The Tax Cuts and Jobs Act of 2017 (TCJA) provides a pass-through deduction that can reduce the top rate for eligible taxpayers from 37 to 29.6 percent. That deduction, however, is limited (subject to certain income threshold exceptions) to individuals that operate a “qualified trade or business.” A “qualified trade or business” as defined in section 199A is a business other than a “specified service trade or business” (SSTB).
Generally, a SSTB is one involving the performance of service in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, and financial services (think trading, not lending). That definition seems simple enough. But section 199A also contains a second, more confusing definition whereby a SSTB is “any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.”
This so-called “principal-asset test” worried practitioners and business owners because if the IRS literally interpreted the clause above then all service-based pass-through businesses (restaurants, photographers, tour companies, mechanic shops, etc.) would be ineligible for the 199A deduction. Fortunately, cooler heads prevailed and the IRS determined that “the ‘reputation or skill’ clause . . . was intended to describe a narrow set of trades or businesses, not otherwise covered by the enumerated specified services, in which income is received based directly on the skill and/or reputation or its employees or owners.”
So what does that mean? Put simply, if a business is not performing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, and financial services, then the business probably can take a deduction under section 199A. Two examples in the Proposed Regulations bear this out (Prop. Reg. § 1.199A-5(b)(4):
Example 7 - G owns 100% of Corp, an S corporation, which operates a bicycle sales and repair business. Corp has 8 employees, including G. Half of Corp’s net income is generated from sales of new and used bicycles and related goods, such as helmets, and bicycle-related equipment. The other half of Corp’s net income is generated from bicycle repair services performed by G and Corp’s other employees. Corp’s assets consist of inventory, fixtures, bicycle repair equipment, and a leasehold on its retail location. Several of the employees and G have worked in the bicycle business for many years, and have acquired substantial skill and reputation in the field. Customers often consult with the employees on the best bicycle for purchase. G is in the business of sales and repairs of bicycles and is not engaged in an SSTB within the meaning of paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.
Example 8 - 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.
So this is great news for pass-through business owners in general service industries, like chefs, photographers, tour guides, mechanics and the like. But there are some important exceptions to this general rule for individuals engaged in certain personality or likeness driven businesses – think motivational speakers, bloggers, and Instagram celebrities.
Namely, reputation or skill is the principal asset of a business (and the business is a SSTB and cannot take the deduction) where an individual or pass-through entity is engaged in the business of: (1) endorsing products or services where the individual provides endorsement services; (2) selling an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity; or (3) receiving appearance fees or income (including fees or income to reality performers performing as themselves on television, social media, or other forums, radio, television, and other media hosts, and video game players). The proposed regulations offer the following example (Prop. Reg. § 1.199A-5(b)(4):
Example 9 - 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.
In summary, despite the narrow exceptions outlined above, last week’s proposed regulations are good news for pass-through business owners in general service industries.