Last December Congress told the millions of high-income taxpayers that income would not qualify for the section 199A passthrough deduction if it was from a business whose “principal asset” was the “reputation or skill of one or more of its owners or employees.” What in the world did all that mean? Interpreted literally, high-income owners of almost any active passthrough in America could be disqualified for the deduction.
Yes, lawmakers back in 1993 had inserted similar language into the code, but nobody paid much attention to old section 1202. Few taxpayers were able to jump through all the hoops needed to qualify for the capital gains relief that section provided. In section 1202’s quarter-century of existence, Treasury, having better things to do, didn’t bother providing any guidance on the “reputation or skill” clause. The judiciary provided a single holding — somewhat suggesting an interpretation at the narrower end of a spectrum of possibilities — but with limited applicability beyond the facts of that case (Owen v. Commissioner, T.C. Memo. 2012-21).
Whatever their shortcomings, the section 199A proposed regulations (REG-107892-18) released August 8 have elicited one nationwide sigh of relief. That’s because Treasury and IRS reg writers wisely interpreted the reputation or skill clause about as narrowly and as cleanly as they could (as suggested in prior articles). (Prior analysis: Tax Notes, Mar. 5, 2018, p. 1320; and Tax Notes, July 16, 2018, p. 293.) In short, under the proposed regulations a business will be disqualified by this clause only if the taxpayer is providing product endorsement or earning “appearance fees” (which presumably includes speaker fees). No longer will passthrough businesses wonder if they are disqualified from the 20 percent deduction merely because they work with skilled and respected people.
Loose Ends
Now let’s move on to less abstruse aspects of defining specified trades or businesses that are disqualified from the deduction. In addition to the now narrowed scope of businesses caught by the reputation or skill clause, section 199A denies or limits the 20 percent passthrough deduction to owners of any trade or business involving performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, and — under one heading — (1) investing and investment management, (2) trading or (3) dealing in securities, partnership interests, or commodities. Let’s call this last category ITD.
Now we will discover that the regulations writers’ penchant for economy — the total document is a mere 182 double-spaced pages — has some annoying consequences. They decided, in most cases, to stick close to what current law, guidance (including non-precedential private letter rulings), and judicial decisions say about similar provisions. We have already noted that section 1202 is a nearly dry well. That leaves pronouncements from the IRS and the courts about section 448, which provides as a point of departure a similar list of professions as found in section 199A. Section 448 allows the cash method of accounting for qualified service corporations. As Treasury admits in the August 8 release, existing guidance under sections 448 and 1202 is “sparse.” There are significant outstanding questions under current law. It turns out that reg writers have only ventured beyond current law in limited cases, so while guidance is less sparse, it is still scanty.
Health
Regarding businesses in the field of health, the new proposed regulations started with “physicians, nurses, dentists, and other similar health care professionals” as found in the section 448 regulations. Then they added veterinarians (discussed in Rev. Rul. 91-30, 1991-1 C.B. 61), physical therapists (LTR 9222004), and psychologists. Because the general approach of the reg writers is to follow current law and guidance, we can probably assume X-ray technicians (FSA 1999-919) and emergency ambulance technicians (LTR 9309004) are not specified. The new proposed regulations clarify that payment processing (LTR 8927006), laboratory testing (LTR 201717010), manufacture or sale of pharmaceuticals (LTR 201436001), and medical devices are qualified. Otherwise, the new regulations repeat section 448’s language so that businesses not qualified for the deduction are directly related to the medical field and do not include health clubs or spas.
Thumbing through the 2012 edition of the North American Industrial Classification System (NAICS) gives us some idea of what other health professions and passthrough businesses are not mentioned in the new regulations and for which uncertainty lingers. They include hospitals, chiropractors, optometrists, occupational therapists, speech therapists, audiologists, family planning counselors, substance abuse counselors, kidney dialysis centers, home healthcare services, nursing home and other residential care services, dieticians, midwives, biofeedback clinics, and diagnostic imaging centers.
It’s important to keep in mind that under prior law, the stakes were generally much lower and taxpayers wanted to be included in these lists (because they would qualify for the cash method of accounting). Under the Tax Cuts and Jobs Act (P.L. 115-97), taxpayers want to avoid being included (so they are not specified and therefore are qualified for section 199A deductions).
Law
There are no guidance or court cases concerning the scope of the field of law for purposes of section 448 or 1202. So it is helpful that the proposed regulations state that lawyers, paralegals, legal arbitrators, mediators, and similar professionals are individuals engaged in specified businesses. In general, only services unique to the field of law are specified services. Hmm, what about economists who in effect practice law without a license, such as transfer pricing economists?
Accounting
There is nothing in the section 448 regulations on the definition of accounting, but new regulations do build on the decision of the Tax Court in Rainbow Tax Services v. Commissioner, 128 T.C. 42 (2007). Thus, return preparers don’t qualify for the deduction. As explained in the proposed regulations, they — along with accountants, enrolled agents, financial auditors, and similar professionals — are specified services. Accounting includes all bookkeeping and all services coming under the common understanding of accounting. No CPA certification is required. The regulations also clarify that payment processing (presumably, including payroll services) and billing analysis, often intermingled with accounting services, are not specified.
