The proposed regulations on the new pass-through deduction created by Section 199A include narrow definitions of many of the disqualified business categories, creating potential planning opportunities that will be complicated by anti-abuse rules.
Section 199A was added by the Tax Cuts and Jobs Act (TCJA) to allow individuals (and certain trusts and estates) to deduct 20% of qualified business income (QBI) from partnerships, S corporations, sole proprietorships, trusts, and estates. The deduction essentially provides a rate cut on income from pass-through businesses, which do not benefit from the TCJA’s deep cut in C corporation rates, but it is subject to certain limitations. The most significant limitation is that the pass-through deduction is not allowed to be claimed against income from a specified service trade or business (SSTB) unless a taxpayer’s income falls under certain thresholds.
For private companies organized as pass-throughs, eligibility for the deduction means the difference between a top effective rate of 37% versus 29.6%. The IRS released proposed regulations (REG-107892-18
) under section 199A in August clarifying what activities fall within the SSTB definition and thus disqualify business owners from claiming the deduction. This Private Company Insights
discusses the proposed rules on SSTBs and their implications in more detail.
The definition of an SSTB in Section 199A incorporates a portion of the definition used in Section 1202 to define qualified small business stock. That Section 1202 language is identical, in part, to the definition of “qualified personal service corporation” under Section 448. As a result, the proposed regulations incorporate existing guidance under both Sections 1202 and 448 when relevant.
The statutory language in Section 199A provides that each of the following services is an SSTB: (1) health, (2) law, (3) accounting, (4) actuarial science, (5) performing arts, (6) consulting, (7) athletics, (8) financial services, (9) brokerage services, (10) 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, (11) investing and investment management, (12) trading, and (13) dealing in securities, partnership interests, or commodities. The proposed regulations provide additional guidance on each of these categories.
The proposed regulations provide 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. On the other hand, the proposed rules exclude services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient (e.g., the operation of health clubs or health spas, payment processing, and research, testing, and manufacture and/or sales of pharmaceuticals or medical devices).
The “law” category in the proposed rules includes the provision of services by lawyers, paralegals, legal arbitrators, mediators, and similar professionals in their capacity as such. Excluded from the category are services that do not require skills unique to the field of law (e.g. printers, delivery services, or stenography services).
The proposed regulations state define “accounting” by the ordinary meaning of the term. This includes services by accountants, enrolled agents, return preparers, financial auditors, and similar professionals in their capacity as such. The definition is not tied to certification, as the regulations clarify that even non-CPAs who provide tax return and bookkeeping services are in the field of accounting. The category does not, however, include payment processing and billing analysis.
Actuarial science includes the provision of services by actuaries and similar professionals in their capacity as such. Specifically excluded from this category are services by analysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial costs of risk or uncertainty of events.
The definition of performing arts includes the services of individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors, and similar professionals. The proposed regulations exclude from performing arts services that do not require skills unique to their “creation.” This includes maintenance and operation of equipment and facilities and broadcasting or otherwise disseminating video or audio of performing arts to the public. The following example from the proposed regulations is intended to clarify the category:
A, a singer, records a song. A is paid a mechanical royalty when the song is licensed or streamed. A is also paid a performance royalty when the recorded song is played publicly. A is engaged in the performance of services in an SSTB in the field of performing arts. The royalties that A receives for the song are not eligible for a deduction under Section 199A.
The proposed rules provide that consulting is the “provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.” The definition explicitly includes lobbying activities. Whether a taxpayer is in the field of consulting depends on their facts and circumstances, but the proposed regulations state that the manner in which a taxpayer is compensated is an important factor. The IRS recognizes that sellers of goods frequently provide small add-on consulting services related to those sales. As a result, it added an exception in the proposed regulations for consulting services that are embedded in, or ancillary to, the sale of goods if there are no separate payments for the consulting services. The following example illustrates the exception for ancillary consulting:
D is in the business of licensing software to customers. D discusses and evaluates the customer's software needs with the customer. The taxpayer advises the customer on the particular software products it licenses. D is paid a flat price for the software license. After the customer licenses the software, D helps to implement the software. D is engaged in the trade or business of licensing software and not engaged in an SSTB in the field of consulting.
Importantly, the field of consulting is defined in greater detail in regulations under Section 448. Thus, taxpayers might be able obtain greater clarity on the scope of the term “consulting” by referring to examples in Treas. Reg. Sec. 1.448-1T(e)(4)(iv)(B) that distinguish consulting from certain other activities, such as brokerage services and sales services.
