for an entirely separate episode, maybe even a separate, uh, series of episodes. But whether an activity is in fact a trade or business is usually a facts and circumstances assessment, uh, judgment as to whether that activity is actually operating like a trade or business. In an earlier episode, I talked about the difference between for profit activities. Uh, [00:05:00] go back and listen to that episode if you have not. But essentially, if the activity is a trade or business, it's not a specified service, trade or business. And it's not a, an individual performing services as an employee, then it's going to qualify as a trade or business for the purposes of the section 199 cap a deduction. Now if the activity qualifies, then the taxpayer, uh, takes [00:05:30] essentially a base deduction of 20% of the qualified business income coming from that activity. For a taxpayer with taxable income at or below the threshold amount, we'll talk about what that means here in a little bit. The deductible amount for each qualified trade or business is equal to the lesser of either 20% of the qualified business income [00:06:00] for that trade or business, or 20% of taxable income over net capital gain.
Jeremy Wells: So the deduction is limited if the taxpayer's taxable income exceeds that threshold, which I'll discuss in a little bit. This is all from section 199 cap a a and then B three. I want to quickly mention that starting with tax year 2026, the one big [00:06:30] beautiful bill act, the OB A added a $400 minimum Qbi deduction before the OB section 199 cap A didn't have a minimum deduction. Whatever the result of the calculation was, is what the taxpayers COVID was with OB, we now get a minimum $400 deduction if the aggregate qualified business income is at least [00:07:00] $1,000 for the taxpayer from all active qualified trades or businesses. Again, that starts with tax year 2026. So I'm recording this in early 2026. We're currently preparing and filing 2025 tax returns. There's still no minimum required for those tax returns. But for this tax year 2026 and on there is that minimum of $400. Covid now both of those amounts, both the $400 [00:07:30] minimum qubit and the $1,000 threshold, minimum Qbi in order to get that minimum deduction, both of those amounts are going to be adjusted annually for inflation starting with tax year 2027 and on. And that's all in the new section 199 cap a subsection I. So what do we mean by qualified business income? It's one thing to say that a business is qualified [00:08:00] for purposes of the deduction.
Jeremy Wells: But what about that. Business is qualified business income. Well that amount is defined as the net amount of qualified items of income gain, deduction and loss with respect to any qualified trade or business of the taxpayer. So we're looking for qualified items of income gain deduction and loss. And we'll break that down [00:08:30] a little bit more here in a second. Qualified items of income gain deduction and loss include items effectively connected with a US trade or business and included or allowed in determining taxable income for the taxable year. So in other words, that income, first of all, has to come from a US trade or business, and it has to be effectively [00:09:00] connected with that US trade or business. Congress's intent here was to incentivize business being done within the US. So if we're looking at income that's either foreign sourced or for a business that is, uh, headquartered abroad, we've got to be very careful. It's likely that income won't qualify if it's a US based business and the income is effectively traced to the US. Then we're looking at that income, likely [00:09:30] qualifying, assuming the business is a qualified business and the income is otherwise qualified for purposes of this deduction. If the business has a loss when calculating its qualified business income. That loss carries over into the succeeding tax year.
Jeremy Wells: This actually results in a reduction of qbi in the future tax year. So qbi losses. [00:10:00] I need to be carried forward in order to accurately calculate the amount of qbi in those future years that carry over is indefinite. So as long as the business continues having losses or if its losses in future years are still greater than net income in those future years, then that loss will continue being carried over indefinitely. This is all [00:10:30] from 199 cap A, subsection C. The other thing that's important to remember here is that we're looking at items that are included or allowed in determining taxable income for the taxable year. What we're not including in Qbi, are any items that are either not included in taxable income or that are disallowed as deductions. This is going to be critical in a case [00:11:00] that I'm going to mention here in a little bit when we start discussing the wage limitation. But if that item of income loss gain or deduction is not included in that business's taxable income, then it doesn't count. It doesn't affect the calculation of qualified business income. So what are some things that are not qualified business income. Qbi does not include any [00:11:30] items of income gain, deduction or loss properly applicable to any of the following. Wages. Wages are out again if If you're in the business of being an employee, that's not a qualified business. And so wages are not included in qbi.
