Specified service trade or business

This is the second in a series of posts reviewing the recently proposed regulations (“PR”) under Sec. 199A of the Code. https://www.federalregister.gov/documents/2018/08/16/2018-17276/qualified-business-income-deduction

 Yesterday, we considered the elements of a “qualified” trade or business under Section 199A. Today, we’ll pick up with those trades or businesses that may be excluded from its coverage, and tomorrow we’ll turn to the meaning of qualified business income. https://www.taxlawforchb.com/2018/09/the-proposed-sec-199a-regs-are-here-part-one/ Hold on to your seats as we continue to look at more . . . definitions.

Effect of Specified Service Trade or Business Status

A qualified trade or business (“QTB”) – the qualified business income (“QBI”) of which provides the basis for the Section 199A deduction – includes any trade or business other than a “specified service trade or business” (“SSTB”).

Thus, if a trade or business is an SSTB, no QBI, W-2 wages, or unadjusted basis (“UB”) of qualified property from the SSTB may be taken into account by an individual owner of the SSTB whose taxable income exceeds a threshold amount plus a phase-in range, even if the taxable income is derived from an activity that is not itself an SSTB.

If the trade or business conducted by a PTE is an SSTB, this limitation will apply to any direct or indirect individual owners of the business, regardless of whether the owner is passive or participated in any SSTB activity. However, the SSTB limitation will not apply to an individual with taxable income below the threshold amount.[i]

SSTB Defined

Conceptually, the definition of an SSTB emphasizes the direct provision of services by the employees or owners of a trade or business, rather than the application of capital.

Although the Code does not require a certain quantum of specified service activity is necessary to find an SSTB, the PR provide a de minimis rule under which a trade or business will not be considered an SSTB merely because it provides a small amount of services in a specified service activity.[ii]

An SSTB means any trade or business involving the performance of 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 such trade or business is the reputation or skill of one or more of its employees or owners, and any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.

Some of these services are considered below.

Health

The PR provide that the term “performance of services in the field of health” means the provision of medical services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals who provide medical services directly to a patient.

The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient.

For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers, payment processing, or research, testing, and manufacture and/or sales of pharmaceuticals or medical devices.

Law

The term “performance of services in the field of law” means the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals in their capacity as such.

It does not include the provision of services that do not require skills unique to the field of law; for example, the provision of services in the field of law does not include the provision of services by printers, delivery services, or stenography services.

Accounting

The PR provides that the term “performance of services in the field of accounting” means the provision of services by accountants, enrolled agents, return preparers, financial auditors, and similar professionals in their capacity as such.

Provision of services in the field of accounting is not limited to services requiring state licensure as a certified public accountant (CPA). The aim of the PR is to capture the common understanding of accounting, which includes bookkeeping services.

The field of accounting does not include payment processing and billing analysis.

Consulting

The term “performance of services in the field of consulting” means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.

Consulting includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such.

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 or educational courses. The determination of whether a person’s services are sales or economically similar services is made based on all the facts and circumstances of that person’s business, including the manner in which the taxpayer is compensated for the services.

In recognition of the fact that, in certain kinds of sales transactions, it is common for businesses to provide consulting services in connection with the purchase of goods by customers – for example, a company that sells computers may provide customers with consulting services relating to the setup, operation, and repair of the computers – the PR provide a de minimis rule under which a trade or business is not an SSTB if less than 10% of the gross receipts (5% if the gross receipts are greater than $25 million) of the trade or business for a taxable year are attributable to the performance of services in a SSTB.

However, the IRS also recognized that this de minimis rule may not provide sufficient relief for certain trades or business that provide ancillary consulting services. Thus, the PR also provide that the field of consulting does not include the performance of consulting services that are embedded in, or ancillary to, the sale of goods or the performance of services on behalf of a trade or business that is other than an SSTB if there is no separate payment for the consulting services.

Financial Services

The PR limits the definition of financial services to services including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings (including in title 11 or similar cases), and raising financial capital by underwriting, or acting as the client’s agent in the issuance of securities, and similar services.

This includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals.

Brokerage Services

The PR provide that the field of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee. This includes services provided by stock brokers and other similar professionals, but does not include services provided by real estate agents and brokers, or insurance agents and brokers.

