The good news? The deduction can shelter the last 20% of the income you earn in a business from income taxes.
But the bad news? Successful service businesses may get disqualified from using the pass-through entity deduction.
Tip: If you’re not yet knowledgeable about the new Section 199A pass-thru entity deduction, stop here, read our blog post Pass-thru Income Deduction: Top Twelve Things Every Business Must Know, and then come back. For purposes of this blog post, I’m going to assume you know the stuff covered in that post.
How Service Business Disqualification Works
Disqualification occurs for most high-income “white collar” professionals (doctors, lawyers, accountants, consultants, and so on), successful actors and musicians and athletes, and then investment bankers, brokers and advisers if a taxpayer’s income rises high enough: over $207,500 for a single taxpayer and over $415,000 for a married taxpayer.
But the statute also includes a vague catchall which says that any high income business owner potentially also gets disqualified if they earn their income in a
trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners.
And it’s this special form of “fuzzy disqualification” I want to talk about here.
Predictably, the fuzzy disqualification generated a bunch of questions from taxpayers right after the Congress passed the law. For the obvious reason, the disqualification appeared to hit every one person business and most businesses employing a tiny handful of people.
Reputation or Skill Definition
When the Internal Revenue Service published the proposed Section 199A regulations in early August, however, they very narrowly defined the “reputation or skill of 1 or more employees or owners” language. Specifically, they said this disqualification refers only to three rather unusual and easy-to-identify situations:
- when someone earns income from endorsing products or services,
- when someone earns income from licensing an individual’s “image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity,” and
- when someone receives income for appearing at “an event or on radio, television, or another media format.”
This useful thought: Tony Nitti, the CPA who pens a popular tax column at Forbes magazine, points out that the regulations essentially require you be a celebrity in order to get disqualified.
In the end, then, unless you can generate income basically just by “renting” your credibility or by “loaning” your name or likeness, you shouldn’t need to worry about getting disqualified from using Section 199A.
A tangential remark? If you really want more detail on the disqualification rules, you may be interested in my Maximizing Section 199A Deductions e-book monograph.
This 135 page, $150 monograph goes into detail about how the new tax deduction works using dozens of simple examples. It provides brief descriptions of about a dozen tactics (some simple, some not) that taxpayers may need to use to maximize their Section 199A deductions. And it covers two topics tangentially related to the pass-thru entity deduction: Whether a business owner should “unincorporate” and whether S corporations should “revoke” their Subchapter S status
When Celebrity Owns Business
A related thought: so what happens when some celebrity owns a business?
Obviously, in a case like this, part of the marketing horsepower and branding relies on the fact that some celebrity has hitched the product or service to their star.
The regulations say in this situation, the celebrity entrepreneur splits the trade or business income into separate chunks–each chunk counts as a separate business– and then only the skill-or-reputation trade or business gets disqualified.
Here’s the actual example from the regulations:
H is a well-known chef and the sole owner of multiple restaurants each of which is owned in a disregarded entity. Due to H’s skill and reputation as a chef, H receives an endorsement fee of $500,000 for the use of H’s name on a line of cooking utensils and cookware. H is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, H is also in the trade or business of receiving endorsement income. H’s trade or business consisting of the receipt of the endorsement fee for H’s skill and/or reputation is an SSTB within the meaning of paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.
Note: The acronym SSTB stands for “specified service trade or business,” the phrase the law uses to refer to disqualified service businesses.
You see the difference the Treasury makes here. A famous celebrity chef can use his personal brand and culinary skills to fill his restaurants with hungry customers. And that restaurant business gets the Section 199A deduction.
But if she or he licenses her or his personal brand and earns income from endorsements, appearances, brand licenses, well, that trade or business gets disqualified.
Obvious Loophole Closed
And just because we’re already on the subject, let me point out one final thing.
Because the tax attorneys at the Treasury are actually really smart, they closed the obvious loophole. A celebrity can’t contribute their personal brand to a partnership that sells some product or service and escape disqualification.
Here’s the example from the regulations:
J is a well-known actor. J entered into a partnership with Shoe Company, in which J contributed her likeness and the use of her name to the partnership in exchange for a 50% interest in the capital and profits of the partnership and a guaranteed payment. J’s trade or business consisting of the receipt of the partnership interest and the corresponding distributive share with respect to the partnership interest for J’s likeness and the use of her name is an SSTB within the meaning of paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.
This makes a lot of sense if you think about. If you’re a celebrity and you really start a business (yes, a business that benefits from your personal brand), that’s okay. But if your only contribution is your personal brand, you don’t get to use the Section 199A deduction.