Jeremy Wells: Capital gains or losses are not including dividends and interest unless the interest is properly applicable to a trade or business. If the business is in the business [00:12:00] of lending money and so its primary source of income is interest income, then in that case, that interest would be included in qualified business income, otherwise normal interest on deposits or bank accounts, that sort of thing. Those are that those amounts are not included in Qbi I for pass through entities for partnerships and S corporations. It's important that those amounts are reported [00:12:30] as separately stated items on the schedule K, and so that they are properly reported on the K K1 and eventually on that partner's or shareholder's tax return as schedule B items not included in gross receipts or other income. A lot of times when I'm reviewing 1065 and 1120 S's that have been prepared for other, uh, prepared by other firms, I will see, especially bank interest are being included as [00:13:00] another income amount on page one of that return. That's actually incorrect. That's going to lead to inflated qbi. Those amounts need to be reported as separately stated items on the schedule K gains or losses from specific transactions that are listed in section 199, cap A, commodities transactions, foreign currency gains, and notional principal contracts, and those are specifically defined in the statute with reference to other [00:13:30] sections in the code. So if you are working with a client or you are running a business that has those types of income, check and make sure you understand whether or not those items of gain or loss are actually included in Cuba or not.
Jeremy Wells: And then finally, annuities not received in connection with a trade or business. So essentially we're looking at things that are separately stated items, things that are not business income, like wages or things [00:14:00] that are generally investment income unrelated to the actual business itself. That all comes from section 199 cap AC3B. So if you have any of these kinds of income, then those all need to be checked to make sure that those are not finding their way into those Qbi calculations. For S Corporation shareholder employees, reasonable compensation [00:14:30] paid to the taxpayer is not included in Qbi and for partners, guaranteed payments for services rendered to the partnership under section 707 C, and then also payments for services rendered not acting as a partner under section 707 A. Those are all excluded from Qbi as well. This was a [00:15:00] bit controversial when section 109 cap A first came out. It's a significant difference between. Especially S corporations with reasonable compensation paid to shareholder employees versus sole proprietors for sole proprietor reporting their business on schedule C, all of the net income coming from that activity is going to be included in Qbi. For an S corporation, those shareholder employees that [00:15:30] are providing services to the business, need to pay themselves reasonable salaries, reasonable compensation.
Jeremy Wells: That amount is actually not included in Qbi. Now, it will help with the W2 wage limitation that I'll discuss here in a minute. But whatever those shareholder employees pay themselves as, reasonable compensation is going to reduce the business's net income and therefore reduce its qbi. And [00:16:00] then finally, qualified tips under the new section 224 as a result of the Oba, do not qualify as Qbi as well. That's all in IRC section 199 cap AC4. So that's how we get Qbi. So what is Qbi? Essentially, it's the business's net income minus those separately stated items minus any of those [00:16:30] other exceptions to qbui reasonable compensation for an shareholder or those guaranteed payments to a partner, as well as the qualified tips. That gets us to Qbi. Essentially, as long as the taxpayer has taxable income below a certain threshold, then the taxpayer's qualified business income deduction is the lesser of [00:17:00] 20% of Qbi total. For all of the qualifying trades or businesses that that taxpayer is invested in, or 20% of taxable income. So what do we mean by taxable income? For purposes of section 109 cap, a taxable income means taxable income without regard to the section 199 cap, a qualified business income deduction. So we're looking at taxable [00:17:30] income before we apply. Section 199 cap A but also before any IRC section 68 overall limitation on itemized deductions. The qualified business income deduction is available to taxpayers regardless of whether they take the standard deduction or.
Jeremy Wells: They itemize and report their deductions on schedule A. The qubit was really the first of these kinds [00:18:00] of. Not below the line, but also not above the line either. Deductions I've seen I've heard these referred to as midline deductions. So they're available to Non-itemizers. A taxpayer can take both the standard deduction and the qualified business income deduction. However the qubit does not reduce adjusted gross income. So on the return on the 1040 the taxpayer will first calculate gross income, then adjustments to income, [00:18:30] and that gets you adjusted gross income. Then you subtract either the standard deduction or the total itemized deductions and the qualified business income deduction before arriving at taxable income. But before we can do that, we have to understand what taxable income is before the qualified business income deduction. So that gives us taxable income. That is the amount that we take 20% of and compare it to 20% of [00:19:00] qualified business income. It's also the amount that we compare to the annually adjusted for inflation threshold. The original 2018 taxable income threshold was $157,500, or $315,000 for a joint return. But now, for 2015, due to inflation, that amount is $197,500, or double that for a joint return $395,000 for [00:19:30] 2026. The threshold is increased to $201,750, or double that for a joint return $403,500. This definition of taxable income and the threshold is from IRC section 199 cap a e.
