One major provision of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, is a new tax deduction for passthrough entities (S corporations, partnerships, and sole proprietorships) under Sec. 199A. The deduction generally provides owners, shareholders, or partners a 20% deduction on their personal tax returns on their qualified business income (QBI). Various limitations apply based on the type of business operated and the amount of income the business has. While the calculation of the deduction amount is beyond the scope of this discussion, a summary follows of the limitations that apply to specified service trades or businesses (SSTBs).
The Internal Revenue Code has historically treated professional service businesses more harshly than any other type of business, and this continues with the Sec. 199A deduction. (For example, before the TCJA, professional service corporations, as defined in Sec. 448(d)(2) were taxed at a flat 35% tax rate rather than the graduated tax rates applicable to a C corporation under Sec. 11(b).) Under the new rules, this deduction does not apply to certain enumerated SSTBs if the taxpayer's taxable income is above certain threshold amounts. The threshold amounts are $315,000 for taxpayers filing jointly and $157,500 for all other taxpayers, with a deduction phaseout range, or limitation phase-in range, of $100,000 and $50,000, respectively, above these amounts.
SSTBs are broken into two distinct categories:
1.Trades or businesses performing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of that trade or business is the reputation or skill of one or more of its employees (these fields are listed in Sec. 1202(e)(3)(A); however, the TCJA specifically excluded engineering and architecture); or
2. Any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities described in Sec. 475(c)(2), partnership interests, or commodities described in Sec. 475(e)(2) (Sec. 199A(d)(2)(B)).
This definition caused much discussion among tax professionals and their clients. Many of the following questions came up in the authors' practice: "What does it mean to have a principal asset be the reputation or skill of one or more of its employees?"; "Does my hair salon that is operated as a sole proprietorship fall under this category?"; "I sell life insurance. Does that mean I am not eligible for this deduction?"; "Does my computer consulting and repair business fall under the category of consulting?"; and "The partners in a law firm also own the building where the law firm is located. Will the rental income qualify for this deduction?"
On Aug. 8, 2018, Treasury issued proposed regulations (REG-107892-18) that provided clarity regarding the definition of an SSTB. The proposed regulations also established a safe-harbor provision and anti-abuse provisions, which were not included in the TCJA.
Before continuing this discussion, two points need to be made clear. First, if taxpayers are below the threshold amounts, they are eligible for the 20% deduction regardless of whether their business is an SSTB. Second, the SSTB classification applies to the business regardless of whether the taxpayer is actively or passively involved in it.
Definitions under Prop. Regs. Sec. 1.199A-5(b)(2)
Many questions about the new law concern the field of consulting and businesses where the principal asset is the reputation or skill of one or more of its employees (reputation and skill provision). The proposed regulations define consulting as providing "professional advice and counsel to clients to assist the client in achieving goals and solving problems" (Prop. Regs. Sec. 1.199A-5(b)(2)(vii)). Additionally, consulting also includes advice and counsel related to lobbying efforts (id.). However, consulting does not include advice performed in conjunction with the sale of goods or services that would not otherwise be an SSTB, if that service is not billed separately (id.). The determination of whether clients are considered to be involved with consulting services is a facts-and-circumstances, case-by-case scenario. When making this determination, a CPA should look for instances where the client is providing recommendations and advice without any type of corresponding goods or services, especially if the client is providing a formal written recommendation report.
The proposed regulations significantly narrow the meaning of the reputation and skill provision. Specifically, they enumerate only the following three instances where a taxpayer would fall under this provision:
- A trade or business in which a person receives fees, compensation, or other income for endorsing products or services;
- A trade or business in which a person licenses or receives fees, compensation, or other income for the use of an individual's image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual's identity; or
- Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format (Prop. Regs. Sec. 1.199A-5(b)(2)(xiv)).
To sum up the reputation and skill provision, it targets celebrities and public figures who make their living in the public eye. This was a welcome relief for many taxpayers, as it was uncertain how expansive this definition would be.
The definitions in Prop. Regs. Sec. 199A-5(b)(2) of performing services in the fields of law, accounting, and actuarial science include all of the expected services and provide no surprises. The field of law includes those legal and related services provided by "lawyers, paralegals, legal arbitrators, mediators, and similar professionals" (Prop. Regs. Sec. 1.199A-5(b)(2)(iii)). The field of accounting includes services provided by "accountants, enrolled agents, return preparers, financial auditors, and similar professionals" (Prop. Regs. Sec. 1.199A-5(b)(2)(iv)). The field of actuarial science includes all services performed by "actuaries and similar professionals" (Prop. Regs. Sec. 1.199A-5(b)(2)(v)).
