Analysis Suggests Deleting Section 199A Clause

June 15, 2018

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

The Honorable David J. Kautter
Acting Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

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

Dear Messrs. Kautter and Paul:

I am pleased to submit the attached paper addressing the definition of a specified service trade or business in section 199A of the Internal Revenue Code of 1986, as amended. As discussed in the paper, this definition raises numerous interpretive issues, particularly with respect to the “reputation or skill” clause in section 1202(e)(3), which section 199A references.

If you have any questions or comments or would like to discuss the analysis and conclusions I reach in the paper, please let me know.

Respectfully submitted,

Alexandre Marcellesi.
New York, NY

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INTERPRETING THE “REPUTATION OR SKILL” CLAUSE IN
SECTION 199A: A FOOL'S ERRAND?

Alexandre Marcellesi

I. Introduction

On December 22, 2017, Congress amended the Internal Revenue Code of 1986 (the “Code”) pursuant to P. L. 115-97 (the “Act”).¹ The Act notably added section 199A to the Code, a provision allowing non-corporate taxpayers to deduct up to 20% of their income from certain pass-through businesses.

Unlike C corporations, pass-through businesses such as S corporations, partnerships, or sole proprietorships are not subject to entity-level tax. Rather, their owners are directly taxed on their share of the business's income. A pass-through owner may thus be taxed on her share of the business's income at a top marginal rate of 37%. If all of her income from this business qualifies for the 20% deduction provided by section 199A, however, her top marginal rate will only be 29.6%.²

There is a great deal of uncertainty as to how to interpret and apply section 199A. It is unclear, for instance, whether a taxpayer may get a deduction if she operates both deduction-eligible and deduction-ineligible businesses through the same pass-through entity.³ It is also unclear whether taxpayers who are nonresident aliens are eligible for the deduction.⁴ This paper focuses on an uncertainty regarding which businesses are eligible for the deduction. Section 199A provides that eligible businesses may not have the reputation or skill of one of their owners or employees as their principal asset.⁵ As I will explain below, it is far from clear what “reputation” or “skill” encompass and in what circumstances they are a business' principal asset.

The aim of this paper is to analyze three attempts to interpret and clarify this “reputation or skill” clause. The eventual conclusion will be skeptical. Any attempt to interpret this clause, including the one I find most promising, faces serious difficulties. So much so, in fact, that the examination of these attempts is perhaps best understood as a reductio ad absurdum of the assumption that such attempts should be made in the first place.

Legal scholars and practitioners looking to resolve statutory ambiguities typically start by interrogating the drafters' intent. One can interrogate Congress's intent in enacting section 199A at several levels. One may inquire as to the justification for enacting the section as a whole. One may also ask what rationale underlies a particular subsection, paragraph, or subparagraph. In this introduction, I focus on general justifications that might provide a backdrop against which to interpret the “reputation or skill” clause. Below, I will consider the rationale for this clause in particular, and for the definition of an eligible business in which it appears.

Two main justifications have been advanced for enacting section 199A. The first is that the deduction it provides for pass-throughs is necessary to put C corporations and pass-through businesses on equal footing, given the cut of the top corporate tax rate from 35% to 21%.⁶ Senator Ron Johnson, for instance, claimed that the “fair treatment” of pass-through business owners compared to C corporation shareholders required such a reduction of their tax burden.⁷ The report of the Committee on Ways and Means on the House version of the Act endorses this justification, claiming that the aim of section 199A is “to treat corporate and noncorporate business income more similarly.”⁸

As Daniel Shaviro points out, however, this justification is flawed in several respects.⁹ First, income earned through a C corporation may be subject to a second tax at the shareholder-level.¹⁰ Dividends distributed by C corporations may be taxed to their shareholders at marginal rates up to 23.8%.¹¹ Even with a corporate tax rate of 21%, therefore, the income of C corporations is subject to a heavier aggregate tax burden than is the income of pass-through businesses taxed once at a top rate of 37%.¹² Second, pass-through businesses can easily incorporate to benefit from the newly cut corporate tax rate if this would improve their tax situation. The deduction provided by section 199A is thus hardly necessary to ensure fair treatment of pass-throughs relative to C corporations.

A second justification advanced for enacting section 199A is that pass-through businesses are, in Senator Johnson's words, “the true engine of economic growth and job creation.”¹³ Giving such businesses a tax cut would, it is argued, accelerate their growth and so lead to increased hiring. Underlying such claims is often the assumption that pass-throughs tend to be small businesses and that small businesses create more jobs than large businesses. According to statistics of the U.S. Small Business Administration (“USSBA”), most small businesses are organized as pass-throughs.¹⁴ Moreover, “[s]mall businesses accounted for 63.3% of net new jobs from the third quarter of 1992 until the third quarter of 2013.”¹⁵ This data seems to lend credence to Johnson's claims. It should be noted, however, that the USSBA defines “small businesses” fairly liberally as including any firm with fewer than 500 employees, with the effect that 99.9% of all domestic firms are small businesses.¹⁶ Note also that there are debates as to the extent to which small businesses do create more jobs than large businesses.¹⁷ Additionally, because the U.S. economy is at or near full employment, encouraging job creation is an unconvincing justification for the enactment of section 199A.¹⁸

More importantly, however, even if small businesses organized as pass-throughs were the engine of growth and job creation, this would hardly justify allowing all pass-throughs, regardless of size (as measured by number of employees or revenue, for instance), to benefit from the deduction. If the intent behind section 199A was exclusively to help small businesses create jobs, one would expect the deduction it provides not to be available to large businesses organized as pass-throughs, such as Fiat Chrysler, Georgia-Pacific, or nearly every NFL team.¹⁹

The two main justifications for enacting section 199A are therefore arguably flawed.²⁰ Even flawed rationales, however, can serve to guide interpretation. Bad reasons to do something are still reasons why the thing was done. When attempting to interpret the “reputation or skill” clause below, I will therefore take these two professed rationales into account.

Resolving ambiguities in section 199A is far from an idle exercise. The stakes are high, for the government, for business owners planning their affairs, and for the lawyers and accountants advising them.

About 95% of all businesses in the U.S. are organized as pass-throughs rather than C corporations.²¹ Pass-throughs now earn more than half of all U.S. business income.²² Moreover, most pass-through income is earned by high-earners, who see a larger share of their income taxed at the top marginal rate and so stand to benefit the most from a deduction.²³ The government thus stands to lose a substantial amount of revenue if ambiguities in section 199A are resolved in taxpayers' favor and a large number of pass-through owners can benefit from a deduction as a result.

Note also that pass-throughs are responsible for a large portion of the total “tax gap”, i.e. the difference between taxes owed and taxes paid. For the 2008-2010 period, about 41% of the gap ($190 billion) was due to pass-through owners underreporting their income.²⁴ The ambiguities in section 199A may incentivize pass-through owners to adopt aggressive tax positions while limiting the IRS's ability to fight these positions in court. This may in turn further increase the tax gap due to underreporting by pass-through owners.

