Principal Offers Thoughts to IRS on Section 199A Guidance

April 27, 2018

The Hon. David J. Kautter
Assistant Secretary (Tax Policy)
Department of the Treasury
1500 Pennsylvania Avenue NW
Washington, DC 20220

Mr. William M. Paul
Principal Deputy Chief Counsel and Deputy Chief Counsel (Technical)
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: “Specified Service Trade or Business” Under Section 199A

Dear Mr. Kautter and Mr. Paul:

I am writing in my individual capacity to share some observations that may be useful to the IRS or Treasury in developing guidance under Section 199A. In particular, many taxpayers and tax advisors appear to have substantial questions about what constitutes the provision of “services” in the nine proscribed professional “fields,” and the relationship of that rule to the “principal asset” test.

A prior submission suggested that the “principal asset” test should be viewed as a mechanical rule¹ that would be consistent with the literal terms of the statute but would nevertheless serve the Congressional purposes of encouraging the creation of jobs paying W-2 wages taxed at normal graduated rates, while limiting the benefits of the 20 percent deduction for income that predominantly represents compensation for the personal services of the owners of a business.

Similar policies appear to be relevant to the determination of what constitutes a “service” in the nine proscribed professional fields (i.e., health, law, accounting, etc.). Fortunately, the IRS appears to have an established ruling position under Section 1202 that — if confirmed as we understand it to be — would go a long way in clarifying the law in this important area. As explained more fully below, the IRS ruling position appears to view the restriction on businesses providing “services” in the proscribed professional fields as limited to services involving “individual expertise.” That term appears to refer to a service that is performed for the client or customer by one or more particular individuals whose identity is of substantial importance to the customer or consumer. That would be distinguished from a service that might well be performed by a highly skilled and specially trained individual, like testing blood for specific antibodies or testing drugs for their effectiveness and performing related research, but which would not be considered to be a “service” in the field of health — for example — because the identity of the particular individual performing the service is a matter of indifference to the customer or consumer. In other words, if the service is essentially a commodity, such that the consumer or customer is indifferent as to which individual performs it, or is indeed indifferent as to whether it is performed by an individual or a machine, then it is not a “service” within the meaning of the proscription on providing services in the nine proscribed professional fields.

The analysis supporting this conclusion is described in more detail below. There does not appear to be any other way to explain the rulings, given their stated facts and analysis.

The IRS Private Rulings Under Section 1202 (e)(3)(A)

In a 2014 private letter ruling (PLR 201436001) the IRS described the taxpayer as a company that provided products and services, “primarily in connection with the pharmaceutical industry.” To wit, the taxpayer “works with clients to help commercialize experimental drugs,” and its business activities include, “research, development, manufacture and commercialization,” including more specifically, “(1) research on drug formulation effectiveness; (2) pre-commercial testing procedures such as clinical testing; and (3) manufacturing of drugs.” Finally, the IRS noted that the taxpayer, “works with clients to solve problems in the pharmaceutical industry, such as developing successful drug manufacturing processes.”

Although the IRS analysis described the company as “a pharmaceutical industry analogue of a parts manufacturer in the automobile industry,” that analogy is evidently an oversimplification. The ruling clearly describes the company as not only manufacturing components or “parts” to be incorporated into another manufacturer's processes, but as providing various “services” — including research and testing and the development of drug manufacturing processes. Indeed, if the company were only engaged in manufacturing components — such as a chemical for use by a customer engaged in manufacturing pharmaceuticals — it clearly would not be engaged in providing “services” of any type.

The ruling recited that the taxpayer used, “its physical assets, such as its manufacturing and clinical facilities, as well as its intellectual property assets, including its patent portfolio.” It seems self-evident that the company must have also had employees. Nevertheless, the IRS held that the company did not “perform services in the health industry within the meaning of § 1202(e)(3).” The analysis supporting this conclusion suggests that the determining factor was the apparent indifference of the customers to the identity of the employees providing their work and expertise. While the customers undoubtedly relied on the assumption that the company employed competent and skilled personnel, the customers were evidently indifferent as to whether any particular service was provided by any particular human being. The services could be performed by a machine or out-sourced to a foreign country thousands of miles away. The IRS first explained generally that the statute was designed to exclude businesses that, “offer value to customers primarily in the form of services, whether those services are the providing of hotel rooms, for example, or in the form of individual expertise (law firm partners).” Barring application of this special concept of “individual expertise,” the term “services” would certainly include providing research or assistance in the manufacture of drugs. However, the IRS concluded that the company was, “not in the business of offering service in the form of individual expertise.” It explained that, “although Company works primarily in the pharmaceutical industry, which is certainly a component of the health industry, Company does not perform services in the health industry within the meaning of § 1202(e)(3).”

