By Lee Ferguson and David Wiggins – CliftonLarsonAllen LLP
Tax reform legislation includes a 20 percent deduction on qualified income for businesses structured as pass-through entities, which include the majority of dealerships. This provision, known as the Section 199A deduction, is one of the Tax Cuts and Jobs Act’s most complicated — but possibly most lucrative — benefits for dealership owners.
Recently released guidance from the IRS sheds some light on how to apply and take advantage of this generous deduction. The guidance also reveals that if you’ve been told that taking this deduction is simple, you’ve been misled.
Claiming the 199A deduction will require extensive planning. There are wage and depreciable asset limitations that curb its potential benefit, and certain types of income will not qualify. There are also aggregations of related businesses that may help owners get the highest tax benefit in certain situations.
199A deduction hinges on qualified business income (QBI)
Section 199A provides for a 20 percent deduction on all combined qualified business income (QBI) from most trades or businesses. Dealerships and related finance companies (RFCs) are eligible. For the purposes of this deduction, QBI includes all items of net income and loss from the dealership, excluding capital gains and losses. This deduction can be taken by individuals, trusts, and estates that have QBI from sole proprietorships, including single-member LLCs, and pass-through entities, such as partnerships and S corporations.
W-2 and depreciable property limitations complicate QBI calculations
Although the 20 percent deduction sounds fairly straightforward, as with most things income tax-related, implementation is not that easy. It isn’t merely calculated based on the limitations of just one entity. The relevant information flows through to the partner’s or shareholder’s income tax return, where the income, losses, and wage and depreciable asset limitations from other entities owned by the taxpayer determine the final 199A deduction.
The amount of QBI available for the 20 percent deduction is limited to the greater of:
- 50 percent of the W-2 wages with respect to your dealership, or
- 25 percent of W-2 wages plus 2.5 percent of the unadjusted cost basis of tangible, depreciable property used in the dealership
This limitation is not applicable to those with taxable income less than $315,000 who file a joint return, or to single filers with less than $157,500 of income. The W-2 and depreciable property limitation completely phases out once taxable income exceeds $415,000 for joint filers and $207,500 for individual filers.
Because payroll is usually one of your largest expenses, most dealerships will not have any problem satisfying the 50 percent W-2 wage limitation; you will likely deduct the entire 199A deduction available. But questions have arisen about the eligibility for dealers with multiple rooftops that share employees or use a management company, professional employer organization (PEO), or other employee leasing arrangement to pay wages, since the employees are not paid directly by your dealership.
The IRS’s guidance confirms that, yes, the 199A deduction generally will be allowed for shared, common law employees. These common law employers will be able to include W-2 wages from other entities, assuming they can be directly allocated to the business, even if they are not paid directly by your entity. There will likely be requirements for specific reporting or recordkeeping of such allocations from other employers. The W-2 wages are specific, however, to each trade or business.
Aggregating related businesses may enhance the 199A deduction for all owners
Although the W-2 limitations mentioned above may not be an issue for your dealership, they could be problematic for entities that have few employees or depreciable assets, such as RFCs, related car wash or other businesses, and certain real estate entities that hold your dealership’s land or buildings. But the IRS’s guidance may offer a solution.
Your dealership can elect to aggregate related business activities together for the purposes of the wage limitation and/or depreciable asset limitations. Careful aggregation of such related businesses will be important to provide the combined reporting necessary to claim the 199A deduction.
The aggregated entities must have at least 50 percent common ownership between the entities. Testing of such common ownership will be critical and will need to be made by each of the dealership’s owners.
For example, assume a dealership, an RFC, and a related rental real estate entity are each owned 40 percent by a father and 30 percent by his three sons, with the remaining 30 percent owned by unrelated (but different) individuals. The three entities would pass the common ownership test, as the father and his sons would be considered common majority owners (70 percent). Because the 50 percent or more common ownership test is passed, the common owners may make the election. The decision to aggregate is available to each owner.
In addition to the majority ownership requirements, you must also demonstrate that the aggregated businesses are part of a large, integrated business structure by meeting two of three requirements:
- The businesses must provide products or services that are the same or customarily provided together
- The business must share facilities or significant centralized business elements, such as using common employees; accounting functions; or legal, purchasing, or information technology resources
- The businesses operate in coordination with or reliance on each other
How we can help
Tax reform has its pluses and minuses for dealerships, but your business stands to significantly benefit from the 199A provisions. Their complexity, however, could keep you from claiming the full 20 percent deduction without proper understanding and planning. Waiting until the end of the year to assess your situation could deprive you of considerable tax savings. CLA’s dealerships professionals can work with you to create strategies for reaping the greatest potential reward from Section 199A.
CLA offers wealth advisory, outsourcing, and public accounting services to help clients succeed personally and professionally. Lee Ferguson is a CPA and manager in the St. Louis office and can be reached at 1-314-925-4361 or Lee.ferguson@CLAconnect.com. Dave Wiggins is a CPA and principal at CLA and can be reached at 1-314-925-4316 or david.wiggins@CLAconnect.com.
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