On December 22, 2017, the Tax Cuts and Jobs Act was signed into law and Internal Revenue Code Section 199A “Qualified Business Income” was created. In its simplest terms, Section 199A allows owners of sole proprietorships, S-corporations, or partnerships to take a 20% deduction on qualified business income. For the last eight months, tax professionals have struggled to make sense of the various aspects of the deduction, including the most key concept: Does my business qualify?
On August 8, 2018, the IRS released proposed regulations which begin to provide guidance and clarification to what is essentially a very complex calculation. Our second article in this series takes a deeper look into what constitutes a qualified trade or business for purposes of the Qualified Business Income (QBI) Deduction.
Before taking a closer look at the definition of a Specified Service Trade or Business (SSTB), it is important to recall that there are certain thresholds which must be exceeded before a taxpayer is impacted by whether or not their business is an SSTB. As discussed in our first article, An Overview of the 20% Qualified Business Income Deduction, if a taxpayer’s taxable income is below $315,000 (married filing joint) or $157,500 (all other taxpayers) before the application of any QBI deductions, then the SSTB rules do not apply. If taxable income exceeds the threshold and the taxpayer’s business is considered an SSTB, then the deduction decreases until it is fully phased out for taxpayers with taxable income above $415,000 (married filing joint) or $207,500 (all other taxpayers).
For purposes of the QBI deduction, it is interesting to note that the IRS did not attempt to define the businesses that would meet the definition of a qualified trade or business. Rather, they defined the ones that would not. Simply put, all activities which meet the definition of a trade or business under IRS Code Section 162 are considered a qualified trade or business for purposes of Section 199A unless it is:
- Engaged in the trade or business of performing services as an employee, or
- It is a Specified Service Trade or Business.
The first bullet point is fairly straightforward. If an individual is an employee of a company, then the employee cannot take a 20% QBI deduction based on his or her wages (even if the company itself is considered a qualified trade or business). For purposes of Section 199A, the presumption is that former employees are still employees. In other words, if an individual was properly treated as an employee and that person ceases to be a full-time employee, but remains at the company performing substantially the same services, either directly or indirectly, then that person is still considered to be an employee for purposes of the QBI deduction and will not qualify for the deduction.
The second bullet point, however, has been the topic of much discussion and is the primary focus of this article.
What is a Specified Service Trade or Business?
In defining an SSTB, the IRS first looked to definitions in other areas of the Internal Revenue Code. After much discussion and debate, the final list that made it into Section 199A is as follows:
- 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, or dealing in securities, partnership interests, or commodities.
- 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.
Some of these are fairly self-explanatory, such as accounting and actuarial services; however, others have been the topic of many discussions and no clear guidance was available until the proposed regulations were issued on August 8, 2018.
Click here to view a table summarizing what is considered an included or excluded service for each of the various fields listed above.
Two of the services which have caused the most confusion are consulting and the catch-all of “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.” See below for guidance on these.
The terms “consulting” and “consultant” are often used in the business world without giving consideration to their definitions. Many individuals will often refer to themselves as a consultant if they are self-employed and work with a variety of businesses. However, the definition of a consultant generally means someone who provides professional knowledge or an expert opinion regarding a business decision with the intention of influencing the decision maker.
- Company A manufactures widgets and hires a consulting company to train their new staff on product details, so they are able to effectively answer customer questions and facilitate the sale of widgets.
- Company B has a high-stakes sales presentation for a contract worth $25 million and hires a consulting company to evaluate the presentation and provide professional feedback, train the sales team on effective delivery of the presentation, and coach management on which benefits to highlight so their presentation is differentiated from the competition.
Under each of these scenarios, both the service provider and the customer likely believe that they either are a consulting firm or are using a consulting firm, but according to the IRS only the second scenario would meet the definition of an SSTB in the field of consulting.
It is important to note that determining whether a business is in the trade or business of consulting, and therefore considered to be an SSTB, must be determined on a case-by-case basis, and the decision must be made based on all the facts and circumstances of that particular business.
The key item to remember when determining whether or not you have an SSTB in the field of consulting is that the service being provided must be intended to assist the client in achieving goals and solving problems. In addition, the proposed regulations clarified that if the consulting services being provided are ancillary to the sale of a product by a business that is not an SSTB, then those consulting services would not be considered consulting services within the meaning of an SSTB if there is no separate payment for the consulting services.
The proposed regulations provide the following examples with regard to consulting services:
Example 1: C is in the business of providing services that assist unrelated entities in making their personnel structures more efficient. C studies its client’s organization and structure and compares it to peers in its industry. C then makes recommendations and provides advice to its client regarding possible changes in the client’s personnel structure, including the use of temporary workers. SSTB or not? C is engaged in the performance of services in an SSTB in the field of consulting.
