Aggregating Multiple Businesses For The Qbi Deduction Cannot Include

The Qualified Business Income (QBI) deduction, established under Section 199A of the Internal Revenue Code, offers a significant tax break for eligible self-employed individuals and small business owners. It allows taxpayers to deduct up to 20% of their QBI, potentially leading to substantial tax savings. However, navigating the complexities of aggregating multiple businesses for the QBI deduction can be tricky, especially when understanding what cannot be included in aggregation. This comprehensive guide explores the rules and limitations surrounding business aggregation, providing clarity and practical examples to help you maximize your QBI deduction while remaining compliant with IRS regulations.

Understanding the Basics of QBI and Aggregation

The QBI deduction aims to level the playing field between individuals and larger corporations. Instead of receiving a flat corporate tax rate cut, individuals can deduct a portion of their qualified business income. QBI is essentially the net amount of qualified items of income, gain, deduction, and loss from a qualified trade or business. This excludes certain items like capital gains or losses, interest income not directly attributable to the business, and wage income.

Aggregation is the process of combining multiple trades or businesses into a single trade or business for purposes of calculating the QBI deduction. This can be beneficial because it allows taxpayers to combine QBI, W-2 wages, and unadjusted basis immediately after acquisition of qualified property (UBIA) across different businesses. This can be particularly helpful when one business generates losses, which can offset income from another, potentially increasing the overall QBI deduction.

However, aggregation is not automatic. Specific criteria must be met, and certain businesses cannot be included. This is where understanding the limitations is critical.

Eligibility Requirements for Aggregation

Before diving into what cannot be included, let's review the requirements that must be met to aggregate businesses in the first place. According to IRS regulations, to be eligible for aggregation, the following conditions must be satisfied:

• Common Ownership: The same person or group of persons must own 50% or more of each trade or business to be aggregated. Ownership can be direct or indirect.

• Common Control: The businesses must be under common control, meaning the same person or group of persons has the authority to make operational decisions or has a significant influence over the businesses.

• Significant Interdependence: The businesses must be interdependent, meaning they are commonly operated in coordination with, or reliance upon, one or more of the other businesses in the group. This can be demonstrated through factors such as:

  • Sharing centralized business functions like accounting, legal, human resources, or IT.
  • Having common customers.
  • Operating in coordination with, or reliance upon, the other businesses.

If all three conditions are met, businesses are eligible to be aggregated for the QBI deduction. However, even if these requirements are met, certain businesses are specifically excluded from aggregation.

What Cannot Be Included in Aggregation for the QBI Deduction

Understanding what businesses cannot be included in aggregation is just as important as knowing the eligibility requirements. Including an ineligible business in your aggregation could lead to errors in your QBI calculation and potential penalties from the IRS. Here are the primary categories of businesses that cannot be aggregated:

1. Specified Service Trades or Businesses (SSTBs) Above the Threshold

A Specified Service Trade or Business (SSTB) is a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.

Why they might be excluded: The QBI deduction rules are more restrictive for SSTBs, particularly for taxpayers with income above certain thresholds. These thresholds are:

• 2024: $191,950 for single filers, $383,900 for married filing jointly.
• Phase-in Range: Deduction is limited if taxable income is within $50,000 above these amounts for single filers and $100,000 for married filing jointly.
• Above Phase-in Range: No QBI deduction is allowed for SSTBs.

When can an SSTB be aggregated? If a taxpayer's taxable income is below the threshold, the SSTB can be aggregated with other businesses, provided all other aggregation requirements are met. However, if the taxpayer's taxable income is above the threshold, the SSTB cannot be aggregated.

Example:

John owns a law firm (an SSTB) and a real estate management company. His taxable income is $400,000 (married filing jointly). Because his income is above the threshold, the law firm cannot be aggregated with the real estate management company for the QBI deduction. He must calculate the QBI deduction for each business separately, and the QBI from the law firm will not qualify for the deduction.

2. Businesses Lacking Common Ownership or Control

As previously mentioned, common ownership and control are fundamental requirements for aggregation. If two businesses do not share at least 50% common ownership and are not under common control, they cannot be aggregated.

Example:

Sarah owns 60% of a bakery and 40% of a clothing boutique. She is the sole manager of the bakery, making all operational decisions. However, she is a silent partner in the boutique, with no involvement in its management. Even though she has some ownership in both businesses, the lack of 50% common ownership in the boutique and the lack of common control prevent her from aggregating the two businesses for the QBI deduction.

3. Businesses Lacking Significant Interdependence

Even with common ownership and control, businesses must exhibit significant interdependence to be eligible for aggregation. If the businesses operate entirely independently, with no shared resources, customers, or operational coordination, they cannot be aggregated.

Example:

David owns 100% of a landscaping company and 100% of a software development firm. The two businesses operate completely separately. They have different customers, different employees, and no shared resources or operational dependencies. Despite the common ownership, the lack of interdependence means David cannot aggregate the two businesses for the QBI deduction.

4. Rental Real Estate That Does Not Qualify as a Trade or Business

Rental real estate can qualify for the QBI deduction if it rises to the level of a trade or business. Generally, this requires regular and continuous involvement in the rental activity. However, simply owning rental property and collecting rent may not be enough to qualify.

