US Tax Reform – Deduction on US Sourced Individual Business Income

The signing into law of the Tax Cuts and Jobs Act by US President Donald J. Trump on December 22, 2017 brought considerable changes to both how individuals and corporations are taxed. This law, which took effect on January 1, 2018, is commonly referred to as the US Tax Reform Bill. One other important change is the introduction of deductions for Qualified Business Income (“QBI”) for individual taxpayers who operate a business through a sole proprietorship, a disregarded entity (single member Limited Liability Companies) or an entity that is taxed on a pass through basis (partnerships, multi-member Limited Liability Companies and S-Corporations that elect to be treated as partnerships), all of which are taxed at individual income tax rates. This deduction is not available for income earned through a C-Corporation, a S-Corporation (that does elect to be taxed on a pass-through basis), or a Canadian corporation.

 

This article presents the QBI deductions and highlights their potential applicability to Canadians who operate businesses in the United States that qualify for QBI deductions.

 

QBI Deductions

An individual taxpayer, whether he or she is US tax resident or a Canadian tax resident, who earns QBI through a sole proprietorship, a disregarded entity or an entity taxed on a pass-through basis may claim one of three deductions on this income. Rental and royalty income qualify as QBI, but interest, capital gains, commodities and income generated through certain specified services businesses do not qualify as QBI. However, rental income that you directly receive without operating the property through a sole proprietorship, a disregarded entity or a pass-through entity does not qualify for any of the deductions for QBI.

 

The US Tax Reform Bill provides that an individual taxpayer who earns QBI through one of the qualifying businesses may claim the lesser of one of three deductions:

 

1. 20% of the QBI of the business;
2. 50% of the taxpayer’s share of wages paid by the business; and
3. 25% of the taxpayer’s share of wages paid by the business, plus 2.5% of the value of depreciable tangible property owned by the business without applying depreciation.

 

What do the QBI Deductions Mean for Canadians?

At first sight, the available QBI deductions appear enticing for Canadian residents who operate active businesses in the United States or earn rental income through US rental properties owned by disregarded entities or pass-through entities. However, the availability of these deductions is likely limited for most Canadians who earn QBI in the United States, especially if the business earns only rental income from rental properties.

 

For many Canadian residents who earn rental income from a qualifying business, the QBI deduction will likely be limited to 2.5% of the value of the property because the lowest available deduction applies and many disregarded entities or pass-through entities do not have any employees. Active qualifying businesses operated by Canadian residents may fare better because they are likely to have employees.

 

However, even if a Canadian resident qualifies for a QBI deduction, he or she will be taxed on the QBI at higher Canadian individual income tax rates. Although a foreign tax credit can be claimed in Canada in certain instances for US tax paid, the higher Canadian individual income tax rate means that a Canadian resident will not benefit from a QBI deduction. It must be noted that the availability of a Canadian foreign tax credit for US tax paid on income earned through a disregarded entity or a pass-through entity is contingent on whether the type entity. A foreign tax credit will not be available to Canadians for income earned through many disregarded entities or pass-through entities including Limited Liability Companies (“LLCs”), US Limited Liability Partnerships (“LLPs”) and Limited Liability Limited Partnerships (“LLLPs”). If you are a Canadian and you own an interest in any of these types of entities, we strongly recommend that you consult one of our qualified cross border tax lawyers for guidance.

 

The comments offered in this article are meant to be general in nature and are not intended to provide legal advice regarding any individual situation. Before taking any action involving your individual situation, you should seek legal advice to ensure it is appropriate for your circumstances.