Principal Asset of the Business: Reputation or Skill of Employees or Owners

Thankfully, the PR rejected a broad, service-based approach to the meaning of what could have been the catch-all “reputation or skill” clause by limiting it to fact patterns in which the individual or PTE is engaged in the trade or business of: (1) Receiving income for endorsing products or services, including an individual’s distributive share of income or distributions from an PTE for which the individual provides endorsement services; (2) licensing or receiving income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity, including an individual’s distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual’s image; or (3) receiving appearance fees or income.[iii]

Investing and Investment Management

The PR provide that any trade or business that involves the “performance of services that consist of investing and investment management” means a trade or business that earns fees for investment, asset management services, or investment management services, including providing advice with respect to buying and selling investments. The performance of services that consist of investing and investment management would include a trade or business that receives either a commission, a flat fee, or an investment management fee calculated as a percentage of assets under management.

The performance of services of investing and investment management does not include directly managing real property.

Trading

The PR provide that any trade or business involving the “performance of services that consist of trading” means a trade or business of trading in securities, commodities, or partnership interests. Whether a person is a trader is determined taking into account the relevant facts and circumstances. Factors that have been considered relevant to determining whether a person is a trader include the source and type of profit generally sought from engaging in the activity regardless of whether the activity is being provided on behalf of customers or for a taxpayer’s own account.

Dealing in Securities

The “performance of services that consist of dealing in securities” means regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. For purposes of the preceding sentence, a taxpayer that regularly originates loans in the ordinary course of a trade or business of making loans but engages in no more than “negligible” sales of the loans is not dealing in securities for purposes of Section 199A.

The fact that businesses are operated across entities raises the question of whether, in defining a “trade or business” for purposes of Section 199A, trades or businesses should be permitted or required to be aggregated, or disaggregated, and if so, whether such aggregation, or disaggregation, should occur at the entity level or at the individual-owner level.

Services or Property Provided to an SSTB

The IRS observed that some taxpayers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the Section 199A deduction. Such a strategy, the IRS has stated, is inconsistent with the purpose of Section 199A.

Therefore, the PR provide an anti-abuse rule pursuant to which an SSTB will include any trade or business (not otherwise an SSTB) with 50% or more common ownership (direct or indirect) with an SSTB, that provides 80% or more of its property or services to the SSTB.

Additionally, if a trade or business provides less than 80% of its property or services to an SSTB, but has 50% or more common ownership with an SSTB, that portion of the trade or business of providing property or services to the SSTB will be treated as part of the SSTB (meaning the income will be treated as income from an SSTB). For example, dentist A owns a dental practice and also owns an office building. A rents half the building to the dental practice and half the building to unrelated persons. The renting of half of the building to the dental practice will be treated as an SSTB.

The PR also provide a rule that if a trade or business (that would not otherwise be treated as an SSTB) has 50% or more common ownership with an SSTB, and has shared expenses with an SSTB, including wages or overhead expenses, it is treated as incidental to the SSTB and, therefore, as part of the SSTB, if the gross receipts of the trade or business represent no more than 5% of the gross receipts of the combined business in a taxable year.

Example. A, a dermatologist, provides medical services to patients on a regular basis through LLC, a disregarded entity owned by A. In addition to providing medical services, LLC also sells skin care products to A’s patients. The same employees and office space are used for the medical services and sale of skin care products. The gross receipts with respect to the skin care product sales do not exceed 5% of the gross receipts of LLC. Accordingly, the sale of the skin care products is treated as incidental to A’s SSTB of performing services in the field of health and is treated as part of such SSTB.

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[i] For purposes of this post, it is assumed that the threshold amount ($315,000 in the case of married taxpayers filing jointly) and phase-in range are exceeded. It should be noted, however, that an individual with taxable income in excess of the threshold amount but within the phase-in range will be allowed to take into account a certain “applicable percentage” of QBI, W-2 wages and QB of qualified property from an SSTB in determining their Section 199A deduction. Thus, some owners of an SSTB may qualify for the Section 199A deduction while others may not.

[ii] For more details on this de minimis rule, see the discussion below, under “consulting” services.

[iii] Oh, to be a celebrity!

In the weeks preceding the introduction of the bill that was just enacted as the Tax Cuts and Jobs Act (the “Act”), my colleagues teased me, “Lou, what are you going to do when Congress simplifies the Code?”

“Simplify?” I responded as I reached for the Merriam-Webster’s Dictionary that I have used since 1980 – it resides next to the HP scientific calculator that I have used since 1987 – change is not always a good thing – “Congress is incapable of simplifying anything.”