Jeremy Wells: The taxable income threshold sets up the limitation on the taxpayer's [00:20:00] maximum qualified business income deduction. Congress's idea here was that we want to create a deduction that is relatively straightforward for taxpayers to calculate, unless their taxable income hits that threshold amount above that threshold amount. We need to put some sort of limitation on the deduction. At least this is what Congress was thinking when they drafted this section 109 cap A. [00:20:30] So here's how the limitation works. First of all, if the taxpayer's taxable income before the section 109 cap, a deduction exceeds that threshold. Then we look at the limitation calculation, which is based on either the W-2 wages that the qualified business, trade or business paid [00:21:00] out for the tax year, or a combination of W-2 wages and the assets that that company owns. This is where the qubit starts to get a little complicated. Add that taxable income threshold. There is a range which extends $50,000 or $100,000 [00:21:30] on a joint return beyond the threshold and within that range. This limitation, based on W-2 wages and assets, phases in and the limitation effectively reduces the qualified business income deduction from the 20% of qubit or taxable income, whichever is less. And then whatever that amount based on the wage [00:22:00] and asset limitation, is another change that the one big, beautiful Bill act introduced was that range is extended from $50,000 to $75,000, and then double that $150,000 for a joint return, starting with tax year 2026.
Jeremy Wells: So for 2025, the calculation is still based on $50,000 after 2025. So starting in 2026, that range increases to $75,000 [00:22:30] and then double that to $150,000 for a joint return. So what is the calculation based on the limitation for a taxable for a taxpayer with taxable income above the threshold range. Right. So the threshold plus that 50,000 or $100,000 the taxpayer is allowed a deductible amount for each qualified but not specified service, trade or business equal to the lesser [00:23:00] of the following. Either 20% of the qualified business income from that business, or the greater of 50% of the W-2 wages, or the sum of 25% of the W two wages, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property of the [00:23:30] trade or business. What does all that mean? If the taxpayer's taxable income is over that threshold, then the way that taxpayer gets the deduction is by owning a business that pays more in W-2 wages or owns more qualified property. Those are essentially the two ways that the taxpayer [00:24:00] can salvage that deduction. When the taxpayer's taxable income is in excess of that threshold range, this is where the calculation can get a little complicated. This way is where a lot of planning opportunities, though, can be created. The most basic case here where you would have some planning opportunities if you're advising a taxpayer is with a [00:24:30] solo owner, s corporation with no other employees.
Jeremy Wells: Remember that reasonable compensation for an S Corporation shareholder employee is not included in Qbi, so that amount will actually decrease Qbi. That taxpayer's taxable income though will not decrease dramatically. There will be a little bit extra in payroll taxes paid as that shareholder employees wages increase. However, all [00:25:00] else equal taxable income won't change much. But what will change is the amount of W-2 wages paid from. That's corporation. So if the taxpayer's taxable income is going to exceed the threshold. And that's corporation is not a specified service, trade or business. Then the way that deduction is calculated is going to be based on the W-2 wages paid out by that business. [00:25:30] Now for purposes of calculating the deduction, it doesn't matter who the employee or employees are that got those W-2 wages right. That earned them. So the owner's W-2 wages still qualify in terms of calculating the limited deduction. This is going to create a planning opportunity because it's one of the rare cases where increasing [00:26:00] wages might actually be a better result for the taxpayer in that fairly common, somewhat common among small business owners. Situation where you've got a relatively high earning solo S Corporation shareholder employee that's also providing services to the business. In those cases, it can be really helpful to run a few different projections if you're doing a planning engagement or if you're offering projections and tax planning as a service through your [00:26:30] firm.
