Originally published on Forbes.com.
The 20% deduction for those of us with qualified trade or business income (Section 199A) is, in my neck of the woods, the most exciting provision of what was called the Tax Cuts and Jobs Act. (I think I will stick with TCJA since “Act to provided for reconciliation pursuant to titles II and V of the concurrent resolution of the budget for fiscal year 2018” is not quite as catchy.) As you know the Internal Revenue Code is something of a white collar jobs program for college graduates who are almost smart enough to be engineers. So the deduction rather than being 20% of an easily derived number is hedged with thresholds and other limitations making it the lesser of one number compared with the greater of two other numbers unless and except for this or that.
Tony Nitti on Tax Geek Tuesday has given a pretty comprehensive discussion of the ‘20% Qualified Business Income Deduction’. The purpose of this post is to dive a little deeper into one aspect. What are the trades or businesses that if beyond the threshold will not qualify regardless of how much they pay in W-2 wages or have in the way of depreciable assets? Most discussions of this aspect are pretty superficial like this story by Alicia Parlapiaono of of the New York Times which includes
People in professional service industries, like partners in law firms, are the most restricted
I’m going to try to give you a fuller picture, but I warn you that you will be frustrated if you want absolute clarity. It is not to be had in this area.
The Disfavored Fields Of Endeavor
If you are in one of the disfavored fields, your deduction starts phasing out at $157,500 of taxable income if you are single and twice that if you are married filing jointly. That is taxable income without regard to the 199A deduction. The phaseout is spread over $50,000 or $100,000 of income, respectively.
Yesterday was really exhilarating for me as I spent the day at a local firm going through various client scenarios to see how the 199A deduction would apply in specific cases. National firms have Washington offices and regional firms have associations that provide them with similar resources. This firm has me. Maybe not quite as comprehensive, but I came bearing a dozen Dunkin Donuts. And the nuances of the naughty list was one of the things we focused on.
In classic Internal Revenue Code style, 199A refers us to as different code section 1202(e)(3)(A) for the list.
any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or 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
Then it modifies that list. It substitutes “employees or owners” for employees in that catch all at the end, drops engineering and architecture and adds
performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).
Room For Interpretation
If you are like me you are probably already scheming to figure out subtle nuances that will allow you or one of your clients to stay off the list or worried that one of your clients is included in that “principal asset” “reputation or skill” catchall. Remember Reilly’s Third Law of Tax Planning – Any clever idea that pops into your head probably has a corresponding rule that makes it not work. Well here we have kind of an exception to that law. There is very little guidance or case law on 1202(e)(3)(A), probably because 1202 – Partial exclusion for gain from certain small business stock – is not something that people found all that exciting or used that much. Here is what I could find. I’m almost arrogant enough to say that is all there is, but there might be something I missed.
It’s The Training And Organiztion
I only found one Tax Court decision TC Memo -2012-21 that addresses the list. It is a mess of a case with a lot of things going on. There are five docket numbers associated with it. One of the eight issues Judge Wherry decided was whether the sale of stock in a company called Family First Advance Estate Planning qualified for nonrecognition under Section 1045(a), which refers to 1202 for its definitions.
FFAEP sold prepaid legal service policies, including estate planning services. The IRS tried to fit it under the catchall “principal asset” “reputation or skill” category, but the Tax Court wasn’t having it.
Although respondent argues that FFAEP is not qualified because one of the principal assets is the skill of Mr. Owen, the Court disagrees. While we have no doubt that the success of the Family First Companies is properly attributable to Mr. Owen and Mr. Michaels, the principal asset of the companies was the training and organizational structure; after all, it was the independent contractors, including Mr. Owen and Mr. Michaels in their commission sales hats, who sold the policies that earned the premiums, not Mr. Owen in his personal capacity.
Given how many other issues there were in this case, I’m wondering if the IRS having already thrown everything at them besides the kitchen sink, used this issue as lieu of the kitchen sink.
Tools For Healthcare Are Not Healthcare
There is a recent private letter ruling that discusses an item on the list. PLR 201717010 ruled that a company was not providing services in the field of health.
Company, a C corporation, was incorporated in Year 1 to develop a tool to provide more complete and timely information to healthcare providers. Specifically, Company uses proprietary X and other technologies for the precise detection of B. You represent that Company is the only person that can legally perform X testing and that its expertise is limited to its patented X testing.