Tax Cuts and Jobs Act

“The word ‘simplify’,” I continued, “is defined as follows: to make simple or simpler; to reduce to basic essentials; to diminish in scope or complexity; to make more intelligible.”

After reviewing the final version of the legislation, two thoughts came to mind: first, Congress must not have a dictionary and, second, the most influential lobbying organization in Washington must be comprised entirely of tax professionals.

In order to better appreciate – if not fully understand – the changes wrought by the Act regarding the Federal taxation of trade or business income that is recognized, “directly or indirectly,” by non-corporate taxpayers, the reader should be reminded of the existing rules, and should also be made aware of the policy underlying the changes.

Pre-2018

A business that is conducted by an individual as a sole proprietorship (whether directly or through a single-member LLC that is disregarded for tax purposes) is not treated as an entity separate from its owner. Rather, the owner is taxed directly on the income of the business.

A business that is conducted by two or more individuals as a general partnership, a state law limited partnership, or a state law limited liability company, is treated as a pass-through entity for tax purposes – a partnership. The partnership is not itself taxable on the income of the business. Rather, each partner/member is taxed on their distributive share of the partnership’s business income.

A corporation that is formed under state law to conduct a business is not itself taxable on the income of the business if it is a “small business corporation” and its shareholders elect to treat it as an S corporation. In that case, the corporation is treated as a pass-through entity for tax purposes. In general, it is not taxable on its business income; rather, its shareholders are taxed on their pro rata share of the S corporation’s business income.

In each of the foregoing situations, the business income of an individual owner of a sole proprietorship, a partnership, or an S corporation (each a “Pass-Through Entity” or “PTE”) is treated for tax purposes as though the owner had realized such income directly from the source from which it was realized by the PTE.

In determining the taxable business income generated by a PTE, the Code allows certain deductions that are “related” to the production of such income, including a deduction for the ordinary and necessary expenses that are paid or incurred by the PTE in carrying on the business.

Because business income is treated as ordinary income (as opposed to capital gain) for tax purposes, the taxable business income of the PTE is taxed to its individual owner(s) at the regular income tax rates.[1]

What’s Behind the Change?

The vast majority of closely-held businesses are organized as PTEs, and the vast majority of newly-formed closely-held businesses are organized as limited liability companies that are treated as partnerships or that are disregarded for tax purposes.[2]

In light of this reality, Congress sought to bestow some unique economic benefit or incentive upon the non-corporate owners of PTEs in the form of a new deduction, and reduced taxes.[3]

However, Congress restricted this benefit or incentive in several ways that reflect a bias in favor of businesses that invest in machinery, equipment, and other tangible assets:[4]

  • in general, it is limited to PTEs that do not involve only the performance of services;
  • it benefits only the net business income of the PTE that flows through to the taxpayer; it does not apply to any amount paid by the PTE to the taxpayer in respect of any services rendered by the taxpayer to the PTE;
  • it does not apply to the PTE’s investment income; it is limited to the PTE’s business income; and
  • the benefit is capped, based upon how much the PTE pays in wages or invests in machinery, equipment, and other tangible property.

Beginning in 2018: New Sec. 199A of the Code

For taxable years beginning after December 31, 2017 and before January 1, 2026, an individual taxpayer[5] (a “Taxpayer”) who owns an equity interest in a PTE that is engaged in a qualified trade or business may deduct up to 20% of the qualified business income allocated to him from the PTE.

Qualified Trade or Business

Taxpayer’s qualified business income (“QBI”) is determined by each qualified trade or business (“QTB”) in which Taxpayer is an owner.[6] A QTB includes any trade or business conducted by a PTE other than a specified service trade or business.[7]

A “specified service trade or business” 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.[8] However, a trade or business that involves the performance of engineering or architectural services is not a “specified service.”

Qualified Business Income

Taxpayer’s QBI from a QTB for a taxable year means Taxpayer’s share of the net amount of qualified items of income, gain, deduction, and loss that are taken into account in determining the taxable income of the QTB for that year.[9]

Items of income, gain, deduction, and loss are “qualified items” only to the extent they are effectively connected with the PTE’s conduct of a QTB within the U.S.[10]

“Qualified items” do not include specified investment-related income, gain, deductions, or loss; for example, items of gain taken into account in determining net long-term capital gain, dividends, and interest income (other than that which is properly allocable to a trade or business) are not included[11]; nor are items of deduction or loss allocable to such income.

