Professional service businesses are weighing the possibility of spinning off administrative or other back-office units of their pass-through businesses to qualify for a 20 percent deduction under the new tax law.
Such moves could help law firms and others sidestep the new tax code Section 199A deduction’s exclusions, practitioners told Bloomberg Tax, though most are waiting for the Internal Revenue Service to issue guidance before moving to restructure.
“Law, accounting—any of the businesses that don’t qualify in and of themselves for the 199A deduction, for whatever reason, whether they’re specified services, or whether it’s just a skills and reputation issue—you could do it with any of them,” said Michael Greenwald, a partner at Friedman LLP. “It would be owned by the same people who own the professional practice, but they’d be making their profit there from non-professional activities.”
Meanwhile, a coalition of S corporation groups is pushing the IRS and the Treasury Department to allow the businesses they represent to do practically the opposite—aggregating into a single unit the pass-through businesses they’ve held as separate entities, often for non-tax reasons, since long before the tax overhaul.
Spinning Off and Writing Off
Under the tax act, individuals who own pass-through businesses can take a 20 percent deduction as long as they don’t earn more than $157,500 for single filers, or $315,000 for married taxpayers filing jointly, after which the deduction begins to phase out.
Beyond incomes of $207,500 for single filers and $415,000 for joint filers, certain “specified service trade or business” types listed in Section 1202(e)(3)(A), along with those involving “performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities,” are excluded, according to the statute. Among those Section 1202(e)(3)(A) trade or business types are those in health, law, performing arts, consulting, athletics, accounting, or “any trade or business where the principal asset” is an employee’s or owner’s “reputation or skill,” but the law left out engineering and architecture trades or businesses.
But if, for example, a law firm spun off its administrative, information technology, or other non-principal operations from the law office and formed a “brother-sister” business structure, the law firm could pay the back-office entity to perform those necessary but non-principal duties, allowing the entity to take advantage of the deduction, said Stephen Looney, chair of the Corporate and Tax Department at Dean, Mead, Egerton, Bloodworth, Capouano & Bozarth P.A. in Orlando, Fla. And it could pay the spun-off entity a lot, he and other practitioners said, maximizing the 20 percent write-off.
The restructuring move should pass muster as long as it is supported by a “business purpose,” Looney said, and not solely for tax reasons. For professions laden with legal risk, he said, such as law and health care, separation of IT and equipment entities from the professional operations could prevent legal liabilities erupting in one entity from contaminating the business as a whole.
That’s the main reason many business owners have held their pass-through businesses in multiple entities for years, according to S corporation group representatives who spoke with Bloomberg Tax. But those organizations fear many of their members won’t get access to the deduction because of another limit based on wages.
Above the $157,500 and $315,000 income thresholds, the deduction is calculated as the lesser of 20 percent of qualified business income or a separate percentage of either W-2 wages or a combination of wages and capital.
If a pass-through business owner has two entities—one that manages payroll and the other that handles operations—the owner will calculate zero qualified business income (or potentially a loss) for the payroll entity, though it may pay wages, and zero wages for the operations entity, though it may generate qualified business income. For each separately, the lesser of the two calculations would be zero, but by making those calculations as if those entities were one business, the owner may be able to get some of the deduction.
In a March 19 letter, 43 groups, including the American Institute of CPAs and the U.S. Chamber of Commerce, as well as associations for roofing workers, cleaning companies, and wine and beer wholesalers, asked Treasury and IRS officials to permit pass-through businesses composed of grouped entities to aggregate when calculating the Section 199A deduction. More specifically, they requested treatment as an economic unit composed of multiple activities in accordance with passive loss rules under Section 469.
“Allowing aggregation or grouping will not open the new deduction to gaming opportunities because the wage and investment limitations provide a strict cap on the size of the deduction, regardless of how it is measured,” the letter said, “while the new rules could ensure that income from excluded service activities is not taken into account for purposes of the calculation.”
