Small businesses waiting anxiously for details on the new pass-through tax deduction are finally getting some answers from the IRS. The Internal Revenue Service released a 184-page document on proposed regulations that include income limits, qualified business categories, and strategies that won’t be allowed to “game” the system. (1)
The 20% tax break for pass-through entities is part of last year’s $1.5 trillion tax overhaul. It was a gift that fluttered down from the sky onto many small businesses, including real estate agents and other real estate professionals, but without clear details on exactly who will qualify. The release of this new document offers some clarification, although the rules remain complex.
Attorney Joseph Darby III of Sullivan & Worcester told Investment News that it’s “very, very complicated, and in many places utterly confusing.” He said, “The law left everyone with a ton of questions, and the regulations provide about half a ton of answers.”
Who Gets to Claim the Deduction?
In general, the deduction applies to single or married owners of limited-liability companies, S corporations, sole proprietorships, and partnerships who fall within income limits. Single filers must earn $157,500 or less. Joint filers must earn $315,000 or less. The deduction will reduce their income by 20%, thereby lowering their overall tax rate.
The deduction does not apply to “all” business owners who operate as pass-through entities, however. According to the Wall Street Journal many “higher-earning owners” of specified service businesses do not qualify. It says, “People in this category include doctors, dentists, and pharmacists; lawyers; accountants and actuaries; consultants; performing artists; financial advisers and investment managers; and athletes and coaches, including team owners.” (2)
The New York Times also clarifies that, “Owners of dental offices may not claim the deduction… but owners of health spas may because they do not directly provide medical services. Investment banks do not qualify, but banks that simply make loans and take deposits — like community banks — do. Paralegals may not, but the owner of a stenography service may. Football coaches do not qualify, but the owner of a company that cleans football stadiums would.”
In other commentary from the Times, the rule could provide a huge tax savings for law firms, real estate trusts, family farms, and even authors because it appears the rule doesn’t apply to writers. If they have lots of income from the sale of books, they could organize themselves as a pass-through company, and get that deduction.
The exclusion does apply to people who earn money based on their “reputation or skill,” such as celebrities who license their names, accept appearance fees, or endorse products. It also applies to income earned by reality performers who are paid to “appear as themselves on television, social media and other forums.”
That exclusion could prevent President Trump from deducting the portion of income attributed to the licensing of his name, for example. But that wouldn’t necessarily apply to real estate income that’s not associated with the licensing fees.
New York University professor Lily Batchelder told Times, “To the extent that he’s getting income from licensing the use of his name, it looks like he is ineligible for the deduction… But even if that licensing income was hypothetically, 51 percent of his business’s income, I think it’s treated as a separate trade or business so he can get the deduction on the other 49 percent of his income.” (3)
“Crack and Pack” Strategy Prohibited
The new information helps clarify whether some companies may need to restructure themselves to separate qualified income streams, but the rule also attempts to prevent tax abuse. One of those abusive tactics is called a “crack and pack” strategy. That’s when a business owner tries to separate two parts of a business that should not be separated.
The proposal also makes it tough for W-2 employees to reclassify themselves as independent contractors for the sake of the tax deduction. It basically excludes those who make that switch unless they can prove they are “performing services in a capacity other than as an employee.”
As I mentioned, the rule is complex, and there are other details I haven’t mentioned, along with those that haven’t yet been clarified. The public comment period will last 45 days beginning with the day the proposal is entered into the federal register. There’s also a public hearing set for mid-October.
The estimated cost of the tax break is $415 billion over the next ten years. The provision is set to expire however, in 2025, if it doesn’t get an extension from Congress.
(1) IRS Document