The Tax Cuts and Jobs Act that President Trump signed into law last month limits the tax deductions that accountants, lawyers and some other types of professionals can claim, reflecting some of the rules for Qualified Small Business Stock.
One of the most important changes in the new tax law involves the taxation of pass-through entities and directly implicates the standards for Qualified Small Business Stock, or QSBS, under section 1202 of the tax code.
Under the new section 199A added by the Tax Cuts and Jobs Act, taxpayers who generate pass-through business income in the fields of accounting, law, health, performing arts, consulting, athletics, financial services or any business where the principal asset of the pass-through business is the reputation or skill of one or more of its employees or owners are subject to a complete phase-out on the 20 percent business income deduction. That means the same types of businesses that cannot be qualified small businesses (and issue QSBS) under section 1202 are now also subject to more restrictive phase-outs for the new business income deduction under section 199A. It starts to phase out on taxable income (as opposed to adjusted gross income) over $315,000 for couples, or $157,500 for single taxpayers.
“This new section 199A generally provides a 20 percent deduction for business income,” said Christopher Karachale, a partner at the California law firm Hanson Bridgett. “Then it starts to phase out above $315,000 for joint filers. What Congress did was they seemed to want to limit service providers from getting too much of this business deduction. So they grafted on the exclusions from 1202 onto this new 199A. Under section 1202 qualified small businesses can’t be these industries where it’s primarily service driven: lawyers, accountants, traders, that sort of stuff. They’re saying we want people that build stuff like computer manufacturers and software developers.”
The tax deduction completely phases out at taxable income above $415,000 for joint filers in accounting firms and the other industries listed. “For people who couldn’t be QSPS, those people similarly can’t get the 20 percent deduction above $415,000 for joint filers. It totally phases out,” said Karachale. “Now, for other people, for example real estate investors, if they have enough employees, and there’s a number of other rules about W-2 wages, the amount of property, the basis of the property, they don’t get that. Under the appropriate circumstances, they don’t phase out on the 20 percent deduction above 415.”
There are a number of other ambiguities involving a $10 million exclusion on qualified small business stock. “Section 1202(e)(3) excludes certain service industries from qualified small business qualification,” said Karachale. “You can’t get the $10 million exclusion if you’re a law firm or if you’re involved in the area of health or any other industry where the primary activity of the business is dependent on the skill or reputation of one or more of the employees. That’s the rules, but the IRS has issued two private letter rulings interpreting 1202(e)(3), both in the health industry area. One involved a pharmaceutical company and the other involved a genetic testing company. Both of those said, notwithstanding the fact that you’re in the health industry you still meet the qualifications, and you get to be a qualified small business. The application of that rule I think will be slapped on top of the 199A rules.”
That may provide a loophole for some firms, but the IRS will need to provide more clarity in its future guidance. “We’re going to have to get a lot of guidance on what is the dividing line between those service industries for 199A purposes and what is not,” said Karachale. “That’s going to be a permeable line.”
At least one tax expert is doubtful that accounting firms will be able to skirt the new rules.
“They’re not going to qualify,” said Dean Zerbe, national managing director at alliantgroup, who is a former senior counsel and tax counsel for the Senate Finance Committee. “They can get out their prayer rug. They’re not going to be qualifying. That’s clear.”
However, he pointed out that small accounting firms and law firms still do get some tax breaks, at least up to the phase-out level. “The interesting part of it is that if you’re a small law firm or a small accounting firm, you do qualify,” said Zerbe. “They’ve got the floor for everyone. My reading is that anybody would qualify for that as a pass-through. In some sense they do benefit, if you’re kind of a small-town lawyer or small-town accountant. But they’re absolutely not going to expand it. It’s certainly rules that you’ve got to bear down and focus on, in who qualifies and how they qualify.”
Above the $315,000 level, some firms may start to look for ways to reorganize themselves to claim a bigger tax break.
“Everybody qualifies,” said Karachale. “It’s just that when you get above $315,000 it starts to phase out. You can be an attorney and your first $315,000 of pass-through income gets the 20 percent. It’s just that above that it starts to phase out, and for attorneys and those other people on the list at $415,000 it’s completely phased out. It stops. But if you’re not on that proscribed list, the 1202(e)(3)(A) list, then provided you have enough wages paid out, or the basis on your property is high enough, you can continue to exclude pass-through income another 20 percent. So for high-earning legal partners at law firms, they’re going to want to figure out a way to say, ‘Hey look, above 415 of pass-through LLP income I still get the 20 percent deduction because I’m not really a lawyer or whatever.’"
At the last minute, the House and Senate Conference Committee added in architects and engineers as qualifying for the expanded tax break, but not accountants or lawyers. But some firms may decide to reorganize themselves to qualify for the bigger tax break.
“There will be some people in gray areas,” said Zerbe. “In the gray areas, I’m sure people will start to think about how they can organize their affairs this way or that way.”
One way that might happen is by claiming different practice areas as different businesses.
“It says that the $315,000 20 percent deduction is for each trade or business,” said Karachale. “I don’t know the rules yet, but you could say, ‘Hey, look, I give tax advice, but I also give corporate advice, so could I end up with two buckets of $315,000 by saying in one trade or business I’m giving tax advice, but in another trade or business, I’m engaged in the business of giving corporate legal advice and advising boards of directors. Is that enough to get me two separate trades or businesses?' A good example would be an accounting firm. They have audit and compliance. If a partner practices in both audit and compliance, has he created two separate buckets of 199A up to the 415 max out? I don’t know yet.”
He anticipates the Treasury Department and the Internal Revenue Service will need to issue detailed regulations on how the different rules work, after Congress’s Joint Committee on Taxation issues a guide. “First the Joint Committee on Taxation will publish its guide, which will be real helpful,” said Karachale. “I think a lot of people are looking forward to seeing what that says. I talk with people at the IRS and Treasury all the time on qualified small business stuff. They’ll come up with workable rules on how to interpret this law, so even if it is complicated and arguably nonsensical, I think there are smart people at the Service who will help create workable guidelines for practitioners.”
Treasury and IRS regulations can take years to finalize, but Karachale believes practitioners will be able to rely on the proposed regs until they’re finished.
“If there’s a temporary reg or a proposed reg, it’s out there,” he said. “At least that gives you guidelines to advise your client, to say this is a proposed reg, but at least we know what people at Treasury are thinking, and that’s going to trickle down to agents in the field. When you have situations like this with a real complicated change, all we want is guidance. Our goal is not to take advantage of this, just to say, ‘We read this and it means this, and when you read it, it means that.' All right. Propose some guidance and we can start talking about what that means as well.’”