The new Qualified Business Income (QBI) deduction will likely have significant implications for qualifying health care organizations. For individuals who operate a business through partnerships, S corporations, or sole proprietorships, the deduction, where applicable, can offer a significant reduction in tax liability—typically 20% of QBI.
On August 8, 2018, the Treasury and IRS issued new proposed regulations providing additional clarification and guidance on the application of the 20% deduction, including caveats for the health care industry. Below are the key takeaways impacting for-profit health care organizations.
Qualified Business Income
QBI includes income and loss connected with the operation of a US business. It doesn’t include the following:
- Certain investment income, such as interest, dividends, and capital gains reported on Schedule K-1
- Reasonable compensation paid to an owner for services rendered to the business
- Any guaranteed payments to a partner or LLC member for services the partner or member rendered to the partnership or LLC
Specified Service Trades or Businesses Limitation
Generally, the QBI deduction isn’t available for income from Specified Service Trades or Businesses (SSTBs).
The proposed regulation’s definition of an SSTB includes any trade or business based on the performance of services in the field of health, which applies to the following:
- Physical therapists
- Other similar healthcare professionals
Income from these practices therefore wouldn’t typically be eligible for the 20% deduction.
Ancillary Health Care Businesses
There are many ancillary lines of businesses related to health care—such as imaging centers, labs, and ambulatory surgery centers—that receive revenue streams from facility-related fees. Based on the language in the law, it isn’t yet clear whether these ancillary health care organizations will be subject to the service-business limitation, and the new IRS regulations didn’t add clarity here. Ancillary health care organizations may need to evaluate to what extent their business operations fall outside of providing health care to patients, and whether their owners are comfortable claiming the QBI deduction absent clear IRS guidance.
Income Limitation Exception
There is one exception in the rules and would allow SSTBs to take the deduction. A limitation applies once an owner’s taxable income exceeds $157,500 for single filers or $315,000 for joint filers, and, thus, income below these amounts is generally eligible for the QBI deduction. However, this exception is completely phased out when income exceeds $207,500 for single filers and $415,000 for joint filers.
The new rules also address tax-planning strategies that practitioners have been contemplating to work around the SSTB limitation.
The common ownership rules were designed to prevent health care organizations from circumventing the rules by breaking into multiple entities—with some entities providing health services, while others rent assets or provide management services.
The proposed regulations contain a provision that a trade or business will be classified as an SSTB if it provides 80% or more of its property or services to an SSTB and the two businesses share 50% or more common ownership. Therefore, even if the trade or business provides less than 80% of its property or services to a commonly-controlled SSTB, the portion of the income earned from the rental of property or provision of services to the SSTB is treated as income earned in an SSTB that is ineligible for the deduction.
These provisions would be especially impactful to organizations that are closely related to health care businesses. If there’s common ownership, and commonly related revenue streams, then the related businesses will be grouped together with the health care organization, treating them as an SSTB ineligible for the QBI deduction. An example provided in the regulations demonstrates how an office building LLC, which is rented back to an SSTB practice with common ownership between the two, would be grouped with the service business, making the rental income ineligible for the deduction.
For pass-through entities other than sole proprietorships, the QBI deduction generally can’t exceed the greater of a noncorporate owner’s share of either:
- 50% of the amount of W-2 wages paid to employees by the qualified business during the tax year
- The sum of 25% of the W-2 wages plus 2.5% of the cost of qualified property
Qualified property is the depreciable tangible property, including real estate, that meets the following criteria:
- Owned by a qualified business at the end of the taxable year
- Used by that business during the tax year to produce qualified business income
- Its depreciable period doesn’t end before the close of the taxable year
The depreciable period begins when property is placed in service and ends on the later of (a) the date that’s 10 years after the property is placed in service or (b) at the end of the qualified property’s recovery period for depreciation purposes.
The W-2 wage limitation applies once an individual owner’s taxable income exceeds $157,500—or $315,000 for joint filers. Above those income levels, the wage limitation is phased in over a $50,000 range—or a $100,000 range for joint filers.
For non-health-care-services businesses, the wage limitation can significantly impact the potential QBI deduction for their owners. Some ancillary health care businesses that aren’t providing health services to patients will need to carefully evaluate whether they have sufficient wage expense and qualifying property to allow their owners to fully utilize the QBI deduction. Generally, health care enterprises require a large number of employees and assets for their operations, making it easier for them to meet the wage limitation requirements.
SSTBs and Planning Opportunities
Despite the limitations on SSTBs and the 20% QBI deduction, health care organizations may be able to reduce their taxable income by leveraging planning opportunities. One of these opportunities is to a utilize hybrid pension plan or cash-balance plans to reduce the individual’s taxable income below the phase-out limitations for the deduction. The use of hybrid pension plans, cash balance pension plans, and other tax planning strategies such as cost segregation studies to reduce an individual’s taxable income to fall below or within the phase-out income levels for the QBI deduction can lead to significant tax savings.
Assume, for example, a physician filing jointly with her spouse has W-2 wages from her practice of $325,000, $200,000 of pass-through income from the practice, and affiliated SSTBs and itemized deductions totaling $50,000. The physician’s taxable income would then be $475,000. This amount is above the phase-out threshold and therefore the pass-through income wouldn’t be eligible for the QBI deduction.
If, however, the same physician utilized a hybrid pension plan or cash balance pension plan to reduce her taxable income by $125,000, this would reduce their taxable income before the QBI deduction to $350,000. This amount of taxable income falls within the phase-out threshold for the deduction and allows a $26,000 QBI deduction on the $200,000 of pass-through income. This further reduces the taxpayer’s total taxable income to $324,000. The reduced taxable income and resultant QBI deduction combine to reduce federal taxes by approximately $54,000 while at the same time allowing the provider to make substantial contributions towards their own retirement fund.
We’re Here to Help
To take find out if you can benefit from these and other opportunities in the new tax law for health care entities and their owners, please reach out to a Moss Adams health care tax specialist. You can also visit our dedicated tax reform page to learn more.