Economic Analysis: Do Skills and Reputation Nix the Passthrough Deduction?

The new section 199A deduction equal to 20 percent of a passthrough’s profits is not available to high-income owners if the principal asset of the passthrough’s trade or business is the skill or reputation of its employees or owners. Because we live in a service economy where human capital is critical to success, this condition on its own would seem to remove many businesses from eligibility for the deduction. But under the interpretation of the statutory language offered here, the provision has more bark than bite.

Although many employees and owners actively engaged in a business have considerable reputation and skills, in most situations those are not assets of the business but are human capital of the employees and owners as individuals, and the business usually provides contemporaneous compensation for use of that capital. That being the case, most businesses would not be disqualified by what we can call “the principal asset test” from eligibility for the 20 percent deduction.

Background

For those unfamiliar with new section 199A, here are the basics. Under it, the deduction equal to 20 percent of qualified business income is available to all qualified real estate investment trust dividends and qualified publicly traded partnership income. That income and any other passthrough income qualified for the deduction may not exceed 20 percent of a taxpayer’s taxable income modified to exclude capital gain. A special rule, which Congress almost surely will amend, provides particularly advantageous treatment for farmers who sell to agricultural cooperatives.

The 20 percent deduction is also available to a taxpayer for all domestic passthrough income from a trade or business (which excludes reasonable compensation paid to owners for services and passive income earned by the business), with no other conditions as long as certain taxable income thresholds are not exceeded. The taxable income threshold for an individual taxpayer is $157,500, and for taxpayers filing jointly it’s $315,000. The amount of qualified income eligible for the deduction without further conditions phases out linearly for individuals with taxable income between $157,500 and $207,500, and for joint filers with taxable income between $315,000 and $415,000. So the much-criticized complexity of new section 199A does not apply to low-, middle-, and upper-middle-income taxpayers.

But many of the fortunate few in the upper crust and the passthrough businesses they own will need plenty of consultation with their tax advisers. Individual taxpayers with taxable income in excess of $157,500 and joint filers with taxable income in excess of $315,000 face two further limitations. First, passthrough income from any trade or business cannot be “specified service trade or business” income. Think of these specified services as a blacklist of business categories that you hope your business is not on.

Specified service trade or business income is from a trade or business (1) that involves the performance of services consisting of investing and investment management, trading, or dealing in securities, partnership interests, or commodities; (2) involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, or brokerage services; or (3) where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. (This wording is precise, but literal quotation is a mess because a large chunk of it is a cross-reference to section 1202(b)(3)(A) with minor deletions and additions.)

The meaning of the third category of specified trades or businesses is the subject of this article. A useful discussion of the meaning and scope of specific fields listed in (1) and (2) has been provided by Daniel E. Mellor (“Gauging the Height of the Specified Service Business Guardrail,” Tax Notes, Feb. 5, 2018, p. 809). Importantly, Mellor makes a convincing case based on court decisions and prior IRS guidance that services provided to the listed trades or businesses are not necessarily themselves listed trades or businesses. (For example, a laboratory that conducts testing but makes no diagnoses may not be considered a provider of health services.) Analysis of the highly advantageous treatment of farmers who sell to cooperatives (but not to other sellers) —now commonly referred to as the “grain glitch” that must be corrected with further legislation — can be found in my previous articles (“Farm Cooperative Patrons Get a Nice New Pickup,” Tax Notes, Jan. 15, 2018, p. 287, and “For and Against the Grain: TCJA Clobbers Co-Op Competitors” Tax Notes, Jan. 22, 2018, p. 426).

The second limitation applicable to each trade or business is that income otherwise qualified for the deduction cannot exceed 50 percent of the W-2 wages paid by that trade or business. A description of these features in equation form can be found in this article’s appendix.

