Taxpayers with taxable incomes greater than $157,500 (for single taxpayers) and $315,000 (for joint filers) that own multiple businesses in pass-through entities should understand the aggregation rules under the Internal Revenue Code Section 199A Proposed Regulations issued on August 8, 2018 (the “Proposed Regulations”).
Internal Revenue Code Section 199A (“199A”) allows for a deduction generally equal to twenty percent (20%) of a taxpayer’s qualified business income from a pass-through entity (referred to as Qualified Business Income, or “QBI”). But, for taxpayers with taxable incomes above the thresholds listed above, the 199A deduction is limited to the lesser of (i) 20% of QBI, or (ii) the greater of (a) 50% of the taxpayer’s share of W-2 wages with respect to the business, or (b) the sum of 25% of the taxpayer’s share of W-2 wages with respect to the business, plus 2.5% of the taxpayer’s share of the unadjusted basis of qualified property with respect to the business (the “QBI Limitation”).
The Proposed Regulations provide that, unless a taxpayer with an interest in multiple businesses is able to aggregate those businesses together, the QBI Limitation is applied for each of taxpayer’s businesses on a separate basis in arriving at the taxpayer’s aggregate 199A deduction for all businesses.
But, when a taxpayer has negative QBI from at least one business, the negative QBI must offset the positive QBI from the other businesses, but, the W-2 wages and the unadjusted basis of the qualified property of the business that produced negative QBI are not taken into account for purposes of the QBI Limitation. In other words, while the negative QBI must be taken into account to reduce the QBI from the profitable businesses, a taxpayer will not receive the benefit of the W-2 wages and unadjusted basis of the qualified property attributable to the poorly-performing business. As illustrated below, this can suppress a taxpayer’s 199A deduction.
For example, assume a taxpayer operates three businesses, one through each of three wholly-owned limited liability companies (LLC 1, LLC 2 and LLC 3). LLC 1 produces QBI of $1,000,000 and pays $500,000 of W-2 wages. LLC 2 produces QBI of $1,000,000, but pays no W-2 wages. LLC 3 generates a loss that produces negative QBI of $600,000 and pays $500,000 of W-2 wages. If the taxpayer does not aggregate the three companies, the QBI Limitation is determined for each company separately.
Because LLC 3 has negative QBI, it must be used to reduce the positive QBI of LLC1 and LLC 2 and, therefore, the adjusted QBI of each of LLC 1 and LLC 2 is $700,000. Now, applying the QBI Limitation to each company separately, the 199A deduction for LLC 1 is $140,000 (lesser of (i) 20% of $700,000, or (ii) 50% of $500,000) and the 199A deduction for LLC 2 is zero (lesser of (i) 20% of $700,000, or (ii) 50% of zero).
Thus, the taxpayer’s aggregate 199A deduction is $140,000. The problem here is that while the negative QBI of LLC 3 was used to reduce the QBI of LLC 1 and LLC 2, the wages of LLC 3 were not added to the W-2 wages of LLC 1 or LLC 2, meaning that the wages of LLC 3, in the amount of $500,000, were wasted for 199A purposes.
After understanding the 199A consequences, the taxpayer above may ask if there is any way to apply the 199A rules so that the wages of LLC 3 are not wasted. The quick answer to the taxpayer’s question is “maybe” and the definitive answer rests within the Proposed Regulations’ aggregation rules.
The Proposed Regulations allow taxpayers to aggregate certain businesses together, thereby treating the aggregated businesses as a single business for purposes of applying the QBI Limitation. Thus, if aggregation is permitted, the QBI, W-2 wages, and the unadjusted basis of the qualified property of each aggregated business is combined into a single business prior to applying the QBI Limitation. The combination of W-2 wages can have a dramatic effect on the 199A deduction, as illustrated below.
Now, assuming the taxpayer is permitted to aggregate LLC 1, LLC 2, and LLC 3 for 199A purposes, the QBI of the aggregated businesses is $1,400,000 and the combined W-2 wages of the aggregated businesses is $1,000,000. The taxpayer’s 199A deduction, therefore, would be $280,000 (lesser of (i) 20% of $1,400,000, or (ii) 50% of $1,000,000). Note that while the aggregate QBI is the same regardless of whether or not the taxpayer aggregates ($1,400,000 in both examples), the W-2 wages of LLC 3 (the business that generated a loss) are included in the QBI Limitation in the aggregation example, thereby allowing the 199A deduction to simply equal 20% of the aggregate QBI. Stated differently, the taxpayer’s 199A deduction in the aggregation example is not limited by the W-2 wage component, as all W-2 wages (even from LLC 3) are taken into account.
The Proposed Regulations contain rules as to when a taxpayer can aggregate multiple businesses for 199A purposes, which include a “facts and circumstances” test, and also contain reporting and consistency requirements if a taxpayer aggregates.
Considering that a taxpayer’s 199A deduction may vary significantly depending upon whether aggregation is permitted (the 199A deduction doubled in the aggregation example above), business owners and their tax advisors should understand the mechanics of the aggregation rules under the Proposed Regulations.