By FJV Tax Staff
There is a great new tax benefit available courtesy of tax reform that our pass-through clients don’t seem to know much about. That great new benefit is IRC Code §199A (“Section 199A”) which provides owners of pass-through businesses, most notably partnerships and S corporations, with an important new tax benefit from a qualified trade or business.
This deduction is for up to 20% of the qualified business income of a U.S. business that is either a sole proprietorship, partnership, S corporation, trust, or estate. For taxpayers with taxable income that exceeds $315,000 for a married couple filing jointly or $157,500 for all other taxpayers, the deduction is subject to limitations such as the type of business, the taxpayer’s taxable income, the total amount of W-2 wages paid by the business or the unadjusted basis of qualified property held by the business.
The motivation for the new deduction is rather simple. It allows pass-through businesses maintain tax benefits commensurate with the significant corporate tax cut also provided by tax reform. Income earned by a C corporation has always been subject to double taxation. The first level of tax is at the entity level and the second is at the shareholder level when the corporation distributes its income as a dividend. Tax reform reduced the entity-level tax imposed on C corporations from a top rate of 35% to a flat rate of 21%. Tax reform did retain the top rate on dividend income of 20% but the significant decrease in the corporate-level tax lowered the top combined federal rate on income earned by a C corporation and distributed to shareholders as a dividend from 48% to 36.8%.
In contrast to a C corporation, income earned by sole proprietorships, S corporations, or partnerships is subject to only a single level of tax at the shareholder level. Owners of these businesses report their share of the business’s income directly on their tax return – Form 1040 – and pay the corresponding tax at ordinary individual rates. Tax reform reduced the top rate on ordinary income of individuals from 39.6% to 37% and Section 199A further reduced the effective top rate on qualified business income earned by owners of sole proprietorships, S corporations, and partnerships to 29.6%.
What is most important here is that owners of sole proprietorships, S corporations, and partnerships retained a significant federal tax rate advantage over owners of a C corporation that they enjoyed prior to the enactment of the new law.
While the purpose of Sec. 199A is clear, its statutory construction and legislative text is anything but clear. As a result, Sec. 199A has created ample controversy since its enactment with many tax advisers anticipating that until further guidance is issued the uncertainty surrounding the provision will lead to countless disputes between taxpayers and the IRS. Adding concern is Congress lowered the threshold where any taxpayer claiming the deduction can be subject to a substantial-understatement penalty. What that means is that they’ve introduced an ambiguous new rule and lowered the margin of error for penalties.
One of the areas giving our clients problems is figuring out exactly what types of business activities are excluded from the 20% deduction. Service businesses are the real problem. Section 199A defined specified service business – for which no deduction is allowed once a taxpayer’s taxable income exceed $415,000 for taxpayers filing jointly or $207,500 for all other taxpayers – as “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”. That definition cast a pretty wide shadow.
Proposed regulations have come to the rescue at least a little bit. The proposed regulations clarified several questions related to specified service businesses. First, there is a de minimis exception that allows a business that sells products and provides a service to escape classification as a specified service business if gross receipts are less than $25 million for the year and less than 10% of total gross receipts are from the performance of services in one of the specified services business listed above. Next, the proposed regulations provide guidance on the meaning of various trades or businesses described in Section 199A as specified service business. These rules are meant to help define who qualifies for the benefits in businesses where the lines are blurry between qualifying and non-qualifying activities.
Some of the most complicated areas are services related to health, consulting, and real estate businesses. Here are examples of the application of Section 199A from each of these businesses:
Health and Health Care
A qualifying health care business 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 excludes the provision of service not directly related to a medical field even though services logically may relate to the health of the service recipient. An example of these non-qualifying activities would be the operation of a health club or health spa that provides exercise or conditioning to customers or payment processing services for health care providers.
Section 199A excludes consulting services defined as the provision of professional advice and guidance to clients to assist in achieving goals and solving problems. However, these services do not disqualify larger businesses that only involve small levels of consulting. Disqualified consulting does not include salespeople who provide training or education courses as an auxiliary service to the sale of product. For example, a construction contractor who provides consultation as part of a home remodeling project is not considered a consultant.
Brokerage services are specifically excluded from Section 199A benefits. This includes services provided by stock brokers, investment managers, and other similar professionals but does not include services provided by real estate agents and brokers or insurance agents or brokers. The proposed regulations clarify that the performance of investing and managing real property services are not included in this definition which allows real estate professionals in the trade or business or managing real property to qualify for the deduction.
As one can see, Section 199A provides a tremendous benefit to owners of sole proprietorships, S corporations, and partnerships. As this post makes clear, granting a 20% deduction to pass-through business owners is far easier in concept than it is in execution. Many questions still remain.
Until time evolves and provides everyone with the guidance needed, taxpayers must still move forward and claim the benefits they’re entitled to. To understand and claim the benefits that you’re entitled to please contact us at fjvtax.com and let us guide you to your benefits.