By Richard Rubin and Ruth Simon
The Trump administration set final rules for a new deduction
that will provide significant savings for many business owners,
providing more clarity for real-estate owners and service-industry
businesses.
The government also offered a cushion for many owners of rental
real estate to claim the deduction if they meet certain tests, but
declined to allow the looser definitions some wanted.
The Treasury Department rejected requests from real-estate
settlement agents, Major League Baseball team owners, writers and
physical therapists, who all wanted more favorable rules for their
specific industries.
The rules for the new 20% deduction for so-called pass-through
businesses -- which include partnerships, S corporations and sole
proprietorships -- will be crucial as business owners begin filing
their first returns under the new system in coming months. Citing
that urgency, the government released the rules during a partial
government shutdown affecting Treasury and the Internal Revenue
Service.
Congress created the pass-through deduction as part of the
sweeping 2017 tax overhaul to give a rate cut to businesses that
wouldn't benefit from the cut in the top corporate tax rate.
The 20% deduction lowered the top rate on business income that
qualifies for the break to 29.6%, down from the 37% top rate that
applies to individuals' wage income. The 2017 tax law reduced the
top corporate tax rate to 21% from 35%.
The final rules make some changes from proposed regulations
released last year, and they will guide business owners and tax
preparers in determining what income qualifies for the deduction.
Each case will be different, and lawyers expect frequent disputes
between the IRS and business owners over who is eligible.
Typical corporations pay corporate taxes and then a second layer
of tax on dividends. For pass-through businesses, by contrast, the
net income flows directly to the owners' personal returns and is
only taxed once, at the owners' individual rates. Many pass-through
businesses are small, but some large closely held businesses use
this structure, too.
Democrats and some tax experts have warned that the pass-through
deduction will distort business decisions, add complexity and help
high-income households. More than half of the benefit of the
deduction goes to the top 1% of households, according to a Tax
Policy Center estimate.
Not every owner of a pass-through business can claim the
deduction. Once income reaches $157,500 for individuals and
$315,000 for married couples, some restrictions apply. For
instance, above those levels, certain service businesses --
including those in medicine, law, athletics and consulting -- start
losing the break. That restriction was designed partly to prevent
people from turning higher-taxed labor income into lower-taxed
business income. Businesses that don't meet specified levels for
assets and wages paid can also lose the break.
When it passed the 2017 tax law, Congress didn't directly answer
many questions about the deduction, including whether all owners of
rental real estate could qualify.
Friday's rules provide a cushion for real estate owners, letting
them claim the deduction if they keep adequate records, have at
least 250 hours of activity per year on the business and avoid
lease structures that make tenants responsible for many expenses.
The hourly requirements don't include time spent arranging
financing or other financial and investment-management
activities.
The regulations also spell out what counts as a service
business, and when having some service-business income taints an
entire business and makes it ineligible for the break.
The rules make it harder for businesses, such as law firms and
doctors, to split their operations apart on paper and pack income
into an entity that would qualify for the more favorable tax
treatment. The government removed one proposal that would have
penalized taxpayers in situations where a service business and a
nonservice business had common ownership.
The proposed regulations had prompted some resistance.
The IRS had proposed a standard last year to help companies with
minimal service income. For businesses with $25 million or less in
revenue, 10% of receipts from specified services is the magic
number that causes them to lose the entire deduction. Above $25
million, the threshold drops to 5%. The government rejected
requests to loosen those rules.
Small banks had said their trust and mortgage services kicked
them over those thresholds, denying them a break they thought they
had won. Insurance brokers, pharmacists and owners of
assisted-living centers, among many others with narrow concerns,
found themselves in similar predicaments.
In many of those cases, the government declined to provide
specific exceptions requested by those service industries,
specifically rejecting the concerns of real-estate settlement
agents, writers and physical therapists. It said assisted-living
centers and skilled nursing facilities would likely have to be
judged case by case.
The final rules give an example of a senior-citizen facility
that contracts with health-care providers who provide medical
services and bill patients directly. In that case, the facility
itself wouldn't be considered to be providing health care. That's a
helpful example, Emily Murphy, an accountant at Plante & Moran
PLLC, said at a tax conference in New Orleans on Friday.
The government did adjust its proposed rules for businesses that
buy and sell commodities, as opposed to those trading financial
instruments based on commodities.
Small banks should be helped by a statement in the final rule
saying that originating loans doesn't count as a financial service
ineligible for the break. But the rules don't reflect some of the
banks' broader requests.
The new rules are "on the positive side of mixed," said Alan
Keller, a vice president with the Independent Community Bankers of
America, a trade group.
Not so for Major League Baseball, which argued that its team
owners should qualify for the break, because their income doesn't
just come from players' on-field performance -- a service that
could render their businesses ineligible.
"While sports club and team owners are not performing athletic
services directly, that is not a requirement," the regulations say,
noting the question is whether the business involves those
services, not whether the owners perform them.
Write to Richard Rubin at richard.rubin@wsj.com and Ruth Simon
at ruth.simon@wsj.com
(END) Dow Jones Newswires
January 18, 2019 17:23 ET (22:23 GMT)
Copyright (c) 2019 Dow Jones & Company, Inc.