IRS Section 199A Final Regs Shed New Light on Service Businesses
Remember, new tax code Section 199A offers you a 20 percent tax deduction gift if you have
- pass-through business income (such as from a proprietorship, a partnership, or an S corporation), and
- 2018 taxable income of $315,000 or less (married, filing jointly) or $157,500 or less (filing as single or head of household).
But once your taxable income is greater than the relevant amount listed above (which Section 199A calls a “threshold”), your Section 199A tax deduction becomes more complicated. Under the rules that apply to this new Section 199A tax deduction, the tax code creates two types of businesses:
- Business that are in favor and can realize the new deduction regardless of taxable income.
- Business that are out of favor. The tax code calls the out-of-favor business a “specified service trade or business.”
If you own an out-of-favor specified service trade or business, you suffer a zero Section 199A tax deduction on that business’s out-of-favor income when you have 1040 taxable income greater than $415,000 (married, filing jointly) or $207,500 (filing as single or head of household).
With taxable income greater than the $315,000/$157,500 threshold and less than the $415,000/$207,500 upper limit, Section 199A reduces the tax deduction available to your out-of-favor specified service trade or business.
This brings us to the question: What if your taxable income is above the limit, but your pass-through business has one part that’s out of favor and another part that’s in favor? You will like what the rules have done for you if you are in this situation. The new regulations make it clear that it is possible for you to benefit from the de minimis rule.
The rule.If the trade or business has annual gross receipts of $25 million or less, it is an in-favor business if it gets less than 10 percent of its gross receipts from an out-of-favor specified service trade or business, such as (among others) law, consulting, accounting, and health care. If gross receipts are greater than $25 million, substitute 5 percent for the 10 percent.
De Minimis Example 1
Green Lawn LLC sells lawn care and landscaping equipment and also provides advice and counsel on landscape design for large office parks and residential buildings.
The landscape design services include advice on the selection and placement of trees, shrubs, and flowers and are considered under Section 199A an out-of-favor consulting business.
Green Lawn LLC separately invoices for its landscape design services and does not sell the trees, shrubs, or flowers it recommends for use in the landscape design. Green Lawn LLC maintains one set of books and records and treats the equipment sales and design services as a single trade or business.
Green Lawn LLC has gross receipts of $2 million, of which $250,000 is attributable to the landscape design services, a consulting business. Because consulting services are 10 percent or more of total gross receipts, the entirety of Green Lawn LLC’s trade or business is an out-of-favor specified service trade or business.
De Minimis Example 2
Veterinarian LLC provides veterinarian services performed by licensed staff and also develops and sells its own line of organic dog food at its veterinarian clinic and online. The veterinarian services are in the out-of-favor specified service trade or business of health care.
Veterinarian LLC separately invoices for its veterinarian services and the sale of its organic dog food. It maintains separate books and records for its veterinarian clinic and its development and sale of dog food. Veterinarian LLC also has separate employees who are unaffiliated with the veterinary clinic and work only on the formulation, marketing, sales, and distribution of the organic dog food products.
Veterinarian LLC treats its veterinary practice and the dog food development and sales as separate trades or businesses for purposes of Sections 162 and 199A. It has gross receipts of $3 million. Of the gross receipts, $1 million is attributable to the out-of-favor veterinary services.
Although the gross receipts from the services in the field of health care exceed 10 percent of Veterinarian LLC’s total gross receipts, the dog food business is a separate, in-favor business.
Note that Animal Care wins because it has two trades or businesses, which it proves with its financial books and its separation of its employees.
Green Lawn LLC, in the previous example, failed because it had one business only, which it also proved by the way it kept its books.