The Tax Cuts and Jobs Act of 2017 created the qualified business income, or QBI, deduction, which allows owners of eligible businesses to deduct up to 20% of qualified business income.
It’s a great benefit for those who qualify. The trouble is, not every business qualifies. According to Internal Revenue Code 199A, a specified service trade or business (SSTB) may not qualify for all or any of the QBI deduction. QBI deductions begin to phase out at $326,600 for joint filers and $163,300 for single filers in 2020.
“Once a taxpayer’s taxable income reaches the maximum phase-in range ($426,600 for joint filers and $213,300 for other filers for the 2020 tax year), the income from the SSTB no longer qualifies as QBI,” says Los Angeles-based Shane Glass, a certified public accountant and president of Colony Business Management at The Colony Group.
This creates two new challenges for financial advisors: First, how to determine if a client’s business is a specified service business, and second, if it is an SSTB, finding ways to minimize the impact this has on the client’s tax deductions.
What is a Specified Service Business?
According to IRC Section 199A, a specified service trade or business is “any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees.”
The definition is both helpful and not helpful.
“Many of these categories clearly define what businesses are an SSTB and what businesses are not,” but it also leaves many businesses undefined, says Harold Hancock, shareholder with Brownstein Hyatt Farber Schreck in the District of Columbia, who advises clients on federal tax policies.
For example, the health category says “physicians, pharmacists, and nurses are SSTBs, but health spas are not,” he says adding that it doesn’t provide any guidance on whether someone who performs acupuncture is in an SSTB. “So there are gray areas.”
These gray areas make it important for financial advisors to help their clients determine if they own an SSTB or not. The best way to do this is to start with the IRS guidelines. Following the initial provisions of Section 199A on QBI deductions, the IRS issued final regulations to clarify the gray areas.
“The final regulations define and provide some guidance with respect to the categories of services that fall within SSTBs,” Glass says. They also “limit the application of the seemingly broad inclusion of any trade or business where the principal asset of such trade or business is the ‘reputation or skill’ of one or more of its employees or owners,” called the “reputation or skill clause.”
Specifically, this clause was limited to businesses that receive income from endorsements, the licensing of an individual’s likeness or feature, and appearance fees, Glass says.
The final regulations also paired back the broad consulting category. For the most part, SSTBs “do not include franchisors, assisted living facilities, personal staffing firms and pharmacies selling prescriptions and over-the-counter medications,” says Bill Smith, managing director for CBIZ MHM’s National Tax Office.
Financial advisors need to make a “good faith and reasonable” effort to determine whether their client’s business is a specified service trade or business through the IRS guidelines alone, Hancock says.
“Look very carefully at the IRS rules,” he says. “It may be possible for a client to change their business model slightly and be treated as a business that is not an SSTB.”
What to do with a Specified Service Trade or Business
There are ways to maximize your QBI deduction within the SSTB rules. The most straightforward strategy is to keep your income below the phase-out thresholds. Glass suggests maximizing other deductions, such as contributions to retirement plans, to help keep your income below the threshold and help increase your QBI deduction.
This can also be done by bunching “income in one year and deductions in the next so qualified business income can be claimed every other year,” says Linda O’Brien, a tax analyst at Wolters Kluwer in Chicago.
If your taxable income will regularly cause you to exceed the threshold for the QBI deduction, you may consider converting your “business to a C corporation and take advantage of the lower corporate income tax rate of 21%,” O’Brien says.
“Multifaceted businesses need to determine if it is possible to reorganize in a way that saves the QBI deduction,” Smith says. He uses the example of a surgery center, which could qualify as a non-SSTB except for the fact that it employs nurses, which fall into a specified SSTB category of health provider.
“Is it possible for the nurses to set up their own company and contract with the surgery center, so the surgery center could now potentially qualify for the QBI deduction?” Smith says.
O’Brien gives similar advice. Look for ways you can maximize the income from your non-SSTB activities, such as by allocating a larger percentage of the wages and other expenses to the SSTB side.
If you are establishing a new business, he says to take extra care in considering if there is the possibility of making it a hybrid business with some SSTB activities and some non-SSTB activities. Doing so could help preserve some of the QBI deduction.
If you can hybridize your client’s business in such a way that limits the gross receipts attributed to the SSTB to 10% or less of the total gross receipts, your client’s business may qualify for the de minimus exception to the SSTB classification. “A trade or business who meets the de minimis exception is treated as 100% non-SSTB,” provided that business has gross receipts less than $25 million, Glass says.
All of the terminology and processes can be overwhelming and confusing if you are new to the business world, or if you are unfamiliar with business structures and taxation. To make it easier, contact our team of experts today.