Business owners deciding whether to operate as C corporations or as pass-throughs are equally eager to see ambiguities in section 199A resolved. As the New York State Bar Association (“NYSBA”) points out in a recent report of its tax section, the fate of a wide variety of businesses is uncertain under section 199A: barbers and beauty salons, interior decorators, gardeners and lawn care providers, call centers, staffing agencies, journalists, agents for writers, real estate agents, home builders, personal trainers, hotel managers, plumbers, electricians, auto repair shops, carpenters, tutors, interpreters, etc.²⁵

Whereas the owner of a C Corporation operating a barbershop, for instance, might be subject to a combined tax rate of up to 40.56%, the owner of a pass-through operating an identical business and whose entire income qualifies for the 20% deduction would be subject to a top rate of only 29.6%.²⁶ The potential tax benefit associated with pass-through status, however, is mitigated by the uncertainty regarding section 199A.²⁷ This provision, moreover, is temporary and does not apply to taxable years beginning after December 31, 2025.²⁸ It may be extended in the future or repealed before its expiration, further adding to the uncertainty faced by tax planners.

This uncertainty has practitioners clamoring for guidance. The NYSBA, in its recent report, expressed “an immediate need for guidance” regarding ambiguities plaguing section 199A, including the ambiguity regarding which businesses are eligible that will be the focus of this paper.²⁹ The American Institute of Certified Public Accountants, in a letter to Assistant Secretary of the Treasury for Tax Policy David Kautter, likewise requested “immediate guidance” regarding several aspects of the Act.³⁰ The organization representing accountants emphasized, in particular, that “under section 199A, guidance is needed on the definition of specified service trade or business. . . .”³¹

Despite business owners' and practitioners' eagerness the see guidance on section 199A, it is unclear when Treasury regulations may be proposed, let alone finalized. Adding to this uncertainty is the possibility that Treasury regulations constituting “significant guidance” may now be subject to thorough review by the Office of Management and Budget (OMB).³² In a recent Senate hearing, for instance, Treasury General Counsel Brent McIntosh suggested that proposed regulations under section 199A would be among the candidates for thorough OMB review.³³

Until regulations are proposed, tax scholars and practitioners must attempt to interpret section 199A based on its text, history, and underlying policies. This is what I attempt to do here. In the rest of this paper, I will briefly introduce the mechanics of section 199A (section II) before examining the rationale underlying Congress's approach to identifying businesses eligible for a deduction (section III). I will then argue that guidance under section 1202, from which section 199A partially borrows its definition of an eligible business, is largely a red herring for purposes of interpreting the “reputation or skill” clause (section IV). The following three sections will be spent analyzing and criticizing three attempts to interpret this clause (sections V-VII). Finally, I will conclude that, given the cost of enforcing the “reputation or skill” clause and the low likelihood that doing so will yield significant benefits for the government, the best solution may be to eliminate this clause altogether.

II. The Mechanics of section 199A

Before examining the ambiguities raised by section 199A, it is necessary to briefly describe its inner workings. Section 199A applies only to noncorporate taxpayers and allows them to deduct the lesser of their combined qualified business income (“CQBI”) or 20% of the excess of their taxable income over their net capital gains.³⁴

A taxpayer's CQBI is the sum of the deductible portion of her qualified business income (“QBI”) from each of her qualified trades or businesses (“QTBs”) plus 20% of the aggregate of the qualified REIT dividends and publicly traded partnership income she received.³⁵

A taxpayer's QBI from a QTB is generally the net income from such QTB.³⁶ QBI excludes, among other items, dividends, capital gains, guaranteed payments to partners for services rendered to the QTB, and reasonable compensation paid to the taxpayer by a QTB.³⁷

A QTB is defined as any trade or business other than the trade or business of performing services as an employee or a specified service trade or business (“SSTB”).³⁸ The definition of a SSTB is the main topic of this paper. The core of this definition is borrowed from paragraph 1202(e)(3), which defines a “qualified trade or business” for purposes of partially exempting gain from the sale or disposition of qualified small business stock. This core has two components: an enumerated list and an additional clause.

According to the enumerated list, SSTBs include any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services.³⁹ This list is identical to the one in subparagraph 1202(e)(3)(A), except that engineering and architecture have been removed.⁴⁰

The additional clause in the definition of a SSTB states that any trade or business the principal asset of which is the reputation or skill of one or more of its owners or employees is a SSTB.⁴¹ Again, this clause is nearly identical to the one in subparagraph 1202(e)(3)(A), except that the reputation and skill of both owners and employees are within its scope, whereas subparagraph 1202(e)(3)(A) only concerns itself with employees.

An important exception to the definition of a SSTB should be noted. Any SSTB is a QTB if the taxpayer's income falls below $207,500 for an individual taxpayer and $415,000 for a married couple filing jointly.⁴² The QBI portion of the income from such a QTB, however, progressively falls to zero as the taxpayer's income rises from $157,501 to $207,500 for an individual taxpayer, and from $315,001 to $415,00 for married couples filing jointly.⁴³

The deductible portion of the QBI from each QTB is capped at the greater of either 50% of the W-2 wages paid by the QTB or the sum of 25% of such wages plus 2.5% of the aggregate unadjusted basis of all of the QTB's qualified property.⁴⁴ All else being equal, pass-throughs operating QTBs thus have an incentive to maximize the amount of W-2 wages they pay to employees. Qualified property is tangible property that is depreciable and as been used to produce QBI during the year.⁴⁵

III. What Justifies The Definition of a QTB?

Interpreting the “reputation or skill” clause in the definition of a SSTB requires one to first understand the purpose of both this definition and the broader definition of a QTB in which it is embedded.

As Shaviro points out in his critical evaluation of section 199A, Congress has long held the view that individuals deriving income from the performance of services should not be able to convert this income into business income taxed at a lower rate.⁴⁶ The evidence surrounding the enactment of section 199A indicates that the exclusion of employees and of certain service businesses from the set of QTBs was motivated by the same concern. The “Unified Framework for Fixing Our Broken Tax Code” released on September 27, 2017 by the GOP, for instance, advanced the idea of a tax cut for pass-throughs. However, it also anticipated that the tax writing committees would “adopt measures to prevent the recharacterization of personal income into business income to prevent wealthy individuals from avoiding the top personal tax rate.”⁴⁷

It is important to note, however, that only certain types of service businesses are prohibited from being QTBs. Thus, a business providing services in the domains of real estate, oil and gas, or manufacturing may be a QTB if it can escape the “reputation or skill” clause. Additionally, an individual providing services as an employee cannot have a QTB while the same individual providing the same services as an independent contractor can. What might justify such fine-grained distinctions between type of service businesses, if Congress's general concern was to prevent the conversion of labor income derived from the performance of services into business income?

First might be revenue considerations. It may be that QTBs, in the aggregate, earn a relatively small amount of income, so that granting them a 20% deduction will have limited effects on tax revenue. Even though assessing this hypothesis is difficult, especially given the uncertainty regarding which businesses are QTBs, there is no reason to expect that service providers in real estate, oil and gas, or manufacturing collectively earn less than service providers in health, law, or accounting.⁴⁸ An alternative hypothesis may be that QTBs tend to engage in less sophisticated tax planning than non-QTBs, so that they are less likely to avail themselves of the deduction, which would in turn help preserve tax revenue. Again, there is little evidence for this hypothesis.

