199A Proposed Regulations: Clarifying Scope Of Specified Services Trade or Business Under Section 199A
The Internal Revenue Service (“IRS”) recently issued proposed regulations on the new deduction for qualified business income (“QBI”) under new Code section 199A. Among other things, the proposed regulations address the hotly debated interpretive issue regarding the term “specified service trade or business” (“SSTB”). SSTB is a key term under section 199A because, if an SSTB exists, the section 199A deduction may be phased-out or totally disallowed depending on the taxpayer’s taxable income.
As discussed below, the statutory definition of SSTB is arguably susceptible to a broad or narrow interpretation. Ultimately, the proposed regulations eschew a broad interpretation of SSTB in favor of a narrower, generally taxpayer friendly, interpretation of SSTB. In addition, the proposed regulations provide generally favorable rules for determining when the activities of an otherwise qualified trade or business will be “tainted” for purposes of section 199A by activities within the definition of SSTB. On the downside, the proposed regulations include an anti-abuse rule that effectively broadens the definition of SSTB to include certain related businesses providing services to an SSTB that would not ordinarily be considered an SSTB. This rule is aimed the so-called “crack and pack” technique, which was designed to avoid the limitations on SSTBs by separating administrative, managerial, and other activities that would ordinarily fall outside the scope of the definition of SSTB from the activities constituting an SSTB. Although the anti-abuse rule will rightfully curb abusive planning, it could also discourage professionals, particularly physicians and dentists, from restructuring their practices for legitimate non-tax business reasons.
This article examines various the definition of SSTB under the proposed regulations. To provide context for the discussion, this article begins by reviewing the purposes section 199A and an overview of the general rules for computing the section 199A deduction.
Background on Section 199A
Section 199A was enacted as part of the Tax Cuts and Jobs Act (“TCJA”), P.L. 115-97 (Dec. 22, 2018) in order to provide parity between the rates applicable to income earned by C-corporations, which the TCJA lowered from 35% to 21%, and the rates applicable to income received from businesses operated as sole proprietorships or through partnerships or S-corporations (sometimes referred to collectively as “passthrough entities”). When fully realized, the section 199A deduction reduces the highest statutory applicable to ordinary income from 37% to an effective rate of 29.6% (.37 x (1-.20)). As with anything Congress produces, however, the devil is in the details. Although the objectives of section 199A are relatively simple, the statute itself is quite complex. The deduction is subject to multiple limitations, and determining the amount of the deduction requires understanding a number of statutory terms and working through numerous calculations.
Computing the Deduction
Section 199A allows taxpayers other than C-corporations to claim a deduction of up to 20 % of QBI received from a domestic business operated as a sole proprietorship or through a passthrough entity (“QBI component”). Section 199A also allows such taxpayers to a deduction of up to 20% of their combined qualified real estate investment trust (“REIT”) dividends and qualified publicly traded partnership (“PTP”) income, including qualified REIT dividends and qualified PTP income earned through passthrough entities (“REIT/PTP component”).
For taxpayers whose taxable income exceeds a statutorily-defined amount (“threshold amount”), section 199A may limit the QBI component of the section 199A deduction based on (i) the amount of W-2 wages paid with respect to the trade or business (“W-2 wages”), and/or (ii) the unadjusted basis immediately after acquisition (“UBIA”) of qualified property held for use in the trade or business (“UBIA of qualified property”). For 2018, the threshold amount is $157,500 for individual taxpayers and $315,000 for married taxpayers filing jointly. These statutory limitations are subject to phase-in rules based upon taxable income above the threshold amount. Importantly, these limitations are not applicable to the REIT/PTP component of the section 199A deduction.
The section 199A deduction is the lesser of:
(1) the sum of
(a) the lesser of (i) 50% of the W-2 wages of the trade or business for the taxable year, or (ii) the sum of 25% of W-2 wages and 2.5% of UBIA of qualified property,
(b) 20% of the combined REIT dividends and PTP income, or
(2) an amount equal to 20 percent of the excess (if any) of taxable income of the taxpayer for the taxable year over the net capital gain of the taxpayer for the taxable year.
Section 199A(c)(1) generally defines QBI as the net amount of “qualified items of income, gain, deduction, and loss” relating to any qualified trade or business (“QTB”) of the taxpayer. For this purpose, qualified items of income, gain, deduction, and loss are items of income, gain, deduction, and loss to the extent these items are effectively connected with the conduct of a trade or business within the U.S. under section 864(c) and included or allowed in determining taxable income for the year. If the net amount of qualified income, gain, deduction, and loss relating to a QTB of the taxpayer for any tax year is less than zero, the amount is treated as a loss from a QTB in the succeeding tax year. QBI does not include (i) certain investment items, (ii) reasonable compensation paid to the taxpayer by any qualified trade or business for services rendered with respect to the trade or business (iii) any guaranteed payment to a partner for services to the business under section 707(c); or a payment under section 707(a) to a partner for services rendered with respect to the trade or business.