Again, if the company was only or even primarily manufacturing products, it would obviously not be providing “services” — so the ruling must have been addressing the services provided by the company and concluding that they did not require or involve “individual expertise.” In that context, “individual expertise” appears to be a reference to services, such as those provided in a typical law firm or physician's office, where the skill or reputation of the particular individual or individuals providing the services is of substantial importance to the customer or consumer. In contrast, the ruling seems to be suggesting that the identities of its personnel were of little importance to the customer. Thus, the ruling emphasizes the fact that the company's “activities involve the deployment of specific manufacturing assets and intellectual property assets to create value for customers.” Again, if it was only manufacturing products, the ruling on “services” would not have been sought. However, the point of this language appears to be that the “value” that customers see has little or nothing to do with the identity of the individual employees who may be using the company's other assets to produce “value for customers.”

This interpretation finds some echo in Code Section 543(a)(7), which defines a corporation's personal holding company income as income from the corporation's provision of services under a personal service contract, but only if, “some person other than the corporation has the right to designate (by name or by description) the individual who is to perform the services, or if the individual who is to perform the services is designated (by name or by description) in the contract.” While Code Sections 543 and 1202 are unrelated, the issues Congress was dealing with are somewhat similar — preventing activities from benefitting from certain corporate tax benefits where the entity is engaged in providing certain types of individualized, personal or professional services.

In a word, if a firm's consumers or customers are generally indifferent to the identity of the individual who will be performing their “services,” the IRS seems to conclude that such services are not prohibited “services” — even if they assist the consumer with their needs in the nine listed areas, such as health, the law, etc. For example, a firm that only provided flu shots would not be viewed as providing “services” in the field of health, and a firm that only provides the service of notarizing or witnessing the signature of legal documents would not be viewed as providing “services” in the field of law. That is because the identity of the physician or nurse giving the flu shot, or individual notarizing or witnessing a signature, is generally of no importance to the customer.

A similar analysis also seems to explain a 2017 ruling (PLR 201717010). In that ruling the taxpayer performed highly specialized laboratory testing of blood samples to screen for certain diseases. The company had a highly skilled and specially trained workforce — seemingly suggesting that the company was providing diagnostic services in the field of health. In negating such a conclusion, the ruling focused on the anonymity, fungibility, or invisibility of the workers, both from the perspective of the health care professionals who were the direct consumers of the service and the patients who were the indirect consumers or beneficiaries of the service. In particular, the ruling noted (emphasis supplied) that —

Company's laboratory reports do not discuss diagnosis or treatment. Company neither discusses with, nor is informed by, healthcare providers about the diagnosis or treatment of a healthcare provider's patients. Company's sole function is to provide healthcare providers with a copy of its laboratory report. Company neither takes orders from nor explains laboratory tests to patients. Company's direct contact with patients is billing patients whose insurer does not pay all of the costs of a laboratory test.

The best summary of this analysis would appear to be that the direct and indirect consumers of the company's services never meet or see the individual employees performing the services, do not know them, and do not care about the identity of the particular individuals involved in performing the services. For that reason, the services do not constitute “services” in the field of health.

Conclusion

In addition to representing the apparent ruling position of the IRS under Section 1202, the foregoing interpretation of the term “services” appears to be a reasonable interpretation of the statutory language and a sensible and workable way of identifying the types of activities Congress did not intend to provide with tax benefits — under Section 1202 or Section 199A. Generally speaking, taxpayers and their advisors, and the IRS, should not have difficulty distinguishing businesses where the services that are provided are essentially a commodity, from those where the identity of the particular individual performing the services is generally of substantial importance to the customer or consumer.

In addition, our suggested mechanical rule for applying the principal asset test would also be relatively easy to apply, and would appear to cover the cases Congress intended to exclude from the benefits of Section 199A.

I hope this information is helpful. If there is any further information that might be of assistance to you, your Department, or the IRS in implementing this or any other aspects of the new law, I would be very happy to try to obtain and provide it.

Very truly yours,

Don Susswein
Principal, Washington National Tax
RSM US LLP
Washington, DC
don.susswein@rsmus.com