If anything, the evidence indicates that oil, gas, and real estate businesses, all of which are likely to be QTBs, are highly sophisticated tax planners.⁴⁹

A second justification for the distinction drawn by Congress between QTBs and non-QTBs might be that QTBs are best positioned to create jobs and so function as Johnson's “true engine[s] of economic growth and job creation.” Again, however, there is no reason to think that a real estate business would create more jobs than an accounting firm if both were able to deduct 20% of their business income. If anything, one would expect a business whose main asset is its workforce — accounting firms, law firms, etc. — to hire more when its income increases compared to businesses that invest primarily in tangible assets, e.g. real estate businesses.

The lack of a clear justification for the line drawn by Congress between QTBs and non-QTBs has led Shaviro to call it an “incoherent and unrationalised industrial policy, directing economic activity away from some market sectors and towards others, for no good reason and scarcely even an articulated bad one.”⁵⁰ His favored explanation is “sociological, or more specifically tribal.”⁵¹ As Shaviro puts it,

The likes of real estate, oil and gas, manufacturing, and retailing are apparently “good”, while the likes of medicine, law, accounting, consulting, the arts, professional sports, and corporate management are apparently less good, but one cannot quite tell why. . . . People from the favoured business groups on the one hand, and educated professionals on the other hand, tend to belong to distinct social groups. Their sociological, cultural, and political differences evidently reduced the former's (and Congressional Republicans') interest in allowing these specially tailored tax benefits to the latter — especially given overall revenue constraints on the 2017 Act.⁵²

Whether or not one endorses Shaviro's explanation, it correctly points out the seemingly arbitrary character of the line separating QTBs from non-QTBs. Although the ostensible goal of the definition of a QTB is to prevent the conversion of labor income into business income, then, there is a great deal of uncertainty as to why Congress settled on the particular definition of a QTB that appears in the final version of the Act.

The NYSBA agrees with Shaviro, noting that “the uncertainty regarding Congress' intention in choosing this particular standard” prevents its members from coming “to a consensus as to a single particular standard to recommend” for interpreting this standard. And even conservative tax scholars, who are otherwise inclined to favor business tax cuts, take issue with Congress's definition of QTB. Douglas Holtz-Eakin, an economist at the conservative American Action Forum, for instance, claimed in a hearing on the Act recently held by the Senate Finance Committee that the definition of a QTB draws “haphazard lines in the sand” that “are the exact kind of lines that tax lawyers and experts will attempt to try to game.”⁵³

Any attempt to interpret the “reputation or skill” clause in section 199A's definition of a SSTB will stand on shaky foundations as a result of this uncertainty. Even though this clause should be interpreted so as to restrict taxpayers' ability to convert labor income into business income, it is unclear what other purposes Congress had in mind in enacting it.

IV. Does Subparagraph 1202(e)(3)(A) Help?

As mentioned above, the part of the definition of a SSTB on which this paper focuses are borrowed from paragraph 1202(e)(3), which defines a “qualified trade or business” for purposes of exempting 50% of the gain from the sale or disposition of qualified small business stock.⁵⁴ One might therefore think that guidance regarding the interpretation of paragraph 1202(e)(3) should shed light on the definition of a SSTB in section 199A and on the “reputation or skill” clause in particular. As Daniel Mellor recently put it, section 1202 might be “the key to unlocking the new 20% income tax deduction available to high-income owners of pass-through entities.”⁵⁵ There are several reasons to be skeptical, however.

First, the rationale underlying section 1202 is markedly different from that underlying section 199A. Section 1202 was designed to provide “targeted relief for investors who risk their funds in new ventures [and] small businesses” so as to “encourage the flow of capital to small businesses, many of which have difficulty attracting equity financing.”⁵⁶ As Daniel Mellor points out, section 1202 targets “start-up and research-based businesses” in particular, as indicated by paragraph 1202(e)(2).⁵⁷ Unlike section 199A, section 1202 was therefore designed to direct investment toward a particular group of businesses facing a specific challenge.

For this reason, section 1202 only applies to a narrowly defined class of businesses. Such businesses, for instance, are subject to limits regarding the amount of aggregate gross assets they may hold at the time they issue the stock gains on the disposition of which may be partially exempt.⁵⁸ Section 199A, by contrast, is much more liberally drafted and can apply to businesses of any size. It may also grant real estate businesses a deduction. Section 1202, by contrast, explicitly prohibits eligible businesses from holding more than 10% of the value of their assets in the form of real property not used in the active conduct of a qualified trade or business.⁵⁹ And it further provides that the ownership of, dealing in, or renting of real property do not constitute the active conduct of a qualified trade or business.⁶⁰

These notable differences in the rationales underlying sections 199A and 1202 cast doubt on the appropriateness of using guidance regarding the latter to interpret the former. But so do more pointed differences in the drafting of the two sections. It is worth quoting in full the provision of paragraph 1202(e)(3) from which paragraph 199A(d)(2) borrows its language:

The term “qualified trade or business” means any trade or business other than 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. . . .⁶¹

Interpreting the “reputation or skill” clause in either subparagraph 1202(e)(3)(A) or subparagraph 199A(d)(2)(A) requires the resolution of a first ambiguity. There are at least three ways to read this clause. The first is as a catch-all to the enumerated list. Under this reading, the enumerated service businesses are businesses in which the reputation or skill of an employee is the business's principal asset, and the “reputation or skill” clause thus aims to disqualify any business that shares this characteristic but is not explicitly listed. Under this first reading, only service businesses bearing similarities to the enumerated ones may be disqualified by the “reputation or skill” clause.⁶²

The second reading would interpret the “reputation or skill” clause as a standalone clause aiming to disqualify only service businesses the principal asset of which is the reputation or skill of an employee, without making the further assumption that such businesses must bear similarities to the enumerated ones. The third reading only departs from the second in interpreting it as designed to disqualify both service and nonservice businesses. Whereas the third reading is arguably correct in the case of section 1202, only the first two are plausible in the case of section 199A.

In paragraph 1202(e)(3), the enumerated list and “reputation or skill” clause serve to directly define a qualified trade or business. Because section 1202 does not create opportunities for taxpayers to convert labor income derived from the performance of services into business income to the same extent section 199A does, its definition of a qualified trade or business does not have as its primary purpose the exclusion of service businesses. Indeed, this definition excludes a number of nonservice businesses, e.g. certain oil and gas businesses.⁶³ This provides some support for the view that the “reputation or skill” clause in subparagraph 1202(e)(3)(A) should be read as a standalone clause designed to disqualify both service and nonservice businesses. Additionally, in the Tax Court case of Owen v. Comm'r examined in more detail below, both the Tax Court and the IRS itself implicitly interpret the “reputation or skill” clause in subparagraph 1202(e)(3)(A) as applying to both service and nonservice businesses.⁶⁴

One might object that, if the “reputation or skill” clause were to be so read, it would have been separated in a distinct subparagraph.⁶⁵ Note, however, that the subparagraphs under 1202(e)(3) mix both service and nonservice businesses. Subparagraph 1202(e)(3)(C), for instance, disqualifies any farming business without drawing a distinction between service and nonservice farming businesses. Likewise, subparagraph 1202(e)(3)(B) disqualifies banking businesses in general, regardless of whether they consist in the selling of financial products or in the providing of financial services. This liberal mixing of service and nonservice businesses in the definition of a qualified trade or business for purposes of section 1202 has a straightforward explanation. Unlike section 199A, section 1202 does not create opportunities for taxpayers to convert into business income the labor income they derived from the performance of services.