Taxpayer’s QBI also does not include any amount paid to Taxpayer by an S corporation that is treated as reasonable compensation for services rendered by Taxpayer. Similarly, Taxpayer’s QBI does not include any “guaranteed payment” made by a partnership to Taxpayer for services rendered by Taxpayer.[12]

The Deduction

In general, Taxpayer is allowed a deduction for any taxable year of an amount equal to the lesser of:

(a) Taxpayer’s “combined QBI amount” for the taxable year, or

(b) an amount equal to 20% of the excess (if any) of

(i) Taxpayer’s taxable income for the taxable year, over

(ii) any net capital gain for the taxable year.

The combined QBI amount for the taxable year is equal to the sum of the “deductible amounts” determined for each QTB “carried on” by Taxpayer through a PTE.[13]

Taxpayer’s deductible amount for each QTB is the lesser of:

(a) 20% of the Taxpayer’s share of QBI with respect to the QTB, or

(b) the greater of:

(i) 50% of the “W-2 wages” with respect to the QTB, or

(ii) the sum of:

(A) 25% of the W-2 wages with respect to the QTB, plus

(B) 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”.[14]

In general, the W-2 wages with respect to a QTB for a taxable year are the total wages subject to wage withholding, plus any elective deferrals, plus any deferred compensation paid by the QTB with respect to the employment of its employees during the calendar year ending during the taxable year of Taxpayer.[15]

“Qualified property” means, with respect to any QTB for a taxable year, tangible property of a character subject to depreciation that is held by, and available for use in, the QTB at the close of the taxable year, which is used at any point during the taxable year in the production of QBI, and for which the depreciable period[16] has not ended before the close of the taxable year.

Example

The taxpayer is single. She is a member of an LLC (“Company”) that is treated as a partnership for tax purposes (a PTE). The company is engaged in a QTB that is not a specified service trade or business.

Taxpayer’s taxable income for 2018 is $500,000 (i.e., gross income of $520,000 less itemized deductions of $20,000), which includes a guaranteed payment from Company of $120,000, for services rendered to Company during 2018, and her allocable share of QBI from Company for 2018 of $400,000. She has no investment income for 2018.

Her allocable share of W-2 wages with respect to Company’s business for 2018 is $300,000.

During 2018, Company purchases machinery and immediately places it into service in its QTB (the machinery is “qualified property”). Taxpayer’s allocable share of the purchase price is $750,000.

The taxpayer is allowed a deduction for the taxable year of an amount equal to the lesser of:

(a) her “combined QBI amount” for the taxable year (the guaranteed payment of $120,000 is not included in QBI), or

(b) 20% of her taxable income of $500,000 for the taxable year, or $100,000.

Taxpayer’s combined QBI amount for 2018 is equal to her “deductible amount” with respect to Company. The deductible amount is the lesser of:

(a) 20% of Taxpayer’s QBI (20% of $400,000 = $80,000), or

(b) the greater of:

(i) 50% of the W-2 wages with respect to the QTB (50% of $300,000 = $150,000), or

(ii) the sum of: 25% of the W-2 wages with respect to the QTB ($75,000), plus (B) 2.5% of the unadjusted basis, immediately after acquisition, of all qualified property (2.5% of $750,000 = $18,750): $75,000 + $18,750 = $93,750.

Thus, Taxpayer’s deductible amount is $80,000. Because this amount is less than $100,000 (20% of her taxable income of $500,000 for the taxable year), Taxpayer will be allowed to deduct $80,000 in determining her taxable income for 2018.

Looking Ahead

It remains to be seen whether the “20% deduction” based upon the QBI of a PTE will be a “game changer” for the individual owners of the PTE.

After all, the deduction is subject to several limitations that may dampen its effect. For example, QBI does not include the amount paid by the PTE to Taxpayer in respect of services rendered by Taxpayer. In addition, the losses realized in one QTB may offset the income realized in another, thereby reducing the amount of the deduction. Finally, the deduction is subject to limits based upon the wages paid and the capital investments made by the QTB.

Maximizing the Deduction?

Might an S corporation shareholder or a partner in a partnership reduce the amount paid to them by the entity for their services so as to increase the amount of their QBI and, so the amount of the deduction? In the case of an S corporation, this may result in the IRS’s questioning the reasonableness (i.e., insufficiency) of the compensation paid to the shareholder-employee.[17]

Or might a PTE decide to invest in more tangible property than it otherwise would have in order to set a greater cap on the deduction?