Actuarial Science
Undefined by Treasury or the courts for purposes of sections 448 and 1202, the proposed regulations simply state that this category includes the provision of services by actuaries and similar professionals. Confusingly, the August 8 release states that statisticians and economists not engaged in analyzing risk and uncertainty are not included in this category. Should we infer that the category does not include professionals who engage in the financial cost of risk but are not in insurance or a similar business?
Consulting
This is a vast and uncertain category. In general, for the definition of consulting, the proposed section 199A regulations follow the fairly detailed guidance provided by section 448. A lot depends on how the individual providing services is compensated for advice. If your advice is provided in the course of selling products or other services and you receive payments for those products or services, you are not a consultant. If you are paid solely for the provision of advice, you are a consultant. This will likely require a lot of facts and circumstances determinations. There is no shortage of consultants in this world (or in my neighborhood, for that matter). As listed in the NAICS manual, these include consultants in the field of marketing, human resources, logistics, general management, environmental issues, motion pictures, security, agriculture, and the sciences, including computer science. The proposed regulations make some useful clarifications. Lobbying is a specified consulting service and, following the decision in Owen, education and training are not specified consulting services.
Performing Arts
Defining performing arts is difficult in any context. Regulations under section 448 stated that actors, actresses, singers, musicians, entertainers, and similar artists were in the field of performing arts, but that managers, promoters, and broadcasters of performances were not. A letter ruling (LTR 9416006) stated that only persons performing before an audience would be considered performing artists, so a director is not a performing artist (“Although a director may contribute artistic skills to the production of a motion picture the activities of a director do not involve performing before an audience”).
In contrast to their method concerning other professions, the proposed section 199A regulations contradict the prior letter ruling. It explicitly adds directors to the list of performing artists. Paralleling the structure of its treatment of legal services, the category does not include skills that are not unique to the creation of performing arts. Also, operation or maintenance of performing arts equipment or facilities is not a specified service.
This still leaves a lot of ambiguity. What about producers, script writers, cinematographers, composers, set designers, costume designers, and all the other folks you see in the credits at the end of a movie? What about newscasters and disc jockeys? Are documentary and educational films considered entertainment with performing artists? Is computer-generated music musicianship? The list is only limited by our imaginations.
Athletics
Athletics was not a field mentioned in any guidance for section 448 or 1202 except to point out that an athlete is not a performing artist. But the new statute explicitly includes the field of athletics, so Treasury’s interpretation in the proposed regulations is appreciated.
Quite reasonably, Treasury says that the rules for athletics and performing arts should be analogous. In this case you might think that only on-field individuals such as players and coaches who “perform” before a live audience would be included as providing specified services. Given the unexpected expansion of performing arts to include directors, there is some question whether trainers, scouts, team managers (not in the sense used in baseball), and others working behind the scenes in sports would be included as specified services.
But still, Treasury has done something here that some would consider unexpected. While it seems likely that a studio that makes movies and employs performing artists is not a specified business, the proposed regulations make it crystal clear that sports teams that employ athletes are specified businesses. Only a few teams have corporate owners, so most of them are passthrough businesses. Given the wording of the statute — any trade or business involving the performance of services in the field of athletics — Treasury certainly has the authority to include them. Conspiracy theorists might say this is a Trump administration slap on the wrist for the NFL.
Also left in limbo is whether such businesses as horse breeding and auto racing are services related to “racing,” which is included as an athletic service in the proposed regulations. Billiards is also included as an athletic endeavor under the proposed regulations. Then what about poker? After all, ESPN covers it.
Financial Stuff
The remaining three categories cover a wide range of financial activities — brokerage services, financial services, and ITDs (defined above). Except for two zingers, all follows pretty much as might be expected given common sense and current-law definitions.
The first surprise is that banks that are organized as passthroughs are not included in the definition of financial services. The reasoning offered by these generally small bankers in an April 30 letter to Treasury is as follows: (1) section 1202 had listed banks and financial service companies separately; (2) banks are distinguishable from financial service companies under section 1202; (3) the section 199A statutory language explicitly cross-references section 1202; (4) section 199A refers only to financial services as a specified service; therefore (5) Congress did not intend banks to be a specified service or it would have explicitly said so. There are 1,646 subchapter S corporation banks in the United States (David Kahn, “S Corps: A Growing Trend in Small Bank Holding Company Formation,” Federal Reserve Bank of Atlanta (Feb. 8, 2018)). Blake E. Crow reports that when his firm ran an analysis, all but one subchapter S bank in the whole country was not subject to the wage and property limitation.
The second surprise is that brokerage services do not include services provided by real estate agents and brokers, or insurance agents and brokers. That, along with the narrow interpretation of the reputation or skill clause, means those folks probably qualify for the deduction. The National Association of Realtors website had been pessimistic about qualification for its members: “It seems clear that most real estate agents and brokers will be considered in a personal service business and would thus not normally qualify for the 20 percent deduction.”
Hot Fun in the Summertime?
The items hastily analyzed here are only a portion of the issues addressed in the proposed regulations. The IRS and Treasury regulation writers may now go on a well-deserved vacation. Too bad they’ve ruined ours.