Section 199A(d)(1) provides that a “qualified trade or business” means any trade or business other than (j) an SSTB, or (ii) the trade or business of performing services as an employee. Therefore, as a general rule, if a trade or business is an SSTB, none of its items are to be taken into account for purposes of determining a taxpayer’s QBI. Section 199A(d)(3) provides an exception for individuals with taxable income below the threshold amount. They are not subject to a restriction with respect to SSTBs. If a taxpayer’s taxable income is above the threshold amount but not in excess of the phase-in range, then the individual must calculate an applicable percentage that limits QBI, W-2 wages, and UBIA of qualified property from an SSTB that are used to calculate the taxpayer’s 199A deduction. The phase-in range is threshold amount plus $50,000, in the case of individuals, or $100,000, in the case of taxpayers who are married filing jointly. Thus, for 2018, the upper limit of the phase-in range is $207,500 for individuals and $415,000 for taxpayers for who are married filing jointly. The application of this phase-in is determined at the individual level, which may not be where the trade or business is operated. Therefore, if a partnership or an S corporation operates an SSTB, the application of the threshold does not depend on the partnership or S corporation’s taxable income but rather, the taxable income of the individual partner or shareholder claiming the section 199A deduction.
Statutory Definition of SSBTs
Section 199A(d)(1) defines SSTB as “any trade or business (A) which is described in section 1202(e)(3)(A) (applied without regard to the words “engineering, architecture,”) or which would be so described if the term “employees or owners” were substituted for “employees” therein, or (B) which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).
Section 1202 provides an exclusion from gross income for some or all of the gain on the sale of certain qualified small business stock. Section 1202 generally requires that, for stock to be qualified small business stock, the corporation must be engaged in a qualified trade or business. Section 1202(e)(3) provides that, for purposes of section 1201(e), the term “qualified trade or business” means any trade or business other than the following:
(A) any trade or business involving the performance of services in the fields of health, law, engineering, architecture, 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 1 or more of its employees,
(B) any banking, insurance, financing, leasing, investing, or similar business,
(C) any farming business (including the business of raising or harvesting trees),
(D) any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and
(E) any business of operating a hotel, motel, restaurant, or similar business.
Thus, after application of the modifications described in section 199A(d)(2)(A), the definition of an SSTB for purposes of section 199A is (i) 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 (ii) any trade or business that involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).
SSBTs Under Proposed Regulations
As noted above, the definition of SSBT under section 199A is susceptible to a broad or narrow interpretation. Although the statutory definition of SSTB includes specifically enumerated categories of SSTBs, the inclusion of “any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its [owners]” provides a justifiable basis for expanding the definition to almost any service business. The proposed regulations indicate that IRS received numerous comments requesting guidance issue. Ultimately, the proposed regulations opt for a narrow definition of SSTB that gives maximum effect to section 199A’s purpose, as opposed to its literal language.
The rules related to SSTBs are located in Prop. Reg. § 1.199A-5. In defining SSTB, Prop Reg § 1.199A-5(b) looks to the existing interpretations and guidance under both section 1202 and section 448 when relevant. The preamble to the proposed regulations notes, however, that the guidance in Prop Reg § 1.199A-5(b) applies only to Code Sec. 199A. Further, given the differing scope, objectives, and, in some respects, language of sections 199A, 448, and 1202, the guidance under the latter two sections is not an appropriate substitute for clear and distinct guidance governing on what constitutes an SSTB under section 199A.
Prop Reg § 1.199A-5(b) does not adopt a bright-line rule for purposes of determining whether a trade or business is within a certain field for purposes of section 199A. While it is beyond the scope of this article to review every the definition of every SSTB, below are the definitions applicable to many common SSTBs:
Health. Prop Reg § 1.199A-5(b)(2)(ii) provides that the 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. It 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. Prop Reg § 1.199A-5(b)(2)(iii) provides that the 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. Prop Reg § 1.199A-5(b)(2)(iv) provides that the 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. It is not limited to services requiring state licensure as a certified public accountant (CPA). Prop Reg § 1.199A-5(b)(2)(iv) is intended to capture the “common understanding” of accounting, which includes tax return and bookkeeping services, even though they may not require the same education, training, or mastery of accounting principles as a CPA. It does not include payment processing and billing analysis.
Financial services. Prop Reg § 1.199A-5(b)(2)(ix) limits the definition of financial services to services typically performed by financial advisors and investment bankers and provides that the field of financial services includes the provision of financial services to clients 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, but does not include taking deposits or making loans.
Brokerage services. Prop Reg § 1.199A-5(b)(2)(x) provides that the field of brokerage services includes services in which a person arranges transactions between a buyer and a seller with respect to securities (as defined in Code Sec. 475(c)(2)) 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 is Reputation or Skill. 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. Prop Reg § 1.199A-5(b)(2)(xiv) limits the meaning of the “reputation or skill” clause to fact patterns in which the taxpayer is engaged in the trade or business of: (1) receiving income for endorsing products or 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; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players).
