As discussed in part one of this series, small business owners received a substantial benefit with the passage of the Tax Cuts and Jobs Act in December 2017. Business interest owners, including shareholders in S corporations, partners in partnerships and sole proprietors became eligible for a 20% deduction on “qualified business income.” Not all taxpayers qualify for the deduction, however. In part one of this series, we examined how one type of income, guaranteed payment income, is not eligible for the deduction. In this second part of the series, we examine another type of income that may not be eligible for the deduction – “specified service trade or business” income. But just like with analysis of guaranteed payments, careful review of specified service trade or business income may reveal opportunities for business interest owners to benefit from the new deduction by restructuring their activities.
The Tax Cuts and Jobs Act provides that, for tax years beginning on or after January 1, 2018, partners in partnerships, shareholders in “S” corporations, and sole proprietors are eligible to claim a deduction on their individual income tax returns for their “combined qualified business income amount,” with a maximum deduction equal to 20% of taxable income (with adjustments for cooperative dividends and net capital gains). The “combined qualified business income amount” is equal to 20% of qualified business income from each “qualified trade or business.” Nearly all trades and businesses are “qualified.” However, there is an exception for specified service trades or businesses, which refer to “any trade or business involving the performance of services in the field of health, law, 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 one or more of its employees or owners.” Additionally, trades or businesses that “involve the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities” are considered specified service trades and businesses, which may not be eligible for the qualified business income deduction.
The fact that income results from a specified service trade or business does not always eliminate eligibility for the deduction. Allowance of the deduction also depends upon the taxable income of the business interest owner. For joint-filing business interest owners with taxable income less than $315,000 (other non-joint-filing business interest owners with taxable income less than $157,500), the qualified business income deduction is still available for specified service trade or business income. For joint-filing business interest owners with taxable income greater than $415,000 (or non-joint-filers with taxable income greater than $207,500), the qualified business income deduction is not allowed for income received from specified service trades and businesses. For joint-filing business interest owners with taxable income between $315,000 ($157,500 for non-joint-filers) and $415,000 ($207,500 for non-joint-filers), there is a phase-out of the deduction for specified service trade or business income; as taxable income increases, the percentage of the allowed deduction decreases on a pro-rata basis.
For joint-filing taxpayers with taxable income exceeding $315,000 (or non-joint-filers with income exceeding $157,500), careful planning is required to maximize the qualified business income deduction. At this point, neither the Treasury Department nor the IRS have issued guidance on activity grouping rules for the qualified business income deduction. So taxpayers are free to design their activities to segregate specified service trades or businesses from non-specified service trades or businesses to maximize the deduction.
For example, a physician who is the sole shareholder in an S corporation may choose to create a limited liability company to own the real estate that houses the physician’s practice, with the practice renting from this new company, instead of providing for the S corporation to own the real estate directly. If the physician is the sole owner of the limited liability company, the physician’s overall income may not change (as the practice operated by the S corporation would most likely be allowed a deduction for rent paid to the limited liability company), but the income earned by the limited liability company for renting to the operating practice within the S corporation may not be considered specified service trade or business income, allowing the qualified business income deduction for the limited liability company’s income. There are numerous possibilities besides this example. A review of the facts and circumstances surrounding each trade or business is important to determine whether such planning will provide benefits and, if so, how much benefit will likely result.
If you are a business interest owner who may receive income from a specified service trade or business, and are unsure about how the new deduction may impact you, contact any of the skilled tax advisors at Clark Schaefer Hackett.