Expat Tax Monitor
Volume 2. Issue 1. 2018
Section 199A Qualified Business Income Deduction
How does the new law affect the expatriates?
by Cezary Tchorznicki, CPA
January 27, 2018
This new law, apart from the decrease of corporate tax rates, can be considered the centerpiece of the recently passed tax legislation. I will refrain from calling it a reform nor will I pour out a bucket of ink critiquing the [as ever] politicized nature of the changes and the apparent wanton disregard for economic realities of the country (the soaring sovereign debt).
I urge the reader to note the date of this article – the U.S. Treasury is yet to write the regulations for this particular statute of the tax code; the IRS is yet to provide proper procedural guidance; and the courts are yet to rule on what already appear to be nearly certain points of contention. Thus several nebulous aspects of the Deduction for Qualified Business Income (QBI) will be, almost certainly, more precisely interpreted over the coming months and years.
199A is not an entirely novel ploy; it echoes the old “manufacturing deduction” under 26 USC §199 (the latest legislation eliminates this section). We will begin with a retrospective look at a particular concept within the “old” §199, which provided a somewhat lesser benefit to manufacturers, energy producers, and film production companies.
Section 199(c)(4)(A)(i)(I) referred to “…qualifying production property, which was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States.” [the emphasis is mine]. The term “significant part” had left much to interpretation and, at times, provided for a more sustainable, favorable position for expat-operated businesses that unquestionably had a core of their business operations abroad.
That is not the case with section 199A. Under the new law, the “qualified items of income, gain, deduction and loss” must be “effectively connected with the conduct of a trade or business within the United States (within the meaning of section 864(c)[…])” The pressure point of the matter is now more precisely defined – much depends on whether the assets (whether tangible or intangible) that generated income, gain or loss were located in the U.S. Thus the key requirement is that the business be a domestic one, or a domestic one to a material extent. The concept is not as straightforward as one may think as certain foreign-sourced income of a company that operates in the U.S. may also be classified as effectively connected with the conduct of trade or business within the United States. In order to be considered, the level of the business activity in the U.S. must rise above a de minimis threshold. In case of agency relationship, i.e. in instances where a foreign entity engages agents working on its behalf, that connection may be established by an existence of a formal agreement or may be inferred from the actions of the relevant parties.
Nevertheless, if your business activities are confined to your current country of residence (other than the U.S.) you may wish to stop here, unless you tend to indulge in reading about income taxes.
At this point, it appears that certain rental activities – those that do not rise to the section 162 definition of “trade or business” - regardless of the landlord’s country of tax residence, would not qualify for the QBI deduction. Moreover, a mere holding of real estate for investment – typically that would apply to an undeveloped land – does not constitute a §162 trade or business.
The geographic scope of the income earning activities is not the only reason why one may be prevented from reaping the benefits of section 199A. QBI is determined along the ordinary income – ordinary deductions axis and the QBI deduction is not available to W-2 wage earners nor can be taken by the recipients of most types of dividends and partnership guaranteed payments, i.e. payments that do not depend on the actual ordinary income of the partnership. The paradigm whereby an owner of a C corporation receives income as a combination of wages and dividends is outside the scope of 199A.
Furthermore, the new law excludes those that are self-employed, or receive flow-through income in form of distributions from a partnership or as non-dividend distributions from an S corporation, if their income is a product of a “Specified Service, Trade or Business”. In order to define such activities, the authors of §199A more or less adopted the definition from section 1202(e)(3)(A) of the code, but specifically removed from the “no entry” list engineers and architects. The overarching principle behind this legislation is that you have to manufacture, construct, at least dig up something to have the section 199A benefit bestowed upon you – engineers and architects, even if acting in a purely consulting capacity, are presumed to contribute directly to one of these processes. If you happen to be a cosmetic surgeon who fixes cleft lips of little kids, oh well, you’re out of luck. Apparently, your contribution to the economy is not as significant as that of an architect who is designing a new Las Vegas casino. For all of you attorneys, accountants, psychologists, professional hockey player… forget about it, or, as we will discuss later, forget about it if you are very successful at what you are doing.
The QBI also excludes investment income, to include gains from speculative currency trading that is unrelated to the needs of the principal business.
One could ask: with this apparent preference for self-employed persons over the W-2 wage earners, wouldn’t there be an outright stampede for the door marked “independent contractors only”? After all, there often is but a hazy line between an employee and an independent contractor status and the IRS, over the years, has struggled to design a well-functioning set of criteria to tell apart one from the other. Firstly, I would not count on not being challenged by the Service on this issue; under most circumstances the IRS will be able to pierce a feeble cover story. Secondly, 199A contains a limitation mechanism that should - if not entirely preventing a wholesale change-over trend - make one think twice whether there would be an actual tax saving from such a rebranding.
