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Editorial 11 MIN READ

The 199A proposed regs, finally: what Treasury said a specified service trade actually is

REG-107892-18 landed on August 8, read like a relief map of the open questions, and gave the reputation-or-skill clause the narrow reading most practitioners were betting on

The Editors
Staff, Incorporator.org
11 min read Updated
Contents 8 sections
  1. What a specified service trade actually is, now in writing
  2. The reputation-or-skill clause, narrowed
  3. The de minimis rule for mixed trades or businesses
  4. Aggregation: the common-ownership test
  5. The anti-stripping rule for S-corporation wages
  6. What still is not answered
  7. What an operator does this week
  8. Sources

reasury released the proposed §199A regulations on August 8, 2018, and the Federal Register published them on August 16 as REG-107892-18 at 83 Fed. Reg. 40884. The 184-page package answers most of the first-order operational questions the statute left open, narrows the reputation-or- skill clause close to the way the tax bar predicted, and sets out aggregation rules that will govern every above-threshold pass-through return filed next April.

The comment period runs 45 days from the Federal Register date, closing around October 1, with a public hearing scheduled for October 16. The regulations are proposed, not final, but the preamble states taxpayers may rely on them until final rules are issued. In practical terms, this is the guidance.

What a specified service trade actually is, now in writing

The specified service trade or business definition is where the proposed regs do their hardest work. Prop. Reg. § 1.199A-5(b)(1) takes each field enumerated at §199A(d)(2) and cross-referenced §1202(e)(3)(A) and writes out what activity counts, what does not, and where the line sits. The drafting is tight and, in most fields, tracks existing tax doctrine closely.

Health, at § 1.199A-5(b)(2)(ii), is the medical services actually provided to patients: physicians, nurses, dentists, therapists, and the like. The preamble is explicit that operating a health club, a medical device seller, or a pharmacy retailing products is not "health" for SSTB purposes. A research lab that does not treat patients is not SSTB health. This is the distinction the §1202 case law had already drawn, and Treasury carried it over without surprise.

Law, at § 1.199A-5(b)(2)(iii), covers the services lawyers provide to clients: advising, drafting, negotiating, advocating, representing. It does not reach the publishing of a legal treatise, the running of a legal research platform, or the selling of form documents. The distinction the regs are drawing is between the professional act and the productized good, and the line runs where it has always run for §1202 purposes.

Accounting, at § 1.199A-5(b)(2)(iv), covers accountants and bookkeepers whether or not they hold a CPA license. The preamble notes that "accounting" is meant as a functional description, not a credentialing one, and that a bookkeeping practice is SSTB even though a bookkeeper is not a CPA. The same functional approach appears in actuarial science at (v) and the performing arts at (vi).

Financial services, at § 1.199A-5(b)(2)(ix), is the definition that moved most. Treasury defined it to include investment advice, wealth management, asset management, and the provision of financial services to clients, plus M&A and underwriting. It does not include the taking of deposits, the making of loans, or insurance underwriting as a principal activity; and, of particular interest to a large share of Incorporator.org's audience, it does not include real-estate brokerage or real-estate property management. The financial-services definition is narrower than a literal reading of the statute would have produced, and it is narrower in ways the industry had lobbied for.

Brokerage services, at § 1.199A-5(b)(2)(x), is limited to services in which a person arranges transactions between a buyer and a seller with respect to securities. Real-estate brokers are outside the definition, which the preamble states in terms. Insurance brokers are also outside. The SSTB brokerage bucket, as Treasury has drawn it, is essentially securities brokerage and its close relatives, not the ordinary-language sense of "broker."

Consulting, at § 1.199A-5(b)(2)(vii), is where the proposed regs work hardest. Treasury defines consulting as "the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems." This is broad on its face and would sweep in a great deal of work that the enumerated professions did not already cover. The regs then add a de minimis rule for the consulting field specifically: if consulting services are embedded in the sale of goods or in non-consulting services for which there is no separate payment, the consulting component is not treated as a separate SSTB. The example in the preamble is a building contractor who advises clients on design choices as part of a construction contract; the advisory element does not convert the construction business into SSTB consulting.