Human Capital

We have to parse the statute starting with the phrase “the principal asset.” Here we maintain that “asset” reflects the accounting definition of an item with a quantifiable value and not the colloquial meaning that one would use in an expression such as “She is a real asset to the team.” (More on that alternative interpretation later.) For the word “principal,” Merriam-Webster provides as its first definition “most important, consequential, or influential: chief” and provides “the principal ingredient” and “the region’s principal city” as examples. Further, the use of the definite article “the” instead of the indefinite article “a” implies that a trade or business whose income is ineligible for the deduction because of the principal asset test has no other principal asset than the collective skill and reputation of its employees or owners. Thus, when the statute refers to “the principal asset,” we will interpret it as the asset with the highest value (although not necessarily the asset that constitutes most of the value).

However, ambiguity remains because rarely does a balance sheet list individual assets, instead routinely mentioning categories of assets. We assume the statute intends that the “skill and reputation of employee or owners” is considered a single asset, but different aggregations of other assets could result in different outcomes. For example, if equipment is 30 percent of assets, plant is 30 percent of assets, and the skill and reputation of employees and owners is 40 percent of assets, the business would be a specified personal service business. But if plant and equipment are categorized together, the skill and reputation of employees and owners would not be the principal asset of the business. The only cases in which aggregation of other assets could not change the result is if the aggregate amount of skill and reputation of employees and owners is no less than 50 percent of total assets. Given the flexibility afforded in financial accounting, unless Congress intended arbitrary classification schemes to matter, a 50 percent threshold only makes sense.

Now what about the words “skill” and “reputation”? We will not attempt to explain these hard-to-define terms beyond what is necessary for our current purposes. First, let’s discuss the skill and reputation of employees. All employees have some degree of skill and reputation in the broadest sense. We can reasonably assume that in this context, skills are reasonably expected to mean abilities that unskilled workers do not have and that these skills are useful in the trade or business in question. Employees’ reputation is the perception that stakeholders of the business have of employees, whether those stakeholders are (both potential and actual) customers, investors, lenders, or other employees.

The skill and reputation of employees can of course be critical to a business’s success. We should not forget, however, that businesses must pay for the use of employees’ skill and reputation. And assuming there are no prepayments or contractual binds favorable to the employer, this human capital is not an asset of the business. Donald B. Susswein made this point in a recent article: 

It is difficult to see how the skills or reputation of employees — who must be paid wages for their services and who generally may terminate their employment at will — could be considered to be an “asset” of their employer — or even if such an asset were deemed to exist how it could reasonably be assigned any positive value. When the wages payable and the value of the services are presumably the same, there would appear to be no positive value to speak of. (Susswein, “Understanding the New Passthrough Rules,” Tax Notes, Jan. 22, 2018, p. 497.)

Thus, if we can depend on the “presumably” in this passage, it is the employee and not the business that captures the value of employee skill and reputation. Of course, workers may be underpaid (or overpaid) because of what economists call market imperfections, such as lack of employer or employee information or the inability of wages to adjust promptly to clear the market. But as a general rule it seems reasonable to assume (consistent with free market economics) that employees are not paid below their fair market value, especially over extended periods.

In rare cases, the assumption of compensation equaling value may not hold. If, for example, an entertainment business signs a long-term employment contract with a rising star that significantly underestimates his value, that contract capturing the skills and reputation of the entertainer is an asset of the business. (Think of the bandleader who employed Johnny Fontane in The Godfather, or Bruce Springsteen in real life in the early 1970s getting only one-tenth of what he earned from the small company that managed him.) In cases like these, the employer’s principal asset could be the reputation and skill of the employee, and therefore the employer’s trade or business could be a specified business. But even in these presumably rare cases, the relationship must formally be one between an employer and employee. Skills and reputation of non-employee (and non-owner) service providers don’t come into play under the statute.

Given the rarity of this situation, as a practical matter, the burden should be on the IRS to prove that the business is a specified business because of the skill and reputation of its employees. To counterbalance this burden on the IRS, perhaps the business should be required to satisfy a lax business judgment rule, in which in the judgment of management, the skill and reputation of employees and owners are not its principal assets.