Jeremy Wells: This limitation applies to each business individually. So even though you have the taxpayer's taxable income, that is a combined result of the income from all these different businesses, this limitation is actually calculated based on each business separately. So it's possible to have the same taxable income for that taxpayer, but get a significantly different limited [00:27:00] deductible amount from different businesses if they pay different amounts of W-2 wages, if they own different amounts of qualified assets. But in any case, with a qualified business, that's not a specified service, trade or business. If the taxpayer has taxable income in excess of that threshold range, then we're going to look at the wages and the unadjusted basis immediately after acquisition [00:27:30] of that property. If you have a client that gets k-1's from either a partnership or an S corporation, there should be a worksheet attached to that K-1 that breaks all of that information out and is going to allow you to do these calculations without knowing the W-2 wages and the assets. The or at least the partners and or shareholders share of those items. It's going to be difficult to [00:28:00] calculate the qubit without that information. Now some businesses might just not pay any wages. They might not own any assets in those cases. If you have that relatively high earning taxpayer, it's possible that even with a lot of qualified business income, the deduction is severely limited, even to the point of being zeroed out.
Jeremy Wells: Without that, those wages or assets, uh, being, uh, [00:28:30] either paid out, uh, by the business or being included in those statements. So if you don't see that statement with AK1, make sure you get that before you start, uh, preparing that return. Now back to what I was saying earlier about amounts being applicable to a trade or business and being included in taxable income for the purposes of calculating the section 199 cap, a deduction. [00:29:00] The term wages means only those that are properly applicable to a qualified business and to qualified business income. The point here is that we have to be careful with nondeductible wages, such as those that are not included in cost of goods sold. For a drug trafficking business under IRC section 280 cap E. If [00:29:30] you haven't listened to episode 22 of this podcast in which I talk about cost of goods sold for tax purposes, go back and listen to that episode. Because for these businesses, the ordinary expenses that are not part of cost of goods sold are not deductible under IRC section 280 cap E. There was a recent tax court case, Savage V commissioner and Torres v commissioner, which were combined into one opinion. 165 [00:30:00] Tax Court five 2025, where the court looked into this question of whether those wages being nondeductible were able, uh, under section 280 cap E were able to be included in the calculation of qualified business income.
Jeremy Wells: And then, uh, used to calculate that limit, that limitation phase in range. The court ended [00:30:30] up finding that because those amounts are not properly applicable to qualified business income, they're not available to the taxpayer to use to qualify to calculate the deduction. There was actually a bit of debate within the tax court. It was an en banc, uh, decision. But one of the judges actually wrote a dissenting opinion and made the case that just because those wages are nondeductible in arriving at [00:31:00] taxable income doesn't necessarily mean they should not be included in the 199 cap. A qualified business income deduction calculations. Now the court overall decided that they're not included in that calculation. This ended up resulting in a severely limited qubit for those two taxpayers. Those taxpayers have since appealed that decision. But I think it's an interesting case. And if you [00:31:30] read through the court's opinion, it gives you a good sense of how the deduction is calculated and all of the various components that go into calculating the qubit and the relationships that that calculation has with other parts of the tax code. So let's look at a quick example of how this actually works. Jessica, a non-ionizing single taxpayer receives a 2026 1120 SK1. [00:32:00] So the k one from an S corporation, which for the most part is a qualified trade or business from lighthouse LLC, which is not a specified service, trade or business.
Jeremy Wells: It's not an STB. I'll talk more about that here in a minute. The QBO worksheet attached to the K one shows qualified business income of $200,000, W-2 wages of $40,000, and no qualified property. So her baseline qubit is going to be 20% [00:32:30] of that $200,000 of Qbi or $40,000. The limitation threshold begins with taxable income of $201,750. Because Jessica is single and we're talking about 2026, and that limitation extends for $75,000, and it phases in over that $75,000. So up to $276,750. So [00:33:00] at that amount of taxable income, the fully limited deductible amount from lighthouse LLC is going to be the greater of the W two wages paid out, which is 50% of that, which is 20,000 or 25% of wages, plus 2.5% of the assets, which is just going to be 10,000. So we take the greater of those two, which is that 20,000. Now notice with taxable income below [00:33:30] the threshold amount the qubit is $40,000. With taxable income above that threshold range it's 20,000. So as Jessica's income increases from $201,750 to $276,750, that deduction is going to decrease ratably from $40,000 to $20,000. And notice that if she has income [00:34:00] in that range, then that deduction will continue to decline, but it will never decline less than $20,000 as a non SS, TB, as a qualified trade or business. It's possible for purposes of the wage and property limitation to aggregate qualified businesses. So a business with high qbi but low wages or property [00:34:30] would probably see it's deductible amount sharply limited because of that with a high earning taxpayer aggregation under regulation section 199 cap A for allows a taxpayer to elect to combine multiple economically related entities if they meet the following criteria.
