The new Section 199A deduction requires taxpayers to identify the individual trades or businesses they receive income from.
The reason for this identification? The 20% deduction you calculate looks at trades or businesses individually.
Example: You own four businesses: a pet food factory, a trucking company, a consulting firm and online retail store. Probably in this case, you make four separate Section 199A calculations for the four separate businesses.
Why the Internal Revenue Service Even Cares
The IRS makes business owners “break down” operations into individual trades or businesses for two reasons.
First, specified service trades or businesses (hereafter SSTBs) lose part or all of the Section 199A deduction if the owner’s taxable income gets high enough.
Note: SSTBs include doctors, lawyers, accountants, consultants, investment bankers, financial planners and a handful of other potentially high income high “personal service” businesses like performers and athletes.
Second, all businesses potentially see their Section 199A deduction limited based on the business’s wages and depreciable property if the business owner’s taxable income rises high enough.
Note: For more information about how the SSTB or wages or depreciable property phase-out rules work, click here.
In any case, as a result of the way the formula works, businesses need to “break apart” their activities into individual trades or businesses.
Now This Bit of Bad News
And here’s the bad news about all this: The identification rules get complicated.
Some business owners might treat a pet food factory, trucking company, consulting firm and online retail store as a single trade or business. (This would be unusual but could occur as I’ll discuss below.)
Other business owners might appropriately break these activities into two, three or most likely four separate businesses.
Accordingly, businesses need to learn the rules the IRS has already provided. And then, frankly, businesses need to make some educated guesses about how to identify each individual Section 199A trade or business for those situations where the IRS hasn’t provided rules.
Fortunately, the recent proposed regulations (from August 2018) provide quite a bit of useful guidance.
De Minimis Rules Says Sideline Specified Service Trade or Business Ignored
Helpfully, the proposed regulations say “ignore” stuff that’s minimal.
For example, if some business does a tiny slice of consulting (an SSTB) as part of some larger business, you ignore the tiny slice.
Example: A pet food factory generates $4.9 million of revenue manufacturing vegetarian organic pet food. The owner also provides about $100,000 of consulting to other similar businesses. In this case, consulting services get ignored. And the pet food factory business and the consultancy get treated simply as a pet food factory.
The proposed regulations, predictably, specify what counts as de minimis, or “tiny”:
For trades or businesses with $25 million or less in sales, de minimis specified service trade or business activity means less than 10%. For example, a $25 million pet food manufacturing and consulting business that includes $2 million of consulting, simply counts as a pet food business.
Note: $2 million represents only 8% of the $25 million combined revenues.
For trades or businesses with more than $25 million in sales, de minimis specified service trade or business activity means less than 5%. For example, a $30 million pet food manufacturing and consulting business that includes $2 million of consulting counts as two trades or businesses: a $28 million pet food business and a $2 million consulting business.
Note: $2 million represents nearly 7% of the $30 million combined revenues.
Ignore Ancillary Embedded Consulting
A related point: If your non-SSTB business provides some consulting to customers when selling its products or other services, that doesn’t count as consulting.
The one wrinkle here: The firm can’t separately bill for consulting, and the customer can’t separately purchase the consulting.
Example: A college kid works at the big box store selling high definition televisions. His name tag identifies him as a “sales consultant.” Theoretically, he (sort of) provides “consulting services” to customers. But that advice, as long as it’s not separately billed or purchased, doesn’t count as consulting for purposes of Section 199A.
Example: A office equipment manufacturer sells giant photocopiers and printers to medium-sized businesses. Its sales representatives also consult with customers about reducing costs with automation. Again, however, as long as it’s not separately billed or purchased, that advice doesn’t count as consulting.
Incidental Business Lumped with Specified Service Trade or Business
Another simplifying rule: If a non-SSTB trade or business is incidental to another larger SSTB, you lump the two businesses together.
This “lumping” rule gets a little complicated. The rule says the incidental business and the SSTB need to share 50 percent or more common ownership. It says the incidental business and SSTB need to share either wage or overhead expenses. And it says the incidental business’s revenue must equal 5 percent or less of the “total combined gross receipts of the trade or business and the SSTB in a taxable year.”
Fortunately, a handful of examples makes things clearer.
Example: A $1 million firm provides $975,000 of management consulting services to the pet food industry. The firm also operates a prototype pet food factory, and the factory generates an additional $25,000 of revenue. The firm gets treated as a single trade or business engaged in the SSTB of consulting. Note that the $25,000 of pet food revenue equals 2.5% of the $1 million of combined revenues.