By contrast with subparagraph 1202(e)(3)(A), the enumerated list and “reputation or skill” clause in subparagraph 199A(d)(2)(A) serve to directly define a SSTB, i.e. a specified service trade or business. Moreover, the only other trade or business disqualified from being a QTB, along with SSTBs, is the trade or business of performing services as an employee.⁶⁶ There is thus little doubt that the “reputation or skill” clause, as it appears in subparagraph 199A(d)(2)(A), is designed to disqualify service businesses, at the exclusion of nonservice businesses.

Note that this leaves open the question of whether, for the purpose of section 199A, the “reputation or skill” clause should be read as a catch-all to the enumerated list, with the assumption that businesses disqualified by this catch-all must bear similarities to the enumerated ones, or as a standalone clause. Both Martin Sullivan and the NYSBA assume that it should be read as a catch-all and that businesses that have the reputation or skill of an owner or employee as their principal asset must bear similarities to businesses providing services in the fields of health, law, etc.⁶⁷ Given that the “reputation or skill” clause is, for purposes of section 1202, best interpreted as a standalone clause, however, there is little support for this assumption. Thankfully, this question does not need to be resolved for the purpose of this paper.⁶⁸

The fact that the “reputation or skill” clause in subparagraph 199A(d)(2)(A) is designed to disqualify only service businesses is a reason to doubt that guidance regarding the application of the “reputation or skill” clause for purposes of section 1202 can be extrapolated to section 199A. Another reason is that, in the case of section 1202, this clause only targets employees whereas, in the case of section 199A, it targets both employees and owners. This difference may be explained by the fact that section 1202 merely provides an incentive to invest in small business stock and does not create an opportunity for taxpayers to convert labor income into business income. There is therefore no need for paragraph 1202(e)(3) to disqualify, for instance, sole proprietorships relying on their owner's skill or reputation, since those businesses are not eligible for favorable treatment under section 1202 in the first place. This is a further reason to think that the “reputation or skill” clause might play starkly different roles in sections 199A and 1202.

A final reason to be skeptical of the view that section 1202 holds the key to interpreting the “reputation or skill” clause in section 199A is that existing guidance under the former is extremely limited and consists of two Private Letter Rulings (PLRs) and one Tax Court case.

In PLR 201717010, the IRS held that a company providing laboratory reports to health care professionals was not itself in a trade or business involving the performance of services in the field of health. As a result, the company was not, on this ground, disqualified from being a qualified trade or business for purposes of section 1202. The IRS based its conclusion on the taxpayer's representation that the company did not provide healthcare professionals with diagnosis or treatment recommendations, and that it had no knowledge of the healthcare professionals' diagnosis or treatment recommendations.

From the IRS's holding, one can derive the general principle that it should be possible for a business to perform services for another business that is a SSTB without thereby being a SSTB itself. This principle has no bearing on the interpretation of the “reputation or skill” clause. The IRS, however, also held that the company was not engaged in a trade or business the principal asset of which is the reputation or skill of an employee.⁶⁹ Unfortunately, the IRS's reasoning is rather opaque. The IRS based its conclusion on the taxpayer's representation that the skills of the company's employees are “unique to the work they perform” for the company and “are not useful to other employers.”⁷⁰ Daniel Mellor interprets this conclusion as implying that businesses offering services that are “one of a kind” may be able to escape classification as SSTBs under the “reputation or skill” clause as it appears in subparagraph 199A(d)(2)(A).

There are, however, several issues with the IRS's approach in PLR 201717010 and Mellor's interpretation of its ramifications for the interpretation of section 199A. First, it is unclear what justifies the IRS's conclusion that business-specific skills should be disregarded. A possible explanation is that business-specific skills tend to be tied to valuable intellectual property (IP) developed by the business. In PLR 201717010, the skills the employees developed were related to the company's “proprietary technology” for conducting laboratory tests.⁷¹ Since section 1202 was designed to encourage investment in start-ups and research-based businesses, presumably to foster innovation, it should provide favorable treatment to investors in businesses developing valuable IP.⁷²

At this point, it is important to remember that the definition of a qualified trade or business plays a different role in sections 1202 and 199A. Disregarding business-specific skills might make sense under section 1202, since the aim of the qualified trade or business requirement there is to identify small, potentially innovative businesses toward which investment should be channeled. This justification, however, does not carry over to section 199A. The purpose of the definition of a SSTB is not to encourage investment in small businesses but to prevent the conversion of labor income into business income. Any artist who operates a business possesses, to a large extent, business-specific skills. There is no sense in which Andy Warhol's skills, for instance, would be useful to another business. It seems unlikely, however, that Congress intended artists offering to perform services for their customers, e.g. painting a mural in your living room, to be QTBs and so benefit from a deduction under section 199A. Mellor's claim that businesses offering “one of a kind” services may be able to avoid classification as SSTBs under the “reputation or skill” clause is thus likely false.

In the other relevant ruling, PLR 201436001, the IRS held that a company advising clients in developing successful drug manufacturing processes was not in a trade or business involving the performance of services in the field of health. The analysis of section 1202(e)(3) on which the IRS rests its conclusion, however, is arguably flawed and is worth quoting in its entirety:

Section 1202(e)(3) excludes various service industries and specified non-service industries from the term “qualified trade or business.” Thus, a qualified trade or business cannot be primarily within service industries, such as restaurants or hotels or the providing of legal or medical services. In addition, § 1202(e)(3) excludes businesses where the principal asset of the business is the reputation or skill of one or more of its employees. This works to exclude, for example, consulting firms, law firms, and financial asset management firms. Thus, the thrust of § 1202(e)(3) is that businesses are not qualified trades or businesses if they 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).⁷³

There are two difficulties with this analysis which, as the NYSBA notes, the IRS provided “[w]ithout citation to any specific authority to support its interpretation.”⁷⁴

The first difficulty is the IRS's apparent interpretation of the “reputation or skill” clause as a catch-all to the enumerated list in subparagraph 1202(e)(3)(A), with the assumption that businesses excluded by such catch-all should bear similarities to the enumerated ones. This is the only reading of the “reputation or skill” clause that is consistent with the IRS's assertion that the general exclusion of businesses that rely on the reputation or skill of their employees “works to exclude” consulting firms, law firms, and financial asset management firms. The obvious issue with the IRS's interpretation is that such businesses are explicitly excluded by the statute, independently of the “reputation or skill” clause. Law and consulting are excluded by the enumerated list of subparagraph 1202(e)(3)(A). Asset management firms are explicitly excluded by subparagraph 1202(e)(3)(B) as investing businesses, a provision which makes no reference to reputation or skill.

