The business income deduction: Aggregate related businesses to increase your qualified business deduction
Aggregate Related Businesses to Increase Your Qualified Business Deduction
When the Whole is Greater Than the Sum of the Parts
Say you own two related businesses that operate as S corporations out of the same facility and share administrative resources, but for business and legal reasons, they are separate entities with separate profit and loss statements. One business, let’s say it’s a window wholesaler, generates $1 million of income and has $100,000 payroll. The second business, a home improvement business, generates $50,000 of income on a $1 million payroll. Assume no depreciable property in used; this is all U.S. income; your taxable income equals or exceeds the income from these businesses; and you file a joint return with your spouse.
Your business income deduction under Section 199A of the Internal Revenue Code on the wholesale business would be $50,000 (50 percent of $100,000), and your business income deduction on the home improvement business would be $10,000 (20 percent of $50,000). Your total deduction is $60,000. This is a very simplistic example to illustrate a point. (For more on calculating the business income deduction, see “Do You Qualify for the 20% Tax Break on Your Business Income?”)
Your next thought, of course, will be that whole could be greater than the sum of the parts, and you would be correct. Your deduction would be $210,000 if you could aggregate the two businesses (20 percent of the combined business income of $1,050,000, which is less that 50 percent of the combined payroll).
Can this be done, short of actually merging the businesses? Yes, if you can run the gauntlet of rules set out in the proposed regulations recently issued by the IRS and the Treasury Department on how to calculate the 20 percent deduction for qualified business income (the “proposed regulations”). In order to be allowed to aggregate your businesses:
- There must be at least a 50 percent overlap in ownership between the businesses by a person or group of persons.
- That ownership must exist for most of the year in which you want to aggregate.
- The businesses must report aggregated tax items on tax returns for that year.
- None of the businesses to be aggregated can be a “specified service trade or business,” a term defined in detail in the Proposed Regulations but which requires careful factual analysis in many cases to apply. (See “Are You in the Consulting or the Sales Business?”)
- You must meet at least two out of the following three factors:
- The businesses to be aggregated offer products and services that are the same, or are customarily offered together.
- The businesses share facilities or significant centralized business elements, such as HR, IT, or accounting.
- The businesses are operated in coordination with, or reliance upon, the other businesses in the group to be aggregated.
If the businesses have multiple owners, not all owners must aggregate in the same way. Aggregation is not required. Once you choose to aggregate, you must continue to aggregate those businesses, but businesses can be added or removed if they later qualify or cease to qualify for aggregation. Business owners have annual tax reporting requirements associated with aggregation.
So, can our owner of the window wholesaler and home improvement businesses aggregate those businesses and save significant tax dollars? This is a case that will require more fact-gathering and analysis. It seems the ownership requirements are satisfied, and these are not specified service trades or businesses. The issue, then, is whether the owner can satisfy the “two out of three test.” The businesses share facilities and centralized business elements, so that’s one. Are they interdependent? Are these products the same or customarily offered together? If the facts and circumstances establish either answer is “yes,” then aggregation will be permitted.
The aggregation rules of the proposed regulations allow business owners to combine certain businesses to increase the amount of their qualified business income and the corresponding deduction. Sometimes the opposite strategy will be desired to break up a business into separate parts to qualify one or more of those businesses for the qualified business income deduction. In some cases that will be effective. But, the IRS and Treasury believe separating out parts of what otherwise would be an integrated specified services trade or business is inconsistent with the purposes of the business income deduction and have made it clear in the Proposed Regulations they will effectively disregard efforts to break up certain types of businesses (See “They Say That Breaking Up Is Hard to Do”).
We also anticipate there will be changes to the proposed regulations or additional regulations will be proposed. The IRS and Treasury moved relatively quickly to issue the regulations because there were so many questions affecting taxpayers in 2018. It seems very likely there will be many more questions and comments on the proposed regulations, so there could be refinements to the rules discussed here.
Thanks for reading this. Please be aware it does not describe all the rules that may apply to your situation. The circumstances of your particular business need to be separately analyzed to determine, in light of all the available guidance, whether and to what extent you may be able to deduct a portion of your business income or make adjustments to increase the amount of your deduction. Consult with a tax professional. In many cases, the savings will be well worth the effort.