Although Section 199A will reduce the tax burden for many owners of pass-through businesses, classification as a “specified service trade or business” (“SSTB”) can severely limit its application for many others. While certain businesses will find it extremely difficult, if not impossible, to avoid such a classification (e.g., law firms, accounting firms, consulting firms), there are a number of other businesses that must understand these rules to avoid unknowing categorization as an SSTB. Importantly, a failure to understand the de minimis thresholds for ancillary SSTB services and a failure to employ the aggregation rules could render the entire business as an SSTB. This could, in turn, leave business owners with a significantly higher tax bill than might be expected.
Avoiding Classification as SSTB and Limitation of QBI Deduction
Generally, Section 199A of the Internal Revenue Code (“I.R.C.”) provides that individuals are permitted up to a 20% deduction with respect to “qualified business income” (“QBI”). As defined therein, QBI means the net amount of qualifying items of income from a qualified trade or business. In order to meet this definition, amongst other things, the income cannot be earned as part of an SSTB or in the business of performing services as an employee. I.R.C. § 199A(d)(1). In other words, to qualify, one must at least own a business and that business cannot be involved in one of many professional services industries where reputation or skill of an owner or employee is its principal asset. The Internal Revenue Service has created a listing of industries that will generally include these specified services. See Treas. Reg. § 1.199A-5(b) (listing industries). (More on how the final regulations approach that article can be found in a separate article found here: Final Section 199A Regulations: Initial Takeaways on Clarification of Definition of “Specified Service Trade or Business.”)
While this may sound straightforward enough, it can be difficult to determine where a “specified service” ends and where a “non-specified service” begins. Furthermore, in situations where a trade or business may offer “specified services” as an ancillary service to the principal services of the business (which may be “non-specified”), it may be difficult to understand how that will impact the overall business’ classification under Section 199A. The final regulations, released earlier this month, have provided much-needed guidance on these issues.
Application of De Minimis Rules to Businesses with Gross Receipts from SSTB-Type Activities
Business owners should take heed of the de minimis rules for gross receipts generated by specified services. Only if the gross receipts are deemed de minimis will the business not be tainted and classified as an SSTB for purposes of I.R.C. § 199A. To this end, Treas. Reg. § 1.199A-5(a)(2) provides that, even if items of income are generated in a non-specified activity, they will not be taken into account for deduction purposes if generated by an SSTB. For this reason, it is important that any income attributable to specified services be de minimis. In order to qualify as de minimis, for businesses with less than $25 million in gross receipts, gross receipts from SSTB-type activities must constitute less than 10% of total gross receipts of the business. Treas. Reg. § 1.199A-5(c)(1)(i). For businesses with more than $25 million in gross receipts, SSTB-type activities must constitute less than 5% of total gross receipts. Treas. Reg. § 1.199A-5(c)(1)(ii). Furthermore, in businesses with at least 50% common ownership and where one business is providing SSTB-type services to a separate business classified as an SSTB, that portion of the business will be treated as a separate SSTB. Treas. Reg. § 1.199A-5(c)(2).
What does this mean? In general, businesses that have some gross receipts from SSTB-type activities should monitor the magnitude. If the gross receipts from am SSTB-type activity approaches the threshold, it may make sense to either stop the activity altogether, plan to earn the income or receipts in a year where the threshold is not at issue (if that is possible) or, more likely, re-structure the business so that a minimal amount of gross receipts from a SSTB-type activity does not taint income otherwise eligible for the deduction under I.R.C. § 199A. In the latter case, it would be important to treat the business as a separate business and/or business entity with due respect for separate business practices (e.g., keeping separate books and records). While Treas. Reg. § 1.199A-5(c)(iii)(B) clearly indicates that a separate entity is not required in order to have separate trades or businesses (and avoid application of the de minimis rules), it may be cleaner to simply segregate these business lines from the outset, if possible.
How Business May Elect Aggregation to Avoid Classification as an SSTB
Those with SSTB-type income can also avoid the de minimis rules by electing to aggregate activities. Treas. Reg. § 1.199A-4(a) provides that each trade or business is treated separately for purposes of this section unless aggregated at the taxpayer’s option. Aggregation may be permitted if the individual can demonstrate that the business had common ownership (50% or more owned by same person or group), common ownership existed for a majority of the year and on the last day of the year, all items are reported with respect to the same taxable year, none of the businesses is deemed an SSTB, and, finally, the businesses have some facts and circumstances indicating commonality. Treas. Reg. § 1.199A-4(b)(1). Commonality is indicated by satisfying two of the following factors: (a) the trades or businesses provide products, property, or services that are the same or customarily offered together, (b) the trades or businesses share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or IT resources, and/or (c) the trades or business are operating in coordination with, or reliance upon, one or more of the businesses in the aggregated group (for example, supply chain management). Id. If aggregation is elected, the individual must continue to report such treatment consistently across tax years and elsewhere on its tax return. Treas. Reg. § 1.199A-4(c)(1). This must be disclosed on a form as required by the Internal Revenue Service or the businesses may be dis-aggregated. Treas. Reg. § 1.199A-4(c)(2).
While the Internal Revenue Service provides many examples for different scenarios, the decision to aggregate will depend on the business and its revenue streams. The purpose of aggregating businesses will most often be done to maximize the ability to claim deductions of QBI; however, the decision to aggregate for purposes of Section 199A should not be done in isolation. Due consideration to future growth of business lines must be considered (i.e., due to temporal consistency requirements) along with other tax considerations (i.e., due to substantive consistency requirements). Further, even in the context of Section 199A, aggregation must include not only consideration of the magnitude of gross receipts from SSTB-type activities, but must also factor in business considerations relating to common ownership and the other elemental requirements for QBI deductions (e.g., wage thresholds and property thresholds). To the extent that multiple businesses are operated under the same entity, it will also be necessary for business to properly allocate income and expense items across business for purposes of I.R.C. § 199A’s aggregation rules. For many, this will not be a simple or straightforward process.
The issuance of final regulations under Section 199A provides owners of pass-through entities with significant tax planning considerations. Particularly for those businesses with SSTB-related gross receipts, it is important to consider both the de minimis and aggregation rules to maximize the tax benefits of the QBI deduction. Failure to properly plan could result in the taint of an entire business unit for tax purposes and, correspondingly, a significant reduction in after-tax return on investment. Rosenberg Martin Greenberg has experience in all aspects of federal and state tax laws, including developments and required compliance affecting all types of business entities and their owners. Our skilled tax advisors have counseled countless clients on how to minimize their tax liabilities. For a free consultation, please contact Brandon N. Mourges at firstname.lastname@example.org or 410.951.1149.