In any case, the business must first be guided by what makes the most sense from a business perspective.

Becoming a Pass-Through?

What if a business is already organized as a C corporation? Should the QBI-based deduction tip the scales toward PTE status?

Before taking any action with respect to changing its status for tax purposes, a C corporation will have to consider much more than the effect of the deduction for PTEs.

For example, does it even qualify as a small business corporation? If not, what must it do to qualify? Must it redeem the stock owned by an ineligible shareholder, or must it recapitalize so as to eliminate the second class of stock? Either option may prove to be economically expensive for the corporation and the remaining shareholders.

If the corporation does qualify, what assurances are there that all of its shareholders will elect to treat the corporation as an S corporation? Even if the election is made, will the presence of earnings and profits from “C” taxable years implicate the “excess passive income” rules?

In any case, a C corporation that is not otherwise contemplating a change in its tax status, should probably not become an S corporation solely because of the PTE-related changes under the Act, especially if the corporation does not contemplate a sale of its business in the foreseeable future.

Wait and See?

The deduction based on the QBI of a PTE will expire at the end of 2025 unless it is extended before then. It is also possible that it may be eliminated by Congress after 2020.

An existing PTE and its owners should continue to operate in accordance with good business practice while they and their tax advisers determine the economic effect resulting from the application of the new deduction to the PTE.

They should also await the release of additional guidance from the IRS regarding “abusive” situations, tiered entities, and other items.[18]


*This post is the first of several that will be dedicated to those portions of the Tax Cuts and Jobs Act of 2017 (H.R. 1) that are most relevant to the closely-held business and it owners.

[1] The Act reduces the highest income tax rate applicable to the individual owner of a PTE to 37% (from 39.6%) for taxable years beginning after December 31, 2017 and before January 1, 2026. Note that the 3.8% surtax continues to apply to the distributive or pro rata share of an individual partnership or shareholder who does not materially participate in the trade or business conducted by the PTE.

[2] Though occasionally, the owner(s) will elect to treat the LLC as a corporation for tax purposes; for example, to reduce employment taxes.

[3] The Act includes a number of business-related benefits that are applicable to both corporate and non-corporate taxpayers. It also includes some that are unique to corporations, such as the reduction of the corporate income tax rate from a maximum of 35% to a flat 21%.

[4] As we will see in the coming weeks, that Act contains a number of such provisions.

[5] More accurately, the benefit is available to non-corporate owners; basically, individual taxpayers, though trusts and estates are also eligible for the deduction.

[6] A PTE may conduct more than one QTB – different lines of business – or Taxpayer may own equity is more than one PTE.

[7] Also excluded is the trade or business of being an employee.

[8] The exclusion from the definition of a qualified business for specified service trades or businesses is phased in for a taxpayer with taxable income in excess of a “threshold amount” of $157,500 ($315,000 in the case of a joint return). The exclusion is fully phased in for a taxpayer with taxable income at least equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[9] If the net amount of the QBI is a loss (negative), it is treated as a loss from a QTB in the succeeding taxable year.

[10] Generally, when a person engages in a trade or business in the U.S., all income from sources within the U.S. connected with the conduct of that trade or business is considered to be effectively connected income.

[11] Qualified items should include the gain recognized on the sale of business assets.

[12] The IRS is authorized to issue regulations that would exclude any amount paid or incurred by the partnership to Taxpayer for services provided by Taxpayer to the partnership other than in his capacity as a partner.

[13] Taxpayer does not need to be active in the business in order to qualify for the deduction.

[14] This “wage limit” is phased in for a taxpayer with taxable income in excess of the threshold amount. The limit is fully applicable for a taxpayer with taxable income equal to the threshold amount plus $50,000 ($100,000 in the case of a joint return).

[15] In the case of a partnership or S corporation, the provision applies at the partner or shareholder level. Each partner or shareholder, as the case may be, takes into account his allocable or pro rata share of each qualified item of income, gain, deduction, and loss, and is treated as having W-2 wages and unadjusted basis for the taxable year equal to his allocable or pro rata share of the W-2 wages and unadjusted basis of the partnership or S corporation, as the case may be.

[16] The “depreciable period” is the period beginning with the date the qualified property is first placed in service and ending on the later of the date that is 10 years after such date, or the last day of the last full year in the applicable recovery period for the property.

[17] State and local taxes also need to be considered; for example, NYC’s unincorporated business income tax and its general corporation tax.

[18] “What we do in haste, we regret at leisure?”