Many provisions of the Tax Cuts and Jobs Act require further regulatory clarification – perhaps none more so than Section 199A. This newly created section of tax code allows eligible pass-through business owners to deduct 20 percent of qualified business income, starting with tax year 2018 and ending in 2025 barring legislative extension.
Since the passage of tax reform in December 2017, business owners and practitioners grappled with the wide range of caveats, criteria and ambiguities contained in the legislative text. In early August, the IRS put forth proposed regulations that included much-anticipated guidance on the application of Section 199A. Let’s examine how these regulations clarify certain definitions and aspects of eligibility for the new pass-through deduction and what ambiguities remain as end-of-year tax planning season approaches.
Clarity: De Minimis Exception to Specified Service Trade or Business
The legislative language of Section 199A specifically excluded any “specified service trade or business” (SSTB) from taking the pass-through deduction, or in other words, professional service companies in fields including law, health, performing arts, actuarial science, financial services or any trade or business that relies heavily on the reputation or skill of employees or owners (more on the reputation/skill issue in the next section). From the start, this definition was problematic for companies that both provide services and sell products – how did they fit into the eligibility criteria for 199A?
In the new regulations, the IRS gives companies in this situation a bit of leeway to deliver services and still take the deduction. A new de minimis exception allows a business that sells products and performs services to escape the SSTB designation if less than 10 percent of gross receipts are attributable to services (or less than 5 percent if the business has more than $25 million in gross receipts).
Here’s an example of how this would apply: ABC Co. has annual revenue of $20 million. $18.5 million of the revenue is attributable to the sales of IT equipment and the remaining $1.5 million is attributable to consulting, installation and training services. Since ABC Co.’s consulting services comprise less than 10 percent of total receipts, those professional services are ignored and the company is not treated as a SSTB. As a result, ABC Co. is eligible to take the 199A deduction.
Clarity: Narrow Definition of Reputation or Skill
In addition to excluding specific industries, the original legislative text also excluded from 199A eligibility any trade or business that relies on the reputation or skill of one or more employees or owners. The catch-all nature of this category concerned and confused business owners; after all, what business doesn’t have skilled and reputable employees that directly contribute to its success?
In one of the biggest taxpayer-friendly developments of the regulations, the IRS takes an extremely narrow definition of reputation or skill and clarifies that this only applies when an employee or owner would:
- Endorse a product or service
- License his or her image, name, trademark, etc.
- Receive appearance fees
Here’s an illustration of this concept taken straight from the text of the regulations: A well-known chef who owns multiple restaurants also receives an endorsement fee of $500,000 for the use of her name on a line of cookware due to her skills and reputation as a chef. The chef is in the trade or business of being a chef and owning restaurants, which does not constitute an SSTB. However, the chef is also in the business of receiving endorsement income, which does constitute an SSTB. In this case, the $500,000 is not eligible for the 20 percent deduction but the profits generated from restaurant sales would be.
This narrow definition of reputation and skill will come as a relief to many owners who trade upon their expertise, persona or name to drive sales, like photographers, auto mechanics, landscapers and more.
Clarity: Anti-Abuse Provisions Disallow Strategies
Once tax reform was signed into law, some companies attempted to work around the specified service definition using a strategy commonly referred to as “crack and pack.” Using this method, an entity cracks apart its specified service trade or business income from other income and packs everything it can into the side of the business that qualifies for the 199A deduction.
From the start, RKL advised its clients to avoid this strategy because it was too early to anticipate how Treasury officials would rule on its usage. Now, the IRS proposed regulations have an anti-abuse provision which prohibits the creation of single-member LLCs to house non-professional services functions. Specifically, a business that provides 80 percent or more of its property or services to a related service business is part of that service business. Businesses are related if they have at least 50 percent common ownership.
The anti-abuse provision of the regulation also bars from 199A eligibility groups of employees who leave their current company and then band together as an entity to provide services back to that same company.
The IRS is accepting comments on the proposed regulations through October 1 and a public hearing will be held later that month. A number of ambiguities still remain to be addressed by regulators, including applicability for rental owners, real estate professionals and landlords. Certain SSTB definitions also remain unclear, such as physical therapy versus occupational therapy businesses or actors versus disc jockeys. Your RKL advisor can identify the appropriate planning strategies to maximize the benefits of the 199A deduction for your unique pass-through business. Contact them directly or reach out to one of our local offices with any questions.
RKL continues to monitor these proposed regulations and all other federal guidance on tax reform. Stay up-to-date by subscribing to our e-newsletter or visiting our Tax Reform Resource Center.