Many self-employed foreign nationals perform consulting services in the U.S. on an infrequent basis. As such, they may not accrue enough days in the U.S. to be considered tax resident under the so-called Substantial Presence Test. Instead, these individuals are nonresidents of the U.S. and generally will be subject to tax on their U.S. source effectively connected income (ECI).
The question arises as to whether nonresidents are eligible for the new 20% Qualified Business Income (QBI) deduction on business income earned in the U.S. This article specifically addresses the QBI deduction for nonresident self-employed consultants.
Background—Tax Reform Created a New 20% Deduction
When the Tax Cuts and Jobs Act of 2017 (TCJA) was passed in December 2017, it added a new provision (Internal Revenue Code §199A) that is effective for taxable years beginning January 1, 2018, and the law expires on December 31, 2025.
This provision provides business owners of pass-through entities, including self-employed consultants (who typically file their returns using Schedule C), a 20% deduction related to the business owner’s “qualified business income” (QBI).
The QBI deduction is only applicable to “effectively connected income” (ECI) from a U.S. trade or business. Generally, when a foreign person who is a self-employed consultant performs services in the U.S., all income derived from services performed within the U.S. is considered ECI.
What is Qualified Business Income (QBI)?
Generally, QBI is ordinary business income less ordinary business deductions. The 20% QBI deduction is generally equal to the sum of the LESSER OF:
- The “qualified business income” of the taxpayer, or
- 20% of the excess of taxable income over the sum of any net capital gain.
Limitations for Self-Employed Consultants
Unfortunately for consultants, the law limits and—at certain income thresholds—ultimately eliminates the 20% QBI deduction if the taxpayer is in a “specified service trade or business” (SSTB). A SSTB means any trade or business involving the performance of services in the fields of:
Health, law, accounting, consulting, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, or which involves the performance of services that consist of investing and investment management, or trading or dealing in securities. However, a trade or business that involves the performance of engineering or architectural services is not a specified service business.
Therefore, since the profession of consulting is a SSTB, consultants need to understand when or if they will be able to avail themselves of the QBI deduction.
What are the restrictions for the QBI deduction related to my specified service trade or business?
For SSTBs, the QBI deduction begins to be phased out for individuals whose taxable income is $157,500. Between $157,500 and $207,500 a partial deduction is available, and the deduction is completely phased out at $207,500.
The law specifies that on a jointly filed income tax return, the phase-out does not begin until $315,000 of taxable income; however, as nonresidents may not file joint 1040 nonresident income tax returns, the phase-out range for a nonresident will always start at $157,500, regardless of whether the nonresident is single or married.
With regard to the phase-out range, §199A uses the term “taxable income,” and therefore, unless guidance is provided to the contrary, we can assume that taxable income for a nonresident is the taxable income that is shown on Form 1040NR (Line 41 for the 2017 1040NR).
I am a G-4 dependent visa holder, self-employed consultant married to a U.S. citizen. Should I file jointly with my spouse?
There may be a tax planning opportunity for a nonresident who is married to U.S. citizen or other U.S. tax resident, to increase the QBI deduction by filing a §6013(g) election in order to be treated as a U.S. tax resident, thereby increasing the QBI phase-out range.
This, of course, may be relevant especially for nonresident consultants who have ECI that is above the phase-out starting point of $157,500. A nonresident electing to be a U.S. tax resident and filing a joint income tax return will increase the phase-out threshold amount to $315,000.
This tax planning strategy should be performed with care, as electing §6013(g) will cause the nonresident to become a U.S. tax resident and will then subject the nonresident to worldwide income taxation by the U.S.
How can I easily estimate my QBI deduction?
If you are a nonresident consultant and (1) your total ECI is composed entirely of consulting income, and (2) your overall taxable income is less than $157,500, then your QBI deduction is generally 20% of your taxable income.
For example, if your consulting taxable income is $150,000, then your QBI deduction is $30,000.
I perform some of my consulting work outside the U.S. How will this affect my QBI deduction?
As discussed, the 20% QBI deduction is limited to work that is ECI. Generally, this means that only the consulting work (reduced by associated expenses) performed within the U.S. will qualify for the 20% QBI deduction.
It is important to note that QBI is determined based on where the work is performed, not based on whether the person or entity paying for the consulting services is located inside or outside the U.S. Thus, it does not matter whether you are consulting for a U.S. or non-U.S. entity—it only matters where you are when you conduct your work.
Careful records should, therefore, be kept regarding the earnings derived for services performed in the U.S. and those outside the U.S. Detailed records should also be kept related to expenses and whether the expense is associated with work performed in or outside the U.S.
I am a G-4 dependent visa holder and a nonresident for income tax purposes. Is my consulting income allowed a 20% QBI deduction?
As a nonresident, whether you are a G-4 visa holder or other nonresident, you should be entitled to a 20% QBI deduction on your consulting income provided you earn QBI within the U.S. and your taxable income is less than $157,500. The consulting income you earn outside the U.S should not be taxable since nonresidents are only subject to tax on income earned within the U.S.
What else should I keep in mind?
Generally speaking, if you are a tax resident of a foreign country, it is likely that you are taxable in that foreign country on your worldwide income, including the ECI you earn in the U.S. To eliminate or reduce double taxation, most countries will allow a foreign tax credit for any income tax you pay to the U.S. on your U.S. ECI.
Please note that when tax reform was passed, the TCJA contained only sparse details with regard to the QBI calculation and nuances. The U.S. Treasury and IRS are expected to release further regulations and guidance in this area. We are closely monitoring developments and will publish updates as they occur.
Do you want to see how these changes will affect you? The Wolf Group offers QBI consulting services for SSTBs, as well as QBI compliance services for individuals who want a 2018 tax projection. Schedule your appointment with International Tax Director Dale Mason, CPA, by contacting firstname.lastname@example.org.