Pass-Thru Section 199A Deduction Update
The Tax Cuts and Jobs Act made significant changes to flow-thru entity taxation with the enactment of new Code Section 199A: pass-thru deduction. In the July 2018 issue of iBi, I provided a general discussion on the new 199A deduction—please refer to this article for an overview. In August 2018, the IRS released proposed 199A regulations to provide additional guidance regarding the deduction. What follows is a discussion of some of the key topics discussed in the proposed regulations.
What clarification has been provided on the definition of an SSB?
As previously outlined by the IRS, a Specified Service Business (SSB) is any business that involves the performance of services in any of the following fields:
- Actuarial science;
- Performing arts;
- Financial services;
- Brokerage services;
- Investing and investment management;
- Dealing in securities, partnership interests or commodities; or
- Any business where the principal asset of such business is the reputation or skill of one or more of its employees or owners.
While a full discussion of all of these fields is beyond the scope of this article, a few industries received helpful definitions from the IRS in the proposed regulations.
Health: Services included involve the provision of medical services directly to a patient (for example, physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists). Excluded services include those that may relate to the health of service recipients but are not directly related to a medical services field, such as health clubs and health spas.
Consulting: Services included involve the provision of professional advice and counsel to clients to assist in achieving goals and solving problems. Excluded services include the performance of consulting services embedded in, or ancillary to, the sale of goods or performance of services on behalf of a business that is not otherwise an SSB (e.g. services provided by a building contractor) if there is no separate payment for the consulting services.
Financial/brokerage/investment services: These fields generally include financial advisors, bankers, wealth planners, retirement advisors and stock brokers; the services of investing, asset management and investment management; or any business providing services similar to those listed. The regulations specifically exclude real estate agents and brokers, insurance agents and brokers, and real property management.
Reputation or skill of one or more employees or owners: Included in the fields of specified service activities is any business where the principal asset of such business is the reputation or skill of one or more of its employees or owners. The regulations explain that this is not a catch-all designed to include a broad range of service businesses in the list of SSBs. Instead, the phrase is narrowly defined to include businesses that are receiving fees, compensation or other income for endorsements of products or services; licensing the use of an individual’s image, likeness, name, signature, voice, trademark, etc.; or making appearances at events or on radio, television or another media format.
Although the proposed Section 199A regulations have provided more clarity to what constitutes a specified service activity, there are still many businesses that will not find their specific service addressed in the regulations, and many whose services are still in somewhat of a gray area that may or may not be defined as an SSB. Making the appropriate determination on whether a business is an SSB is important given the impact it has on whether the business’s QBI is limited or disallowed for purposes of the Section 199A deduction.
What if a segment of business revenues are from SSB activities? What happens to the 20% deduction?
The proposed regulations attempt to clarify how to account for businesses that may generate a portion of their revenues from activities that would be considered SSBs.
De minimis rule: The de minimis rule provides some relief to businesses with little SSB income by allowing a business with gross receipts of $25 million or less to avoid SSB treatment if less than 10 percent of gross receipts of the business are attributable to the performance of specified service activities. The threshold percentage drops to five percent for businesses with receipts over $25 million.
Incidental trade or business: If a business that would not otherwise be treated as an SSB has the following characteristics, it is treated as incidental to, and therefore, part of the SSB:
- 50 percent or more common ownership with an SSB;
- Shared expenses with the SSB (including shared wage or overhead expenses); and
- The gross receipts of the business are five percent or less of the total combined gross receipts of the trade or business and the SSB.
An example given in the proposed regulations indicates that if a dermatology practice (an SSB) also sells skin products, and the skin care product business was more than five percent of the combined gross receipts, the skin care product business would not be an SSB. In that case, the skin care product business would be more than incidental and therefore eligible for the deduction. This rule is quite favorable as it seems to allow “cracking off” (breaking apart) a non-SSB from the main SSB as long as the non-SSB revenue is five percent or more.