Jeremy Wells: First of all, there has to be common ownership, at least 50% owned by the same person or group. They have to use the same tax year. There cannot be any specified service [00:35:00] trades or businesses, and they have to be economically related. They have to meet at least two of the following three criteria. Provide products or services that are the same or customarily offered together. Share facilities or significant centralized business elements such as personnel, back office, manufacturing, purchasing and then operate in coordination with or reliance upon one another. So if the business if the businesses share any two [00:35:30] of those three criteria, none of them are stb's. They use the same tax year and they have at least 50% common ownership. Then the taxpayer can elect to aggregate those businesses that would add together the qbi, but it would also more importantly add together the wages and the property, the Unadjusted basis at acquisition, which would allow for a higher limited amount of deduction [00:36:00] from those businesses. Okay. I mentioned it a few times now. Specified service trade or business. What is that. A specified service trade or business is any trade or business involving the performance of services in any of the following fields health law, accounting, actuarial science, performing arts consulting, athletics, financial services, brokerage services, investing and investment management, trading [00:36:30] or dealing in securities, partnership interests or commodities, or any trade or business where the principal asset of such trade or business is the reputation or skill, or one or more of its employees.
Jeremy Wells: That's a relatively long list. It comes from section 199 cap AD2. And then also, uh, these specific fields and are listed and discussed. And there are examples given [00:37:00] in Treasury regulation section 1.1 99 cap a five. If you're working with clients or if you own a business that sounds like it could be in any of these categories, go read through that regulation. It breaks all of those categories down. It also gives several examples that are going to help you identify whether your business belongs to one of those categories or not. Now, that last group, a trade or business where the principal asset of such trade or business is the reputation [00:37:30] or skill of one or more of its employees, is actually more narrowly defined in the regulation. It means a business where the owner or employees receive fees, compensation or other income for endorsing products or services, or for the use of an individual's image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual's identity or for [00:38:00] appearing at an event or on radio, television, or other media format where this particular type of specified service, trade or business has become interesting over the last couple of years is with, uh, athletes.
Jeremy Wells: Athletes are often paid to, uh, sponsor or promote products or services based on their image or likeness. That would essentially be what we're talking about with a trade or business where the reputation or [00:38:30] skill, uh, is the primary means of that business. This STB characterization is critically important because, as I mentioned before, as the taxpayer's taxable income increases. Not only do we have the phase in of the limitation based on the W-2 wages and the property owned by that business, [00:39:00] but we also have a phase out of the deduction entirely, but only for specified service trades or businesses. So the way this reads in the statute is that a qualified trade or business does not include stb's. However, there is an exception for Stb's where the taxpayer has taxable income below that [00:39:30] threshold amount. And then once the taxpayer's taxable income crosses the taxable amount, the deduction phases out or the deductible amount phases out Ratably throughout that same range that the limitation phases in. So for Stbs, you have a very complicated calculation because at the same time, when you have a taxpayer with taxable [00:40:00] income within that threshold range, you have to calculate both the phase in of the limitation, the W-2 wage or and or W-2 wage and property limitation, and at the same time calculate the phase out of the deductible amount.
Jeremy Wells: And that is also ratably across that 50,000 or $100,000 amount of filing jointly. And [00:40:30] then if we're talking about tax year 2026 and beyond, $75,000 or $150,000 filing jointly above that threshold range. There is no deductible amount for an STB. No amount of W-2 wages or property can salvage any of the deductible amount beyond that threshold range. It is a complete phase out of the deduction beyond that range. [00:41:00] So let's go back to the example with Jessica. She had the business income of $200,000 and W-2 wages of $40,000. So her baseline qubit is still $40,000. But now let's say that lighthouse LLC is an STB and we're talking about 2026. So if her taxable income is below the threshold of $201,750, she gets the full amount of $40,000 or 20% [00:41:30] of her, uh, you know, taxable income, which in this case would be less than the qubit, right? And so it would be the, uh, the lesser of that $40,000, 20% of the qualified business income, or 20% of her taxable income. But either whichever one of those is lesser, that would be the amount of her deduction from that amount up to $276,750. [00:42:00] We would have the phase in of the W-2 wage limitation or the W-2 and property limitation combined. At the same point, though, for each of those $75,000, we would have to ratably decrease the maximum deduction that she could take all the way down to zero.
