Is There a Section 199A Deduction Cliff?
In the months since the IRS published the proposed Section 199A regulations, people have discussed the absurd deduction “cliff” that hits businesses providing a specified service as part of their operation.
I still struggle to see how such a cliff makes any sense, and the recently updated Publication 535 suggests to me that it doesn't actually exist. Then again, we don’t have the final regulations for Section 199A, and that is really the only place we’ll get a definitive answer.
In this post, I’m going to talk about why such a cliff may (or may not) be an issue. Then, I want to suggest a way some affected businesses may be able to salvage their Section 199A deduction if it turns out one does exist.
The Section 199A Formula and its Many Limitations
Superficially, Section 199A gives owners of unincorporated businesses as well as S corporations a deduction equal to 20 percent of the business’s income. Example: A sole proprietor who earns $100,000 may receive a $20,000 Section 199A deduction. An S corporation that generates $10,000,000 of profit may also create $2,000,000 of deductions for its shareholders.
The deduction formulas, however, include a number of limitations. First, taxpayers don’t get to use the deduction to shelter income that is already preferentially treated (such as capital gains) or income already sheltered by other deductions. Further, high-income taxpayers will be limited.
For example, a single person with taxable income more than $207,500 and a married person with taxable income more than $415,000 see their Section 199A deduction limited to the greater of 50 percent of the W-2 wages paid by a business or 25 percent of the W-2 wages plus 2.5 percent of the undepreciated basis of property used in the business.
Now another example, and one that connects to the “cliff:” These same high-income taxpayers either don’t receive or get phased out of a Section 199A deduction on business income from a specified service: healthcare, law, accounting, consulting, performing arts (so actors and musicians), athletes and then a handful of other high-income, white-collar industries.
Falling Off the Section 199A Cliff
You may already know, but here’s something many of us (me included) missed or got wrong with Section 199A. In the case of a business conducting some “specified service” activity inside another larger entity, that specified service possibly erases the Section 199A deduction for the entire operation. That erasure is the “cliff.”
I know: Confusing, right? But don’t try to make sense of this because the “cliff” doesn’t really make sense. It doesn’t even clearly appear in the regulations that purportedly create it.
What the Proposed Regulations Said
The Section 199A proposed regulations seem to show elegant symmetry. A de minimis rule appearing in Regulation 1.199A-5(c)(1) said that firms performing only minimal specified services (less than 10 percent for small businesses and less than 5 percent for everybody else) ignore the specified services. These firms get the full Section 199A deduction on all of theit business income.
Almost a “mirror image” de minimis rule appears nearby in Regulation 1.199A-5(c)(3), which pretty much says that firms performing only a minimal amount of “not” specified services (less than 5 percent) can ignore the “not” specified services. These firms get zero Section 199A deductions.
These de minimis rules make good administrative sense. The only question left was: What about when a taxpayer crosses the 5 or 10 percent thresholds?
Combine the two de minimis rules, and the answer seems obvious. When neither simplifies the situation, you break the business into two parts: a “specified service” portion that gets the deduction and another “not a specified service” one that doesn’t. In retrospect, however, this reading turns out to be incorrect.
According to an IRS attorney, the 1.199A-5(c)(1) regulations mean if you run a business with specified service activity and that activity rises above the de minimis threshold of 5 or 10 percent, you lose your entire Section 199A deduction.
So, then, what is the right way to interpret the 1.199A-5(c)(3) regulations? I don’t know, but applying the public comments the Treasury made in October, you almost want to ignore the section entirely and treat an entire firm as a specified service trade or business, even though it doesn’t just provide “specified services.”
Salvaging Section 199A Deductions
The 1.199A-5(c)(3) regulations do, however, suggest a way that firms may be able to salvage a Section 199A deduction. They could completely separate the specified service activity from the other “not” specified one.
Example: In 2018, a small business generates $25 million in revenue with $22 million coming from manufacturing activities and $3 million coming from a consulting business. As a combined enterprise, that $3 million of consulting revenue zeros out the firm’s Section 199A deduction on the manufacturing activity’s profits due to the “cliff.”
That said, I’m not sure exactly how this reading of Regulation 1.199A-5(c) meshes with preamble statements the Treasury made about wanting to “ensure that significant choices over ownership and management relationships within businesses are not chosen solely to increase the Section 199A deduction.”
Moreover, it’s unclear how this reading meshes with the statement that “Congress enacted Section 199A to provide a deduction from taxable income to trades or businesses conducted by sole proprietorships and pass-through entities that do not benefit from the income tax rate reduction afforded to C corporations under the TCJA.”
Why the Inconsistency?
If the cliff exists, we tax professionals will need to be extremely careful as we look at the specified service activity of any trade or business. You or I could miss spotting that a client’s minor product or service causes them to lose their entire deduction.
And this related point: We may be able to help clients reorganize their operations starting in 2019 so as to avoid the cliff in future years. This can be accomplished by splitting a barely “specified service” trade or business into two firms, one that gets a big Section 199A deduction and one that doesn’t.
Three Final Caveats
1. We need to wait for the Section 199A final regulations before taking action for 2019. The regulations, by the way, should probably appear soon. And we’re all going to need more information to deal with this absurdity.
2. We all need to be alert to the possibility that the final regulations may differ significantly from the proposed regulations the Treasury published in August. (A number of statements in the late December draft form instructions for the Section 199A deduction, for example, conflict with the proposed regulations from early August.)
3. We all need to stay really alert to the specified service definitions provided by the final regulations. The proposed regulations use nearly 10 pages to define and describe what counts as a “specified service.” We’re going to need to know those definitions cold or have them close at hand to apply the specified service limitations.
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A managing member in a Seattle area CPA firm, Stephen L. Nelson specializes in serving Subchapter S corporations and their owners. He has an MBA in finance from the University of Washington and an MS in tax from Golden Gate University. A former adjunct professor at Golden Gate University’s graduate tax school, he is also the author of the...