The business income deduction: Are you in the consulting or the sales business?
Are You in the Consulting or the Sales Business?
The Right Answer Can Cut Your Bill By 20 percent
You have no doubt heard the Tax Cuts and Jobs Act of 2017 dropped the corporate tax rate to 21 percent.
You have probably also heard some (but not all) owners of businesses operating as S corporations, partnerships (including limited liability companies), or sole proprietorships will be able to deduct 20 percent of their business income starting in 2018.
So, who does not get to deduct 20 percent of their business income? Answer: Employees never get the business income deduction on their W-2 income, regardless of the type of business or the amount of that income; and owners of “specified service trades or businesses,” or SSTBs do not get the deduction if the owners’ taxable income exceeds a threshold amount. The threshold amount for 2018 is $157,750 (or $315,000 for joint filers). These limits phase in over the threshold, with the effect that the deduction is not allowed to owners of SSTBs if their taxable income exceeds $207,500 ($415,000 for joint filers). The thresholds will be indexed for inflation.
Generally, an SSTB is a professional service business. Doctors, lawyers, accountants, actuaries, and investment advisors are clear examples of professional services that are excluded from the business income deduction above the threshold phase in. But, what about veterinarians or real estate brokers? (Read on.)
On Aug. 8, 2018, the Internal Revenue Service and the Treasury Department published proposed regulations shedding some light on how this deduction is calculated and what constitutes an SSTB.
These proposed regulations are significant because business owners of SSTBs do not get the 20 percent deduction above the threshold phasein. Therefore, as owners of pass-through businesses, they will pay federal income tax on the business income at their individual rates, which may be as high as 37 percent. For business owners who qualify for the 20 percent deduction for qualified business income, the top federal income tax rate would be 29.6 percent.
Here is a quick run down of what types of businesses are SSTBs, with highlights from the Proposed Regulations:
- Health. Services in the field of health include services by physicians, pharmacists, nurses, dentists, veterinarians, physical therapists, psychologists and others providing professional health services directly to patients. Services in the field of health do not include, for example, the operation of health clubs and health spas, or to research, testing and manufacture and/or sales of pharmaceuticals or medical devices, so these businesses can qualify for the deduction.
- Law. Services in the field of law include services by lawyers, paralegals, legal arbitrators, and mediators. Legal services do not include services of printers, delivery services, or stenographer services.
- Accounting. This includes services by individuals such as accountants, enrolled agents, return preparers or financial auditors. The field of accounting, as defined in the proposed regulations, is not limited to services requiring state licensure as a certified public accountant.
- Actuarial Science. This includes the performance of service by actuaries. The preamble to the proposed regulations observes that the field of actuarial science does not include the provision of services by analysts, economists, mathematicians, and statisticians not engaged in analyzing or assessing the financial cost of risk or uncertainty of the events.
- Performing Arts. The performance of service in the field of performing arts means services by actors, singers, musicians, entertainers and directors. This does not include services by people involved in the maintenance and operation of equipment or facilities for the use of the performing arts, and does not involve services by persons broadcasting or otherwise involved in disseminating video or audio of performing arts to the public.
- Consulting. Consulting is defined in the proposed regulations as the “provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.” This is a very broad definition. The proposed regulations specifically name lobbyists as consultants. The proposed regulations also specifically state that consulting does not include “sales or economically similar services or the provision of training and educational courses.” The determination of whether services relate to sales or economically similar services will be based on all facts and circumstances. The manner in which the taxpayer is compensated for the services is mentioned as one with the relevant facts and circumstances. A significant exception, perhaps, is the statement in the proposed regulations that consulting does not include the performance of consulting services “embedded in, or ancillary to” the sale of goods or performance of services for a business that is otherwise not an SSTB if there is no separate payment for the consulting services.
