The Tax Cuts and Jobs Act created a deduction of up to 20 percent of qualified business income (QBI) for sole proprietors, owners of S corporations, partnerships and trusts and their beneficiaries. The concept is very simple, but as with many tax rules, the devil is in the details.
In August, the U.S. Treasury released 184 pages of proposed regulations, much of which is taxpayer friendly and goes a long way to expand upon the legislative intent of providing a widely available tax break. In order to understand who this impacts and how, we need to explore what type of business income qualifies and what does not, due to their Specified Service Trade or Business (SSTB) classification.
Even the Treasury Department acknowledges that there is a massive amount of information that needs to be gathered and analyzed before computing this deduction. Treasury estimates that there will be 25 million hours spent, per year, by taxpayers and their advisers in dealing with these new reporting requirements.
The overriding goal of defining the SSTBs is to prevent the conversion of personal-service income into QBI. While the list of SSTBs are black and white, most of the detailed definitions remain undefined or only broadly defined. The list, and some color where available consists of:
Services as an employee — Income from services as an employee is not QBI and income from services performed by an independent contractor is not QBI if services were previously provided by the taxpayer as an employee. For example, if you are employed as a plumber for your employer, you could not resign and then hold yourself out as an independent contractor to the same entity and convert income from services as an employee to a QBI service.
Field of health care — This includes services provided by licensed professionals directly to patients by individuals such as doctors, pharmacists, nurses, dentists, physical therapists, psychologists and other, similar health care professionals. Under certain conditions, facilities such as assisted living and extend care facilities may qualify under new de minimus rules, which are discussed later. While providing in-home nursing service will be treated as health care, companion services should fall outside this exclusion.
Field of law — This includes services provided by lawyers, paralegals, legal arbitrators and mediators in their capacity as such. Ancillary services that are not unique to the practice of law, such as legal printing and stenography, will qualify as QBI. While not specifically mentioned, services such as bail bondsman should also qualify.
Field of accounting — All services provided by accountants, enrolled agents, return preparers, auditors and bookkeepers are included. The broad reach of this is to capture all services using the common understanding of accounting, beyond those requiring the same mastery of accounting principles that CPAs possess. The only fields that qualify are bill payment and processing.
Field of actuarial science — This is limited to services performed by actuaries and does not apply to related services that do not assess or analyze the financial cost, risk or uncertainty of events. This includes the services of economists, mathematicians and statisticians.
Performing arts — Performing arts services means the performance of services by individuals who participate in the creation of performing arts such as actors, singers, musicians, entertainers, directors and similar professionals performing in their capacity as such. This category includes the provision of services that require skills that are unique to the creation of performing arts. However, it does not include broadcasting or disseminating video or audio of performing arts to the public.
Consulting — This category could have been defined as including almost all professionals, but has been given a narrow definition, which turns on separating QBI from SSTB, based on facts and circumstances, including the manner in which one is compensated. While treating those that provide professional advice and counsel to assist in achieving goals as an SSTB, the new regulations make the point that the services of salespeople and “economically similar services” are involved in providing QBI-eligible services. A mortgage broker, whose role it is to connect a potential borrower with a financial institution appropriate to their needs, will also qualify as a QBI.
Services as athletes — This includes all “on field” services of athletes, as well as coaches and managers of team sports. It also includes a business that owns and operates a professional sports team. Those involved in the maintenance of equipment and facilities, as well as those that broadcast or disseminate sporting events, are not involved in an SSTB.
Financial services — Services that are tainted with the SSTB label include all services commonly provided by financial advisors and investment bankers. The prohibited services include managing wealth, providing financial advice and developing retirement and estate plans and services related to business valuations, mergers, acquisitions and sales and issuance of securities. The only significant exclusion from this list is the provision of standard banking services such as taking deposits and making loans.
Securities brokers and traders — As these fall under the larger umbrella of financial services, they are considered to be SSTBs and therefore ineligible for the “20 percent” deduction. Securities are defined in the common investment sense (i.e., stocks, bonds, mortgages, etc.). Some taxpayer-friendly exclusions from the brokerage SSTB group are real estate and insurance agents and brokers, real estate managers and any taxpayer who is involved in hedging transactions as part of their operating business.
Skill and reputation businesses — This catch-all phrase in the law was the most feared and most talked about for the seven months between enactment of the Tax Cuts and Jobs Act and the issuance of these regulations. The plain language of the law (“any trade or business where the principal asset is the reputation or skill of its owners or employees”) could have resulted in every service business, including the local barber shop or popular restaurant, being treated as an SSTB. However, the regulations took a very narrow view and only include the ineligible SSTB group businesses in which a person receives fees for product endorsements, public appearances, or for the use of their image, likeness, name or voice. By way of example, if a famous chef or athlete has a restaurant bearing his or her name and at the same time sells a line of products with their name on them, the restaurant would be a qualified business but the name product sales would not.
Real estate has its own issues
In order to qualify for the QBI deduction, a taxpayer’s activity must rise to the level of a trade or business, which involves activity “with continuity and regularity.” The ownership and operation of real estate has long been the subject of court cases, in order to determine if an activity is an investment or a trade or business. Courts have looked at factors such as type of property rented (a commercial building may be a trade or business and a single condo unit may not be), the number of properties rented and the types of services performed in the day-to-day operations of the property by the owner or their agent. The takeaway here is that real property rental will not automatically qualify for the deduction.
One exception to this rule is a provision that treats the rental of property as a trade or business if it is rented to a 50 percent or more owned trade or business. This “self-rental” exception eases the rules when, for example, a manufacturer leases its office and warehouse space from a pass-through entity that has at least 50 percent common ownership with the manufacturing company, even if all the expenses and operations of the real estate are the burden of the manufacturer.
The definitions described, while important, are just the starting point. Part 2 of this article will discuss the “make or break” options presented by the regulations, including real estate issues, abilities to combine businesses for computation purposes and some rules designed to prevent abuse.