Is your construction business organized as a sole proprietorship or pass-through entity (such as a partnership, S corporation or limited liability company)? If so, the new 20% “pass-through” deduction can be a valuable tax break.
But the deduction is subject to complex limits and restrictions. That’s why it’s important to review your situation carefully to determine whether you’re eligible and to identify potential strategies for maximizing its benefits. Proposed regulations published in August 2018 — which you can rely on until final regulations are issued — provide guidance.
A Quick Refresher
The pass-through deduction — found in Section 199A of the Internal Revenue Code — allows eligible owners to deduct 20% of their qualified business income (QBI) from eligible businesses or 20% of their taxable income (excluding net capital gains), whichever is less. QBI generally means your allocable share of the business’s net income from a trade or business conducted within the United States (including Puerto Rico).
It doesn’t include investment income, reasonable compensation from an S corporation or guaranteed payments from a partnership.
The deduction may be reduced or eliminated if your taxable income exceeds a certain threshold: $315,000 for married couples filing jointly, $157,500 for everyone else. Above the threshold, two important limits apply:
- Exclusion for certain service businesses. For a “specified service trade or business” (SSTB), the deduction is gradually phased out. It’s eliminated when taxable income reaches $415,000 for joint filers ($207,500 for others). Construction isn’t a listed SSTB, but a “catchall” provision disqualifies a business whose “principal asset . . . is the reputation or skill of one or more of its employees or owners.”
- Wage and capital limit. The deduction is limited to the greater of 1) 50% of the company’s W-2 wages or 2) 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property (generally, depreciable business property). This limit is phased in over the same income ranges as the SSTB exclusion.
The Proposed Regs
Some contractors feared that Sec. 199A’s catchall language would encompass companies in any industry — including construction — whose success was tied to name recognition or word of mouth. Fortunately, the proposed regulations interpret this provision very narrowly, limiting it to owners or employees who generate income from endorsements, licensing of their image or likeness, or appearance fees.
Another concern was that many contractors provide consulting services — which is on the list of SSTBs — relating to their construction projects. The proposed regs clarify, however, that the exclusion doesn’t apply to consulting services that are:
… embedded in, or ancillary to, the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB (such as typical services provided by a building contractor) if there is no separate payment for the consulting services.
Even if these services are paid for separately, however, you’ll avoid SSTB treatment so long as they account for less than 10% of your gross receipts (5% if your gross receipts exceed $25 million).
The proposed regs also include several provisions that will help contractors minimize the impact of the wage and capital limit. Under one provision, owners may elect to aggregate separate related businesses for Sec. 199A purposes, so long as they are commonly owned, are part of a larger integrated business and meet certain other requirements. The election can be advantageous if, for example, one company has high QBI and low wages and capital, while a related company has low QBI and high wages or capital.
Another provision allows entities that lease real estate or other property to commonly controlled businesses to claim the pass-through deduction, even if these rental activities don’t rise to the level of a “trade or business.” This may be helpful for construction businesses that set up separate entities to lease real property or equipment to one or more operating entities.
Planning Ideas
If you have QBI from a pass-through entity or sole proprietorship and your taxable income is below the threshold, you’re generally entitled to the full deduction. If your taxable income exceeds the threshold, here are some tips for maximizing the deduction:
Bundle your charges. If your business provides consulting services to construction clients, be sure they aren’t purchased or billed separately, to avoid being treated as an SSTB.
Consider hiring. If your deduction would be reduced or eliminated because the business has insufficient wages, depreciable property or both, consider strategies for increasing them, such as aggregating related businesses or hiring employees in place of independent contractors (keeping in mind that adding employees will increase your employment tax and benefits costs).
Increase benefits contributions. If feasible, look to reduce your taxable income below the threshold by boosting contributions to qualified retirement plans. A cash balance plan, for example, may enable your business to make generous contributions on behalf of owners without having to make significant contributions for rank-and-file employees.
The Most of It
Contact your IMC tax professional to discuss these and other strategies for making the most of this tax break. He or she can also apprise you on the final regulations when they’re issued.
Sidebar: Watch out for antiabuse rules
Even if you’re otherwise eligible for the pass-through deduction, beware of new “antiabuse” rules. For example, under proposed regulations, an employee who converts to independent contractor status to qualify for the deduction, but who continues to perform substantially the same services, is presumed to be an employee for Section 199A purposes.
The proposed regs also contain provisions designed to prevent companies from “stripping out” business segments that qualify as a “specified service trade or business” (see main article) into separate entities to become eligible for the deduction.