Jeremy Wells: So once her taxable income hit $276,750, [00:42:30] she would essentially have no more deduction left because it's an STB. Taxable income over that threshold range would mean absolutely no deductible amount from this STB, no matter how much it paid in wages or in owned in qualified property. Now, this might lead some savvy business owners who own businesses that have elements of both STB and non STB activities [00:43:00] to split those businesses. Right. In order to prevent that STB activity from causing a limitation or phasing out of the deduction. However, there are a couple rules in the 199 cap A regulations that affect this sort of thinking. So the first is a de [00:43:30] minimis STB rule that effectively disregards minimal STB activity within a single entity. So a trade or business is not treated as an STB. If it's STB, activities are only a relatively small portion of the business. So there are two thresholds here. For business with gross receipts less than 25 million. If the STB receipts are less than 10% [00:44:00] of the total, then we just ignore the fact that it's STB activity and the entire amount of qbi is treated as coming from a qualified trade or business. If gross receipts exceed 25 million, then we're looking at STB receipts being less than or equal to 5% of the total. So if the business meets its respective threshold, then the entire business is treated as non STB or as qualified trade or business.
Jeremy Wells: Otherwise, [00:44:30] and this is a big otherwise. Otherwise the Entire trade or business is treated as an STB. So even if you have a business with gross receipts, less than 25 million and the STB receipts are just slightly over 10% of that total, the entire business is treated as an STB. So this might lead those business owners to think, well, let's just split off the STB portion of the business and then have two separate businesses and treat them separately. However, the [00:45:00] very next paragraph, so that de minimis rule came from Treasury regulation section 1.199. Cap A5C1. Then in 5C2 we get the Anti-abuse rule. If an entity's ownership decides to split off the STB activity, but then keep common ownership of both entities, then they're essentially going to be aggregated [00:45:30] for purposes of determining whether the activity is an STB or not. So if the entities have greater than 50% common ownership and either a non STB provides more than 80% of its property or services to the STB or the business shares, expenses or facilities with the STB and its gross receipts are less than or equal to 5% of the combined receipts. Then that [00:46:00] Anti-abuse rule will kick in and the entire uh. Both entities will be treated as an STB. So be careful when you are advising taxpayers or if you own a business that has aspects of both STB and non STB operations.
Jeremy Wells: Understand that trying to get out of that STB classification may not be possible, especially if you're going to maintain common ownership [00:46:30] with both businesses. I want to quickly go over how rental real estate can take advantage of section 109 cap. A rental real estate has some aspects that make it behave like a trade or business. So it can. For example, rental real estate property can take expenses, normal operating expenses. It can take depreciation expense. However, there are some aspects of it that are not quite like a trade or business. And so for purposes [00:47:00] of section 199 cap A, a rental activity that's not normally considered a section 162, trade or business can still be treated as one strictly for the purposes of section 109 cap A, if the property is rented or licensed to a commonly controlled business conducted by the individual or a relevant pass through entity. So this is going to help with some of those self rental situations. There's also [00:47:30] a safe harbor provided in Revenue Procedure 20 1938. An individual or pass through entity can treat a rental real estate enterprise as a single trade or business. For purposes of section 199, cap A. A rental real estate enterprise consists of one or more interests. It it. Calling it an enterprise makes. It sounds like it needs to be a big portfolio of rentals, but it can just be one rental property, uh, held [00:48:00] for the production of rent.
