The IRS’s new Proposed Regulations push tax discrimination between professions to new heights.
The lyrics of Bob Seger’s hit “Beautiful Loser” ring true when reading the Proposed Regulations under Section 199A, which are riddled with disparities that push the envelope of the IRS’s regulatory authority.
In May 2018, the IRS promised that the Proposed Regulations regarding the pass-through deduction would be issued in mid-June, however, they were only issued on August 8th. The IRS’s new Proposed Regulations push tax discrimination between professions to new heights under tax and regulatory law that we have not seen since the Windfall Profits Taxes that were imposed on oil companies in the 1980’s. The chart at the end of the article summarizes the Winners and Losers in each of the 11 categories of the statute, and a new 12th category called “In the Trade Or Business of Being an Employee” that was introduced by the Proposed Regulations.
The crux of the discrimination is whether the trade or business meets the definition of a Specified Service Trade and Business, also known as an “SSTB”.
For example, engineers, architects, bankers, property and casualty insurance agencies, hash bars, tattoo shops, brothels in Nevada and e‑smoking dens can receive a 20% income tax deduction if they are S‑corporations, partnerships, or individual Schedule C businesses and satisfy certain wage or qualified property requirements regardless of how high their income might be.
On the other hand, the professions of medicine, law, accounting, consulting, athletes, performers, and financial service companies are not able to take the 199A deduction if their personal income exceeds $207,500 if they are single, or $415,000 if they are married filing jointly.
It is noteworthy that individuals, trusts and estates with between $157,500 and $207,500, and also married couples with taxable income between $315,000 and $415,000, may take a partial Section 199A deduction, which is prorated based upon the excess taxable income over $157,500 divided by $50,000 for single individuals. As an example, if the single individual owner who has $182,500 of taxable income, which includes $100,000 of dividend income from a law firm S corporation, then the deduction would be one‑half of 20% of $100,000, which would be $10,000. For married couples, the ratio is based upon the excess of taxable income over $315,000 divided by $100,000.
Will this favoritism cause social pressure, and push industrious young people to steer clear of condemned careers in law, medicine, and finance? It is certainly not going to help. A 20% tax deduction makes a big difference on net after tax income.
Another primary discrimination is briefly mentioned in the Proposed Regulations, and is the subject of a confusing example. Are individuals and businesses who lease property on a triple‑net basis conducting a “trade or business” that can qualify for the deduction? An example in the regulation discusses an individual who leases vacant property to an airport and qualifies for the deduction, but the language of the regulations indicates that, in order to qualify, the trade or business must meet the requirements of being an “active trade or business” under Internal Revenue Code § 162.
Internal Revenue Code § 162 has been around for many decades, and courts have required that taxpayers have a certain level of activity and entrepreneurial risk in order to qualify. There are cases where individuals who did nothing but collect rent, or otherwise comply with the obligations of being a landlord under a triple‑net lease, did not qualify as a trade or business under Section 162.
This puts landlords who have net income in the position of having to renegotiate their leases, or to become more active in seeking leases and otherwise being in the “active trade or business” of being a landlord. This issue is discussed in a recent article that we wrote for a professional newsletter that can be provided to readers upon request.
To make matters worse, the new Proposed Regulations provide that an architect, engineer, banker, or other non-SSTB business can consider the rental of the office building a separate trade or business, that can qualify for the 20% deduction if certain requirements are met, but a doctor, lawyer, accountant, consultant, or other SSTB’s rental of the office building will be aggregated and considered income from the SSTB to the extent of rental income attributable to the SSTB entity, or entirely if at least 80% of the income is attributable to the SSTB. This applies even if the building is held in a separate entity! So, own a building rented to a brothel, not your accounting practice.
This aggregation also applies to providing management, marketing, billing, intellectual property rights, or services for one of the SSTB categories, by any business entity or person that has common ownership of 50% or more including ownership attributed to another under Internal Revenue Code Section 267(b), which combines ownership between families, trusts and related entities.