Company analyzes the results of X testing and then prepares laboratory reports for healthcare providers. Company’s clients are doctors and other healthcare providers. You represent that the information the Company provides in a typical laboratory report only includes a summary of z detected and z tested for and not detected. Company’s laboratory reports do not diagnose or recommend treatment. You represent that Company does not discuss diagnosis or treatment with any healthcare provider, and is not informed by the healthcare provider as to the healthcare provider’s diagnosis or treatment. Company’s sole function is to provide healthcare providers with a copy of its laboratory report. Company receives compensation for reporting results of tests to healthcare providers, which is based on each test performed.
There is a decision we discuss further on, that is only subtly different from the ruling, but goes the other way.
Maybe There Is More
There are other sections of the Code with lists that are similar to the list being used for 199A that have been the subject of litigation and rulings. Sometimes the taxpayer might want to be on the list and sometimes not.
Other Lists
Code Section 448 restricts the use of the cash method of accounting by C corporations. Among the C corporations that are allowed to use the cash method are “qualified personal service corporation which perform services in the fields of “health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting”. Here is a little catch. Since this is a list you want to be on, it is harder. “Substantially all” of the services have to be in one of the fields, while that list you don’t want to be on just talks about “involving the performance of services” in health, etc. On the other hand, if you have to pay corporate tax, you don’t want onto this list, since you will be denied the graduated rates.
Section 535 defines accumulated taxable income and provides a list that, if it came up, you would not want to be on, because you will get a lower exclusion. That one is:
corporation the principal function of which is the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting,
Note the subtle difference – “principal function” vs, “substantially all”.
Generally professional service corporations that are C corporations, which is in itself usually a bad idea, blow out their earnings as salary, so these sections have not generated a lot of case law and guidance, but there is a bit, some of which would be relevant to 199A.
Even If There Are Numbers It Might Not Be Accounting
Private Letter Ruling 8927007 (sorry no link) concerns a medical billing company – call it MBC.
A corp. is in the business of processing computerized billings for the filing of insurance claims and for patients for individual doctors and hospitals. This includes maintaining accounts receivable balances for the clients and mailing statements to patients until the patients pay the bills. The corp. prepares a monthly report for the client, detailing the patients’ outstanding balances and activities for the month. The cost of the services to the doctors and hospitals is based on the outstanding accounts receivable balances. RULED: The corp. isn’t in the business of providing accounting services under Reg. 1.448-1T(e)(5)(vii). It neither prepares audit and financial statements or tax returns nor performs bookkeeping services, isn’t required to change its tax year to the calendar year, and isn’t subject to the lower minimum accumulated earnings credit of Sec. 535(c)(2)(B), because its principal business isn’t accounting
A lot of accounting firms provided a host of services, many of which could be carved out and put in a separate company. You will probably be seeing a lot of that.
All Creatures Great And Small
Revenue Ruling 91-30 asks whether a corporation performing veterinary services is a “qualified personal service corporation”. It is.
Veterinarians are “similar health care professionals” within the meaning of section 1.448-1T (e) (4) (ii) of the temporary regulations. Thus, for purposes of section 448 (d) (2) (A) of the Code and section 1.448-1T (e) (4) (i), the term “field of health” includes the provision of medical services by veterinarians.
Pretty clearly, the same logic should apply for 199A. Once again we might think about dividing businesses up. Some vets run boarding operations. They will want to separate that out.
Tax Returns Are Accountinng
A regular Tax Court decision 128 TC 5 was about whether Rainbow Tax Service Inc qualified for the graduated corporation rates.
During the years in issue, petitioner’s tax return preparation services generally consisted of the preparation of clients’ Federal and State individual, corporate, partnership, gift, and estate tax returns. Petitioner’s bookkeeping services generally consisted of the preparation, from client records, of profit and loss statements and various other reports and forms relating to client Federal payroll taxes, State unemployment taxes, and sales taxes.
Petitioner is not a public accounting firm, and petitioner’s employees do not perform services that require petitioner’s employees to obtain Certified Public Accountant (C.P.A.) licenses. Neither Rodgers nor Joyner-Rodgers ever held C.P.A. licenses. ….
Petitioner argues that under Nevada law, accounting services can be performed only by C.P.A.s, and that because petitioner is not a C.P.A. firm, does not employ C.P.A.s, and does not perform services which are restricted under Nevada law to C.P.A.s, petitioner should not be treated as performing accounting services.
