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August 15th, 2018
Claiming the New 20% Pass-Thru Business Deduction—IRS Proposed Regulations Provide Guidance on Meaning of “Specified Service Business”
Background. On August 8, 2018, the IRS issued proposed (not final, but taxpayers can rely on them currently) regulations (the "Regulations") intepreting the 2017 Tax Cuts & Jobs Act's new rule under which an individual taxpayer may deduct up to 20% of his income from a domestic business operated as a sole proprietorship or through a partnership (including an LLC taxed as a partnership) or S corporation (a "pass-thru business"). With this 20% deduction, the effective federal marginal tax rate on an individual taxpayer's qualified business income (assuming he is otherwise subject to the maximum 37% tax rate) is 29.6%. The deduction is available through 2025.
Deduction Limitation for a "Specified Service Business." Availability of the 20% pass-thru business deduction is limited in the case of so-called "specified service businesses" -- defined as businesses providing services in such fields as health, law, accounting, performing arts, consulting, athletics and financial and brokerage services, in which the "principal asset is the reputation or skill of one or more of its employees or owners," or which involves the performance of services that consist of investing and investment management and trading, or dealing in securities, partnership interests or commodities. Engineering and architecture are specifically excluded from "specified service business" classification. If an individual's pass-thru business is a "specified service business," he is eligible for the 20% pass-thru business deduction with respect to such business only if his taxable income is less than $315,000 (for married taxpayers filing a joint return) or $157,500 (for individuals). If his taxable income exceeds this threshold amount, the benefit of the deduction is phased out over up to $100,000 (for married individuals filing jointly) or $50,000 (for other individuals) of such excess. If his taxable income exceeds the phase-out amount, he is not eligible for the 20% deduction. These amounts apply to 2018 and will be adjusted for inflation in later years.
Regulations Clarify Meaning of "Specified Service Business;" Unanswered Questions Remain. Prior to issuance of the Regulations, there was considerable uncertainty regarding the meaning of a number of terms in the "specified service business" definition, and many questions were raised as to whether a particular business (including many in which our clients are engaged) would be deemed, for example, a "consulting," "performing arts" or "athletics" business or a business in which the principal asset is "the reputation or skill of one or more of its employees or owners." The Regulations provide some helpful guidance on these questions and generally take a less expansive approach than many had feared, but a number of questions remain.
Consulting. The Regulations define "consulting" as "the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems." It does not include "the performance of services other than advice and counsel, such as sales or economically similar services." The determination of whether the services involve "sales or economically similar services" is based on all the facts and circumstances, including the manner in which the business is compensated for the services. The Regulations also indicate that the performance of consulting services will not be treated as a "consulting" business in certain cases, e.g., where such services are "embedded in, or ancillary to, the ... performance of services" on behalf of a business that is otherwise not a "specified service business" if there is no separate payment for the consulting services. While this guidance is useful with regard to many service businesses, there remain others (e.g., advertising or marketing firms) which it does not seem to clearly address.
Performing Arts. With regard to "performing arts," the Regulations provide that "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 services in their capacity as such" will be deemed to be engaged in the "performing arts" business. A "performing arts" business does not include "the provision of services that do not require skills unique to the creation of performing arts, such as the maintenance and operation of equipment or facilities for use in the performing arts," or "the provision of services by persons who broadcast or otherwise disseminate video or audio of performing arts to the public." Again, while this guidance may be useful to many entertainment industry-related business owners, there may be others for whom the definition of "performing arts" remains unclear. For example, how are the services of a producer, cinematographer, set or scenic designer or casting director to be treated? Are all actors treated as engaged in the "performing arts" business or only the principal cast? A similar question remains for singers, musicians and others identified as engaged in a "performing arts" business. That is, does the term encompass all such individuals or a more limited group "involved in the creation" of performing arts? In answering these questions, is the distinction between 'above the line' and 'below the line' costs used in budgeting relevant? Questions like these still require clarification.
Athletics. The Regulations also clarify that an "athletics" business for purposes of the 20% pass-thru business deduction includes a business involving the performance of services by "individuals who participate in athletic competition such as athletes, coaches, and team managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, skiing, snowboarding, track and field, billiards, and racing," but does not include "the provision of services that do not require skills unique to athletic competition, such as the maintenance and operation of equipment or facilities for use in athletic events," or "services by persons who broadcast or otherwise disseminate video or audio of athletic events to the public." An example in the Regulations illustrates the application of this provision with reference to an individual who is a partner in a partnership that owns and operates a professional sports team, employs athletes and sells tickets to the public to attend games in which the sports team competes. The example concludes that (i) the partnership is engaged in the "specified service business" of "athletics," and (ii) even though the partner is a passive owner in the partnership and does not provide any services to the partnership or the sports team, his share of the partnership's income is not eligible for the 20% pass-thru business deduction because the partnership is engaged in a "specified service business" in the field of "athletics."
Reputation or Skill. With regard to the "reputation or skill" prong of the "specified service business" definition, the Regulations provide valuable guidance generally limiting its application. Prior to issuance of the Regulations, this prong of the definition seemed the most open-ended and potentially cast the widest net. Under the Regulations, however, the meaning of "reputation or skill" is limited to situations in which the individual or relevant pass-thru business receives (1) income for endorsing products or services; (2) income for the use of an individual's image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual's identity; or (3) fees or income for appearing at an event or on radio, television or other media format (including fees or income to reality performers performing as themselves on television, social media or other forums, radio, television and other media hosts and video game players). The Regulations illustrate the application of this provision with two examples, one of which is particularly instructive. In this example, a well-known chef and the sole owner of multiple restaurants (each of which is owned in a disregarded entity) receives an endorsement fee for the use of his name on a line of cooking utensils and cookware due to his skill and reputation as a chef. The example concludes that the business of being a chef and owning restaurants is not a "specified service business" for purposes of the 20% pass-thru business deduction, but the chef's receipt of endorsement fee income for his skill and/or reputation is a separate "specified service business" and is not eligible for the 20% pass-thru business deduction. The limited application of the "reputation or skill" prong of the "specified service business" definition should be a welcome clarification to many pass-thru business owners who anticipated that the IRS would interpret "reputation or skill" more broadly.
De Minimis Rule. Finally, the Regulations provide a de minimis rule under which a pass-thru business will not be considered a "specified service business" if it has gross receipts of $25 million or less in a tax year and less than 10% of its gross receipts are attributable to the performance of services in a "specified service business." In the case of a pass-thru business with gross receipts greater than $25 million in a tax year, a 5% test is substituted for 10%. While there exists some uncertainty regarding the manner in which the de minimis rule is to be applied, it seems that in determining eligibility under the de minimis rule, it will be necessary to consider what constitutes a separate trade or business for purposes of the 20% pass-thru business deduction and other provision of the Regulations.
In conclusion, the Regulations go a long way toward answering a number of the questions regarding the meaning of "specified service business" that had been raised since the 2017 Tax Cuts & Jobs Act's institution of the 20% pass-thru business deduction. Nevertheless, many important issues remain unresolved, and it is hoped that these issues will be addressed through the public hearing on the Regulations scheduled for October 16, 2018 and comments from the public.
If you have questions about any of the provisions summarized above or any other issues related to the application and operation of the new 20% deduction for pass-thru business owners, please contact Jeffrey M. Marks at (212) 826 5536 or firstname.lastname@example.org, Bernard C. Topper at (212) 826 5547 or email@example.com, or any other member of the Frankfurt Kurnit Tax Group.
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