New Treasury Department rules clarify ‘specified service trade or business’

In some ways the sweeping tax reform law that was passed at the end of 2017 left as many questions unanswered as it answered. Just last week, the Treasury Department issued rules that seek to clarify some issues related to qualified business income.

The Tax Cuts and Jobs Act created a new provision, Section 199A, which permits business owners of sole proprietorships, S corporations or partnerships to deduct 20 percent of qualified business income.

Certain businesses, however, were disqualified from this deduction. Specifically, owners of specified service businesses were prohibited from claiming a Section 199A deduction related to the business once their taxable income reached $415,000 (married filing jointly).

A “specified service  trade or business” (SSTB) is one that is primarily involved in performing services in the fields of health, law, accounting, consulting, financial services, and others where the principal asset of such a trade or business is the reputation or skill of at least one of its employees.

Consequently, many business owners of specified service businesses looked for ways to still be able to take advantage of the newly created 20 percent QBI deduction. One of the strategies considered by some in these industries was to spin off portions of their businesses that would not fall under the definition of being strictly a provider of services. For example, a law firm, a specified service business not eligible for 20 percent deduction, would spin off its bill collection department into a separate entity.

Prior to the new regulations, this newly formed entity would not have been considered a “specified service business” and would have been eligible for the 20 percent QBI deduction.

Under the new regulations, this strategy will not work. The IRS knows that some taxpayers have been contemplating these types of strategies so under the new proposed regulations they have put a halt to these.

Per the IRS, these strategies are inconsistent with the purpose of Section 199A. Proposed regulation 1.99A-5(c)(2) indicates that an SSTB includes any trade or business with 50 percent or common ownership (directly or indirectly) that provides 80 percent or more of its property or services to an SSTB.

Furthermore, if a business has 50 percent or more common ownership with an SSTB and the business provides property or services to the commonly owned SSTB, the portion of the property/services provided will be treated as income from the SSTB.

Proposed regulation 1.199A-5 additionally says that if a trade or business has 50 percent or more common ownership with an SSTB and they shared expenses (e.g. wages, overhead expenses) with the SSTB, the trade or business will be treated as incidental to the SSTB and therefore will be considered as SSTB if the trade or business represents no more than 5 percent of the gross receipts of the combined business.  We therefore, do not advise employing this strategy.

Below are some examples:
Example 1: Taxpayer B, a medical practice, wants to create a separate business for its billing department, but that newly formed business shares the same owners as the medical practice and the new entity provides services or property to the medical practice. The IRS will recognize both entities as a specified service trade or business (SSTB).

Example 2: Taxpayer A, a dentist, owns a dental practice and also owns an office building. Taxpayer A rents half the building to the dental practice and half the building to unrelated persons. Under proposed §1.199A-5(c)(2), the renting of half of the building to the dental practice will be treated as an SSTB.

Clarity on the TCJA continues to evolve, and we will keep you apprised as new rules and regulations are released. In the meantime, please contact us if you have any questions.

Sources: Thomson Reuters; Forbes