Jeremy Wells: The taxpayer or entity must hold each interest directly or through a disregarded entity, and then a taxpayer or a pass through entity can either treat multiple interests in real property as separate enterprises, or treat similar properties as a single enterprise. And for the purposes of this revenue procedure, similar rental real estate means either residential or commercial, and if a property [00:48:30] is mixed use, then it needs to be bifurcated so that the residential use part of the property is combined with other residential properties, and the commercial use part of the property is combined with other commercial properties. Now, to qualify for the safe harbor, the taxpayer has to maintain separate books and records for each property and real estate enterprise. Perform at least 250 hours of rental services per year in [00:49:00] any three of the past five years, unless it's been in effect for four years or less. And then in that case, all four years. And it needs to maintain contemporaneous records, including time reports, logs or similar documents substantiating the services performed, including a description of all services performed, hours worked dates, and who performed the services. In other words, it needs a time log of the work that was being done in order to substantiate that claim that at least 250 hours [00:49:30] of rental services were actually performed. And then the taxpayer includes a statement with the tax return that asserts that the enterprise qualifies under this safe harbor.
Jeremy Wells: Now, this is a safe harbor. In other words, what that means is it puts the onus of the burden of proof on the IRS if the taxpayer meets the conditions of the safe harbor. It doesn't [00:50:00] mean that a real estate activity that doesn't meet the safe harbor is not a qualified trade or business. For purposes of section 109, cap A. It just means that the taxpayer then has the burden of proof to show that it is. But if the taxpayer can can qualify under the safe harbor, then it gives a presumption that the activity does qualify. When would this be advantageous for the taxpayer? [00:50:30] When the rental activity is actually showing net income. If for tax purposes. If the rental activity has net income, you would want that income included in Qbi to increase the deduction. If the rental activity was running at a loss, then that would reduce qbi. So I'm not sure you would want to claim that that real estate activity was actually a qualifying trade or business for purposes of qbi. The rep has a list of rental services [00:51:00] that qualify. In other words, just acting as an investor, looking at properties, reviewing reports and financial statements doesn't qualify. But things that are actively managing and operating the rental, such as advertising, negotiating leases, collecting, rent, maintenance, repair, the property, those sorts of things actually will qualify. The safe harbor does not work for the taxpayers own residence under section [00:51:30] two, 80 cap a D any real estate rented or leased under a triple net lease, which is where the person leasing the property pays for taxes, fees, insurance and maintenance, real estate rented to a commonly controlled trade or business, and then the portion of a property treated as an STB under the regulation 1.199 cap A five.
Jeremy Wells: So it's important to keep in mind that those criteria will [00:52:00] disqualify a property from the safe harbor. But otherwise, for a normal rental activity, uh, where the taxpayer meets those criteria, then the property may qualify as a trade or business. Okay. That is a brief overview. There's a lot more to it than that. Uh, the section 199 cap A by itself is pretty complex. You'll notice I did not get into talking about publicly [00:52:30] traded partnership or qualified REIT income. That should all be considered as well. That's a whole separate part of the calculation of the qubit though. Uh, the regulations under section 199 cap A are pretty substantial as well. So this really serves as a high level overview of the qubit. But already you can tell how important complicated a [00:53:00] concept this is. So for a few key takeaways here. For the most part, for most taxpayers the qubit will be 20% of the net income of the business. However, it's important to understand, especially with those higher earning taxpayers, how quickly the calculation can get much more complicated, both for compliance when it comes to actually preparing the returns, as well as planning when it comes to thinking about opportunities to maximize [00:53:30] the qubit aggregation and the de minimis STB rule, allow or requires taxpayers to treat multiple separate entities as one trade or business.
Jeremy Wells: Again, more planning opportunities here. Whether it makes sense to aggregate activities or whether including STB elements in a trade or business is going to cause problems for the calculation of qubit. And then finally, make sure [00:54:00] you understand how those wage and property limitations are going to affect the calculation. If you have a relatively higher earning taxpayer, that is going to have to deal with those limitations, especially for S Corporation shareholders where they have control over their own W-2 wages. Those are important planning considerations, especially as we get later in the year when you're going to want to make sure that you're maximizing that qualified business income [00:54:30] deduction as much as possible. The section 199 cap a deduction is simple below the income threshold. But above that threshold it becomes a pretty intense calculation driven by whether the business is an STB and how much it pays in wages or owns in property. If you found value in this episode, please let me know by liking and leaving a comment in your podcast application of choice or on YouTube. And [00:55:00] uh, thanks as always for listening or watching.