Treasury issued the final rules on 199A earlier this month. You can read the rules and accompanying guidance here:
You can also read a terrific “how does it all work” review published in Forbes the other day. As the writer notes:
I believe in giving credit where credit is due, and I’ll be damned if the IRS doesn’t deserve some serious credit. It was less than 13 months ago that Congress dumped 500 pages of sloppy statutory language on the Service in the form of the Tax Cuts and Jobs Act, and somehow, in that span the IRS has managed to provide final regulations on the most controversial, convoluted and complicated provision of the new law: Section 199A, better known as the “20% pass-through deduction.” It required a Herculean effort, particularly when you consider that, you know…most of the government has been on unpaid leave since December 22nd.
We agree. Treasury did a great job of getting a workable set of rules based on a very complicated law out the door quickly. They also embraced some very taxpayer-friendly ideas, like the ability to aggregate multiple businesses together when calculating the deduction in certain circumstances, as well as the option to calculate the deduction at the entity, rather than the taxpayer, level. These are welcome and will help make the 199A deduction workable for most businesses.
That said, there were many details that we hoped Treasury would improve in the final rules. The aggregation rules are still too restrictive, and the imposition of a two-tiered de minimis threshold is simply too low and could give rise to needlessly complexities.
Our biggest objection to the final rules, however, is the starting point. How so? When Congress created 199A, it needed guardrails to distinguish between business income that would qualify for the deduction and wage income that would not. It’s the old “John Edwards, Newt Gingrich” dilemma all over again, only more so since the 199A tax benefit is potentially bigger.
But instead of a targeted approach that distinguished business income from wages, Congress chose a wholesale exclusion of entire industries (so-called Specified Service Trades or Businesses or SSTB’s) from the deduction. The idea was that since a law firm’s income is largely due to services, let’s just say that all law firm income is ineligible for the deduction and not mess around with difficult distinctions of business income and an owner’s wages.
The statute accordingly describes an SSTB 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, investing and investment management, trading, dealing in securities, partnership interests, or commodities, 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.
It is an extensive list and a classic case of picking winners and losers. Obviously, litigating which trades or businesses get the deduction will be an issue for years to come. There’s not much Treasury could have done about that.
Where Treasury went wrong, in our opinion, is in defining the term “involving” narrowly to encompass any level of activity in those listed professions. They explicitly rejected arguments that they should define “involving” more broadly where substantially all the corporation’s activities for a taxable year must involve the performance of services in the listed fields in order to trip the exception.
Treasury argues “… section 199A looks to the trade or business of performing services involving one or more of the listed fields, and not the performance of services themselves in determining whether a trade or business is an SSTB.”
Yet it can be argued that the final rule does exactly the opposite. If “involving” means any level of activity in the listed services, then any trade or business that has even a modicum of revenue from one of the listed services would be precluded from getting the deduction. For example, banks may earn revenue from many listed services and so would be disqualified under Treasury’s narrow interpretation, even though Congress explicitly chose not to list banking as an SSTB. The rule effectively puts the emphasis on the service, not the business.
So how does Treasury get out of this conundrum? They embrace two “outs.”
First, they established a two-tiered de minimis threshold for SSTB revenue in a business that would otherwise qualify for the deduction. The threshold is 10-percent for businesses with gross receipts of $25 million or less, and 5-percent for those businesses above $25 million. Allowing a minimum level of disqualified income is obviously inconsistent with the notion that “involving” is triggered by one penny of specified service revenue, but it’s necessary. Otherwise, all businesses would be at risk of being characterized as SSTBs, which obviously isn’t what Congress intended.
Second, Treasury relies on the fact that there can be multiple trades or businesses within a single business entity. Treasury argues that an S corporation bank that would otherwise be disqualified as an SSTB under their strict interpretation can still get the deduction for their qualified lending and banking operations by segregating other, disqualified services into a separate “trade or business.”
The final rules say “… a subchapter S bank could segregate specified service activities from an existing trade or business and operate such specified service activities as an SSTB separate from its remaining trade or business, either within the same legal entity or in a separate entity.”
This approach will work, albeit at a significant burden to the taxpayer. The approach also opens the door to gaming. As S-Corp argued in making the case for generous aggregation rules, gaming under 199A is more likely to come from disaggregation than aggregation. Treasury’s approach opens the door to disaggregation by law firms and other listed trades or businesses.
In our opinion, it would have been better to adopt a higher bar of activity in order to trip the SSTB definition. In practice, this higher bar would have established a single de minimis threshold that would have eased compliance and administration burdens, reduced the number of companies that are unintentionally tripped up, and limited the need for Treasury and the courts to continuously weigh in on what might and might not be an SSTB.
Of course, it would have been better still had Congress targeted wage income itself rather than whole trades or businesses for exclusion from the deduction, but that horse left the barn a long time ago.
One area where the Treasury did taxpayers a huge service was stomping on any expansive notions of the phrase “principal asset is the skill or reputation of one or more employees or owners.” This phrase is wholly unworkable (what exactly is a “principal asset” and how do you measure it?) and had the potential to open up a wide variety of trades or businesses to SSTB designation. Treasury correctly rejected that option and limited “the meaning of the reputation or skill clause to fact patterns in which an individual or RPE is engaged in the trade or business of receiving income from endorsements, the licensing of an individual’s likeness or features, and appearance fees.”
The bottom line is that S corporations and other pass-through businesses now have the rules in place to move forward. While the rules are not as broad as we had hoped, they are better than many possible alternatives and they now form the foundation from which we intend to build. Our agenda for 2019 is to continue to make the case for pass-through parity and working to make the 199A deduction broader and more permanent. Like so many S corporations, these final rules provide us with a starting point.