The 20% Pass-Through Deduction Gets Clarified: Prohibited Specified Service Businesses Defined.

When the Tax Cuts and Job’s Act was signed into law on December 22, 2017 – a brand new provision was added: Section 199A. It permitted owners of sole proprietorships, S corporations, or partnerships to deduct up to 20% of the income earned by the business. While the purpose of Section 199A was clear, its statutory construction and legislative text was anything but. The provision was rife with limitations, exceptions to limitations, phase-ins and phase-outs, and critical but poorly-defined terms. As a result, Section 199A created significant controversy after its enactment.

The widely anticipated rule had huge implications for law firms, real estate, family farms and other companies that are structured so their profits are taxed as individual income for their owners.

Background.

When first released Section 199A’s definition of the “specified service businesses” for which a taxpayer is generally ineligible to claim the deduction included:

…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.

This suggests that even a small amount of services provided in a disqualified field could taint an entire business. It also failed to clarify what type of “consulting” was intended to be excluded.

Current Ruling.

The current ruling does not adopt a bright-line licensing rule for purposes of determining whether a trade or business is within a certain field for purposes of Code Sec. 199A. It just provides guidance for services in the following fields:

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). The aim of Prop Reg § 1.199A-5(b)(2)(iv) is 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.

• Actuarial science. Prop Reg § 1.199A-5(b)(2)(v) provides that the performance of services in the field of actuarial science” means the provision of services by actuaries and similar professionals in their capacity as such. It does not include the provision of services by analysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events.

• Performing arts. Prop Reg § 1.199A-5(b)(2)(vi) provides that the performance of services in the field of the performing arts means the performance of services by individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors, and similar professionals performing services in their capacity as such. It does not include the provision of services that do not require skills unique to the creation of performing arts, such as the maintenance and operation of equipment or facilities for use in the performing arts. It also does not include the provision of services by persons who broadcast or otherwise disseminate video or audio of performing arts to the public.

• Consulting. Prop Reg § 1.199A-5(b)(2)(vii) provides that the performance of services in the field of consulting means the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems. It includes providing advice and counsel regarding advocacy with the intention of influencing decisions made by a government or governmental agency and all attempts to influence legislators and other government officials on behalf of a client by lobbyists and other similar professionals performing services in their capacity as such. It does not include the performance of services other than advice and counsel. This determination is made based on all the facts and circumstances of a person’s business. Prop Reg § 1.199A5(b)(2)(vii) provides that the field of consulting does not include consulting that is embedded in, or ancillary to, the sale of goods if there is no separate payment for the consulting services. For example, a company that sells computers may provide customers with consulting services relating to the setup, operation, and repair of the computers, or a contractor who remodels homes may provide consulting prior to remodeling a kitchen.

• Athletics. The field of athletics is not listed in Code Sec. 448(d)(2) , and there is little guidance on its meaning as used in Code Sec. 1202(e)(3)(A) . However, IRS notes that the field of athletics is similar to the field of performing arts. Prop Reg § 1.199A-5(b)(2)(viii) provides that the performance of services in the field of athletics means the performances of services by individuals who participate in athletic competition such as athletes, coaches, and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing. It does not include the provision of services that do not require skills unique to athletic competition, such as the maintenance and operation of equipment or facilities for use in athletic events. It also does not include the provision of services by persons who broadcast or otherwise disseminate video or audio of athletic events to the public.

• 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.

• 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 individual or RPE is engaged in the trade or business of: (1) receiving income for endorsing products or services, including an individual’s distributive share of income or distributions from an RPE for which the individual provides endorsement 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, including an individual’s distributive share of income or distributions from an RPE to which an individual contributes the rights to use the individual’s image; 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).Prop Reg § 1.199A-5(b)(4) contains two examples illustrating the application of this definition.

It also then adds to the list of specified service businesses any business which involves the performance of services that consist of investing and investing management, trading, or dealing in securities, partnership interests, or commodities. The proposed regs include the following trades or business under this category:

• Investing and investment management. Prop Reg § 1.199A-5(b)(2)(xi) provides that any trade or business that involves the performance of services that consist of investing and investment management means a trade or business that earns fees for investment, asset management services, or investment management services including providing advice with respect to buying and selling investments. It include a trade or business that receives either a commission, a flat fee, or an investment management fee calculated as a percentage of assets under management. It does not include directly managing real property.

• Trading. Prop Reg § 1.199A-5(b)(2)(xii) provides that any trade or business involving the performance of services that consist of trading means a trade or business of trading insecurities, commodities, or partnership interests. Whether a person is a trader is determined taking into account the relevant facts and circumstances. Factors that have been considered relevant to determining whether a person is a trader include the source and type of profit generally sought from engaging in the activity regardless of whether the activity is being provided on behalf of customers or for a taxpayer’s own account.

• Dealing in securities, partnership interests, and commodities. For purposes of Prop Reg § 1.199A-5(b)(2)(xiii), the performance of services that consist of dealing in securities means regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. A taxpayer that regularly originates loans in the ordinary course of a trade or business of making loans but engages in no more than negligible sales of the loans is not dealing in securities. (See Reg § 1.475(c)-1(c)(2) and Reg § 1.475(c)-1(c)(4) for the definition of negligible sales.) For purposes of Prop Reg § 1.199A-5(b)(2)(xiii), the performance of services that consist of dealing in partnership interests means regularly purchasing partnership interests from and selling partnership interests to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in partnership interests with customers in the ordinary course of a trade or business. For purposes of Prop Reg § 1.199A-5(b)(2)(xiii), the performance of services that consist of dealing in commodities means regularly purchasing commodities from and selling commodities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in commodities with customers in the ordinary course of a trade or business.

The IRS is aware that some taxpayers have contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the Code Sec. 199A deduction. 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 (meaning the income will be treated as income from an SSTB).

As such, the evolution of Section 199A is far from over. There will be comments aplenty from taxpayers and their advisors, and final regulations may look drastically different. For now, however, the release of the proposed regulations represent a huge step forward in being able to make some sense of Section 199A and its practical application. If you would like to discuss how these changes affect your particular situation, and any planning moves you should consider in light of them, please contact your KatzAbosch representative; or contact us by clicking here.

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