Do you own a pass-through entity? You may already know the new tax law provides a gigantic new tax break. The Section 199A pass-through entity deduction.
The deduction counts as really good news. It 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 deduction.
Tip: If you’re not yet knowledgeable about the new Section 199A pass-thru entity deduction, stop here. Go read our blog post Pass-thru Income Deduction: Top Twelve Things Every Business Must Know. This blog post assume you know the stuff covered in that other post.
Note: One other thing to mention here. We have updated this blog post’s information for the Section 199A final regulations that appeared in January 2019. Just so you know…
How Service Business Disqualification Works
Disqualification occurs for most high-income “white collar” professionals (doctors, lawyers, accountants, consultants, and so on). Also, successful actors and musicians and athletes get lassoed into the specified service category. And then so do then investment bankers, brokers and advisers.
What counts as “high income?” When a taxpayer’s income rises over $207,500 for a single taxpayer and over $415,000 for a married taxpayer.
Further, the statute includes a vague catchall. That catchall says that any high income business owner 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.
Reputation or Skill Definition
When the IRS published its Section 199A regulations , 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 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, name or likeness, you shouldn’t need to worry about getting disqualified.
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 taxpayers can use to maximize their Section 199A deductions. And it covers two topics tangentially related to the 199A 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 such a case, much of the marketing relies on the celebrity’s star power.
The regulations say in this situation, the celebrity may split the activities into separate business– and then only the skill-or-reputation trade or business gets disqualified.
Here’s the actual example from the final regulations:
L is a well-known chef and the sole owner of multiple restaurants each of which is owned in a disregarded entity. Due to L’s skill and reputation as a chef, L receives an endorsement fee of $500,000 for the use of L’s name on a line of cooking utensils and cookware. L is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, L is also in the trade or business of receiving endorsement income. L’s trade or business consisting of the receipt of the endorsement fee for L’s skill and/or reputation is an SSTB within the meaning of section 199A(d)(2) or paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.
Note: The acronym SSTB stands for “specified service trade or business.”
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 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. She 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 start 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.