Update 1/23/19: The IRS released guidelines for a safe harbor to help determine if a rental real estate enterprise qualifies as a trade or business for purposes of getting the 20% deduction. For more info, check out our article breaking down the safe harbor.
Early in 2018 we published an article detailing the various aspects of the Tax Cuts and Jobs Act’s (“TCJA”) 20% deduction on pass-through business income. At the time, much was still unknown about the specifics of the deduction and the criteria required to be met to qualify for it. However, since the publication of that article, the IRS has released proposed regulations that clarify and/or change a few important points. One of these clarifications is related to the concept of aggregation of multiple business entities.
As you read in the original article, there are several factors that may limit or eliminate the 20% deduction for certain taxpayers. Two of these factors include:
- Wages paid by the business to its employees, and
- Qualified assets owned by the business
When the deduction was first announced, it was indicated that a single taxpayer who owns multiple entities that are related to each other would not be able to combine or aggregate these entities for the purposes of calculating the pass-through deduction. This was a potential problem for many taxpayers, as it has been a common practice to establish multiple entities related to the same trade or business to segregate revenue generating aspects of the business from the related assets and wages for legal, administrative or other purposes.
For example, a taxpayer may own 10 multi-family residential rental buildings, each of which is owned in a separate entity (for legal protection) and having substantial qualified assets (e.g. the building itself). For the purposes of simplifying the administrative process of managing the payroll for each building (e.g. supers, doormen, maintenance, etc.), the taxpayer created a separate managemententity that hires all of these employees (meaning the taxpayer only has to deal with payroll on one entity, instead of on ten). Each building then pays a management fee to the management company, and the management company provides each building with the necessary employees. In the past, there was no downside to this method and it could drastically decrease the overhead costs to the taxpayer. However, when the TCJA first announced this deduction without aggregation, this structure suddenly became a big problem.
Before aggregation was allowed, the taxpayer could have ended up with rental income in each of the ten building entities, which is income that qualifies for the pass-through deduction, but without any wages (because all of the wages are paid by the management company), causing some or all of the 20% deduction for the rental income to be disallowed.
However, the IRS has since released proposed regulations advising that aggregation would be allowed under certain circumstances and when certain criteria are met.
When can a I aggregate my trades or businesses for the purposes of calculating the 20% pass-through deduction?
To aggregate, the following criteria must be met:
- Each entity that will be aggregated must itself qualify as a trade or business under the rules governing this deduction
- The same person (or group of people) must,directly or indirectly, own a majority interest in each of the businesses to be aggregated for a majority of the taxable year
- None of the aggregated trades or businesses can be a Specified Service Trade or Business1 (“SSTB”)
- The taxpayer must establish that the aggregating entities meet at least two of these three factors:
- The businesses provide products and services that are the same (e.g. a restaurant and a food truck) or are customarily provided together (e.g. a gas station and a car wash)
- The businesses share facilities or share significant centralized business elements (e.g. common personnel, accounting, legal, HR, IT, etc.)
- The businesses are operated in coordination with, or reliance on, other businesses in the aggregated group (e.g. supply chain interdependencies)
- Definition of Specified Service Trade or Business1 – An SSTB is:
- Any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners
- Any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities
I qualify to aggregate my entities! Am I now required to do so?
No, aggregating is optional. However, once multiple entities are aggregated, they must continue to be aggregated in subsequent tax years.
Okay, I’ve decided to aggregate. How does this help me?
Aggregating allows you to combine entities that, when combined, qualify for a higher 20% deduction than when considered independently. For example:
- Alex owns two buildings (each in their own LLC) and a management company, Alex Management Inc. (which is an S-Corp)
- Building A has qualified assets of $20,000,000 and generated a profit of $1,000,000
- Building B has qualified assets of $10,000,000 and generated a profit of $400,000
- Alex Management Inc. paid wages totaling $500,000 and had a break-even year, generating no profit or loss
- Building A has $1,000,000 of qualified business income (“QBI”), but is limited to either 50% of the wages paid (which is $0) or 25% of the wages paid + 2.5% of the qualified assets ($0 + $500,000). Instead of having QBI of $1,000,000 (which would lead to a 20% deduction of $200,000), Building A is limited to $500,000 when calculating the 20% deduction and ends up with a deduction of only $100,000
- Building B has $400,000 of QBI, but is limited to either 50% of the wages paid (which is $0) or 25% of the wages paid + 2.5% of the qualified assets ($0 + $250,000). Instead of having QBI of $400,000 (which would lead to a 20% deduction of $80,000), Building A is limited to $250,000 when calculating the 20% deduction and ends up with a deduction of only $50,000
- Alex Management Inc. has $0 of QBI, so despite having paid $500,000 of wages, it has a 20% deduction of $0
- Without aggregating, the total 20% deduction is $100,000 (from Building A) + $50,000 (from Building B) = $150,000
- The QBI, qualified assets and wages are all combined for the purposes of calculating the 20% deduction. The aggregated group has QBI of $1,400,000, qualified assets of $30,000,000 and wages paid of $500,000
- The limitation is calculated as 50% of wages ($250,000) or 25% of the wages paid + 2.5% of the qualified assets ($125,000 + $750,000 = $875,000), allowing for a 20% deduction of $175,000
The $1,400,000 of QBI is still limited, but aggregating allows the wages from Alex Management Inc. to be factored into the calculation of this limitation, increasing the 20% deduction from $150,000 (without aggregation) to $175,000 (with aggregation). While this is not a drastic difference, other business structures and circumstances can have deductions that vary substantially when aggregation is considered.
While the specifics of these rules are still being ironed out, and many of them will likely end up being challenged in tax court over the coming years, the opportunity to aggregate related businesses was a win for taxpayers. Is aggregating a possibility for your businesses? Will it help you decrease your tax bill? If you’re not sure, give us a call, we can help you plan for the most tax effective structure and help to ensure that you maximize your savings.
The topics discussed in this article are complex, and we were not able to cover all of the specific details of this aspect of the tax law in only a few pages. You should always consult your tax advisor about your specific situation and circumstances before making any tax planning decisions.