Section 199A: Specified Services and Rental Activities

In a previous blog post regarding the new Section 199A “Qualified Business Income” deduction, we mentioned that the deduction is reduced or eliminated for higher income owners of Specified Service Trades or Businesses (“SSTBs”). These are businesses that typically rely on the personal efforts of the owner, rather than their ability to expend capital hiring employees or purchasing assets. Unlike other businesses, higher income owners of SSTBs miss out on the deduction based simply on the type of business they operate, even if they do in fact hire many employees or make large capital outlays.

While it is clear that being designated as an SSTB will have significant negative tax implications for owners, it was not entirely clear at the creation of Section 199A which businesses would fall under this definition. In light of proposed regulations recently published by the Service, we now have a better idea whether the deduction from your business is potentially limited as an SSTB. We hope this blog post will assist you in determining whether you need to contact a tax attorney to obtain further guidance regarding your eligibility for the Section 199A deduction.

When Section 199A was created, SSTBs were defined in two parts, first by reference to certain specific businesses, and second through the somewhat subjective “reputation or skill” test. In this blog post, we will discuss both tests. We will also discuss previously proposed strategies for avoiding SSTB classification, as well as the Service’s response to such strategies. Finally, we will discuss whether Section 199A is available for real estate rental activities.

SSTBs – Listed Businesses

Section 199A specifically states that businesses which provides services in any of the following fields are considered SSTBs: health, law, accounting, actuarial science, performing arts, consulting (including lobbying), athletics, financial services, brokerage services, investing, investment management, and trading or dealing in securities. Conspicuously, the statute excludes engineering and architecture services from the definition of an SSTB.

The new proposed regulations under Section 199A clear up the exact scope of several of the professions listed above. For certain professions, the scope is broader then many initially hoped. For instance, health services would include not only doctors, but also pharmacists, physical therapists, and even veterinarians. They would not include, however, services that aren’t provided directly to patients, such as pharmaceutical manufacturing, or hospital IT services, or services that aren’t specifically medical, such as health spas or yoga studios. Additionally, law includes lawyers, paralegals, and mediators, while accounting includes tax preparers and auditors.

For other professions, the proposed regulations create a narrower scope than many may have initially feared. For instance, “brokerage services,” and “financial services” do not include real estate agents, traditional (ie, non-investment) bankers, insurance agents, or insurance brokers. Additionally, while athletics includes everyone actually involved in playing a sport (such as the athletes, coaches, and team managers), it does not include related businesses such as operating and maintaining equipment or facilities, or performing broadcasting services.

SSTBs – “Reputation or Skill” Test

While Section 199A is clear that certain businesses (listed above) are by definition SSTBs, such businesses are actually examples of a broader category of businesses intended to be subject to limitations. Specifically, any trade or business “where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners” is considered an SSTB.

This expansive definition led many to question whether any business could in fact escape the specter of the SSTB deduction limitations. After all, any solo plumber, landscaper, or chef, will tell you that their personal knowledge and their reputation among customers are their principal assets, without which they’d do little to no business.

Fortunately, the Service seems to have recognized that the language employed by the statute is so broad that a literal reading would not be “objective and administrable.” In its effort to give some meaning to the reputation or skill test while not denying the deduction to virtually all businesses, the Service’s proposed regulations limit the general test to trades or businesses deriving income from (1) endorsing products or services, (2) use of an individual’s image, likeness, signature, voice, trademark, or any other symbols associated with the individual’s identity, or (3) appearing at an event or on radio, television, or another media format.

SSTBs – Multiple Lines of Business

When Section 199A was first created, many commentators expected that if they could separately account for the different lines of business within their company, without actually breaking up the business, they could treat certain parts as SSTB income, subject to limitations for high earners, and other parts as non-SSTB income, not subject to the same limitations.

Unfortunately, the Service’s proposed regulations do not endorse such an accounting strategy. Rather, the proposed regulations would create a rule whereby if a certain percentage of income is from a specified service, the entire business is considered a SSTB. For businesses with $25 million or less in annual gross revenue, this would be ten percent, while for businesses above $25 million, this would be five percent.

For example, Liza owns a chiropractic business, OuchMyBack, with $5 million in annual gross revenue. Of this amount, only $300,000 is earned from diagnosing back problems and recommending treatment options. The remaining $4,700,000 is from the manufacture and sale of back stretching devices and exercise videos. Because less than ten percent of her annual gross revenue is from a specified service (ie, providing medical advice), OuchMyBack is considered a non-SSTB and Liza may qualify for the Section 199A deduction.