In essence, petitioner would treat only those services which require a C.P.A. license as accounting services and would treat other tax return preparation and bookkeeping services as nonaccounting services.
Nice try, but the Tax Court was not buying it.
We disagree with petitioner’s overly restrictive definition of accounting services.
Petitioner fails to appreciate the distinction between “public accounting” and “accounting”. Public accounting, which generally consists of the preparation and/or audit of financial statements, and generally requires a C.P.A. license, represents a branch of accounting, not the entire realm of accounting.
I like the sound of that – the entire realm of accounting. Sounds kind of majestic compared to “field”.
The Cattery
I could probably skip over DKD Enterprises TCM 2011-29. The corporation has two activities going on computer consulting and cat breeding. Can’t make this stuff up. That meant that the company was not 95% computer consulting. The language in 199A is “involving”, so I don’t think you will be able to qualify your accounting income, by putting a hot dog stand next to the office.
Radiation
WW Eure TCM 2007-124 is another failed attempt to get out of the health field. This case is interesting. The corporation provided radiation therapy, so the taxpayer argued that some of what was going on was controlling the radiation. Even if they had won it might not matter much for 199A since they were trying to beat the 95% test.
It Is Not About Licensing
Saying that the deduction is denied to lawyers and accountants and doctors is a deceiving shorthand. As we saw with accounting the “field” of health can include people who are not licensed. That was the lesson in a Tax Court Summary Opinion – 2017-39.
Sound Diagnostic asserts that its employees do not perform services in the field of health because employees who operate the ultrasound equipment (sonographers) are not required to be licensed in Colorado, do not provide direct treatment services to patients, and do not make healthcare decisions. Healthcare professionals, however, are not limited to physicians or to licensed medical service providers.
Sonographers are more similar to physicians and nurses than to health club or health spa employees. Therefore, Mr. Zia-Ahmadi, in performing the ultrasound activities as a sonographer, was a healthcare professional.
There is a subtle difference between this case and the PLR about testing. It is also worth noting that this decision had many other things going on with it and as a Summary decision is not precedent. On the other hand, it is recent.
A Practical Point
The AICPA standards of tax practice prohibit me from giving audit lottery advice. Well I figure you are not my client and besides I am such a cheapskate that I let my AICPA membership lapse. One of the questions on business returns is the Business Code. It is Line B on Schedule C and it is on Page 2 of Form 1120 and it is Box C on page 1 of Form 1065. I’m sure it is different in other firms, but my experience is that the code gets copied from one year to the next without a lot of thought. Well even though it doesn’t matter so much on the 2017 return, think about it. Don’t lie, but see if there is a code you might use that does not sound so much like one of the disfavored fields. If the IRS ever gets going on this issue, I suspect that the business code will be something they use to pick their audit victims . Regardless, if you have picked a code that places you squarely in the disfavored fields, that can be held against you in Tax Court.
Summary
TCJA has been hawked as simplifying. There is some truth to that as more people will be able to file 1040-EZ, but that is about it. Section 199A is a massive complication. Simplification would be saying all income is income to which either progressive or flat rates are applied. Having different flavors of income and some ambiguity or a gray area about where particular transactions fall is a fantastic source of complexity. Before the bill we had income that is not recognized at all, capital gains (either subject to NII or not), ordinary income (which might be subject to NII or SE or neither). Now we will have Qualified Business Income that can be subject to NII or SE or neither. That is not making it simple.
The one part of the list that will cause the most heartburn to conservative taxpayers (I’m talking attitude not politics) is the catchall “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”. RIA observed:
…there is no instance in which either the Code or the regs use the term “principal asset” in the context of an intangible human quality like “reputation” or “skill.” And, the relevant Congressional Committee reports do not add any insight as to Congress’ intent with respect to this language. Thus, it is quite unclear which trades or businesses will fail this test for treatment as a QTOB as a result of this language, or which more-specific characteristics of any given trade or business are indicative of it failing this test.
I suspect that the IRS will go after that with somebody who has a lot of other things going on. A salutary effect of that provision is that it might encourage professions of humility by entrepreneurs who will want to argue that it is all about the team. Something good should come out of the act besides work for people like me. Not that it is a bad thing. I get my first Social Security check in February and I am worried that Paul Ryan will be snatching it from my mailbox.