Workforce in Place

Workforce in place is an intangible asset whose value is not routinely measured. The need for its valuation arises, for example, after an acquisition for accounting purposes or in some transfer pricing cases. It is generally conceptualized as the total direct (for example, recruitment and training) and indirect (for example, lost productivity) cost of replacing a business’s workforce. In general, those costs per employee are much higher for more senior and more skilled employees. (See Kimberly K. Merriman, Valuation of Human Capital: Quantifying the Importance of an Assembled Workforce (2017).) It is of course possible that when that ambiguous statutory language refers to the reputation and skills of employees, it could be including workforce in place. However, that’s unlikely for several reasons.

First, workforce in place can partially or even exclusively include unskilled labor. Clearly, the value of assembling that type of workforce is not intended by the statute. Second, although workforce in place under usual valuation methods can be calculated on a worker-by-worker basis, it’s usually referred to in aggregate terms, that is, for the entire business. The statute, however, implies that the principal asset that could trigger disqualification of business income from the section 199A deduction can be the skill or reputation of a single employee. Third, as already noted, the replacement cost (used to calculate the value of workforce in place) for most businesses in the United States is not routinely calculated as part their normal accounting practices, so for many businesses, complete compliance with the statute could require valuation studies that are more expensive than the amount of tax in question.

Passive Owners

What about the reputation and skill of owners? Let’s talk about passive owners first. Presumably not being actively engaged in the business, they cannot be currently contributing skill. Perhaps these owners, now retired, had contributed skills in the past for which they have been compensated with ownership shares. Skills contributed previously are probably now best considered know-how owned by the business. (But given the vagueness of the term “skill” and no clear reference as to when the skill of the owners was made available to the business, the IRS could argue that extraordinary skills of a retired owner, perhaps a founder, and now a passive investor could make a business a specified personal service business under section 199A.)

Regarding reputation, passive owners could add value to a company in some situations. If an original owner, now retired, allows her name to continue to be used, that clearly could be an intangible asset of the business. Or perhaps a prominent individual previously unaffiliated with the business is given an ownership stake for use of his name. Again, this could be an intangible asset of the business. If it became a potential obstacle to the business’s eligibility for the section 199A deduction, however, the reputation-bearing owner’s compensation could be replaced with a royalty payment (equal, for example, to a percentage of gross receipts) for use of the name, and that individual would no longer be an owner to which the principal asset test applied.

The reputation of a highly successful individual investor or investment fund that becomes a part owner of a business may noticeably boost that company’s value. That usually happens with a start-up business. But it’s unlikely that a start-up business in which an investor could have a significant bellwether effect is generating taxable income.

Active Owners

Owners that are actively engaged in a trade or business present a more complex situation because of their dual role as investors and service providers. For a larger passthrough business with a clean line between an owner’s role as service provider and her role as investor, we can divide the analysis into two parts. The owner (assuming the owner is an individual) who provides services is like an employee to whom reasonable compensation is paid, and therefore any intangible asset is not property of the business but of the individual (as explained by Susswein) in most cases.

With the provision-of-service component of the relationship accounted for, what’s left is the passive-ownership component in which case (as described immediately above) the relationship between owner (entitled to profits) and business (using the reputation of the owner) can often be reconstituted as a relationship between licensor (entitled to royalties) and the trade or business (using the reputation of the owner).

If an owner is another entity or another trade or business, rules under section 482 would provide arm’s-length compensation for any skill or access to reputation made available to the potentially specified trade or business. Again, in this case, the relationship cannot be an asset to the company if these intangible items are paid for on an ongoing basis.

In a sole proprietorship or a family owned passthrough business, it’s almost impossible in practice to disentangle the (1) owner’s monetary investment, (2) the owner’s in-kind investment of services (for which no current compensation is received, sometimes referred to as sweat equity), and (3) provision of services for which compensation is contemporaneously provided. It is for item (2) that we might expect the reputation and skills of an owner to be assets of the business.

This might happen with a highly successful sculptor, painter, or novelist (whose profession clearly is not included within the performing arts category in the statute) who has made a relatively small monetary investment in his business and does not pay himself a significant salary. Assuming the inventory of unsold work is not large (and valuable) relative to the future prospects (and expected longevity) of the owner, this type of business could fall under the definition of a specified business.

