On December 22, 2017, the President signed HR.1, the Tax Cuts and Jobs Act (the Act) into law. There are several significant provisions that went into effect beginning on January 1, 2018. Some provisions will result in tax increases to restaurant owners and operators, but many will result in tax decreases including a new tax deduction of up to 20% of “qualified business income” (QBI). This new deduction in particular should provide a substantial tax benefit to individual owners and operators of restaurants with QBI from a partnership, S corporation, LLC, or sole proprietorships. This income is sometimes referred to as “pass-through” income.
The deduction is 20% of your QBI from a partnership, S corporation, or sole proprietorship, defined as the net amount of items of income, gain, deduction, and loss with respect to your restaurant and other associated trades or businesses. QBI does not include reasonable compensation received from an S corporation, or a guaranteed payment received from a partnership for services provided to a partnership's business. In other words, the deduction is calculated on the net business income from your business after subtracting amounts that are paid to the business owner in the form of wages or guaranteed payments. Each trade or business is evaluated separately with regard to this 20% deduction.
Certain limiting rules apply to businesses classified as “specified service businesses” (SSB) which include businesses in which the principal asset of the business is the reputation or skill of one or more of its employees. This particular section of the new law is open to interpretation and will certainly be tested in the coming years, but some case law does currently exist that tends to exclude businesses with sufficient “training and organizational” systems in place from falling into this classification. It would appear that most, if not all restaurant businesses, would not meet the SSB definition and would therefore not be subject to the SSB limiting rules.
For taxpayers with “taxable income” below $315,000, the deduction is relatively straightforward and will generally be 20% of QBI. For taxpayers with taxable income above that level, other limiting factors begin to come into play to include a phase in of the limiting factors discussed below on taxable income between $315,000 and $415,000. For QBI of $415,000 and above, the limiting wage and capital investment factors discussed below are in full effect. For most restaurant owners and operators, the important limiting factor to be aware of is that the 20% deduction could be limited due to the fact that the deduction cannot exceed the greater of:
(1) 50% of the W-2 wages with respect to the qualified trade or business (“W-2 wage limit”), or
(2) the sum of 25% of the W-2 wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis of qualified (depreciable) property of the business.
In very basic terms, here's how the 20% deduction calculation would work for most restaurant owners and operators:
Assume you are an S-corp business owner of a single location full service restaurant and you own 100% of the outstanding stock. For simplicity, assume this is a leased location and your capital investment element is not a significant factor. The restaurant grosses $2 million in sales, has W-2 wages of $750,000 (to include the owner’s reasonable wages) and food beverage and other expenses totaling $750,000, so that the net taxable income (same as QBI in this example) is then $500,000, which “flows” to the owner’s personal return. The first step in this example would be to calculate the maximum potential deduction ($500,000 x 20% = $100,000). The next step would be to look to your W-2 wages for restricting limitations. In this case there would not be any restrictions because 50% of wages equals $375,000 and that is well in excess of the 20% of QBI amount. Restaurants are labor intensive businesses so they will generally not be restricted due to their high wage base, but for purposes of demonstrating how the wage restriction might limit the deduction, assume the restaurant pays a significant amount of its labor cost in the form of “contract labor” and W-2 wages were only $150,000. In this case, the deduction would be restricted to $75,000 (the lower of $100,000 or $75,000) and the business owner would be out of a potential $25,000 deduction, because the W-2 wage base was not high enough. If you are a partner in a 50/50 partnership and, assuming there are no special allocations of income or deductions, the math is essentially the same, only divide the QBI and wages by half and that would be your allocable share to consider at your individual level.
To make a point and until we can get further clarification from congress or the IRS (perhaps in a grouping type election similar to what is available for passive activities), it matters where your W-2 wages are recorded. It’s important to note that management fees and contract labor (ie labor costs reported on form 1099-Misc) are specifically not the same as W-2 wages and tip wages for restaurants that are paid and reported on quarterly payroll tax returns. Until we can get clarification, this becomes very important if your business is commonly structured so that all of your W-2 wages and other employee benefits are reported by a related management company and the operating entity either reimburses the management company for the cost of labor, or the labor is absorbed by the management company in the management fee income received from the operating entities.
Also, for owners of restaurant real estate, if you have structured your businesses into separate “op-co/prop-co” companies maybe for financial or asset protection purposes, it seems that the prop co company with profits may also stand to benefit from this new deduction if the lease is structured properly and meets the definition of a trade or business as defined by the Internal Revenue Code. Depending on the unadjusted cost of the real estate, a deduction would be calculated on the QBI of this rental activity, but since no wages are likely reported by the prop co, the limiting factor of 2.5% of unadjusted cost comes into play.
The 20% flow through deduction is only one of several very significant changes of which a restaurant owner or operator should be aware. Most provisions, including this 20% deduction, are in effect for years beginning after January 1, 2018 and before January 1, 2026. In fact, most provisions are scheduled to sunset on January 1, 2026. However, some (which you may have heard about) are permanent, including the reduction of “C-corporation” tax rates from a high of 35% to a flat tax rate of 21% and the permanent reduction of the “individual health insurance mandate” to zero, effectively repealing that provision of the Affordable Care Act.
As a restaurant owner or operator that qualifies for this new 20% deduction, you do not necessarily need to wait until filing your returns in 2019 to enjoy the benefits of this new tax deduction. Giving concern to the so called “safe harbor” rules for withholding and other factors, an opportunity may exist now to adjust your Federal tax withholdings and quarterly estimates for 2018 as a result of your lowered projected taxable income.
Most experts that have been following the course of this tax legislation and are now immersed in many of its most complicated aspects expect several developments and clarifications, as noted above, from Congress and the IRS to follow (and some quickly) to address needed technical corrections and to provide clarification and guidance on a host of issues. Obviously, the complexities surrounding this substantial new deduction can be formidable, especially if your taxable income exceeds the thresholds discussed above. If you wish to work through the mechanics of the deduction, with particular attention to the impact it can have on your specific situation, we are available at Carr, Riggs and Ingram (CRI) to assist you with this analysis.