The Internal Revenue Service has provided much-needed guidance on its proposed regulation for a 20 percent deduction on qualified business income (QBI) for owners of sole proprietorships, trusts, S-corporations and partnerships – such as private equity funds and real estate investment trusts.
In a call for comments on the proposed regulation, due by October 16, the IRS says the deduction will generally be available to eligible taxpayers whose 2018 taxable incomes fall below $315,000 for joint returns and $157,500 for other taxpayers. Funds will first need to determine what qualifies as QBI; capital gains or losses, dividend income and interest income are not treated as such. Also, shareholders or partners in flow-through businesses such as private equity funds will not be entitled to the QBI deduction on wages, or on any guaranteed payments received from the business.
The proposal – referred to as the Section 199A deduction or the deduction for qualified business income – is a key addendum to last year’s Tax Cuts and Jobs Act. It is intended to maintain the competitive tax advantage of flow-through entities such as S-Corporations and partnerships over C-corporations, which saw their top rate decrease to 21 percent from 35 percent. The new rules would allow anyone who generates qualified business income to take a 20 percent deduction of their QBI, thus maintaining a tax rate differential between these entities and C-corporations of around 10 percent.
Tax experts and fund managers have been clamoring for guidance on Section 199A and other changes under the new tax law.
Jeff Bilsky, the technical practice leader for BDO’s National Tax Office Partnership Taxation group, said that a private equity fund that has investments in a number of different operating businesses will need to evaluate each to determine its trades or businesses, qualified business income and the wages and qualified property associated with the qualified business income from each trade or business. This information will then need to be accurately allocated to each of the fund’s partners, he added.
The tax consequences of the QBI deduction suggest that owners in a private equity firm structured as a partnership could see their effective federal tax rate drop from 37 percent to 29.6 percent, which is a huge hurdle to overcome for a company considering whether to incorporate, Bilsky noted.
“If investors are eligible for the 199A deduction – purely from a tax perspective and after-tax cash perspective – we don’t see many situations where it’s more beneficial to incorporate,” he said.
The reduced corporate tax rate at 21 percent, though, could be increased with future legislation, which private equity firms need to take into account when deciding whether to switch to C-corporation status, Bilsky added. He noted that an important potential benefit from the lower corporate tax rate is having incremental retained cash that firms can use to pay debt, issue dividends or reinvest in new opportunities.
According to Bilsky, the IRS’s proposed regulations have overall helped to address many of the questions asked since 199A was enacted, such as the definition of specified service trade or business and the ability to aggregate rules regarding negative amounts and lost carryovers. But, he said, there is still some uncertainty regarding the interpretation of some rules, such as the ability to identify and aggregate multiple trades or businesses.
Dominic Diongson contributed to reporting in this article.