New IRS Guidance on the Businesses that Qualify for the New 20% Pass Through Deduction
I don’t often enjoy plane rides, especially when I’ve been downgraded out of first class and end up in BWI instead of Dulles (American Airlines sucks). However, one redeeming aspect of the miserable flight was the opportunity to read the IRS guidance that was released a few weeks ago on the new tax law. Flying from Las Vegas to Baltimore in the middle seat gave me plenty of time to read 184 pages of joyful IRS prose giving us the IRS opinion on which businesses qualify for the new 20% pass through entity deduction.
If you read my original blog entry, published here January 2nd, you know that Congress left a lot of room for interpretation on the new 20% deduction. We waited a full seven months to get the IRS opinion. I expected nothing but bad news from the IRS, given how my day was unfolding. However, after reading the IRS guidance, I wanted to buy my fellow passengers a drink in celebration. I wanted to, but I didn’t. I am a CPA after all.
In the spirit of not forcing you to reread my January 2nd post, I will start with explaining the basics of the new deduction by repeating the first few paragraphs of that post. Then I’ll tell you what changed with the IRS guidance and some of the implications.
Jan 2nd post: “What Businesses Qualify for the New Pass Through Entity Deduction?”
The answer to this question is pretty simple – pretty much all businesses, which are organized as pass through entities qualify for the new deduction – with a bunch of caveats. For the purposes of the new deduction, a pass through entity is a business treated for tax purposes as a sole proprietorship, partnership, or S corporation. Yes, sole proprietorships count even though they technically aren’t separate entities for tax purposes. Only C corporations are excluded. They got their own tax break.
If your total income from all sources is less than $157,500 for single taxpayers or $315,000 for married taxpayers, you get a deduction of 20% of the taxable income from your business. If your total income is above those thresholds, you have some potential limitations.
First, if your business provides services in the following fields, your deduction phases out over $157,500 – $207,500 for single taxpayers or $315,000 – $415,000 for married taxpayers:
- Actuarial science
- Performing arts including athletics
- Financial services
- Any service business where the principal asset is the skill and reputation of one or more employees.
End of post
We were pretty clear on the businesses in the first seven categories, however, category eight really scared us. Doesn’t this pretty much describe every small business in the U.S.? Fortunately, the IRS didn’t interpret category eight literally.
On page 65 of the IRS guidance, I found the following listing of businesses that make up category eight. Surprisingly, the list is quite small. Here are the businesses that the IRS believes are category eight businesses:
- Receiving income from endorsing products or services,
- Licensing or receiving income for an individual’s image or likeness,
- Receiving appearance fees or income.
Well, that’s not so bad is it? I did not expect the list to be anywhere near this short. Whoever wrote the IRS guidance was in a generous mood. In our client base, we have almost no clients in these categories.
The first seven categories are bad news, particularly the unfair exclusion of accounting, but we can live with this IRS interpretation of category eight.
The IRS guidance also included some examples of tricks that don’t work with any of the eight categories. You cannot separate a business into operating and administrative entities, and then charge a management fee to the operating entity from the administrative entity. The aim of this maneuver was to drain profits out of the disqualified operating business, for example a law firm, into the administrative entity, which would then qualify for the new deduction. Nope, doesn’t work according to the IRS. We weren’t advising anyone to do this anyway.
What we believe will work is splitting a business into separate components where one line of business doesn’t qualify for the deduction, but other business lines may qualify for the deduction. The great news from my standpoint is everything we suggested to clients from January through July appears to be good advice.
First, unless you are truly a consulting firm, providing nothing but advice and counsel, remove all mention of the word “consulting” from your company name, web site, or any other literature. Very few of our clients truly meet the definition of consulting.
Second, determine which of your lines of business qualify for the new deduction and which don’t. Put the lines that do qualify for the deduction into a separate entity. The entity must truly operate separately. One of the examples buried in the IRS guidance concerned a medical firm that sold products. The IRS opined that the product sales could qualify for the deduction even though they were medical products. This is an invitation to follow our advice. The IRS will likely not allow the deduction for the product sales in the medical firm’s entity under the idea that the product business is not a material factor in the medical firm’s operations.
Here’s what I would like you to take away from this post. The clock is running on getting your tax strategy right for this year. This post is very brief synopsis of the IRS guidance. There is a lot more that may apply to your business. Please contact us to meet about your specific situation.
Thanks for reading!
Frank Stitely, CPA, CVA