Safe Harbor for Rental Real Estate: The IRS provides a safe harbor under Notice 2019-07 for rental real estate to qualify as a trade or business. To meet the safe harbor, the following requirements must be met for each rental property or group of similar properties:

• Maintain separate books and records for each rental real estate activity.
• Perform 250 or more hours of rental services per year. These services can include advertising to rent the property, negotiating and executing leases, verifying information contained in prospective tenant applications, collecting rent, and day-to-day operation, maintenance, and repair of the property.

What if the Safe Harbor is Not Met? If the safe harbor requirements are not met, the rental real estate may still qualify as a trade or business based on facts and circumstances. However, if the rental activity is considered a passive investment and does not rise to the level of a trade or business, it cannot be aggregated with other businesses for the QBI deduction.

Example:

Maria owns a small retail store and also rents out a condo. She spends significant time managing the retail store. She hires a property manager to handle all aspects of the condo rental, including finding tenants, collecting rent, and handling repairs. Because Maria is not actively involved in the condo rental, and the safe harbor requirements are not met, the rental activity may not qualify as a trade or business. Therefore, the condo rental cannot be aggregated with the retail store for the QBI deduction.

5. Activities Conducted Through a C Corporation

The QBI deduction is available to individuals, partnerships, S corporations, and trusts. It is not available to C corporations. Therefore, if a business is operated through a C corporation, its income cannot be included in the QBI calculation or aggregation.

Example:

Robert owns 100% of a plumbing business operated as an S corporation and 100% of a manufacturing business operated as a C corporation. The QBI from the plumbing business (S corporation) is eligible for the QBI deduction and can be aggregated with other eligible businesses if the requirements are met. However, the income from the manufacturing business (C corporation) is not eligible for the QBI deduction and cannot be included in any aggregation.

6. Disregarded Entities Owned by Ineligible Entities

A disregarded entity, such as a single-member LLC that is not taxed as a corporation, is generally treated as part of its owner for tax purposes. However, if the owner is an entity that is not eligible for the QBI deduction (e.g., a C corporation), the QBI from the disregarded entity cannot be included in the QBI calculation.

Example:

A C corporation owns a single-member LLC that operates a restaurant. Because the C corporation is not eligible for the QBI deduction, the QBI from the restaurant operated by the LLC cannot be included in the QBI calculation of any individual shareholder of the C corporation.

7. Trades or Businesses That Use Different Methods of Accounting if it creates a material distortion

While not an outright prohibition, using different methods of accounting across businesses that are considered for aggregation can raise red flags with the IRS. If the use of different accounting methods materially distorts income, it can be a factor weighing against aggregation. The IRS may scrutinize such situations more closely.

Example:

Two businesses, otherwise eligible for aggregation, use significantly different inventory valuation methods (e.g., FIFO vs. LIFO) that result in a substantial difference in reported income. The IRS might challenge the aggregation if it believes this creates a material distortion of income.

The Importance of Consistency

Once you aggregate businesses for the QBI deduction, you must continue to aggregate them in subsequent tax years unless there is a significant change in facts and circumstances. Consistency is key to avoid scrutiny from the IRS. If you choose not to aggregate in a particular year, you cannot aggregate those businesses in a future year unless the original aggregation requirements are no longer met, or you have a significant change in circumstances.

Documenting Your Aggregation Decision

It is crucial to properly document your decision to aggregate (or not aggregate) businesses for the QBI deduction. This documentation should include:

• A list of all businesses being considered for aggregation.
• An explanation of how each business meets the eligibility requirements for aggregation (common ownership, common control, and significant interdependence).
• A detailed calculation of the QBI deduction for each business, both individually and as an aggregated group.
• Documentation supporting the QBI, W-2 wages, and UBIA for each business.

This documentation will be essential if you are ever audited by the IRS.

Avoiding Common Mistakes

Here are some common mistakes to avoid when aggregating businesses for the QBI deduction:

• Failing to meet all eligibility requirements: Make sure that all businesses being aggregated meet the common ownership, common control, and significant interdependence requirements.
• Incorrectly classifying an SSTB: Carefully evaluate whether a business qualifies as an SSTB. If it does, remember that aggregation is only allowed if your taxable income is below the threshold.
• Ignoring the consistency requirement: Once you aggregate businesses, you must continue to do so in subsequent years unless there is a significant change in facts and circumstances.
• Failing to properly document your aggregation decision: Keep detailed records of your aggregation analysis and calculations.
• Overlooking the rental real estate safe harbor: If you have rental real estate, determine whether you meet the safe harbor requirements or if the activity otherwise qualifies as a trade or business.

Seeking Professional Advice

The QBI deduction and the aggregation rules can be complex. If you are unsure whether you are eligible to aggregate businesses or how to calculate the QBI deduction, it is always best to seek professional advice from a qualified tax advisor. A tax professional can help you navigate the rules, maximize your deduction, and avoid potential penalties.

Conclusion

The QBI deduction can provide significant tax savings for eligible small business owners and self-employed individuals. Aggregating multiple businesses can further enhance these benefits. However, understanding what cannot be included in aggregation is crucial to ensure compliance with IRS regulations. By carefully reviewing the eligibility requirements, avoiding common mistakes, and documenting your decisions, you can confidently navigate the complexities of the QBI deduction and optimize your tax savings. Remember, when in doubt, seeking professional tax advice is always a wise investment.