The Tax Cuts and Jobs Act, enacted in December, made sweeping changes to the United States tax system. One major change is the new deduction for Qualified Business Income (QBI). The QBI deduction allows taxpayers to deduct 20% of the income they make from pass-through trades or businesses (S Corporations, Partnerships, and Trusts).
The legislation seemed to leave tax planners many options to take advantage of this valuable deduction. Two strategies which have become widely discussed are:
- “Crack and Pack” in which an ineligible service firm breaks up services into separate businesses to take advantage of the deduction.
- The other involves an employee leaving her job and then doing the same services for their old employer, but as an independent contract rather than an employee, thus qualifying for the deduction.
These two major strategies have been all-but-eliminated by a new round of IRS proposed rules. However, some daylight still exists, making it possible for many still to take advantage of this valuable deduction.
“Crack and Pack”
An example of this strategy would be a law firm (which is a prohibited service under the QBI deduction), setting up a real estate LLC to rent their office building back to themselves. The real estate rent might have qualified for the QBI deduction. The new bright-line rule denies the deduction for the cracked business if:
- It provides 80% or more of its property or services to another, prohibited trade or business; and
- There is 50% or more common ownership between the businesses.
Some tax planners see a twist on this strategy, by gathering groups of unrelated business owners who could pool resources and provide qualifying services to each other. Another sliver of daylight would be a law firm (again, a prohibited service), which owns a building but can rent enough rooms to unrelated entities to get under the 80% threshold.
The anti-abuse provision provided in the new proposed rules presumes that former employees are still employees if they are performing substantially the same services, making the QBI deduction unavailable. This means that even though they have left and set up a new business, an employee will retain employee status if they are doing the same thing for the same business.
This will be determined based on a facts-and-circumstances basis, meaning there is no bright-line test. An ex-employee might have an argument to claim the QBI deduction if she gets a few separate clients, or changes some of the nature of their work. Only time will tell how the IRS will determine the extent of this rule.
What This Means for You
Generally, these rules will close the door on many who could otherwise take advantage of these strategies. However, new rules always offer planning opportunities. Every taxpayer’s circumstance is different. Your specific ownership and service offerings may leave planning opportunities available. The New QBI deduction is a valuable tax break, and it could lead to large tax savings for you.
To learn more about how the new QBI deduction, and these new proposed rules, and to discuss how these rules may affect you, please contact us here or call 513-241-8313.