Perspective Needed

Based on the analysis so far, it seems that passthrough businesses outside those explicitly enumerated in the statute will rarely book an asset of significant value that is attributable to the reputation or skill of their employees. The attribution of significant value to the skill and reputation of passive owners and owners of companies not closely held also seems rare. But for a business with a single owner or that is family owned, owner skill and reputation could have significant value.

Here it’s useful to take a step back from the details and get some perspective. First, as noted, the principal asset test applies only to businesses whose income flows to owners with incomes above the threshold amounts. Second, the principal asset test matters only if the trade or business is not already considered a specified business because it is one of the fields (health, law, etc.) explicitly enumerated in the statute. Third, the statute requires the reputation and skills of employees and owners to be the principal asset, which, based on the discussion above, for practical purposes means at least 50 percent of the assets of the trade or business.

Fourth, although for many trades or businesses it may be readily apparent that other tangible assets overshadow any value to the business from the reputation and skills of employees or owners, it may be difficult to determine that for a service business with relatively few assets, in which case uncertain and costly valuation studies must be undertaken. Fifth, even when exhaustive valuation studies can be performed, it will be nearly impossible to distinguish the value of reputation and skills of employers and owners from other intangible assets, such as customer lists, software, copyrights, contractual rights, trade names, domain names, trade secrets, and goodwill. Given these considerable and costly administrative and compliance issues that will be needed to properly conduct the principal asset test and the relatively small likelihood that the trade or business would fail the test, and given that the test comes into play only when the trade or business is not providing services on the blacklist, Treasury and the IRS should consider providing significant safe harbors to taxpayers, and Congress should consider repealing the test altogether or extensively clarifying it.

For now, a practitioner who is concerned about a client failing the principal asset test can take several steps. Other assets can be increased in value vis-à-vis reputation and skill. This is perhaps most easily done, as suggested above, by recharacterizing the reputation and skill of employees and owners as other intangible assets in valuation studies. Or services currently provided by employees and owners can be removed from consideration in the principal asset test by making skilled employees independent contractors and reputable owners licensors of their names.

An Alternative Interpretation

A less finicky interpretation of the principal asset test would follow if we took the expression “the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners” to identify a trade or business in which professional skill or reputation was the critical factor for its success, as with a medical practice or law firm. That alternative interpretation would be consistent with the intention of the drafters trying to add to other trades or businesses involving the performance of services in fields analogous to health, law, etc. In this case, other passthrough service businesses in fields such as computer programming, lobbying, designing, or scientific research (assuming they were not already included under the vague listed field of “consulting”) would be expected to be specified personal trades or businesses.

This would not be an unreasonable way to interpret legislative intent, except that the language of the law refers to an “asset of such trade or business.” If the drafters had slightly modified the final language to “an asset of other such trades or businesses” when “other” would mean “similar in nature to” other professional firms, the analogy to what we commonly think of professional service corporations would be much clearer. But taxpayers who could be disqualified by the principal asset test would certainly have a strong case that the common meaning of “asset” or “assets” in a tax code saturated with accounting terminology in which the reference to the term is not to general features or characteristics of a business from which value creation (or, more precisely, value added) arises but to capital, both tangible and intangible, can be quantified and appear on the balance sheet of the taxpayer in question.

Appendix

Assuming that a taxpayer has taxable income below the threshold amounts and all income from trades or businesses is from businesses that are not specified personal service trades or businesses, the section 199A (D199A) deduction is:

where,

Again, if income is below the threshold, all trades or businesses qualify (whether or not specified service businesses), and wage limitations also do not apply. CQBAI is the combined qualified business activities income. TI is the individual’s taxable income. CAPGAIN is the individual’s capital gain. REIT is the total amount of qualified REIT dividends received by the taxpayer. COOP is the total amount of qualified cooperative dividends received by the taxpayer. MLP is the total amount of qualified publicly traded partnership income received by the taxpayer. TB is the number of qualified trades or businesses. QBI_i is each trade or business’s net qualified domestic business income allocable to the taxpayer; W2_i is each trade or business’s wages allocable to the taxpayer; and UNADJ_i is the unadjusted basis of tangible depreciable property in each trade or business allocable to the taxpayer.