The proposed regulations define athletics as the performance 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. The definition excludes the provision of services that do not require skills unique to athletic competition, such as the maintenance and operation of equipment or facilities and the services of broadcasters or others who disseminate video or audio of athletic events to the public.
The proposed regulations limits the definition of financial services to those typically performed by financial advisors and investment bankers. The category specifically includes (1) financial services to clients, such as managing wealth, advising clients with respect to finances, developing retirement plans, and developing wealth transition plans; (2) advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings; and (3) raising financial capital by underwriting, or acting as the client’s agent in the issuance of securities, and similar services. The definition encompasses services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals. This category does not include taking deposits or making loans (i.e., it excludes traditional banking from the definition of SSTB). The proposed regulations provide the following example to illustrate the definition of financial services:
E is in the business of providing services to assist clients with their finances. E will study a particular client's financial situation, including, the client's present income, savings and investments, and anticipated future economic and financial needs. Based on this study, E will then assist the client in making decisions and plans regarding the client’s financial activities. Such financial planning includes the design of a personal budget to assist the client in monitoring the client's financial situation, the adoption of investment strategies tailored to the client's needs, and other similar services. E is engaged in the performance of services in an SSTB in the field of financial services.
Brokerage services in the proposed regulations are defined fairly narrowly, limited to the category to services in which a person arranges transactions between a buyer and a seller with respect to securities (as defined by Section 475) for a commission or fee (e.g., stock brokers). Professionals who arrange transactions that do not relate to securities, such as real estate agents or brokers, and insurance agents or brokers, are not included. The following example illustrates brokerage services:
F is in the business of executing transactions for customers involving various types of securities or commodities generally traded through organized exchanges or other similar networks. Customers place orders with F to trade securities or commodities based on the taxpayer’s recommendations. F's compensation for its services typically is based on completion of the trade orders. F is engaged in an SSTB in the field of brokerage services.
Reputation or skill of employees or owners
The IRS recognized that a broad definition of the “reputation or skill” category could prevent trades or businesses that Congress intended to be eligible for the Section 199A deduction from claiming it. Therefore, the proposed regulations limit the scope of the term to fact-patterns in which a taxpayer 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). The following examples from the proposed regulations illustrate the intended narrow scope the category:
Bicycle Shop Example: G owns 100% of Corp, an S corporation, which operates a bicycle sales and repair business. Corp has 8 employees, including G. Half of Corp’s net income is generated from sales of new and used bicycles and related goods, such as helmets, and bicycle-related equipment. The other half of Corp's net income is generated from bicycle repair services performed by G and Corp’s other employees. Corp’s assets consist of inventory, fixtures, bicycle repair equipment, and a leasehold on its retail location. Several of the employees and G have worked in the bicycle business for many years, and have acquired substantial skill and reputation in the field. Customers often consult with the employees on the best bicycle for purchase. G is in the business of sales and repairs of bicycles and is not engaged in an SSTB.
Celebrity Chef Example: H is a well-known chef and the sole owner of multiple restaurants each of which is owned in a disregarded entity. Due to H’s skill and reputation as a chef, H receives an endorsement fee of $500,000 for the use of H’s name on a line of cooking utensils and cookware. H is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, H is also in the trade or business of receiving endorsement income. H’s trade or business consisting of the receipt of the endorsement fee for H’s skill and/or reputation is an SSTB.
Investing and investment management
The proposed regulations define an investing and investment management trade or business as one that earns fees for investment, asset management services, or investment management services including providing advice with respect to buying and selling investments. Specifically, the category include entities that receive commissions, flat fees, or investment management fees calculated as a percentage of assets under management. Real property management is expressly excluded from this category.
Under the proposed regulations, determining whether a person is trading in securities, commodities, or partnership interests is decided by a “facts-and-circumstances” test. Relevant factors 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. Manufacturers and farmers who engage in hedging transactions as part of their manufacturing or farming trades or businesses are explicitly excluded from the category.
Securities, partnership interests and commodities
The proposed regulations define dealing in securities, partnership interests and commodities to include regularly purchasing those items from and selling them to customers in the ordinary course of a trade or business. The category also includes the activity of regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities, partnership interests or commodities with customers in the ordinary course of a trade or business. Taxpayers that originate loans but engage in no more than negligible sales of those loans are explicitly excluded from this category.
Taxpayers should determine whether the services provided by their business fall within the SSTB definition. If so, they should evaluate whether the business performs any ancillary activities that result in income which may be deducted under Section 199A. However, while the proposed regulations explicitly allow for certain ancillary activities, anti-abuse rules for entities with common ownership may complicate such opportunities. Taxpayers should also remember that the proposed regulations may change when finalized.
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