The fields of athletics and performing arts are similar in the approach of who and what is considered to be providing services. In both cases, it is the service of those participating in the creation of performing arts, including the performers and the directors, or those who are participating in the athletic competition, including the players, coaches, and team managers. However, in both cases, it does not include the maintenance and operation of equipment or facilities, nor does it include the "services by persons who broadcast or otherwise disseminate video or audio . . . to the public" (Prop. Regs. Secs. 1.199A-5(b)(2)(vi) and (viii)).
The field of health is defined as providing medical services by medical professionals directly to a patient by "physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals" (Prop. Regs. Sec. 1.199A-5(b)(2)(ii)). However, it does not include the provision of services not directly related to a medical services field — for example, the operations of health clubs, payment processing, research, testing, or manufacturing or sales of pharmaceuticals or medical devices. The key is that there has to be a direct service connection between the medical professional and the patient.
Moving on to the categories of money management (financial services, brokerage services, investing and investment management, services of trading), the definition of financial services is broad, encompassing those services provided by financial advisers, investment bankers, wealth planners, retirement advisers, and similar professionals. Notably, though, traditional banking services (e.g., taking deposits or making loans) were excluded from this definition. These individuals advise clients on wealth management and corporate business transactions (Prop. Regs. Sec. 1.199A-5(b)(2)(ix)). The definition of brokerage services is very narrow; it includes only stockbrokers and similar professionals. The proposed regulations specifically excluded real estate and insurance agents and brokers (Prop. Regs. Sec. 1.199A-5(b)(2)(x)). Excluding these two sets of professionals significantly increased the number of those taxpayers eligible for the deduction.
The fields of trading and investing and investment management also run hand-in-hand, as they both relate to securities and commodities trading. Trading means being in the business of trading securities, commodities, or partnership interests either on the taxpayer's own account or on others' account (Prop. Regs. Sec. 1.199A-5(b)(2)(xi)). Investing and investment management "involv[es] the receipt of fees for providing investing, asset management, or investment management services" (Prop. Regs. Sec. 1.199A-5(b)(2)(xi)). It does not include directly managing real property.
Multiple activities and the de minimis rule
What happens if a client has a trade or business with multiple lines of businesses, where one of the lines is an SSTB? The proposed regulations included a de minimis rule for this situation. If a taxpayer has $25 million or less in gross receipts for the tax year from SSTB activities, it will not be considered an SSTB if less than 10% of the receipts are generated by the SSTB activity (Prop. Regs. Sec. 1.199A-5(c)(1)(i)). If the taxpayer has more than $25 million in gross receipts, it will not be an SSTB if less than 5% of those receipts are generated by the SSTB activity (Prop. Regs. Sec. 1.199A-5(c)(1)(ii)).
There were many discussions between accountants, lawyers, and their clients about possible reorganization of business entities or reclassification of employees into independent contractors and various other methods to increase the benefit derived from the 20% deduction. In response to this, the IRS included in the proposed regulations various anti-abuse rules. One in particular related to the characterizations of SSTBs.
A non-SSTB entity may still be characterized as an SSTB, or have a portion of its income be considered from an SSTB, if it provides property or services to an SSTB related through common ownership. In this case, common ownership is considered as having 50% or more common owners, after applying the direct and indirect attribution rules of Sec. 267(b) or 707(b) (Prop. Regs. Sec. 1.199A-5(c)(2)(iii)). If the non-SSTB entity provides 80% or more of its property or services to a commonly owned SSTB, then the non-SSTB will be considered an SSTB even if it does not provide any of the enumerated services. If the non-SSTB entity provides 50% or more, but less than 80%, of its property or services to an SSTB, then the portion of the non-SSTB providing property or services to the SSTB will be treated as part of the SSTB (Prop. Regs. Sec. 1.199A-5(c)(2)(ii)).
Due to these proposed regulations, the second and third questions posed at the beginning of this discussion can be answered with relative confidence based on very limited information. The hair salon does not fall under the reputation or skill provision, as it is not generating income from any of the "celebrity" provisions. An individual selling life insurance as an insurance broker is specifically excluded from the SSTB definition.
Unfortunately, it is impossible to answer the final two questions without more information related to what the computer consultant actually does and whether the rental income from the law firm is subject to the SSTB provisions. However, there is now more specific guidance from the IRS to help answer those questions. The proposed regulations certainly did not discuss every situation that CPAs can encounter with clients; however, practitioners know more today than they did last December when the TCJA was enacted.
Michael D. Koppel, CPA (Retired)/PFS/CITP, is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.
For additional information about these items, contact Mr. Koppel at 781-407-0300 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.