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How the Qualified Business Income Deduction Affects Government Contractors Related to Consulting
Government contracting is a unique industry. It is upon you to support the largest enterprise in the world: the U.S. government. Being a government contractor can be rewarding work and lucrative but also very complex, especially around tax season.
One question we hear a lot these days are: How will the 199A Qualified Business Income (QBI) deduction affect Government Contractors related to consulting?
The answer is complex.
A brief of QBI:
Section 199A of US Code defines QBI as the net amount of qualified items of income, gain, deduction, and loss in regards to a qualified trade or business of taxpayers within the U.S.
Taxpayers (other than C corporations) are allowed a deduction of up to 20% of their QBI from each qualified trade or business carried on by the taxpayer. These businesses can be passthrough entities such as partnerships, S corporations, sole proprietorships and LLCs taxed as partnerships, S corporations or sole proprietorships.
Several factors can limit or phase out the QBI deduction. A common factor is when government contractors are classified as a specified trade or business (SSTB) since they provide consulting services and the owners of the business have taxable income above a certain threshold.
An 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, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.
The proposed regulations defined consulting by an SSTB as, “the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.”
The IRS also stated that, “the performance of services in the field of consulting does not include the performance of services other than advice and counsel, such as sales or economically similar services or the provision of training and educational courses…Performance of services in the field of consulting does not include the performance of consulting services embedded in, or ancillary to, the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB (such as typical services provided by a building contractor) if there is no separate payment for the consulting services.”
Thankfully the proposed regulations included a de minimis rule stating that if a company’s gross receipts are less than $25 million in a taxable year, up to 10 percent of the company’s gross receipts can come from consulting services without causing the entire business activities to be treated as an SSTB; if gross receipts are more than $25 million, the threshold decreases to 5 percent. It will be important for government contractor’s to classify revenue between consulting and non-consulting services in the accounting system if they do provide consulting services as part of their business.
The 20% QBI deduction for an SSTB begins to phase out when the taxpayer’s income exceeds $315,000 for married filing jointly ($157,500 for other than joint filers) and completely phases out when it exceeds $415,000 for married filing jointly ($207,500 for other than joint filers). For a government contractor, which is not an SSTB, there are income limitations, however, the owner of the company could still take the 20% QBI deduction if they meet other requirements. This is why it is important to determine if a government contractor is an SSTB or not.
QBI Related to Government Contractors and providing consulting services.
Many GovCons based in the Washington DC Metro Area are services based, performing a variety of services spanning many industries such as Information Technology, R&D, Operations and Professional services. Previous to 2018 a GovCon would have employed the descriptor “Consultant” or “Consulting” to define this range of services. For Government contractors, it is critically important to determine whether they operate as an SSTB, especially since under Section 199A an SSTB includes a provision of “consulting” services as presented earlier in this article.
Here are two examples of how the 199A regulations relate to “consulting.” The first shows a Government Contractor providing services which would be seen as an SSTB, which could make the owner(s) ineligible for the 20 percent QBI deduction because of income limitations. The second example shows a contractor providing non SSTB work, which could make the owner(s) eligible for the 20 percent QBI deduction because they are not subject to income limitations.
GATOR helps unrelated entities make their personnel structures more efficient. GATOR studies its client’s organizational structure, comparing it to industry benchmarks and peers to recommend changes in the client’s personnel structure, including using temp workers. GATOR would be considered a Consultant SSTB considering how the IRS defines consulting.
BULLDOG licenses software to clients. BULLDOG discusses and evaluates the client’s software needs with the client, advising the client on the particular software products it licenses. BULLDOG is paid a flat price for the software license. After the client licenses the software, BULLDOG helps implement the software. BULLDOG is engaged in the trade of licensing software and not engaged in an SSTB in the field of consulting as defined by the IRS.
What about me?
The most critical question a Government Contractor can ask themselves these days related to taxes is, “Am I a consultant?” The term may be in your name or website, but further analysis of your products, services, contracts, or NAICS code may reveal whether you are providing consulting services which fit the definition outlined in the proposed regulations. Looking into this now will help you determine if you are an SSTB, or not. And if you do provide consulting services, it would be good to track how much percentage of your business revenue relates to consulting. If your government contracting company meets the de minimis rules based on the size of your company and the percentage of consulting being provided, you could avoid being classified as an SSTB and take fuller advantage of the QBI deduction. There is something to note, the results could differ year-to-year based on how income was earned; you could be an SSTB in 2019 and not in 2020. It will be important to monitor this each year for tax planning purposes.
WendroffCPA specializes in Government Contract Accounting and can provide tax planning services to determine your QBI, consulting status and the most effective tax structure considering the QBI deduction and your business.
For more information on Government Contracting Tax Planning Service contact Darren Wendroff at 703-286-5845 or firstname.lastname@example.org.