Dividing Business Functions to Avoid the Specified Services Limitations for the QBI Deduction (PR §1.199A-5)
An individual with “specified service” income cannot benefit from the new Qualified Business Income (QBI) deduction if the individual has taxable income in excess of a threshold. Therefore, those in a specified service trade or business who have taxable income above $157,500 ($315,000 MFJ) are subject to a phase-out of their QBI deduction, and at taxable income of $207,500 ($415,000 MFJ), they cannot claim any QBI deduction.
- Note. Generally a specified service trade or business (SSTB) includes a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business where the principal asset is the reputation or skill of one or more of its employees.
Is there a way to minimize the impact of the SSTB limitation? Maybe pay rent from the SSTB to a controlled entity for use of its building?
Sharon and Vern operate a medical practice. Income from the medical practice is from a specified service trade or business (SSTB) and does not qualify for the QBI deduction since Sharon and Vern have taxable income in excess of $415,000. They are looking for ideas to get some benefit from the well-advertised (and much discussed at their medical conventions) QBI deduction. They want to crack their practice into pieces and pay rent or fees from their medical practice to other businesses performing qualifying functions.
Loopholes closed. "Crack and Craft" Strategy Busted
Tax planners contemplated a strategy to separate out parts of what otherwise would be an integrated SSTB, such as the administrative functions, in an attempt to qualify those separated parts for the 20% QBI deduction. The IRS believes that such a strategy is inconsistent with the purpose of §199A and addressed the strategy in proposed regulations released Aug. 8, 2018. The regulations provide that an SSTB includes any trade or business with 50% or more common ownership (directly or indirectly) that provides 80% or more of its property or services to an SSTB. Additionally, if a trade or business has 50% or more common ownership with an SSTB, to the extent that the trade or business provides property or services to the commonly-owned SSTB, the portion of the property or services provided to the SSTB will be treated as an SSTB (PR §1.199A-5(c)(2)).
- Example. Mark owns a dental practice and also owns an office building. Mark rents half the building to the dental practice and half the building to unrelated persons. The renting of half of the building to the dental practice will be treated as an SSTB (PR §1.199A-5(c)(2)).
- Example. Law Firm is a partnership that provides legal services to clients, owns its own office building and employs its own administrative staff. Law Firm divides into three partnerships. Partnership 1 performs legal services to clients. Partnership 2 owns the office building and rents the entire building to Partnership 1. Partnership 3 employs the administrative staff and through a contract with Partnership 1 provides administrative services to Partnership 1 in exchange for fees. All three of the partnerships are owned by the same people (the original owners of Law Firm). Because there is 50% or more common ownership of each of the three partnerships, Partnership 2 provides substantially all of its property to Partnership 1, and Partnership 3 provides substantially all of its services to Partnership 1, Partnerships 1, 2, and 3 will be treated as one SSTB(PR §1.199A-5(c)(2)(iv)).
Additionally, if a trade or business (that would not otherwise be treated as an SSTB) has 50% or more common ownership with an SSTBand shared expenses, includingwages or overheadexpenses with the SSTB, it is treated as incidental to an SSTB and, therefore, as an SSTB, if the trade or business represents no more than 5% of gross receipts of the combined business (PR §1.199A-5(c)(3)(ii)).
- Example. Allen, a dermatologist, provides medical services to patients on a regular basis through Dermatology LLC, a disregarded entity owned by Allen. In addition to providing medical services, Dermatology LLC also sells skin care products to Allen’s patients. The same employees and office space are used for the medical services and sale of skin care products. The gross receipts from the skin care product sales do not exceed 5% of the gross receipts of Dermatology LLC. Accordingly, the sale of the skin care products is treated as incidental to Allen’s SSTB of performing services in the field of health and is part of such SSTB.