- Athletics. The services of athletes, coaches and team managers are mentioned. Curiously, specific sports are mentioned, including baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snow boarding, track and field, billiards, and racing. (What about lacrosse, stock car racing, cricket, or bass fishing?) Performance of services in the field of athletics does not include the maintenance and operation of equipment, or services by persons who broadcast or otherwise disseminate video or audio of athletic events to the public.
- Financial Services. This includes managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory or other services regarding valuations, mergers, acquisitions, dispositions, restructuring, raising financial capital by underwriting, or acting as a client’s agent in the issuance of securities. Financial advisors, investment bankers, wealth planners, and retirement advisors are specifically mentioned as included within this category. Significantly, the preamble to the proposed regulations explicitly states banking is not included in the definition of financial services, so owners of banks operating as pass-throughs may qualify for the business income deduction.
- Brokerage Services. This will include the services of arranging transactions between a buyer and seller with respect to securities for a commission or a fee. Significantly, this does not include services provided by real estate agents and brokers, or insurance agents and brokers.
- Investing and Investment Management. This refers to the receipt of fees for providing investor, assets management, or investment management services, including advice with respect to buying and selling investments. Significantly, this does not include directly managing real property.
- Trading. This is defined as the business trading securities, commodities, or partnership interests. Manufacturers or farmers who engage in hedging transactions as part of their business of manufacturing or farming are not considered to be engaging in trading.
- Dealing. This is defined to be dealing with securities, including regularly purchasing securities, commodities, or partnership interests from and selling such interests to customers in the ordinary course of a trade or business or offering to enter into, assume, offset, assign, or otherwise terminate positions in securities, commodities or partnership interests with customers in the ordinary course of a trade or business.
Significantly, engineering and architecture are excluded from the definition of a specified services trade or business in the tax code, as modified by the TCJA.
Another category of an SSTB is any business where the principal asset of the business is the reputation or skill of one or more of its employees. There was some concern the IRS would take a broad view of this and exclude many more types of businesses withparticularly popular and competent employees,for example stylists, plumbers, or mechanics who attract business because of their stellar reputations and the quality of work. Happily, the Proposed Regulations appear to have taken a very limited approach to this category of SSTB, describing it to include businesses that consist of receiving fees for product endorsements licensing fees for the use of images, likenesses, or trademarks; and fees for personal appearances.
Are You Selling or Consulting?
Many businesses occupy a middle ground between consulting and sales. Consider how Section 199A and proposed regulations may cause business owners to rethink their operations, including how they get compensated for the products and services they provide. The proposed regulations give an example of a business that involves licensing software to customers. The owner discusses and evaluates the customer software needs and advises the customer about particular software products it licenses. The business is paid a flat price for the software if and when the customer licenses the software. The Proposed Regulations conclude that this owner is engaged in the trade of business of licensing software and is not engaged in consulting, which is a specified service trade or business, or SSTB. In other words, this business can qualify for the 20 percent deduction, subject to the other limitations that apply, including the W-2 and property limitations.
We expect a great deal of planning efforts will focus on whether and how businesses can be divided into separate lines of business to prevent characterization as an SSTB and qualify for the business income deduction. (See the related posting https://mcdonaldhopkins.com/Insights/Blog/Tax-and-Benefits-Challenges/2018/08/20/What-do-proposed-regulations-on-the-business-income-deduction-say-about-crack-and-pack) Or, alternatively, a lot of planning will focus on how businesses can be combined to increase the amount of income eligible for the deduction. The proposed regulations go into considerable detail describing when and how the IRS will respect a restructuring strategy for purposes of improving eligibility for the deduction, but certainly there is room for appropriate planning under these complex rules, and such planning is certainly worth the effort if the outcome is a 20 percent deduction on some or all business income.
Thanks for reading this. Please be aware it does not describe all the rules that may apply to your situation. The circumstances of your particular business need to be separately analyzed to determine, in light of all the available guidance, whether and to what extent you may be able to deduct a portion of your business income or make adjustments to increase the amount of your deduction. Consult with a tax professional. In many cases, the savings will be well worth the effort.