Example 2: 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. SSTB or not? D is engaged in the trade or business of licensing software and not engaged in an SSTB in the field of consulting.
Example 3: G owns 100% of Corp, an S corporation, which operates a bicycle sales and repair business. Corp has eight 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. SSTB or not? G is in the business of sales and repairs of bicycles and is not engaged in an SSTB.
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
Perhaps the most confusing aspect related to the definition of an SSTB was the catch-all “skill or reputation” clause. As stated above, Section 199A specifically states that 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 will be considered an SSTB. Tax professionals attempted to apply many different schools of thought to what has been viewed as, up until now, a particularly problematic section of 199A. For example, a professional trainer is not considered to be in an SSTB in the field of health. However, one could argue that the only reason the trainer had any clients was because of his or her skill and reputation. Thankfully, the guidance provided by the proposed regulations has confirmed that this catch-all clause is not as onerous as we once thought.
Based on the guidance, the skill or reputation clause will only come into play if a taxpayer is compensated under the following scenarios:
- Endorsing a product or service
- Using the taxpayer’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity
- Appearing at an event or on radio, television or other media format
For purposes of this section, compensation is not limited to cash, but also includes receipt of a partnership interest or stock in an S-corporation and the distributable net income associated with those ownership interests.
The proposed regulations provide the following examples with regard to the “skill or reputation” clause:
Example 4: 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. SSTB or not? 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.
Example 5: J is a well-known actor. J entered into a partnership with Shoe Company, in which J contributed her likeness and the use of her name to the partnership in exchange for a 50% interest in the capital and profits of the partnership and a guaranteed payment. SSTB or not? J’s trade or business consisting of the receipt of the partnership interest and the corresponding distributive share with respect to the partnership interest for J’s likeness and the use of her name is an SSTB.
Special rules – As with all things IRS, there are exceptions to the rules.
De minimis rule: For a trade or business with gross receipts of $25 million dollars or less for the taxable year, a trade or business is not an SSTB if below 10% of the gross receipts of the trade or business are attributable to the performance of services in an SSTB. For purposes of determining whether this 10% test is satisfied, the performance of any activity incident to the actual performance of services in the field is considered the performance of services in that field. If gross receipts are in excess of $25 million for the taxable year, then the threshold is reduced to 5%.
Services or property provided to an SSTB: In general, an SSTB includes any trade or business that provides 80% or more of its property or services to an SSTB if there is 50% or more common ownership of the trades or businesses. However, If a trade or business provides below 80% of its property or services to an SSTB and there is 50% or more common ownership of the trades or businesses, that portion of the trade or business of providing property or services to the 50% or more commonly-owned SSTB is treated as a part of the SSTB. For purposes of determining common ownership, both direct and indirect ownership by certain related parties must be considered.
Example 6: Law Firm is a partnership that provides legal services to clients, owns its own office building and employs its own administrative staff. Law Firm divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and, through a contract with Partnership 1, provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Law Firm). SSTB or not? Because there is 50% or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 will be treated as one SSTB.
Incidental to an SSTB: In general, if a trade or business (that would not otherwise be treated as an SSTB) has 50% or more common ownership with an SSTB, including related parties and has shared expenses with the SSTB, including shared wage or overhead expenses, then such trade or business is treated as incidental to and, therefore, part of the SSTB if the gross receipts of the trade or business represents no more than 5% of the total combined gross receipts of the trade or business and the SSTB in a taxable year.
Example 7: A, a dermatologist, provides medical services to patients on a regular basis through Dermatology LLC, a disregarded entity owned by A. In addition to providing medical services, Dermatology LLC also sells skin care products to A’s patients. The same employees and office space are used for the medical services and sale of skin care products. The gross receipts with respect to the skin care product sales do not exceed 5% of the gross receipts of Dermatology LLC. SSTB or not? Accordingly, the sale of the skin care products is treated as incidental to A’s SSTB of performing services in the field of health and is treated as part of the SSTB.
With regard to the exceptions discussed above, it is important to note that the proposed regulations provide guidance and clarity regarding businesses which fall under certain percentages, but remain silent with how to deal with taxpayers who exceed limits.
If we take a closer look at example 9 above, it is quite clear that if a dermatologist sells skin-care products and if the total gross revenue related to those products is below 5% of the total gross revenue of the practice, then the income derived from the sale of those products is treated no differently than the income derived from providing medical services. In other words, it is all treated as income derived from an SSTB.
But what if the sale of skin-care products exceeded the 5% revenue threshold? Presumably you would be able to prepare two separate calculations in which you would treat the income associated with the provision of medical services as an SSTB and then treat the sale of products as income derived from a non-SSTB. However, this is not specifically stated in the proposed regulations and could potentially lead to issues for taxpayers who fall into this grey area.
In conclusion, this chart lists the various service areas and details the types of services which are included or excluded from the definition of a SSTB.