The Tax Cuts and Jobs Act of 2017 created a new deduction through Code Section 199A for owners of certain pass-through businesses. Sole proprietors, partners, and S corporation owners could potentially receive a deduction of up to 20% of the qualifying business income earned by their trades or businesses.
While many taxpayers will qualify for this deduction, owners of a “Specified Service Trade or Business” (SSTB) face strict limitations or are excluded altogether. On August 8th, the IRS released several proposed regulations, including guidance on what types of businesses should and should not be considered an SSTB.
Defining an SSTB
The new law defined an SSTB as any trade or business in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing, investment management, trading or dealing in securities, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners. The proposed regulations provided guidance on specific business activities that should not be included in these designated fields and could still qualify for the deduction:
De Minimis Exception Rule
Often a single business will conduct several different business activities. The proposed regulations set forth a rule that will allow a business to disregard the unfavorable SSTB status of an activity if the activity is considered de minimis. The de minimis exception rule states:
A trade or business with gross receipts of $25 million or less in the taxable year is not considered an SSTB if less than 10% of the gross receipts are attributable to the performance of SSTB activities.
If the business has gross receipts greater than $25 million, the threshold to qualify for the de minimis exception is lowered to 5%.
When the new law was enacted, many commentators played with the idea of separating a singular SSTB into component businesses that would otherwise qualify for the deduction. For example, could a physician that does not qualify for the deduction spin off the administrative staff into another commonly-owned entity that charges the physician for its services. The goal of this strategy is to shift income away from an SSTB that does not qualify for the deduction (i.e., the physician’s practice) to a business that does qualify for the deduction (i.e., the administrative function). The proposed regulations targeted this strategy with an anti-abuse provision known as the “80/50 rule.”
Under this provision, if an otherwise qualifying business has 50% or more common ownership with an SSTB, and the otherwise qualifying business provides 80% or more of its property or services to the SSTB, the business will be treated as part of the SSTB and not qualify for the deduction. If the business provides less than 80% of its property or services to an SSTB, but still meets the 50% or more common ownership requirement, the portion of the business's profits that are derived from providing property or services to the SSTB will be considered part of the SSTB and not qualify. Therefore, the only way to avoid being affected in some way by this anti-abuse rule is to have less than 50% common ownership between entities.
What's To Come
While the proposed regulations addressed many questions about the pass-through deduction, further guidance is still needed in a number of areas. Practitioners and commentators have 45 days from the release of the proposed regulations to submit questions, after which, we expect more guidance to follow. DGC will continue to monitor the release of all information related to this very substantial tax deduction.
If you have questions about the pass-through deduction or want to know if your business may qualify, contact a member of your DGC engagement team or Joel Rothenberg, CPA, JD, LLM at 781-937-5135 / firstname.lastname@example.org or Matt Iannetti, CPA at 781-937-5730 / email@example.com.