One of the cornerstones of the Tax Cuts and Jobs Act of 2017 is the new rule allowing pass-through entities to claim a 20 percent deduction under Section 199A of the new law. This is an important deduction against taxable income of up to 20 percent of qualified business income (QBI) from a domestic business operated as a sole proprietorship, partnership, S-corporation, trust or estate. However, many months later, there remains confusion regarding the exclusion for “service” businesses.
Congress created the 20 percent deduction for pass-through businesses that pay taxes through their owners’ individual tax returns. Lawmakers wanted to cut rates for closely held businesses as they did for corporations. However, there were exclusions for service businesses, including doctors, lawyers, athletes, accounting, financial services, and others. Why? Congress wanted to prevent high-taxed income from being converted to lower-taxed business income. For excluded businesses, once income reaches $157,500 for an individual or $315,000 for a married couple, the break begins to phase out. Under the tax law, the deduction for service businesses fully phases out at $207,500 for single and $415,000 for joint returns.
Government leaders and companies are still determining who is and isn’t eligible for the tax break. For example, consider a Texas bank that also sells mortgages to a secondary market. As an S corporation, that bank technically qualifies for the 20 percent deduction. However, some of the activities it conducts may be deemed ineligible and cast doubt on whether the entire business could qualify.
"If we are not able to include revenue from these types of core banking services in [the] qualified business income deduction, it would clearly place our bank and our holding company at a disadvantage to those C-corporation banks that are taxed at a 21-percent corporate tax rate," said Steve Lewis, chairman of the board of Jefferson Bank in San Antonio at the IRS hearing."
IRS Urged to Make Clarifications and Changes
Businesses and trade groups made their case at a recent IRS hearing meant to clarify rules for the 20 percent deduction. For example, should escrow agents be eligible for the tax break? What about franchised businesses and automobile dealers? Insurance brokers are concerned their consulting services could make them at risk.
A representative from the National Association of Realtors said that rental real-estate activity should be treated as a trade or business, while others made a case for the IRS creating a safe harbor that would allow low- and middle-income taxpayers with rental income to take the deduction under certain conditions.
The final rules are expected to resolve questions, such as how much of a specified service can a business perform before it becomes a specified-service business and therefore excluded from the tax break. Treasury and the IRS will take the comments into consideration as they finalize the rules on the pass-through deduction.
Questions about the Section 199A deduction or other tax matters? Contact Allan Peiser, CPA, at 214-635-2503 or use the contact form below.
Note: This content is accurate as of the date published above and is subject to change. Please seek professional advice before acting on any matter contained in this article.