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One of the more controversial aspects of the recent tax reform is that while corporations received a generous rate reduction (to 21%), rates generally remained higher for sole proprietors and owners of pass-through businesses.
So Congress included a workaround: A deduction of up to 20 percent for those individual taxpayers to bring their rate down. That deduction, called the Section 199A deduction, raised a number of questions. In response, the IRS has finally issued proposed regulations for Section 199A intended to address some of those questions.
The new deduction, which eligible taxpayers can start claiming on their 2018 federal income tax returns, is generally available to sole proprietors and business owners with pass-through businesses including partnerships, limited liability companies (LLCs), trusts and S corporations. The deduction also applies to certain trusts and estates.
That seems like good news for many individual taxpayers on the higher end of the income scale unless they are considered to be engaged in a Specified Service Trade or Business (SSTB).
Broadly speaking, an SSTB is any business involving the performance of services in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading or dealing in securities, partnership interests or commodities 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 owners."
In other words, if the success of your business or practice depends on you and not on something that you sell, you could very well be left out of the deduction.
To save you the trouble of reading through 180-plus pages of proposed regulations, we have highlighted five key takeaways from the proposed 1.199A-5 regs aimed to clarify the SSTB definition:
1. The “reputation or skill” category may not be so broad after all.
The proposed regs have provided a lot more insight into the definition of SSTB, especially when it comes to the category of “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 owners.”
Based on the definition and examples in the proposed regs, this category may not be so broad after all and has been defined to be much less than it sounds. Per proposed reg 1.199A-5(b)(2)(xiv), this SSTB category means any trade or business that consists of any of the following (or any combination thereof):
A) A trade or business in which a person receives fees, compensation, or other income for endorsing products or services,
B) 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,
C) Receiving fees, compensation, or other income for appearing at an event or the on radio, television, or another media format.
The proposed regulations clarify that the term fees, compensation, or other income includes the receipt of a partnership interest and the corresponding distributive share of income, deduction, gain or loss from the partnership, or the receipt of stock of an S corporation and the corresponding income, deduction, gain or loss from the S corporation stock.
2. Consulting may also be a lot more limited than originally thought.
Per proposed reg 1.199A-5(b)(2)(vii), the performance of services in the field of consulting refers to the provision of professional advice and counsel to clients to assist clients in achieving goals and solving problems.
The subsection adds that “ the performance of services in the field of consulting does not include the performance of services other than advice and counsel” and that the “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.”
The proposed regulations provide the following illustrative example:
Example: D is in the business of licensing software to customers. D discusses and evaluates the customer's software needs with the customer. The taxpayer advises the customer on the particular software products it licenses. D is paid a flat price for the software license. After the customer licenses the software, D helps to implement the software. D is engaged in the trade or business of licensing software and not engaged in an SSTB in the field of consulting.
3. The proposed regs make several friendly carve-outs for real estate related activities.
The proposed regulations specifically exclude real estate agents and brokers from the SSTB definition of brokerage services. Under proposed reg 1.199A-5(b)(2)(x), the performance of services in the field of brokerage services does not include services provided by real estate agents and brokers.
Real estate/property management companies are also specifically excluded from the SSTB definition of investing and investment management under proposed reg 1.199A-5(b)(2)(xi). The performance of services of investing and investment management does not include entities that directly manage real property.
4. Fifty Percent (50%) common ownership is a consistent theme as it relates to SSTB classification.
If there is 50% or more direct, or indirect, common ownership, then under proposed reg 1.199A-5(c)(2), a trade or business that provides 80 percent or more of its property or services to an SSTB, will be treated as part of the SSTB.
If the trade or business provides less than 80 percent of its property or services to an SSTB, then only that portion of the trade or business that provides property or services to the 50 percent or more commonly-owned SSTB will be treated as part of the SSTB.
The proposed regulations provide the following illustrative example:
Example: Law Firm is a partnership that provides legal services to clients, owns its office building and employs its administrative staff. Law Firm divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and through a contract with Partnership 1 provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Law Firm). Because there is 50% or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 will be treated as one SSTB.
The proposed regulations also address trades or businesses that are considered incidental to an SSTB.
Under proposed reg 1.199A-5(c)(3), if a trade or business (that would not otherwise be treated as an SSTB) has 50 percent or more common ownership with an SSTB and if the gross receipts of that trade or business, when combined with the SSTB is less than 5 percent of the total combined gross receipts for a taxable year, then that trade or business will be treated as incidental to and part of the SSTB if the trade or business has shared expenses with the SSTB, including shared wage or overhead expenses.
50 percent or more common ownership includes direct or indirect ownership by related parties within the meaning of sections 267(b) or 707(b).
5. De minimis rule under proposed reg 1.199A-5(c)(1).
Under proposed reg 1.199A-5(c)(1)(i), if a trade or business has gross receipts of $25M or less and less than 10 percent of its gross receipts are attributable to the performance of services defined under SSTB, then the trade or business will not be treated as an SSTB.
If a trade or business has gross receipts of more than $25M, and less than 5 percent of its gross receipts are attributable to the performance of services defined under SSTB, then the trade or business will not be treated as an SSTB.
The proposed regulations and examples do help to clarify the SSTB definition somewhat. Although some business owners may now breathe a sigh of relief, others may still be left with unanswered questions. With the help of their tax professionals, these business owners will no doubt need to navigate and interpret the proposed regulations themselves to find the answers.
About the author
Julia Chan, CPA is a senior tax manager in the West Los Angeles, California office of HCVT. She can be reached at firstname.lastname@example.org | 310-566-6837.