Example: Assume the following year, the business revenue mix changes. That year consulting revenues equal $900,000 and pet food revenues equal $100,000. With the pet food revenue equal to 10% of the combined revenues, the business owners break the operation into two separate trades or businesses. The consultancy counts as one trade or business. The pet food manufacturer counts as the other.
Finally, this important note: The incidental trade or business doesn’t need to be part of the larger SSTB entity. It only needs to share 50 or more common ownership and then wages or overhead expenses.
Example: An attorney practices law as a single shareholder S corporation and generates $475,000 in revenue. She also earns $25,000 as a freelance author operating as a sole proprietorship. To write, however, she uses her law office computer. The writing sole proprietorship gets treated as an incidental business that’s part of the law firm. Why? The two firms share a common owner. The two firms share overhead. The $25,000 of writing royalties equal 5 percent of the total combined $500,000 of gross receipts.
Looking Beyond Specified Service Trades or Businesses
And now an awkward way station in this discussion: Everything discussed in the preceding paragraphs comes right out of the Section 199A proposed regulations–and mostly out of the Regulation Sections 1.199A-4 and 1.199A-5.
But beyond this point, things get a little murkier–at least to me.
For business operations that are neither SSTBs or nor de-minimis-type situations, the IRS hasn’t provided much guidance.
Arguably, however, businesses and their tax advisers can look at the IRS grouping rules in proposed regulation 1.199A-4 to figure out how to identify and separate individual trades or businesses. But let me share what I’m thinking. And then see if you agree.
Those grouping rules say someone who owns separate non-SSTB businesses can aggregate the businesses if any two of the following three things is true:
- Products and services are the same or customarily offered together,
- Operating units share facilities or share “significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources, or information technology resources,”
- Trades or businesses coordinate or rely on each.
Some nit picky rules exist when you do an aggregation. You’ll want to confer with your tax accountant about making an aggregation election. Or carefully read the regulations yourself.
But if you’re trying to identify individual trades or businesses, I think you can channel the logic of the aggregation rules.
Examples of Identifying Section 199A Trade or Business
Say, for example, that you own interest in an S corporation or partnership. Further suppose the firm really does operate four businesses: a pet food factory, a trucking company, a consulting firm and an online retail store.
In this case, you treat the consultancy as a separate business because it’s an SSTB (unless you can use the de minimis rule described earlier.)
And then probably the pet food factory counts as one trade or business. Ditto for the trucking company. Ditto again for the online retail store.
As stand alone businesses inside the S corporation or partnership, these individual operating units have the same ownership. They surely sell the same stuff to the same people. They use the same resources. And probably each business operates as an integrated unit.
But here’s the other weird thing to observe. The pet food factory, trucking company and online retail store may also be the same business.
If all three business activities share ownership, resources and a supply chain, they arguably should count as a single business.
For example, obviously the pet food factory makes the pet food. But then say the trucking company transports some of that pet food to large retailers. And then say the online retailer sells the some of the pet food directly to pet owners.
In this situation, bingo, the fully integrated operation should work as a single trade or business.
And continuing with this logic, if you can’t make a grouping election? Gosh, doesn’t that strongly suggest you shouldn’t treat the various operations as a single trade or business? I think so. Even if you’ve lumped them all together into a single S corporation or partnership.
Fake Trades or Businesses Don’t Pass the Giggle Test
A quick warning to people with a creative flair: An SSTB cannot carve off a chunk of its operation, place that chunk into another entity (an entity purportedly operating a “different” trade or business), and then generate qualified business income in the process.
Here’s why: The Section 199A proposed regulations say that if any trade or business provides 80% or more of its property or services to an SSTB and if that other trade or business and the SSTB share 50% or more common ownership, then that other business is an SSTB too.
Note: The above gambit was an early idea some tax nerds came up with to avoid the SSTB disqualification stuff. Predictably, the tax nerds at the IRS easily foiled this maneuver.
Cost Accounting Rules for Section 199A Trade or Business
A final quick point to end this discussion: With multiple trades or businesses, business owners will also probably need to do good cost accounting by individual trade or business.
In other words, if a business owner needs to worry about the whole “multiple trades or businesses” thing, the business owner needs to worry about doing good cost accounting for individual trades or businesses.
The reason for this gets back to very heart of the matter. Some business owners will need granular income, wages and depreciable property information for each individual business in order to calculate the Section 199A deduction.
And this observation: All this cost accounting and fiddling mostly explains why the Internal Revenue Service estimates the average pass-through entity tax returns will now take about an extra three hours to prepare.
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