Thus we are finally arriving to the basic mathematical formula of 199A. This computation is performed on business activity by business activity basis.
The deductible amount is the lesser of
(1) 20% of the QBI from a given activity (pass-through or self-employment income); or
(2) the greater of
(a) 50% of the W-2 wages with respect to the trade or business; or
(b) the sum of 25% of the W-2 wages with respect to the trade or business and 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property.
We will sort it out by means of an example. Doug Blue operates Doug Blue Brick and Tile Enterprises, Inc. The company, which has no employees other than Doug, has elected to be an S corporation. In 2017, the company yields a profit of $500,000. Doug, the corporation’s sole shareholder, is not keen on paying too much in payroll taxes and accordingly, he suppresses the level of ‘reasonable compensation’ to a paltry $75,000 and takes a succulent non-dividend distribution of $425,000; the latter not subject to SE tax. Assuming there were no acquisitions of qualified property, while ‘saving’ on self-employment tax, Doug has limited his QBI deduction to just $37,500 (50% of $75,000). Had Doug paid himself a salary of $143,000, his QBI deduction would be $71,400 (20% of $357,000). Naturally, in absence of any W-2 salary, there would be no QBI deduction.
It is noteworthy that in case of S corporations and partnerships, the W-2 wages referenced in the formula represent a partner’s or a shareholder’s pro rata share of all W-2 wages. Therefore, if in the example above Doug were a 60% shareholder; his daughter Alexis held the remaining shares; and the corporation had three non-owner employees, Doug’s limitation would be based on his pro rata share of the aggregate wages paid out by the corporation.
The reader may ask - “what is that 2.5% of unadjusted basis about in (2)b.”? Well, in order to add color to the characterization of this element of the formula, we need to remind ourselves that the tax code has always treated some businesses or people more warmly than others. It was the railroads once, then, oil and gas, and now, it may be the time for real estate development. In real estate development and commercial leasing the beneficial owners rarely take out the profit in form of W-2 wages, but rather do it via management fees and other intricate arrangements. Take a look at the formula above once again – no wages no QBI deduction, but for that little caveat in part captioned “b.”.
The new law is not devoid of sweeteners for the less affluent. The wages limitation evident in the basic section 199A formula does not apply to a taxpayer who has not crossed the $157,500 in taxable income ($315,000 for married couples filing jointly). The same rule ‘absolves’ those that would be otherwise excluded due to having their income generated from a “Specified Service, Trade or Business”. The thresholds are subject to phase-ins and phase-outs. Thus for non-W-2 actuary the QBI deduction becomes completely unavailable upon reaching taxable income of $207,500 ($415,000 for married couples filing jointly). We will not cover here the details of the phase-ins and phase-outs.
Section 199A(c)(2) provides for a carryforward of aggregate losses from qualified trades or businesses to the next tax year. We will not get into the weeds on this one.
There is a number of exceptions and special treatments, some covering trusts and estates, but these matters are outside the scope of this introductory write-up.
The final determination of the deduction amount goes as follows:
it is the lesser of
the sum of taxpayer’s QBI deduction for all qualified trades or businesses, to include loss carryover from the prior year; or
an amount equal to taxpayer’s 20% of taxpayer’s taxable income (reduced by net capital gain)
The last issue of importance is whether the QBI deduction affects the amount of self-employment income and, by extension, the self-employment tax. The deduction is a below-the-line deduction; it will not reduce your Adjusted Gross Income and will not impact the amount of SE tax due. At this moment, it is not entirely clear whether it will be an itemized deduction in a classical sense (Schedule A) and whether one will have to otherwise itemize in order to claim it, or whether there will be a specially dedicated to it line on Form 1040.
On balance, section 199A may prove relatively consequential in encouraging entrepreneurship – the actual tax benefit (or the lack thereof) would have to be determined on case by case basis. It is also a nod toward the already bulging “gig economy,” where workers are predominantly Form 1099 wage earners, i.e. those lacking health and retirement benefits normally associated with the W-2 employee status.
The presented here information is not intended to be “written advice concerning one or more Federal tax matters” subject to the requirements of section 10.37(a)(2) of Treasury Department Circular 230.
The information contained herein is of a general nature and based on authorities that are subject to change. Moreover, the information is presented here for educational purposes and is not specific to any individual’s personal circumstances. As such, this information should not be used for the purpose of avoiding penalties that may be imposed by law. A determination as to how your specific circumstances may relate to the presented material should be made by means of a consultation with your tax adviser.
Cezary Tchorznicki, CPA LLC does not provide legal or investment advice.