By Len Green
“Proven Strategies” is a new regular series in the TDN, presented by Keeneland. It is written by Len Green of The Green Group and DJ Stables, who won the 2018 GI Breeders' Cup Juvenile Fillies with Jaywalk (Cross Traffic).
Does Your Horse Business Income Qualify for the Special 20% Deduction?
When Congress announced a tax cut for C Corporations under the 2017 Tax Act, other business owners such as sole proprietors, shareholders of S Corporations, members of Limited Liability Companies (LLCs) and partners in partnerships all demanded tax relief as well.
Congress listened and enacted the new and complicated Qualified Business Income (QBI) deduction, also known as the IRC §199A deduction.
Great news: If you are eligible, you can claim the new deduction on your 2018 tax return.
Who is Eligible for the Special 20% Deduction?
Individuals, including Schedule C sole proprietors, as well as trusts and estates with qualified business income are eligible for the deduction.
S Corporations, LLCs and partnerships are flow through entities so they report each shareholder's, member's or partner's share of QBI components on Schedule K-1 in order for the individual shareholders, members and partners to be eligible to claim the deduction.
What is QBI?
General Rule: QBI is the net amount of qualified items of income, gain, deduction and loss from any effectively connected U.S. trade or business.
Portfolio items, such as capital gains and losses, certain dividends and interest do not constitute QBI, nor do W-2 wages or guaranteed payments from partnerships.
Exceptions to General Rule
Congress then decided to exclude certain Specified Service Businesses activities.
Specified Service Businesses
Special rules apply to a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.
Since veterinarians fall under the Specified Service Businesses rule, the 20% QBI deduction is available in full when taxable income is below the $315,000/$157,500 thresholds (with a $100,000/$50,000 phase-out above those amounts).
Assuming you did qualify, here is how to calculate the deduction.
How Does the QBI Deduction Work?
IRC §199A allows business owners to deduct up to 20% of business income, subject to these limitations:
a. The deduction cannot exceed 20% of a taxpayer's taxable income exclusive of capital gains.
b. Income from Specified Service Businesses qualifies only if the owner's taxable income is less than $315,000 for a married couple or $157,500 for all other taxpayers (then subject to a phase-out over the next $100,000/$50,000).
c. For Non-Specified Service Businesses, if an owner's taxable income exceeds the $315,000/$157,000 thresholds, then the QBI deduction is the lesser of 20% of QBI or the greater of (i) 50% of W-2 wages paid or (ii) 25% of W-2 wages plus 2.5% of the original cost of owned property.
Now the Good News
Under the Specified Service Businesses rule, the reputation or skill of an owner or employee could “taint” the business.
However, since the Tax Law was issued, favorable IRS regulations have been issued limiting this language only to an individual who endorses a product, licenses its image or receives appearance fees.
As a result, we feel these individuals are now eligible to qualify for the 20% exclusion:
– Horse Trainers
– Farm Owners
Here are a few examples to further assist you in the calculations if you now qualify:
a. Just as a picture is worth a thousand words, examples can illustrate the rules of the new QBI deduction.
As an example, suppose a married farm owner has $100,000 of qualified business income in 2018, along with the $50,000 of long-term capital gains and $25,000 of deductions, so that taxable income is $125,000. The QBI deduction is limited to the lesser of $25,000 (20% of $125,000) or $15,000 (20% of $75,000, the excess of taxable income of $125,000 over capital gains of $50,000).
b. In another example, suppose a high-income member of a horse-related LLC has pass-through business income of $600,000. The LLC pays no W-2 wages, yet the taxpayer's share of the unadjusted basis of depreciable assets is $8 million. The taxpayer is eligible for a QBI deduction of $120,000, which is less than $200,000 (2.5% of $8 million).
c. In the right set of circumstances, generally when the taxpayer's taxable income is above the $315,000/$157,000 thresholds, aggregation of businesses may be beneficial, as the combining of W-2 wages and/or the inclusion of the unadjusted basis of assets from another business may serve to boost the QBI deduction calculation.
Certain ownership and similarity of characteristics need to be satisfied in order to make the aggregation election.
d. When a taxpayer owns several businesses or receives many K-1s from pass-through entities, one or more with positive QBI and one or more with negative QBI, the income and losses need to be integrated, such that the losses will serve to reduce the income, and, as a result, reduce the corresponding QBI deduction.
Further, in the event such netting gives rise to an overall negative QBI, there will be no QBI deduction for the current year and the net negative QBI will carry forward to the next year's QBI calculation.
As you can observe, these new QBI rules are far from tax simplification.
We are available to guide you through the QBI maze and help you determine your eligibility and amount of deduction.
This deduction is available for the 2018 tax year.
Please take advantage of our one-hour free consultation for readers of this column.