In sum, the regulations take a narrow view of the definition of the specifically enumerated services. This is generally taxpayer friendly. Although the rules do not provide the crystal clear bright-lines that we had hoped for, they provide workable principals for discerning, in most cases, whether a service is included within the scope of the definition. At the same time, the regulations are not perfect some of the definitions are contradictory. For instance, healthcare includes pharmacists, but in the enumeration of heath care professionals providing medical services directly to patients, but it also indicates that performance of services in the field of health generally does not include sales of pharmaceuticals. In other cases, the issue is concerns the scope of the activities included. For instance, an argument can be made that the definition of performing services in the field of law includes services provided by a trustee or executor because the services generally require application of knowledge specific to the field of law. All in all, though, the definitions are a step in the right direction.
De Minimis Rule and Anti-Abuse Rule
The proposed regulations provide a rule under which a trade or business will not be considered to be an SSTB merely because it provides a small amount of services in a specified service activity. Prop Reg § 1.199A-5(c)(1) provides that a trade or business (determined before the application of the aggregation rules in Prop Reg § 1.199A-4, a discussion of which are beyond the scope of this article) is not an SSTB if the trade or business has gross receipts of $25 million or less in a tax year and less than 10% of the gross receipts of the trade or business is attributable to the performance of services in an SSTB. For trades or business with gross receipts greater than $25 million (in a tax year), a trade or business is not an SSTB if less than 5% of the gross receipts of the trade or business are attributable to the performance of services in an SSTB.
In contrast to the de minimis rule, the anti-abuse rule addresses the circumstances under which a trade or business that would otherwise not be considered an SSTB to be treated as such. The anti-abuse rule is aimed at the so-called “crack and pack” technique, under which a business that would otherwise be an SSTB separates all its administrative functions into a separate entity to qualify that separate entity for the section 199A deduction. To curb this strategy, Prop Reg § 1.199A-5(c)(2) provides that an SSTB includes any trade or business with 50% or more common ownership (directly or indirectly) that provides 80% or more of its property or services to an SSTB. In addition, if a trade or business has 50% or more common ownership with an SSTB, to the extent that the trade or business provides property or services to the commonly-owned SSTB, the portion of the property or services provided to the SSTB will be treated as an SSTB. Further, Prop Reg § 1.199A-5 provides 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 shared expenses, including wages or overhead expenses with the SSTB, it is treated as incidental to an SSTB and, so, as an SSTB, if the trade or business represents no more than 5% of gross receipts of the combined business. As an example of the latter rule, the proposed regulations include the example of a dermatologist who sells skincare products through her practice.
The de minimis rule is certainly taxpayer friendly, and it provides a warranted safe harbor for many businesses that ancillary services in connection with the activities of a larger business. The anti-abuse rule is justifiable to the extent that it is aimed at truly abusive practices that have no economic substance or business purpose apart from saving taxes. The problem with the rule, however is that it uses ownership as a proxy for abuse; it assumes that any trade or business that has 50% or more common ownership with an SSTB and that provides property or services to an SSTB is, to a greater or lesser degree, engaged in an abusive practice.
In reality, there are many legitimate reasons why professionals, particularly doctors and dentists, might restructure their practices in a manner that would be covered by the anti-abuse rule. One reason is estate planning. For many doctors and dentists, their practice is their primary source of income, and in many circumstances, it is the primary source of income for their spouse. If they die today, their practice dies with them because there is essentially noting of value to pass on, apart from the liquidation value of the equipment and realty, if any. At the same time, unless the spouse is a licensed professional, state laws restrict ownership. One way to preserve the value of a practice and avoid running afoul of state laws regulating professional practice is to create a practice management company and invert the revenue of the practice so that the majority of the value is shifted form the professional practice, which cannot be passed on or owned by a nonlicensed professional, to the practice management company, which can be passed on and owned by a licensed professional. If the professional dies today, the spouse would own the practice management company. If the structure is properly implemented there is no reason the surviving spouse could not continue to own the practice management company and receive a sizeable income after the professional spouse’s death. All the surviving spouse would have to do is hire a licensed professional to provide professional services to the practice. This raises a second non-tax reason for a practice management company is business succession. It provides a mechanism for transferring (by sale or otherwise) the practice or brining in a new partner without transferring all of the cash flow from the practice. A third and related reason is to provide expanded employee compensation opportunities. The bottom line is that not all structures that resemble the crack and pack are abusive. Many of them reflect commonly used planning techniques for professionals. The IRS should not discourage legitimate planning motivated by non-tax business reasons.
The proposed regulations resolve a number of interpretive issues related to the definition of SSTBs; however, they leave some issues unaddressed, and the rules contained in the proposed regulations raise additional questions regarding their interpretation. These proposed regulations will affect a multitude of taxpayers, and it will take time for all the implications of them to surface. Accordingly, taxpayers should expect additional developments and changes to be made as the proposed regulations proceed through the notice and comment period.