After initially missing their intended deadline of providing Section 199A guidance by the end of June, the IRS finally delivered the promised guidance on August 8th, with the release of proposed regulations. These proposed regulations have clarified critical parts of Section 199A, including the aggregation of businesses, definition of a specified service trades or business, and anti-abuse rules related to the splitting up of existing businesses. Section 199A—commonly referred to as the “20% pass-through deduction,” provides a deduction of up to 20% of income from a domestic business operating as a sole proprietorship or through a partnership, S corporation, trust or estate. The deduction may be taken by individuals and by some estates and trusts.
Under the proposed regulations, certain businesses can aggregate net income, wages and property in calculating the 20% pass-through deduction. To qualify for aggregation:
This aggregation is optional; however, once an individual chooses to aggregate, that aggregation must remain in place for all subsequent years. So, considerations need to be made about how aggregation will affect not only 2018, but also all future years.
Service professionals (including us accountants!), were eagerly awaiting further guidance and clarification on the specified service trades or businesses (SSTB) provisions. Under the law, many owners of SSTBs do not qualify for the 20% pass-through deduction, unless their income is under certain limits. Being classified as an SSTB is a huge blow to those individuals expecting to benefit from the 199A deduction. Generally, SSTB’s include entities providing legal, accounting, investing, healthcare and other services. The proposed regulations clarified that we can mostly rely on the definitions under the qualified personal service corporation provisions for guidance on which service businesses will be considered SSTBs. Unfortunately, the personal service corporation rules don’t provide much, if any, leeway in the initial definition of SSTBs. SSTBs specifically include, among others, most all healthcare professionals, attorneys, accountants, stock brokers and many other consultants who provide professional advice. Specifically excluded from SSTB are bankers, real estate managers, real estate brokers and most salespersons who participate in the selling of goods.
The proposed regulations also address the tax strategy of splitting up businesses. This was a very popular potential approach being floated ahead of the issuance of these proposed regulations. The idea was that an SSTB could spin off their nonprofessional services functions into separate entities to be able to use the 20% pass-through deduction on that income, without the SSTB limitations. This approach was commonly referred to as “crack and pack.” Unfortunately, the proposed regulations significantly limit this strategy. In another blow to the professional service industry, if an SSTB owns 50 percent of an enterprise, that controlled enterprise is also going to be considered an SSTB, to the extent the services and/or rentals are provided directly to that original SSTB. For example, a dentist owns a practice and a building. He rents the building 50% to his dental practice and 50% to an outside party. The 50% rented to his practice will be considered SSTB.
Conversely, proposed rules also contain an exception for pass-through businesses earning a small amount of service income relative to their total income. Those businesses with gross receipts of $25M or less and less than 10% of gross receipts from personal services are not considered to be an SSTB. Also, those businesses with gross receipts of $25M or more and less than 5% of gross receipts from personal are not considered to be an SSTB.
As expected, not all of these proposed regulations are advantageous to taxpayers; however, the clarifications provided are crucial for both individuals and businesses in their 2018 tax planning and beyond. Consult with your HORNE LLP tax advisor for how these proposed regulations will specifically affect you. Also, be on the lookout for upcoming HORNE LLP blogs as the IRS continues to issue additional guidance pertaining to other provisions of the Tax Cuts and Jobs Acts.