Your Move, IRS
The IRS, which declined to comment, included “computational, definitional, and anti-avoidance guidance under new §199A” in its updated 2017-2018 Priority Guidance Plan, a list of projects it hopes to finish by June 30.
Practitioners are encouraging clients to wait for an IRS decision before spinning off their back-office operations into separate entities, according to those who spoke with Bloomberg Tax.
“It is among the highest priorities for the government to do some regulatory guidance, but we don’t know how far they’re going to go with it,” said Kevin Anderson, a partner in the National Tax Office of BDO USA LLP. “We don’t know whether an idea like this will work, and we also think that there should not be any hurry to rush into a structure like this.”
The issue is complicated by the effort of representatives of multi-entity, aggregated S corporations to keep the IRS from forcing their members to do something similar as a means of getting the deduction.
“We already know there are businesses that want to disaggregate to take advantage of the statute, and there are businesses that want to aggregate to take advantage of the statute,” said David Kamin, a New York University School of Law professor who focuses on tax and budget policy. He added that the provision is “very hard to govern,” and that regulating it is “going to be messy.”
Kamin, who served as special assistant to the president on federal tax and budget issues in the later years of the Obama administration, described a potential decision by the IRS to let pass-throughs have it both ways as a worst-case scenario that “would clearly maximize revenue loss.” (The Joint Committee on Taxation, in a Dec. 18 report (JCX-67-17), estimated the Section 199A deduction would cost $414.5 billion over 10 years.) He also stressed that the limitation only applies above the income thresholds.
But Brian Reardon, president of the Washington-based S Corporation Association, one of the groups that signed the letter, warned that, absent a decision by the government to let pass-throughs aggregate, companies could be ushered into costly reorganization. Other representatives from groups that signed the letter who spoke with Bloomberg Tax decried a lack of tax fairness between pass-throughs and C corporations, which the law afforded a 21 percent rate.
“I think they can deal with both” aggregating and disaggregating, Reardon, who served as special assistant for economic policy under former President George W. Bush, said of the IRS. “The goal there is not to game the system. These are real businesses—they’re not very large.”
Worth the Cost?
The letter, to Treasury Assistant Secretary for Tax Policy David Kautter and IRS Principal Deputy Chief Counsel William Paul, warned that “moving business activity from one form to another, particularly a form that is going to be taxed at just 21 percent, will not save the Treasury revenues, but it will impose significant transaction costs on these businesses.”
Similar costs would likely hit excluded professional service firms’ bottom lines if they decide to split with their administrative or other non-principal services, practitioners told Bloomberg Tax.
“There’s obviously a natural tendency to try to overpay for those things, so you’d want to have a kind of a transfer pricing study to make sure that your pricing between the two entities was appropriate,” said Greenwald. “The issue is, is the cost of setting up that other business worth it based on how much you’re going to actually save in the long run? That’s going to turn on how much profit you can shift to that entity.”
Still, Looney said the decline in the top rate for pass-throughs with the help of the deduction, to 29.6 percent from 37 percent, is “a pretty big spread,” so “there’d have to be a lot of added costs for it not to be worth it.”
Anderson pointed out that Treasury Regulations Section 1.448-1T(e)(4) stipulates, for a similar group of professional services, that “administrative and support services” are considered “incident to the actual performance of services in a qualifying field.” This, he said, could raise questions of whether a spun-off administrative entity should really be considered separate, and could be an argument the IRS “might want to pursue if they see all these side-by-side entities popping up.”
In Moline Properties, Inc. v. Commissioner, on the other hand, the U.S. Supreme Court ruled in 1943 that, for federal tax purposes, a company created for a business purpose will be treated as a separate entity.
While a 2011 case—Morton v. United States—broke the precedent set by Moline, two officials in the IRS Office of Associate Chief Counsel in October 2017 issued a memorandum addressed to another agency official in the Large Business & International deputy commissioner’s office suggesting that the break in precedent ought to be ignored. The 2011 decision, they said, “is an aberration that the Service should not follow, because Moline Properties is broadly applicable to S corporations.”