The second difficulty is the IRS's interpretation of the qualified trade or business requirement for purposes of section 1202 as essentially targeting “trades or businesses if they offer value to customers primarily in the form of services. . . .” This interpretation cannot be squared with the text of the statute, which excludes a number of nonservice businesses and only mentions services in the enumerated list of subparagraph 1202(e)(3)(A), i.e. in one of its five subparagraphs.

On the basis of this problematic analysis of the statute, the IRS held that the company the stock of which was owned by the taxpayer did not perform services in the field of health. The company did work “primarily in the pharmaceutical industry, which is certainly a component of the health industry. . . .”⁷⁵ However, it “was not in the business of offering service [sic] in the form of individual expertise.”⁷⁶ Instead, it created value for its customers via the “deployment of specific manufacturing assets and intellectual property assets. . . .”⁷⁷ In this way, the company was “a pharmaceutical industry analogue of a parts manufacturer in the automobile industry.”⁷⁸ Note that, as might have been the case in PLR 201717010, the development of valuable IP by the company, “including its patent portfolio”, seems to have played a role in motivating the IRS's conclusion.

The IRS's arguably flawed analysis of paragraph 1202(e)(3) does not undermine this holding. Indeed, it is not clear why an analysis of paragraph 1202(e)(3) was needed in the first place, since the question at hand was simply whether the company's business fell into one of the explicitly disqualified categories. The NYSBA, however, relies on this holding and on the IRS's underlying analysis of paragraph 1202(e)(3) to support the proposition that businesses that do not offer value to customers primarily in the form of services, i.e. “individual expertise”, are not SSTBs.⁷⁹ In other words, the NYSBA hopes to use PLR 201436001 to help businesses that perform some services in one of the prohibited fields escape the dreaded SSTB status.

There are at least two issues with the NYSBA's inference. First, if the IRS's analysis of paragraph 1202(e)(3) is in fact incorrect, then this inference relies on a false premise. Second, and most importantly, even if the analysis of PLR 201436001 was appropriate in the context of section 1202, it may not be appropriate in the context of section 199A. Once again, identifying qualified trades or businesses serves very different purposes in sections 1202 and 199A. It may make sense, in the context of section 1202, to give favorable treatment to investors in businesses that perform some services in one of the prohibited fields but otherwise develop valuable IP. This provision was, after all, designed to encourage investment in “start-up and research-based businesses”, as Mellor put it.

In the context of 199A, however, where the worry of taxpayers converting labor income derived from the performance of services into business income looms large, it may make sense not to give favorable treatment to business that perform any services in one of the prohibited fields, regardless of their other activities. Such a strict exclusion of such businesses would, for instance, prevent taxpayers from adopting aggressive positions regarding which of their business activities primarily provides value for customers and so would limit litigation related to this issue.

The last piece of guidance regarding the definition of a qualified trade or business within the meaning of paragraph 1202(e)(3) is the Tax Court case of Owen v. Comm'r.⁸⁰ The petitioners, John and Laura Owen, sold their 50% stake in the Family First Companies (FFC), a group of companies created by Mr. Owen and his associate, Mr. Michaels. FFC offered both “financial products such as tax deferred annuities, longterm [sic] care insurance, and whole life insurance to its client consumers” but also “prepaid legal service policies, including estate planning services.”⁸¹

Importantly, John Owen worked for FFC in two distinct capacities, both as an officer and “as an independent consultant who furnished services through his personal service corporation, J & L Owen.”⁸² The question arose as to the capacity in which Owen performed sales services for FFC.⁸³ At trial, Owen argued that he performed those services in his capacity as an independent consultant and explained that, “in the industry, independent contractors generally sold the products and services offered by the Family First Companies.”⁸⁴ In fact, FFC grew to employ “around 350 independent sales agents.”⁸⁵ The Tax Court, convinced by Owen's argument, held that “where Mr. Owen was engaged in selling independent of his position as an officer of the Family First Companies, he was an independent contractor. . . .”⁸⁶

The Owens sought to defer recognition of gain on sale of their FFC stock under section 1045. This section allows noncorporate taxpayers to elect to defer capital gains on sale of qualified small business stock held for more than 6 months to the extent the proceeds from such sale are used to purchase other qualified small business stock within 60 days.⁸⁷ Importantly, paragraph 1045(b)(1) provides that the meaning of “qualified small business stock” for purposes of section 1045 is given by subsection 1202(c), so that section 1045 only applies to businesses that are qualified trades or businesses for purposes of section 1202.

The Tax Court examined the issue of whether First Advanced Estate Planning (FFAEP), one of the two companies under the FFC umbrella, was a qualified trade or business for purposes of section 1202. The IRS argued that it was not, so that section 1045 only allowed the Owens to defer a portion of their capital gain on sale of FFC stock, not their entire capital gain. The particular argument advanced by the IRS was that “FFAEP is not qualified because one of the principal assets is the skill of Mr. Owen. . . .”⁸⁸

The Tax Court disagreed with the IRS, holding instead that while the success of FFC was “properly attributable to Mr. Owen and Mr. Michaels, the principal asset of the companies was the training and organizational structure. . . .”⁸⁹ As the Court added, “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.”⁹⁰

The Tax Court's reasoning seems to be that since the individuals providing their skills to FFC were independent contractors, not employees, FFC's principal asset cannot have been the reputation or skill of its employees. Rather, it is the training and support FFC provided to its independent sales agents (including, presumably, sales training and leads) which generated its revenue and so was its principal asset.⁹¹

What lessons can one draw from the Owen case for the purpose of interpreting section 199A? Subparagraph 199A(d)(2)(A) differs crucially from subparagraph 1202(e)(3)(A) in that it disqualifies trades or business the principal asset of which is the reputation or skill of an employee or owner. It should not matter, for purposes of section 199A, whether an owner of the business also happens to be an independent contractor. If it did, owners could easily avoid disqualification of their business as a non-QTB for purposes of section 199A by becoming independent contractors and performing services for their business in their capacity as such.⁹²

It is therefore unclear what conclusion the Tax Court would have reached had it examined the issue of whether FFAEP was a QTB for purposes of section 199A. On the one hand, it is unlikely the Court would have emphasized the contrast between Owen's activities as an independent contractor and his activities as an owner in the way it actually did. On the other hand, the claim that Owen contributed his skill to the business in his capacity as an owner is compatible with the claim that the business's principal asset was nonetheless its training and organizational structure.

There are two further noteworthy aspects of the Owen decision. First, FFAEP was the component of FFC which provided “prepaid legal service policies, including estate planning services.”⁹³ The IRS, however, did not argue that FFAEP was engaged in a trade or business involving the performance of services in the fields of law, accounting, actuarial science, or financial services. This is presumably because the IRS assumed that FFAEP was in the business of providing its customers with financial products, namely prepaid policies, not with the services these policies entitled their holders to receive. The fact that FFAEP was not a service business, however, did not prevent the IRS from arguing that it was disqualified under the “reputation or skill” clause.

