Business owners got a bit of good news last week when the IRS released long-anticipated word on how businesses can claim one of the biggest perks of the Tax Cuts and Jobs Act: the new 20% deduction for pass-through businesses (Section 199A) that will impact a huge number of taxpayers -- from mom-and-pop shop owners to private equity investors. Though these new regulations claim to make it simpler for businesses to determine if they can or cannot get the tax break, and though they have the potential to be extremely profitable, they’re some of the most complex in the TCJA, particularly for taxpayers who own multiple pass-through entities. Still, there are some upsides to Friday’s regulations.
Here’s what we know for sure:
- Income from originating and selling mortgages is eligible for the deduction. Taxpayers had been worried that they wouldn’t see final rules in time for the filing season due to the partial government shutdown, and that confusing parts of the original provision could leave them exposed to penalties plus interest on improperly reported income.
- Shareholders of mutual funds with real estate investment trust investments can get the deduction. The IRS is still considering whether publicly traded partnership investments held through a mutual fund will qualify for the deduction.
- The proposed regulations also provide guidance for taxpayers who hold interests in regulated investment companies, charitable remainder trusts, and split-interest trusts.
- Rental real estate owners can get the tax break if they -- or someone they hire, such as a contractor -- spend at least 250 hours a year on the business and keep records of their activities.
The pass-through deduction was included in TCJA to give a tax break to businesses whose owners pay the taxes on their personal tax returns -- partnerships, limited liability companies, and S corporations. All taxpayers who earn less than $157,500, or $315,000 for a married couple, can deduct 20% of the income they receive via pass-through businesses from their overall taxable income.
If taxpayers earn above those amounts and aren’t service professionals (think lawyers or accountants), they must meet certain tests to take the full deduction. The size of their deduction will depend on how much they paid in employee wages or how much they invested in capital like real estate the previous year.
For service professionals, the tax break is eliminated if they earn more than $207,500 if they’re single, or $415,000 if they’re married.
No ‘Crack and Pack’
The new regulations make clear that companies cannot use a tax planning technique called “crack and pack” to avoid limits on the new tax break. ‘Crack and pack’ involves splitting a professional services firm into different entities to get around the income limits set for the owners of that pass-through businesses. For example, an accounting or legal firm would have pulled its administrative staff into one entity and its accountants (or lawyers) into another to get the full deduction on the income tied to the administrative work. IRS’ new regulations prohibit this practice.
Note that companies with some income that qualifies and some that don’t can still delineate different activities, such as through separate accounting books, to get the deduction on the eligible income. Example: a bank that provides wealth management services. The banking activities qualify for the deduction but the wealth management services don’t. This bank could still separate the bookkeeping for those two units and still get the deduction on the qualifying income. It just couldn’t separate the entities.
Keeping it simple
You cannot separate, but you can combine. The rules make it easier for related pass-through businesses to maximize their deduction combining at the entity level or at the owner level. For example, two related businesses -- one with a lot of employees but little profit, and another with a lot of profit but few wages -- could aggregate their payroll and income to get a bigger tax break.
The rules also retain a provision meant to simplify record-keeping if companies only have a small amount of income from ineligible activities, such as health or law. If less than 10% of the income is from ineligible sources, the company can still get the full deduction on all its profits.
Where it gets tricky
The final rules allow taxpayers to choose whether to use prior proposed regulations or the final regulations when preparing their returns. That’s really unusual, and we urge you not to make this decision yourself. In addition, there are still lingering questions regarding taxpayers with multiple trades and businesses held within the same entity, as the regulations didn’t address these situations. Please consult your BGW teammate for advice here, too.
Bittersweet news overall? Perhaps. But, we’ll take it. Clarity is always a good thing when it comes to taxes, and these new regulations provide at least a bit.