Another example given in the regulations is a dental practice (an SSB) which rents the office from a commonly controlled real estate holding company. In that case, if more than 80 percent of the rent income of the holding company is from the dental practice, then the entire profit from the real estate would be an SSB and ineligible for the deduction.
If I own rental real estate, does that qualify as a trade or business under Section 199A?
A determination as to whether the 20-percent deduction will be allowed for owners of rental real estate could be determined based on the type of property owned or the terms outlined in the lease agreement.
Self-rental (owner-occupied real estate): The proposed regulations under 199A issued by the IRS in August provide a safe harbor for rental income received from commonly controlled entities. This was welcome news to taxpayers. If a taxpayer rents tangible or intangible property to a commonly controlled operating business, the self-rental activity is treated as a trade or business. A commonly controlled business is one in which the same person or group of persons own 50 percent or more of both the operating and real estate entity. Family attribution rules apply such that a taxpayer’s spouse, children, grandchildren and parents can be included in the 50-percent test.
There is a special rule for self-rental if the operating company is a “specified service trade or business.” This can include businesses such as doctors, lawyers, accountants and consulting firms, among others. In this case, the rental income from the real estate will be considered a specified service trade or business and ineligible for the 199A deduction. In cases where a portion of the real estate is leased to third parties (not all is self-rental), there is an additional set of rules:
- If 80 percent or more of the rental income is from a dental practice (SSB), then 100 percent of the rental income is not eligible for the 199A deduction.
- If less than 80 percent of the rental income is from a dental practice, then just that portion that is self-rented is ineligible.
Therefore, if a dentist rents 60 percent of his/her facility to a commonly controlled real estate holding company and the other 40 percent is rented to third parties, then 40 percent of the dentist’s rental income will be eligible for the deduction.
Triple net leases: It appears likely that the IRS will challenge a taxpayer who takes the 199A deduction on net income from triple net leases, where the tenant is responsible for items such as real estate taxes, insurance and maintenance, and where there is little to no involvement by the landlord.
I own multiple entities that operate similar businesses. Can these be combined for the 199A deduction?
The 199A regulations propose a new aggregation regime, distinctly separate from the aggregation rules under the passive activity loss rules. The IRS has designed a test composed of six requirements (not disclosed in this article) to determine whether a group of trades or businesses may be aggregated. All six of the requirements must be met.
Aggregation is determined at the individual level. Any number of businesses that meet these tests may be aggregated, and individuals may have multiple aggregations. This is not an all-or-nothing rule, and taxpayers are not required to aggregate any or all eligible businesses. Instead, taxpayers may “slice and dice” different entities however they choose, as long as all entities in an aggregation meet the tests. Different owners may choose to aggregate or not aggregate the same business in different ways.
Once a taxpayer aggregates businesses for Section 199A, the election is generally irrevocable. An aggregated trade or business must be aggregated consistently in future tax years, and taxpayers will be required to report which entities are being grouped together each year. Newly created or acquired businesses can be added to existing aggregations, but businesses cannot be removed.
Because of the permanency of an aggregation once elected, it is crucial that taxpayers consider the tax effect of aggregation—not just in the current year, but in the years to come. The only way the IRS will allow aggregated businesses to be disaggregated is when the facts and circumstances change such that any of the aggregated trades or businesses no longer meet the above requirements to be aggregated.
There are several more detailed items discussed in the proposed regulations that are unable to be discussed in an article of this length. We must remember the proposed regulations released by the IRS are just that: proposed. We hope to see more guidance after the IRS’ public hearing, which was held on October 16, 2018, to discuss Code Section 199A and the proposed regulations issued in August 2018. However, it is unknown when final regulations will be issued. The recommended course of action for business owners is to keep an open line of communication with their professional advisors to stay informed as new guidance is issued. iBi
Nathan Isenberg, CPA, ABV is a shareholder at Heinold Banwart, Ltd. He can be reached at (309) 694-4251 or firstname.lastname@example.org.