The argument made by the IRS against the taxpayer in Owen therefore belies the IRS's very own claim, in PLR 201436001, that businesses are not qualified trades or businesses for purposes of section 1202 “if they offer value to customers primarily in the form of services. . . .”⁹⁴ What the IRS assumes in its argument, and the Tax Court makes the same assumption, is that the “reputation or skill” clause in subparagraph 1202(e)(3)(A) applies to both service and nonservice businesses, and so should be read as standalone clause rather than as a catch-all to the enumerated list.⁹⁵

The second noteworthy aspect of the Tax Court's decision in Owen is that, when inquiring whether the skill of Mr. Owen was FFAEP's principal asset, the Court asked about the main source of the business's sales, and therefore revenue.⁹⁶ In other words, the Court did not take the “asset” language in the “reputation or skill” clause in subparagraph 1202(e)(3)(A) at face value and examine FFAEP's balance sheet, looking for a reputation or skill asset on its left-hand side.

Section 1202 thus can hardly be the key to unlocking section 199A. The stark differences in the rationales underlying the two sections and their respective guardrails undermine any attempt to extrapolate the limited guidance available regarding the former to the latter. Indeed, some practitioners have claimed that “a fresh look at the statutory language is warranted to determine how it should be applied for purposes of section 199A.”⁹⁷ In sections V through VII, I examine three attempts to interpret the “reputation or skill” clause in subparagraph 199A(d)(2)(A) in the face of this lack of guidance.

V. Comparing Assets to Assets

Martin Sullivan, one of the editors of Tax Notes, recently proposed an interpretation of the “reputation or skill” clause in subparagraph 199A(d)(2)(A) which takes the “asset” language at face value and as reflecting “the accounting definition of an item with a quantifiable value. . . .”⁹⁸ According to Sullivan, the skill or reputation of an owner or employee is the principal asset of a business just in case the value of what one might call “reputation or skill” assets exceeds 50% of the total value of the business's assets. The challenge, however, is to identify and value such assets, as Sullivan acknowledges.

Consider first the case of employees. The skills and reputations of a business's employees cannot be an asset, since employees are typically compensated for the use of such human capital on an ongoing basis.⁹⁹ By contrast, workforce in place (WIP), i.e. the cost of replacing a business' workforce, is a bona fide intangible asset that may be invoked in applying Sullivan's approach. WIP, however, is typically value on an aggregate basis, and so will include the cost of replacing employees contributing neither skill nor reputation to the business. Moreover, as Sullivan remarks, the value of WIP “is not routinely calculated as part of [most business's] normal accounting practices.”¹⁰⁰ As the NYSBA also notes, this approach “may be difficult to apply in the case of small businesses that do not maintain audited financial statements.”¹⁰¹ An additional difficulty identified by the NYSBA is that the valuation of intangible assets such as WIP is “relatively subjective” and so is “ripe for abuse”.¹⁰²

In the case of owners, whether passive and contributing their reputation or active and contributing both skill and reputation, the difficulties are even more severe. Any ongoing payments for contributions of reputation or skill will fail to create an asset for the same reason as in the case of employees. But, in the case of owners, there is the added difficulty of determining whether the payments received are compensation for services rendered to the business, a return on their monetary investment in the business, or a payment for the use of their reputation.¹⁰³ The reputation of owners, moreover, is likely to be captured by intangible assets such as goodwill, an asset which, by its very nature, cannot be disaggregated into its component parts.¹⁰⁴

From these considerable difficulties and the assumption that few businesses are likely to be classified as SSTBs on the basis of the “reputation or skill” clause, Sullivan concludes that Treasury should “provide significant safe harbors to taxpayers” but also that “Congress should consider repealing the test altogether or extensively clarifying it.”¹⁰⁵

One might, however, draw a different conclusion from the difficulties faced by Sullivan's proposal. One might, for instance, conclude that Sullivan's literal reading of the “asset” language in subparagraph 199A(d)(2)(A) is inappropriate. As explained above, for instance, the Tax Court in the Owen case did not read this language, in the context of section 1202, in the way recommended by Sullivan. Rather, it focused on the main source of the business's revenue.¹⁰⁶

Sullivan considers this “less finicky” alternative interpretation of the “principal asset” language but quickly rejects it.¹⁰⁷ In his view, taxpayers whose businesses would be disqualified as SSTBs under this alternative interpretation would have “a strong case” that the “principal asset” language should be interpreted literally to refer to “capital” that “can be quantified and appear [sic] on the balance sheet of the taxpayer in question.”¹⁰⁸

The only Tax Court case interpreting the “reputation or skill” clause and its “principal asset” language, however, interprets it as requiring an inquiry into the main source of the business's revenue, not as requiring an examination of the business's balance sheet. And the two PLRs analyzed above implicitly adopt the same approach, since neither requires representations regarding the taxpayer's business's balance sheet to conclude that the business does not fail to be a qualified trade or business by reason of the “reputation or skill” clause in subparagraph 1202(e)(3)(A). If anything, then, it seems that a disappointed taxpayer's arguing that the IRS misinterpreted the “principal asset” language would have a weak case, based on available precedent.¹⁰⁹

VI. Comparing Assets to Revenue

Donald Susswein partially agrees with Sullivan's reading of the “principal asset” language of subparagraph 199A(d)(2)(A) as requiring an inquiry into the business's “reputation or skill” assets. He briefly considers the alternative interpretation of the “principal asset” language “as referring to the principal sources of value in a company's inventory or output of goods or services.”¹¹⁰ However, he understands this alternative in a narrow fashion and as implying that “any company that paid wages amounting to more than 50% of its gross revenues would be excluded.”¹¹¹ As Susswein notes, this alternative encourages businesses to keep wages below 50% of gross revenue and so cannot be reconciled with Congress's professed intent in enacting section 199A, namely encouraging job creation.¹¹²

In Susswein's view, instead of comparing wages to revenue, as the alternative he considers does, or assets to assets, as Sullivan does, one should compare assets to revenue. His approach is thus predicated on a somewhat less literal reading of the “principal asset” language of subparagraph 199A(d)(2)(A) than Sullivan's.

According to Susswein's proposal, the relevant inquiry should focus on “the relative proportion of the company's annual gross revenue that can fairly be attributed to [reputation or skill] assets.”¹¹³ He proposes, as a safe harbor, that the “reputation or skill” clause should not disqualify a business “if 50 percent or less of the company's annual gross revenue is properly attributable to [reputation or skill] assets.”¹¹⁴

Susswein's preferred approach has the advantage of being easy to apply. He provides two examples in which WIP is adopted as the relevant “reputation or skill” asset for employees. He then assumes that the amount of revenue the owner's “reputation or skill” asset is responsible for cannot exceed the share of profits inuring to such owner for the year. The advantage of this approach is that one does not need to identify such an asset or value it. In Susswein's first example, for instance, the business has $1,600,000 of revenue for the year, a $100,000 amortization deduction for WIP, and net income of $500,000. Because only $100,000 + $500,000 = $600,000 of the business's $1,600,000 of revenue, i.e. 37.5%, is attributable to the reputation or skill of its owner or employees, this business satisfies Susswein's proposed safe harbor and so is not classified as a SSTB by reason of the “reputation or skill” clause.

