In January, the IRS issued final regulations under Internal Revenue Code Section 199A. This section allows owners of pass-through entities — sole proprietorships, partnerships, limited liability companies and S corporations — to deduct up to 20% of their qualified business income (QBI) from those entities.
Owners of construction companies organized under these entity types should take a close look at the regs in consultation with their CPAs. Their eligibility for the deduction may have changed or there might now be more opportunities for maximizing this potentially valuable tax break.
A Tale of Two Limits
The deduction is subject to two significant limitations for owners whose taxable income exceeds certain thresholds. First, it’s unavailable for specified service trades or businesses (SSTBs), including consultants. Second, the deduction is limited to 50% of the owner’s allocable share of the entity’s W-2 wages or, if greater, 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified depreciable property.
Both limitations are phased in gradually, beginning at taxable income of $157,500 ($315,000 for joint filers). They’re fully applicable when taxable income reaches $207,500 ($415,000 for joint filers).
Highlights for Contractors
For the most part, the final regulations conform to proposed regulations issued in August 2018, with a few important modifications. Although the final regs generally apply to tax years ending after February 8, 2019, taxpayers may rely on either the final or proposed regulations for tax years ending in calendar year 2018. Here are some highlights for construction companies:
Independent contractor vs. employee. Sec. 199A specifically excludes “performing services as an employee” from the trades and businesses eligible for the QBI deduction, so there may be an incentive for construction workers to convert from employee to independent contractor status to qualify for the deduction.
The proposed regulations put a damper on this strategy by providing that an employee who’s subsequently treated as a nonemployee while performing substantially the same services is presumed to be an employee for Sec. 199A purposes. The final regulations take this a step further, providing that the presumption will continue for three years after the conversion. The presumption can be rebutted with evidence that the worker is performing services as an independent contractor.
Consulting services. Construction businesses may provide certain consulting services connected with the performance of construction services without being considered SSTBs (provided they’re not paid for separately). But certain standalone consulting services may jeopardize the pass-through deduction for high-income owners. Fortunately, the regulations contain a “de minimis” rule: A business is not an SSTB if less than 10% of its gross receipts (5% if gross receipts exceed $25 million) is attributable to consulting or other specified services.
What if a construction company’s standalone consulting services exceed the de minimis threshold?
Under the proposed regulations, that would have tainted all the business’s income, making its high-income owners ineligible for the pass-through deduction. The final regulations, however, allow owners to claim the deduction for QBI attributable to non-SSTB services if the firm’s SSTB and non-SSTB trades or businesses are “separate and distinct.”
What defines “separate and distinct” is a factual question.
But, at minimum, the company must keep a “complete and separable set of books and records” for each trade or business. An example in the final regulations suggests that it’s helpful if each trade or business has separate employees, though it’s unclear whether that’s a requirement.
Aggregation. To maximize the deduction, the proposed regulations allow owners to aggregate separate businesses for Sec. 199A purposes, provided they’re part of a larger, integrated trade or business and meet certain other requirements. The final regs contain several provisions that make aggregation easier, including an option to make an aggregation election at the entity level.
A Complex Deduction
The Sec. 199A deduction is complex. The final regulations and accompanying commentary are well over 200 pages. Again, if you own a pass-through entity, you should consult your CPAs to determine eligibility, calculate the amount of the deduction and identify strategies for maximizing it.