As another example, Tyler owns a “family office” business, WealthPals, with $20 million in annual gross revenue. Of this amount, $5 million is earned from insurance sales commissions, $3 million is earned from real estate commissions, $2 million is earned from tax preparation, and $10 million is earned from providing investment advice and management. The insurance and real estate commissions on their own would not be considered specified service income, while the tax preparation and investment advice and management income would. Because the $12 million from specified services is more than ten percent of WealthPals’ total annual gross revenue, the entire business would be considered an SSTB and Tyler would receive no Section 199A deduction.

Business owners such as Tyler may benefit from spinning off parts of consolidated business into their own entity. The extent of the benefit depends, however, upon the business’ net income, whether it has employees or property, and upon the business owner’s other income, and must be weighed against the additional time and expense required to operate the lines of business as separate entities. Consultation with a tax professional, particularly one well versed in the Section 199A deduction, is therefore recommended before making any changes.

In addition to the practical hurdles of spinning off parts of a business, the proposed regulations create another rule for incidental lines of business. Under this rule, if an otherwise non-SSTB business shares 50% ownership with an SSTB, and shares expenses (such as employees, rent, etc), then it is considered part of the STTB unless it’s gross receipts exceed 5 percent of the gross receipts of the combined gross receipts of it and the commonly owned STTB.

For example, Liza owns a chiropractic service OuchMyBack, which receives all of its $5 million in revenue from diagnosing and treating back problems (a specified service). Liza notices that the “back rolling” devices on the market which she prescribes to her customers are poorly built. She decides to create a separate business, LizaRollers, to create and sell higher quality products (a non-specified service). She sells the products out of OuchMyBack’s office, and has OuchMyBack’s secretary fulfill orders. During the taxable year, her new business has $200,000 in gross revenue. Because LizaRollers shares expenses with OuchMyBack, and it’s $200,000 in gross revenue is less than five percent of the $5.2 million aggregate gross revenue, LizaRollers is considered part of OuchMyBack, and an SSTB for purposes of figuring the deduction.

SSTBs – Self-Service aka Crack-And-Pack

Another strategy that was put forth by commentators involved not only dividing up the business based on the different services it provides to customers, but actually dividing the company into separate parts which serviced each other.

For example, it is customary for accountants to print off a copy of a client’s tax return and provide it to the client for their records. When accountants learned that they would be limited by the STTB provisions of Section 199A, many reasoned that they could form a new company to provide printing services to their accounting firm, charging their accounting firm an amount in excess of the cost of printing, generating a deduction for the accounting firm, and non-SSTB income for the newly created printing business.

Unfortunately, the Service devised a way to prevent this strategy, by creating a scenario where otherwise non-SSTBs would be designated as SSTBs based on whom they provide services to and how the businesses are owned. First, if a business provides 80 percent or more of its property or services to an SSTB with which it shares 50 percent or more (direct or indirect) ownership, the business providing the service is considered part of the SSTB. If the 50 percent ownership component exists, but less than 80 percent of the services are provided to the commonly owned company, then a ratable portion is considered part of the SSTB. These rules prevent the strategy discussed above, but would have no effect on third-party, non-commonly controlled business, such as commercial printing services, which provide services to SSTBs.

SSTBs – Switching Employment Classification

Over the years, a large body of case law and regulations has been developed to deal with properly classifying workers between independent contractors and employees. While the criteria (which exceed the scope of this blog post) are meant to be objective, the actual choice of whether to treat someone as an employee or independent contractor has often been a matter of simple agreement between the company and worker. Generally, most workers preferred to be treated as employees, as the company would then be liable for half of their FICA taxes, and would take care of their income tax withholding. On the other hand, independent contractors are responsible for their own estimated tax payments, and must pay SECA taxes in lieu of FICA taxes. While many companies tried to get their workers to go along with being treated as independent contractors, this was a risky proposition given that their status could be challenged by the Service. Ultimately, however, as long as the FICA or SECA taxes are paid, the Service typically does not challenge the classification agreed upon by the company and worker.

With the introduction of Section 199A, the calculus has dramatically shifted. While before it was favorable to be treated as an employee, now many taxpayers would like to be considered independent contractors in order to obtain the benefit of the Section 199A deduction. In order to prevent companies and workers from working together to artificially change their classification and reduce both of their tax burdens, the Service has proposed regulations creating a presumption that if a worker was formerly treated as an employee, any compensation they receive from the company in the future is also as an employee. This presumption can only be overcome by showing that the worker is in fact an independent contractor under the general body of law on the subject.