Leaving aside the serious difficulties regarding the definition and valuation of WIP already described above, Susswein's approach, and his safe harbor in particular, faces a number of serious difficulties. Consider the case in which the business's net income is $800,000 instead of $500,000. In such a case, since more than 50% of its revenue may be attributable to the reputation or skill of owners and employees, the business would be outside Susswein's safe harbor. But the standard underlying Susswein's safe harbor, comparing “reputation or skill” assets to revenues, must nonetheless be applied. In such a case, one would need to identify and value a particular “reputation or skill” asset for the owner. This would in turn require distinguishing the portion of the profits inuring to the business' owner representing a payment for her reputation or skill from the portion representing a return in her capital investment in the business. In other words, Susswein's proposal is at best a partial solution.

More problematically, Susswein's proposed standard runs into the very issue that leads him to dismiss the alternative approach proposing to compare wages and revenue. A better trained and more valuable workforce tends to receive higher wages. But the more valuable a workforce, the costlier it is to replace, and the larger the amortization deductions generated by WIP. Businesses on the verge of leaving Susswein's safe harbor may thus have an incentive to restrict the size of their workforce, the wages paid to their employees, or the training such employees receive.

There is another difficulty with Susswein's use of a business's net income as the upper bound for the portion of the business's revenue that is properly attributable to the “reputation or skill” of owners. Consider a version of the example introduced above in which the business's net income is $705,000, so that the business is barely outside the safe harbor. Assume that this business would, but for the safe harbor, be classified as a SSTB under paragraph 199A(d)(2), for instance because the totality of the net income inuring to the owners compensates them for their contribution of reputation or skill to the business.

In such a case, the business would have a strong incentive to understate its income so as to fit in the safe harbor. If it reduced its net income to $700,000, for instance by paying off some accounts payable shortly before the end of the year, it would then fit in the safe harbor. The business's owners may then be entitled to a deduction of up to 20%, if the business satisfies the other requirements of section 199A. Its owners' aggregate post-tax income, assuming for simplicity that all of its owners are taxed at an effective rate of 37%, would be $492,800.¹¹⁵ By contrast, their aggregate post-tax income if the business's net income was $705,000 and it was a SSTB would be $441,000.¹¹⁶ In other words, the business would be able to increase its owners' post-tax income by decreasing its pre-tax income. Giving businesses such incentives can hardly have been what Congress had in mind when it enacted a provision designed to unleash Johnson's “true engine of economic growth and job creation.”

In fact, the issue is even worse for Susswein's safe harbor than for the alternative he criticizes, and which would classify as SSTBs businesses with wages exceeding 50% of revenue. Under subparagraph 199A(b)(2)(B), decreasing a business's W-2 wages, so that wages in general do not exceed 50% of its revenue, will reduce the deductible portion of the QBI from this business. There is thus a penalty for businesses that attempt to escape classification as SSTBs in such a way.¹¹⁷ Decreasing a business's net income so that it fits in Susswein's safe harbor, by contrast, will not decrease the deductible portion of the QBI from such business and so carries no penalty. Indeed, if such a reduction in net income is achieved via an increase in the business's W-2 wages expense, it will increase the deductible portion of QBI.¹¹⁸

VII. Comparing Payments to Revenue

The NYSBA, in its recent report on section 199A, briefly considers, among other approaches, a mechanical test based on the alternative interpretation of the “principal asset” language under which one should inquire into the main source of the business's revenue. According to the NYSBA's proposal, one should compare employee wages and payments to independent contractors and owners on the one hand, to the business's revenue on the other hand.¹¹⁹ On the payment side, the NYSBA suggests subtracting payments to “back office” personnel, i.e. those employees, independent contractors, and owner “who do not routinely interact with customers or provide skills used by those who do interact with customers.”¹²⁰ If the ratio of “reputation or skill” payments to revenue is “high”, the NYSBA suggests, there could be a rebuttable presumption that the business's principal asset is the skill or reputation of its owners or employees. By contrast, if such ratio is “low”, there could be a rebuttable presumption that the opposite is true.

As the NYSBA concedes, its report merely sketches an approach to interpreting the “reputation or skill” clause in subparagraph 199A(d)(2)(A). Indeed, the NYSBA explicitly offers to further develop this approach at the request of Treasury and the IRS.¹²¹ The NYSBA's proposal has several appealing features. It is based on the interpretation of the “principal asset” language adopted by the Tax Court in Owen and the IRS in PLRs 201436001 and 201717010. It does not require an inquiry into “reputation or skill” assets that may not appear on a business's balance sheet, or the value of which may be hard to assess and easy to manipulate. It does not create a perverse incentive for businesses to decrease their pre-tax income in order to maximize their post-tax income to the extent other proposals might. It is consistent with both reading the “reputation or skill” clause as a catch-all to the enumerated list and reading it as a standalone clause. For these reasons, I find this approach most promising among the various approaches currently on offer.

There are, however, a number of unresolved issues. The first is that of determining the threshold at which each rebuttable presumption should be triggered. What is a “high” or “low” ratio of “reputation or skill” payments to revenue? There are several considerations to take into account. If the boundary between “high” and “low” is set at 50%, then an issue similar to the one besetting Susswein's safe harbor will arise, i.e. businesses on the cusp will have an incentive to artificially decrease “reputation or skill” payments in order to benefit from the more favorable presumption.¹²² If “high” is defined as “over 60%” and low as “below 40%”, however, then this incentive will be reduced.

There is, however, an inescapable tension between certainty and gaming opportunities, here as throughout the tax law. The larger the space between the “high” threshold and the “low” threshold, the lesser the incentive for businesses to artificially reduce “reputation or skill” payment. This is simply because, if the “low” threshold is 40% and a business has a “reputation or skill” ratio of 65%, then it will need to drastically rearrange its affairs to lower its ratio below 40%. The larger the space between “high” and “low” thresholds, however, the more businesses in the intermediate band in which neither presumption applies. Since the aim of the definition of a SSTB is to prevent the conversion of labor income into lower-taxed business income, however, lowering both thresholds seems appropriate. One possibility would be to set the “high” threshold at 50% and the “low” threshold at 30%.

The second issue with the NYSBA's proposal is that, if one requires businesses to compute the ratio of the “reputation or skill” payments they make to employees and owners to their revenue, then why not simply adopt a rule according to which a business has the reputation or skill of its owners or employees as its principal asset if and only if its “reputation or skill” ratio exceeds 50%? To be sure, this rule would have a drawback similar to the one identified by Susswein, i.e. it would incentivize businesses with a ratio slightly over 50% to artificially reduce their “reputation or skill” payments. Such a rule, however, would be much simpler to apply than the NYSBA's dual-presumption proposal. No factual inquiry would be required, for instance, for businesses with ratios in the intermediate band between “high” and “low” thresholds.

