When Congress negotiated the Tax Cuts and Jobs Act (TCJA) last year, a major part of the discussion centered on how much businesses and corporations should be taxed. When the final law passed in December, corporations saw their tax rate permanently lowered to 21 percent. (Previously, corporations had to pay graduated rates that resulted in a 35-percent tax rate for income over $10 million, with a phase-out of the lower rates.)
However, reducing the corporate tax rate did nothing to help most small businesses, such as sole proprietors, LLCs, partnerships or S corporations. That’s because these types of businesses are considered “pass-through entities.” Instead of paying corporate income tax, profits pass through to the business owners, who then report that income on their individual tax returns, along with any other normal income. Enter Section 199a – a workaround included in the TCJA that would enable pass-through entities to deduct 20 percent of a taxpayer’s qualified business income, or QBI. QBI is defined as the net amount of items of income, gain, deduction and loss with respect to a specified trade and business that is connected with the operation of a business in the United States. (Certain types of investment-related items, employee compensation and guaranteed payments to a partner are excluded.)
The IRS promised to clarify some of the more confusing parts of Section 199a by this summer, and earlier this month, it finally issued a set of proposed regulations intended to address some of the lingering questions surrounding Section 199a. It also issued a “Q&A” sheet to help pass-through entities make better sense of the law.
Clarity Around SSTBs
A particularly confusing aspect of Section 199a involved which types of businesses were a “specified service trade and business,” or SSTB. Taxpayers who are SSTBs, with taxable income higher than $157,000 (or $315,000 for joint filers) are limited in the amount they can deduct, and once their income surpasses $207,500 ($415,000 for joint filers), it goes away completely. The IRS’s proposed regulations clarify that SSTBs include any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets, or any trade or business in which the principal asset is the reputation or skill of one or more of its employees. AMDG Financial, for example, would be an SSTB. The same would be true for you if your company’s success depends on your expertise as opposed to something you sell.
When the TCJA first passed, some tax experts were recommending that SSTBs consider a workaround, such as spinning off administrative or nonprofessional parts of the business into a separate unit to qualify for the QBI deduction. Since income earned from the trade or business of being an employee also doesn’t qualify as QBI, some businesses contemplated turning their employees into independent contractors. With the new proposed regulations, the IRS limits these options.
In the case of spinning off business units, the proposed regulations provide two limitations. If the spin-off provides more than 80 percent of its property or services to an SSTB, and the two businesses share common ownership of 50 percent or more, then the IRS will consider the spin-off to be an SSTB.
In the case of employees vs. independent contractors, the IRS will presume someone to be an employee even if the employer reclassified the individual as an independent contractor, if that individual is still doing the same job. In this case, the burden will rest on the independent contractor to show that he or she has been properly reclassified. If the person is performing different duties in a new position, the IRS will not presume the person is an employee.
Dealing with the Law’s Complexities
The proposed regulations are open for comment now, and a public hearing is set to take place in October, so we may see further changes to the rules before they are finalized. However, I expect a number of questions to remain even after that point. With these complex changes, it makes sense to plan ahead, by consulting with a tax professional before the end of the year. At AMDG Financial, we consider the impact of taxes as part of helping clients create a holistic plan for their future. If we can be of assistance to you and your business, please contact us to schedule a complimentary consultation. It’s not too early to think about tax time!