That reading keeps many hybrid businesses out of SSTB status. It also creates a bookkeeping problem for any firm that does charge separately for advisory work, which is now its own determination each year.

The reputation-or-skill clause, narrowed

The single largest interpretive question left by the statute was whether "any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners" was a narrow backstop aimed at celebrity-style arrangements or a broad capture of every service business that runs on human capital. Our February 20 piece flagged this as the largest open question in §199A planning.

Prop. Reg. § 1.199A-5(b)(2)(xiv) gives it the narrow reading. The clause, as Treasury defines it, covers only three specific fact patterns: (1) receiving income for endorsing products or services, (2) licensing or receiving income for the use of the individual's image, likeness, name, signature, voice, or trademark, and (3) receiving appearance fees or similar income for appearing at an event or on media. That is the universe. A consulting firm whose value derives from the skill of its partners is not captured by the reputation-or-skill clause (it may still be captured by the "consulting" field directly, but through a different door). A software developer selling her own code is not captured. A graphic designer running a studio is not captured.

The practical effect is that the reputation-or-skill clause is now what the tax bar had predicted it would be: a celebrity-endorsement rule with a narrow footprint, not a professional-services trawler. The Tax Foundation's early commentary had argued the structural logic pointed in this direction; Treasury agreed.

Treasury also added a de minimis rule specifically for the reputation- or-skill clause: endorsement or licensing income is SSTB only if it exceeds 10 percent of the gross receipts of the trade or business. A business owner who earns an occasional appearance fee on top of an otherwise non-SSTB operating business does not convert the whole business into an SSTB through the incidental endorsement.

The de minimis rule for mixed trades or businesses

Prop. Reg. § 1.199A-5(c)(1) handles the mixed-trade-or-business problem: a single legal entity that conducts an SSTB activity alongside a non- SSTB activity. The rule is a bright-line test with two tiers.

For a trade or business with gross receipts of $25 million or less, the entire business is treated as non-SSTB if less than 10 percent of gross receipts are attributable to the SSTB activity. For a trade or business with gross receipts over $25 million, the threshold drops to 5 percent. Above those thresholds, the SSTB portion is bifurcated and treated as its own trade or business for §199A purposes, with the non-SSTB portion eligible for the deduction and the SSTB portion treated as an SSTB.

That is cleaner than most practitioners expected. It also effectively ends the most aggressive crack-and-pack planning: separating a small SSTB piece into its own entity to purify the main business no longer changes the answer because, at the level at which the question is asked, the small SSTB piece would have been ignored anyway.

The anti-abuse rule elsewhere in the package (discussed below in the aggregation section) closes the other direction.

Aggregation: the common-ownership test

Prop. Reg. § 1.199A-4 sets out the aggregation rules. A taxpayer may elect to aggregate trades or businesses that meet all of the following tests: (1) the same person, or group of persons, owns 50 percent or more of each trade or business, directly or indirectly under the §267(b) or §707(b) attribution rules; (2) the ownership exists for a majority of the taxable year and on the last day of the taxable year; (3) all aggregated trades or businesses use the same taxable year; (4) none of the aggregated trades or businesses is an SSTB; and (5) the trades or businesses satisfy at least two of three factors demonstrating they are part of a larger, integrated business.

The three factors are: the businesses provide products, property, or services that are the same or customarily offered together; the businesses share facilities or significant centralized business elements (personnel, accounting, legal, manufacturing, purchasing, human resources, information technology); and the businesses are operated in coordination with, or reliance upon, one or more of the other businesses.

The common-ownership test will govern how most multi-entity operating structures are handled. An operating LLC and a real-estate LLC that holds the operating company's building, both owned by the same individual, can aggregate if they share personnel or are operated in coordination. The owner can then bring the building's UBIA into the wage-and-capital calculation for the operating business, which is the planning outcome most of the industry was hoping for.