So, what that means is, if a lawyer owns his own firm, and sets up another company to do dictation and stenography for the law firm ‑ services that do not fall under the practice of law ‑ that company will not qualify for its 20% deduction under 199A. The kicker is, these services would otherwise fall under the 199A deduction, but because a lawyer owns 51% of the stenography company it will not qualify for its deduction.
The regulations take things even further by providing that a trade or business that sells products or provides services incidental to the SSTB that would otherwise not be considered a SSTB, will be subject to the SSTB limitations if (1) the gross receipts from the non-SSTB business do not exceed 5% or more of the total combined gross receipts of the SSTB and the non-SSTB, (2) the non-SSTB business is owned 50% or more by common owners of a SSTB and (3) the non-SSTB business shares expenses, such as wages or overhead, with the SSTB. This applies even though other businesses selling the same products or services would otherwise qualify for the deduction. So, a dermatologist that sells sun screen at her office has to pay more in taxes on these sales than the local beach shop selling the same sun screen right next door.
As if all of this was not enough, the IRS took things a step even further under these new Proposed Regulations, which if enacted would provide that trusts established by professionals in these penalized categories that earn less than $157,500 may not be able to take the 20% deduction, although identical trusts holding non-SSTB interests would be effective in many situations. Specifically, the language of the Proposed Regulations provide that such trusts will be “disrespected” if the purpose of the trust was to avoid tax, but does not give any indication of what it means for a trust to be “disrespected”. Presumably it means that the income level of the grantor of the trust will be considered to be the income level of the trust, or that the income of the trust will be attributed back to the grantor, but the fact that the Proposed Regulations do not explain this is a sign that this was a last minute addition that was not thought through, or that it is not expected to survive to the final regulations.
Trusts have been used to circumvent taxes for over 100 years, and not a single tax statute or regulation has ever provided that trusts cannot be used to avoid tax.
It seems as if someone in Washington, D.C. may be very angry, or is intent on acting discriminately towards, doctors, lawyers, accountants, consultants, those in financial services, athletes and performing artists while allowing other businesses and professionals to have numerous ways to qualify for the 199A 20% deduction.
Even if this portion of the Proposed Regulations are passed, the aggressive and discriminatory nature of the statute may be found by the courts to go well beyond the authority the IRS was granted to interpret these regulations. Years of litigation over the interpretation of aggressive IRS regulations will further reduce any perception of fairness, and reason to comply with the tax system, especially when accountants are one of the main groups being discriminated against.
Notwithstanding these rules, planners have already found ways around paying the full rate of tax on all SSTB income. For example, although the regulations may be issued to prevent the use of certain types of “non‑grantor” trusts, there are other kinds of trusts that can be established to benefit and individual, and considered as owned by that person for income tax purposes.
Many taxpayers will use management, billing, marketing, and intellectual property entities held at arms’s-length to reduce taxes in the meantime. They may go as far as to shift ownership of such entities to trusts that can be held for descendants, parents, and other lower-bracket taxpayers (who have income below the $157,500/$315,000 levels).
For example, Joe Accountant may wish to establish an arm’s-length management company that provides billing, management, marketing, and other services for his accounting firm.
Joe’s arm’s-length management company may be owned one‑third each, by separate trusts for his three children, who each earn less than $157,500. Instead of using non-grantor trusts, these may be what are called “Section 678 Trusts”, which are treated as being owned by the child for income tax purposes, as opposed to being treated as a non‑grantor trust, which will be the topic of my next post.
There are many disparities in treatment and fairness under the new Section 199A regulations. Let’s hope that the Internal Revenue Service gets the message from taxpayers and advisors that an unfair statute does not authorize the IRS to issue even more unreasonable regulations. In the meantime, lobbyists will have more income, but will pay more in taxes if they cannot turn this around, and those with knowledgeable advisors will pay less in taxes than those who just keep their nose to the grindstone without engaging in complex tax planning. I’ll pay more in taxes but will be very busy for the remainder of 2018 engaging in 199A planning – and that says it all!
You can get a copy of our white paper on Section 199A planning by contacting me at firstname.lastname@example.org.