Can Service Based Businesses Take the 199A Deduction?
There’s been a fair amount of confusion surrounding the new 199A deduction since the passage of the Tax Cuts and Jobs Act (TCJA) back in December of 2017. Specifically, there is a clear misconception floating around regarding eligibility for owners of service trades or businesses.
These misconceptions stem from taxpayer’s, and even practitioner’s, reliance on highlights and headlines from the media coverage of legislative proposals back in 2017. One clear misconception stemming from the initial media coverage is the notion that operating a service based business automatically disqualifies business owners from claiming the 20% qualified business income deduction as described in section 199A of the Internal Revenue Code (IRC).
This claim in not only false but it’s also costly for small business owners who operate in such trades or businesses who could be losing out on thousands of dollars in tax breaks. Much has changed since 2017 with the IRS issuing final regulations on section 199A and this article is intended to clarify some of the misconceptions for owners of service based businesses.
Which Businesses Qualify for the Deduction?
Under the final regulations an eligible trade or business is one that rises to the level of a trade or business under section 162 (other than a trade or business performing services as an employee). For those who are wondering, section 162 of the IRC doesn’t actually clearly define a trade or business but simply states that any trade or business “shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year”.
In essence, if the IRS allows your business to deduct ordinary and necessary expenses paid or incurred during the taxable year then your business may qualify as an eligible trade or business for the 199A deduction. What the IRS really means when it refers to a 162 trade or business is any activity that the courts and the IRS have considered a legitimate trade or business in the past.
The clearest example of a court case which clarifies the meaning of a 162 trade or business is Groetzinger v. IRS Commissioner. Generally, the courts held that under section 162, to be engaged in a trade or business, the taxpayer must (i) be involved in the activity with continuity and regularity and (ii) the taxpayer’s primary purpose for engaging in the activity must be for income or profit.
Under this definition you can clearly determine the difference between a hobby and a legitimate trade or business. With that being said, if you are the owner of a service based business then odds are your business will be considered a qualified business for the 199A deduction.
What is a Specified Service Trade or Business?
Although owners of service based business are allowed a deduction under 199A there are limitations for taxpayers with taxable income in excess of $315,00 if married filing jointly or $157,500 for all other taxpayers. Specifically, owners of “Specified Service Trade or Businesses” will get no deduction if their taxable income is above $415,000 as a married couple or $207,500 for all other taxpayers.
Where the confusion exists, and rightfully so, is the distinction between a service based business and a Specified Service Trade or Business (SSTB). The final regulations are clear and specific in this regard in their outlining of “bad” service based businesses and service business which won’t have their deduction eliminated if their owner’s taxable income exceeds the specified threshold.
Before we discuss which businesses are considered SSTBs under the final regulations it’s important to note that an owner of an SSTB may still claim a 199A deduction as long as their taxable income is under the applicable threshold. The following are a list of SSTBs are defined by the regs:
- Health – provision of medical services such as physicians, pharmacist, nurses, dentists, veterinarians, physical therapist, phycologist, and other similar healthcare professionals performing services in their capacity as such. Performance of services in the field of health does not include the operations of health clubs or spas, payment processing or the research, testing and manufacture and or sales of pharmaceuticals or medical devices.
- Accounting – provision of services by individuals such as accountants, enrolled agents, return preparers, financial auditors, and similar professionals performing services in their capacity as such.
- Actuarial Science – provision of services by individuals such as actuaries and similar professional services in their capacity as such.
- Performing Arts – performance of services by individuals who participate in the creation of performing arts, such as actors, singers, musicians, entertainers, directors, and similar professionals. The performance of services in the field of performing arts does not include services that don’t require skills unique to the creation of performing arts such as maintenance and operations of equipment or facilities and broadcasting or dissemination of video or audio of performing arts to the public.
- Consulting – provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems – including lobbyist or agencies that influence government officials on behalf of a client. Services in the field of consulting does not include consulting services embedded in the sale of goods or performance of services on behalf of a trade or business – specifically, services within the fields of architecture and engineering are not treated as consulting services.
- Athletics – performance of services by individuals who participate in athletic competitions such as athletes, coaches, and team managers in sports such as baseball, basketball, football, etc. The performance of services in the field of athletics does not include services that don’t require skills unique to athletic competition such as maintenance and operations of equipment or facilities and broadcasting or dissemination of video or audio of athletic events.
- Financial Services – provision of financial services to clients including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans and other similar services regarding valuation, mergers acquisitions, etc.
- Brokerage Services – services in which a person arranges transactions between a buyer and a seller with respect to securities.
- Investing and Investment Management – trade or business involving receipt of fees for provision investing, asset management, or investment management services.
- Trading – trade or business of trading in securities whether for the person’s account, for the account of others, or any combination thereof.
- Dealing – regularly purchasing securities from and selling securities to customers in the ordinary course of a trade or business or regularly offering to enter into, assume, offset, assign, or otherwise terminate positions in securities with customers in the ordinary course of a trade or business. Origination a loan is not treated as dealing.
- Reputation or skill of one or more employees or owners – a trade or business which receives income from endorsing a product, use of individual’s image, voice, trademark, public appearances, or other symbols associated with the individual’s identity.
The last example of an SSTB is where many business owners and practitioners fall short in determining the eligibility of a service based trade or business. For some, this final example of an SSTB acts like a “catch all” but for savvy practitioners this is not the case.
For example, if a celebrity chef owns and operates a restaurant one could argue that the income generated from that activity is income derived from the reputation or skill of one or more employees or owners. However, according to the final regulations a celebrity chef who owns and operates a restaurant will not be considered an SSTB under section 199A. However, a celebrity chef who derives income from endorsing products or is paid to be featured on a television show will generally fall under the SSTB limitations.
Final Thoughts
Making a determination of a business’s eligibility under section 199A can be immensely difficult. However, making the correct determination can save a taxpayer thousands of dollars in taxes each year. For example, a business owner who pulls in a bottom line income of $1,000,000 a year and is wrongly classified as an SSTB will potentially lose out on upwards of $200,000 worth of deductions each year.
These provisions in the law expire in 2025 so it’s more critical than ever to have an important discussions with your CPA about taking advantage of every tax opportunity over the next 7 years.