The 50-percent common-ownership floor is stricter than the §469 grouping rules, which had been one of the templates practitioners were looking at. It is also more permissive in one respect: aggregation is elective, not mandatory. Treasury chose to give the taxpayer the benefit of the flexibility in most cases.

The anti-stripping rule for S-corporation wages

The companion to aggregation is the anti-abuse rule. Prop. Reg. § 1.199A -2(b) and the preamble discussion address the S-corporation wage- splitting pattern: taking a services business that would otherwise be an SSTB or wage-limited, spinning out a portion as a separate entity that pays W-2 wages to the owner, and claiming the spun-out entity is not an SSTB because it only provides "back office" services.

Treasury's treatment is direct. Where an SSTB has 50 percent or more common ownership with another trade or business that provides property or services to the SSTB, the related trade or business is itself treated as an SSTB to the extent of its transactions with the SSTB. The effect is that a dentist cannot drop her hygienists, receptionist, and clinical equipment into a separate entity and claim the support entity is not SSTB. The support entity inherits SSTB status as to the dentistry revenue.

That rule is specific enough to kill the most common crack-and-pack variants the tax-blog ecosystem had been workshopping since January. It does not reach every planning move that involves separate entities; a genuine third-party services business that happens to have one SSTB customer among many is not swept up. The line is drawn at the 50- percent common-ownership threshold.

What still is not answered

The proposed regs do not fully resolve the §162 trade-or-business question for rental real estate. The preamble acknowledges the issue, observes that the §162 standard applies, and declines to write a safe harbor. Rev. Proc. guidance on a rental safe harbor is one of the things the Comments period is likely to ask for. For now, rental owners are in the same place they were in February: document the hours, keep the books, and build the §162 facts for the activity.

The regs do not address how tiered partnership structures flow QBI, W-2 wages, and UBIA through multiple passthroughs in edge cases. The basic flow-through rule is in § 1.199A-6, but the hardest tiered- partnership questions are deferred.

The interaction between §199A and the pre-existing §1411 net investment income tax is not addressed in the proposed regs at all. The interaction between §199A and the §469 passive loss rules is addressed partially. Both will likely generate technical corrections or clarifying notices before final regulations issue.

The engineering-and-architecture carve-out, which we flagged in our January 23 outline as unusual, survives unchanged. Engineering and architecture firms are not SSTBs under the proposed regs because the statute does not list them. The carve-out remains difficult to justify on any principled basis, but it is the law.

What an operator does this week

The defensible estimated-tax position for Q3 2018, due September 17, has now shifted. A pass-through operator above the threshold whose trade or business is clearly non-SSTB can compute the third-quarter estimate with the deduction factored in at the proposed-reg rate, using the wage and UBIA figures available through August. Treasury has affirmed in the preamble that taxpayers may rely on the proposed regs, which makes this a reasonable position rather than a gamble.

For taxpayers near the SSTB line (consulting firms especially), the 90-day window between now and the first Q4 payment is the time to run the de minimis and mixed-trade analysis against actual gross receipts. The 10 percent threshold under $25 million is a forgiving number, but only if the business knows what revenues are attributable to what.

For owners of multiple related entities, the aggregation election is made on the timely filed return. Modeling the election's effect for 2018 means running the wage-and-capital calculation both ways, with and without aggregation. If the building-and-operating structure is the common fact pattern, aggregation almost always helps. If the entities have genuinely different characters, it may not.

For S-corporation shareholder-employees whose reasonable-compensation calculation was already uncomfortable, the anti-stripping rule eliminates one of the planning moves on the table. The core reasonable-compensation doctrine, anchored by Watson v. Commissioner, 668 F.3d 1008 (8th Cir. 2012), continues to run the same way it always has.

The statute at signing was a set of terms without definitions. The proposed regs are Treasury's first serious attempt to build the lattice the statute was leaning against. The lattice has holes, and some of them are load-bearing, but a practitioner in August 2018 has substantially more to work with than a practitioner in February did. The final regulations are expected by year-end or shortly after, and the Comments period running into October is the one moment when industry-specific arguments can still shape the rule they are going to have to live under.

Sources

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