The third, and most pressing, issue with the NYSBA's proposal is that of identifying the appropriate “reputation or skill” payments. Let me start with payments to employees or independent contractors. First, payments to independent contractors who are not also owners should be disregarded. Otherwise a business with no employees and whose only payments are to independent contractors (none of which are owners) may find itself presumed to have the reputation or skill of its owners or employees as its principal asset if the ratio of its payments to independent contractors exceeds 60% of its revenue. This is presumably not the outcome Congress intended. If none of a business's revenue is attributable to the reputation or skill of an owner or employee, then it should not be classified as a SSTB by reason of the “reputation or skill” clause of subparagraph 199A(d)(2)(A).

Second, any payment to a skilled employee is presumably a payment for the use of both their skill and reputation. An employee's reputation as an employee should, in most cases, be tied to her job-relevant skills.¹²³ If so, there is no need to disaggregate payments to such employees to determine whether they are being compensated for their reputation, skill, both, or neither. The challenge, of course, is to distinguish skilled employees from other employees.

The NYSBA suggests distinguishing skilled service providers, whether employees or owners, from unskilled ones by considering whether they “received a substantial amount of training” or “have otherwise achieved a high degree of skill in a given field.”¹²⁴ The problem with this suggestion is that skilled service providers may have developed their skills by learning on the job, rather than by being formally trained, and that whether a service provider has achieved a high degree of skill is a highly subjective inquiry. Consider the case of a plumber operating through an S corporation and paying herself reasonable compensation for the services she provides to the business.¹²⁵ It would be inappropriate to grant favorable treatment under section 199A to an inexperienced plumber who is learning on the job and can only make basic repairs but deny it to a more established and highly reputed plumber who was formally trained.¹²⁶ After all, these two hypothetical plumbers are engaged in the same business and provide their customers with services of a similar kind. Additionally, it would be inappropriate to first grant favorable treatment to the inexperience plumber but later deny her such treatment once she has “achieved a high degree of skill” as a plumber.

Turning now to owners, the difficulty in identifying “reputation or skill” payments is compounded by the fact that the payments received by owners may be compensation for the performance of services, where these services may be skilled or unskilled, compensation for the use of their reputation, or a return on their monetary investment in the business. Consider the case of S corporations. Under case law, S corporation shareholders who provide substantial services to the corporation are treated as employees and must be paid “reasonable compensation”.¹²⁷ The substantial services provided by S corporation shareholders, however, may be skilled or unskilled. Moreover, S corporation shareholders are not required to be paid reasonable compensation for their reputation. If they are at all compensated for their reputation, it will most likely be via the distribution of a dividend. But such a dividend may both compensate them for their reputation and be a return on their monetary investment in the S corporation. Identifying “reputation or skill” payments to S corporation shareholders is thus far from easy. And the case of S corporations is arguably the easiest.

In the case of partnerships, there is no requirement that partners receive guaranteed payments as defined by subsection 707(c), i.e. fixed payments for services or the use of capital.¹²⁸ In other words, partners may be compensated for their services or the use of their capital, including their reputation, via their distributive share of the partnership's income.¹²⁹ The challenge then arises of disentangling the part of a partner's distributive share that represents a “reputation or skill” payment from the part that is merely a return on their monetary investment. This is precisely the issue raised by the carried interest received by private equity fund managers.¹³⁰ Except that, in the case of these managers, the questions of whether the services they provide are skilled or unskilled and of whether they receive any compensation for their reputation do not arise. For this reason, proposals regarding the taxation of carried interest are of limited help for identifying “reputation or skill” payments.

By the same token, provisions of the Code that define “earned income”, by contrast with return on monetary investment in a business — e.g. paragraphs 401(c)(2), 911(d)(2), or 1348(b)(1) (repealed in 1981) — are of limited help. Distinguishing compensation for services from return on investment is only part of the challenge. The most difficult task is to distinguish payments for reputation from both, and to distinguish payments for skilled services from payments for unskilled services.

The case of sole proprietorships is similar to that of partnerships.¹³¹ Sole proprietors are not required to pay themselves reasonable compensation and there is no such thing as a guaranteed payment for sole proprietorships. Identifying “reputation or skill” payments in the case of sole proprietorships thus raises essentially the same challenges.

In the face of these difficulties, one might be tempted to suggest that a fixed portion of payments to owners, e.g. 25%, should be deemed to constitute a “reputation or skill” payment. There is no sound basis, however, for treating payments to a service partner who contributes her reputation and skill, but did not contribute any financial capital, in the same way as payments to purely passive owners who contributed financial capital but neither skill nor reputation.

An alternative solution would be to codify the “reasonable compensation” judicial requirement currently applied to S corporations and to extend it in three ways. The first would be to extend it to owners of any pass-through business, whether an S corporation, a partnership, or a sole proprietorship. The second would be to require that owners be reasonably compensated for the provision of both skilled services and reputation. The third would be to require that businesses distinguish payments to owners that compensate for the provision of skilled services from payments compensating them for the provision of unskilled services. These suggestions, however, are just that, and further developing them is beyond the scope of this paper.

The approach suggested by the NYSBA, despite its many attractive features, thus faces two dauting challenges. The first is to distinguish skilled services from unskilled ones. The second is to distinguish, among payments to owners, those that are for their reputation from those that are for their performance of skilled services and those that are returns on their monetary investments. It is unclear, at this point, how these challenges may be addressed. As the NYSBA acknowledges, its members “have reached no conclusions regarding the correct metrics for this sort of approach.”¹³²

VIII. Conclusion

All of the approaches to interpreting the “reputation or skill” clause in subparagraph 199A(d)(2)(A) face seemingly insurmountable obstacles. Even the approach that is, in my view, most promising faces serious obstacles. Remember that the aim of the “reputation or skill” clause, and of the definitions of a SSTB and of a QTB in general, is to prevent the conversion of high-taxed labor income into lower-taxed business income. It is unclear, however, that the amount of tax revenue preserved by enforcing the “reputation or skill” clause would make it cost-effective for the government to enforce it. As Sullivan reminds us, the “reputation or skill” clause only becomes relevant when a business is not disqualified by the enumerated list of prohibited fields.¹³³ It should also be remembered that section 199A is not to apply to tax years starting after December 31, 2025.¹³⁴ In fact, it may even be repealed as early as 2020 if Democrats can regain majorities in the House and the Senate and win the presidency.¹³⁵

It is an empirical question whether it would be cost-effective for the government to enforce this clause. The arguments developed above, however, indicate that the cost of doing so is likely to be high. And the cost of compliance is also likely to be high for taxpayers. Whatever standard may be adopted in the end, it will have to be rather complex to draw the distinctions required by the “reputation or skill” clause (e.g. the distinction between skilled and unskilled services). The best solution may therefore be for the government to remove this clause from the Code altogether, as Sullivan suggests.