By James P. McAndrews IIIDirector of Tax

On August 7, 2018, the U.S. Treasury Department issued proposed regulations on the new 20% tax break included in last year’s $1.5 trillion tax reform bill. These regulations spell out what kinds of companies and professionals will qualify as eligible pass-through entities for this new deduction.

This long-awaited clarification has significant implications for law firms, real estate trusts, family farms and other businesses that are structured so that their profits are taxed to their owners as personal income.

The 184 pages of proposed regulations appear to be a windfall for authors and small banks, who may be eligible for this 20% deduction, but disappointing for dentists, who are not eligible under these regulations.  The regulations also outline steps intended to prevent some individuals and businesses, including law firms, from taking advantage of these new rules to reduce their tax liabilities.

The comprehensive tax reform bill enacted last December gave the Internal Revenue Service substantial latitude to interpret key provisions of the 20% pass-through deduction and which businesses may qualify to claim it.  These proposed regulations are now open for a public comment period, intended to clarify which businesses qualify for the deduction before the regulations are finalized.

The law allows most business owners (except certain service offerings such as doctors and lawyers) earning less than $157,500 ($315,000 for couples filing jointly) to take the deduction.

The law limits the deductions for some businesses based on the total salaries and wages paid to employees in the business.  Following are a few important clarifications offered by this latest regulations:

  • Owners of dental offices may not claim the deduction, but owners of health spas (who do not directly provide medical services) may claim the deduction.
  • Investment banks do not qualify for the deduction, but banks that simply make loans and take deposits (e.g. community banks) do.
  • Paralegals may not claim the deduction, but the owner of a stenography service may get this deduction.
  • Football coaches do not qualify, but the owner of a company that cleans football stadiums would be eligible.
  • As a result of the “reputation or skill” exclusion, authors with substantial book income could organize themselves as pass-through companies and qualify for the deduction, but celebrities who license their names or voices, endorse products or accept appearance fees, “including fees or income to reality performers performing as themselves on television, social media or other forums” would not qualify.
  • “Crack and Pack” strategies (where business owners split their operations into separate entities to avoid prohibitions on taking the deduction) have been outlawed.
  • Businesses can now aggregate the activities of a group of related companies to maximize these tax benefits in several ways (e.g. organizations that pay employees through a different entity than the one that brings in revenue).
  • Workers who were previously treated as employees cannot reclassify themselves as independent contractors to claim the 20% deduction.

These proposed regulations in their entirety can be found at:
https://www.irs.gov/pub/irs-drop/reg-107892-18.pdf