From the Desk of Ryan J. Hood, CPA
Reach Ryan at 423-486-9297 or at firstname.lastname@example.org
Eight months ago, the government passed a set of new tax laws that has since left some people scratching their heads and others crossing their fingers. Ambiguously referred as “tax reform,” businesses and individuals are turning to their accountants for answers and hoping they benefit from the tax overhaul. At J.D. Frost and Company, we’ve been earnestly trying to provide this information through regular seminars that provide clarity to specific industries on the Tax Cuts and Jobs Act of 2017. However, there remains one group that has been anxiously awaiting clarification from the IRS: Pass-through entities (namely sole proprietorships), S corporations, limited liability companies (LLCs), and partnerships.
These groups make up the majority of businesses in the country, and some stand to win big by taking advantage of a 20% small-business tax break tucked into last year’s overhaul. On August 8th, the Treasury Department gave the public (some) of the long-anticipated answers by more specifically defining who can benefit from this deduction. Here are the main takeaways I believe you need to know:
A service business is one where the “principal asset” is the reputation or skill of one or more of its employees or owners.
The new restrictions defined by the IRS limit this definition. The restriction would apply to those that receive income for appearances or their endorsements of products and services. They even specifically name “reality performers” as those in this losing category. Sorry, Snooki and the rest of the cast of the Jersey Shore, this one’s not for you.
A business with gross receipts of less than $25M can claim the 20% deduction if less than 10% of those receipts come from a “specified service business” (law, accounting, etc.)
First, you might be wondering what a “specified service business” is in the first place. The IRS defines this 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… or any business which involves the performance of services that consist of investing and investing management, trading, or dealing in securities, partnership interests, or commodities.” That definition sounds great, but since there are no court decisions or administrative rulings to make sense of it, the definition still lacks clarity.
A business cannot re-label employees to independent contractors so that the employee can claim the 20% deduction.
This is one of a few “anti-abuse” provisions included in the proposed rules. The IRS has designed such stipulations in anticipation of maneuvers that may have helped business owners or employees take unwarranted advantage of the deduction. For example, it could have been easy for employees to rush to their employer and ask to be reclassified as an independent contractor and perform the same tasks solely to take advantage of this deduction. While clever, that could have led to significant abuse. The key piece of clarity that the IRS provided was that if the employee is still providing substantially the same services, the Section 199A deduction is unavailable. However, if the employer changes (Example: If you left McDonalds and started working for Burger King), then the deduction would be available!
The IRS has disallowed the “crack and pack” strategy where service businesses split operations to get the 20% deduction on certain operating segments.
Another anti-abuse provision that the IRS is said to really be cracking down on, this strategy might have been implemented by those seeking to have as much income as possible taxed at the lower rate. When the new set of tax laws was passed last year, this was one of the first “loopholes” identified by many businesses to get around income limits.
Here’s a great example Tony Nitti provided to Forbes:
Ex. A and B own law firm AB. A and B purchase a building in AB LLC, and rent the entire building to the law firm. The building is the only asset the LLC owns. Even though the rental of real property is generally not treated as an SSTB, because 1) more than 80% of the building is being rented to an SSTB (the law firm), and 2) the same owners own 50% or more of both the LLC and the law firm, the rental income is treated as being earned in an SSTB, and is not eligible for the 20% deduction.
Business owners will be able to aggregate multiple entities for tax purposes, which could allow for a bigger tax break.
Before owners of multiple businesses get too excited, there are still multiple rules that need to be followed. Namely, you must own at least 50% of the aggregated business, the businesses must share the same tax year, none of the businesses can be among the previously mentioned Specific Service Trade or Businesses, and the services must have some sense of coordination, such as being offered together or sharing facilities.
I hope this brief rundown has been helpful for you. At J.D. Frost and Company, our first two core values are “Customer Service and Technical Competency.” I take these two pieces to heart and see a significant connection between them. If there is anything I can provide additional clarity to in regards to your tax plan, the Tax Cuts and Jobs Act of 2017, or your business, please don’t hesitate to reach out. It’s my pleasure to help!