For new workers, it is also possible that the Service will challenge whether their classification as independent contractors is legitimate. In the past the Service typically attempted to establish that a worker was an employee, thus putting the company (with typically deeper pockets) on the hook for FICA taxes, whereas a contractor (who may not be able to pay) would be the sole person on the hook for their own SECA taxes. With the introduction of Section 199A, we may begin to see litigation and case law in the opposite direction.

Rental Activities – “Traditional Landlords”

Due to the manner in which Section 199A was drafted, it left some uncertainty as to whether the deduction would be available to landlords. The source of this uncertainty stems from the fact that the deduction is calculated with reference to “income . . . effectively connected with the conduct of a trade or business within the United States,” and excludes investment income. This is important, as it is possible for rental income to be considered “trade or business” income, or investment income, depending on the nature of the landlord’s role. While the new proposed regulations do nothing to clarify this important distinction, there is some limited case law tax advisors can look to in determining whether a taxpayer is entitled to the deduction, or what they can do to become so entitled.

Part of the reason for the uncertainty surrounding whether rental activity should be considered a trade or business is that “trade or business” is not actually defined. Section 162 of the Internal Revenue Code merely states that deductions are allowed for expenses incurred in the operation of a trade or business, leaving the courts to fill in the gaps about what constitutes a trade or business. Additionally, the issue is less important in real estate rental activities, because Section 212 also allows deductions for expenses incurred in the production of income, including renting or leasing property.

While available case law regarding the definition of trade or business frequently arises in the context of differentiating a business from a hobby, such cases still provide some broad standards that should be applicable in the case of determining whether a rental operation is a trade or business or an investment activity. In the shortest terms possible, such cases tell us that to be considered a business, the involvement of the taxpayer in the rental operation must be substantial, continuous and not sporadic, and engaged in for a profit motive. In other words, the more “hands-on” the landlord, the more likely that they would be considered as engaging in a trade or business, and would be entitled to a deduction under Section 199A.

As almost all landlords will be engaged in their rental activities for a profit motive, the salient question will be whether their activities and involvement with the rental process reach the proper degree of regularity for the income to be considered business income. For instance, it’s highly questionable whether an out-of-state landlord who offloads the entire soliciting, collection, maintenance, and eviction process to a third-party property manager could be considered as actively involved in the process, rather than as a passive investor. Additionally, it is unlikely that landlords engaged in commercial “triple net” leases (where the tenant is responsible for all costs of the property, such as maintenance and taxes), are engaged in a trade or business and thus entitled to the deduction.

Some activities that would lend credibility to a Section 199A claim would be regular house calls, involvement with the tenant vetting process, supervising repairs and personally collecting rents. Additionally, one example in the proposed regulations, though not actually intended to provide clarity on rental operations, seems to suggest that owning and managing multiple properties might help demonstrate that a business is being conducted, rather than a one-off investment. Things that would detract would be the use of a property management service, or only sporadic rentals (ie, renting a second home out once or twice per year).

While additional regulations would be welcome, prior case law gives us some guidance as to which types of rental activities will qualify for the Section 199A deduction. It is likely that tax preparers will take an expansive view of which activities qualify, and that we will only know the true boundaries of who qualifies when the Service begins to push back. Nevertheless, knowledgeable tax advisors can currently advise clients on whether claiming the Section 199A deduction is prudent, and the likelihood of such a claim being challenged by the Service.

Rental Activities – REITs

For taxpayers wishing to gain exposure to real estate rental markets while availing themselves of the 20% Section 199A deduction, Real Estate Investment Trusts (REITs) may be an attractive option. REITs are essentially businesses that own and lease a large number of properties, the income of which is pooled and distributed to owners of publicly traded trust “units” (essentially the equivalent of stock shares or partnership interests). Because REITs typically own a large number of properties, Section 199A treats them by default as engaging in a trade or business, and owners of REIT units are allowed the 20% Section 199A deduction.

In addition to being treated by default as derived from a trade or business, REIT income, along with income from publicly traded partnerships (PTPs), is not subject to the same income limitations and phase-outs as qualified business income. This makes REITs and PTPs especially attractive investments for both high and low income taxpayers. It also provides incentives for passive investors in individual properties to divest themselves of such interests and instead purchase units in REITs, and for other investors to re-allocate REITs to their individual taxable accounts, while allocating taxable bond or dividend income to their retirement accounts.

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*This post was originally published on October 30, 2018