Tax Law Insights

Congress enacted the new Section 199A 20% profit deduction for the owners of pass-through businesses, and which include Subchapter S corporations, LLCs, sole proprietorships, and even certain trusts. Section 199A is intended to provide a deduction to owners of these pass-through business entities who do not otherwise benefit from the new 21% flat tax Congress has given to corporations under the new tax law. While Section 199A is intended to benefit these generally smaller types of business entities and their owners, the new tax law is riddled with complexity and exceptions, and so that many well-meaning small business owners may not receive the deduction, or at least its full amount. Also, and due to the complexity of new Section 199A, the IRS recently issued Proposed Regulations providing its administrative guidance on the new tax law. This is a case study applying the new Proposed Regulations under Section 199A to a court reporter and her business.

Jane is single, and owns and operates a court reporting, or stenography business - "Jane's Court Reporting, LLC." Jane is the sole owner. Jane has two employees who provide stenographic services for the business, and Jane also does stenographic-related work for the business when needed. The business operates from a leased office, and has no material assets. The business is treated as a single-member disregarded entity, and Jane reports the income, expense and profit from the business on Schedule C to her annual federal income tax return, Form 1040.

For 2018, Jane's business had total income of $250,000, total expenses of $150,000, and a profit of $100,000. 20% of this $100,000 profit is $20,000. Included in the $150,000 of expense is $120,000 of W-2 wage income paid by the business to the two stenographer employees, and also Jane herself. Jane also has other sources of income in 2018, however, and her total taxable income for 2018 (including the $100,000 in profit from her court reporting business) is $300,000.

The 20% pass-through deduction is not applicable generally to businesses that provide services, such as doctors, lawyers, accountants, athletes, stock brokers, and others, except where the service provider has taxable income of less than $315,000 (married) or $157,500 (individual). The benefit to these service providers is phased out over these income thresholds (another $100,000 for married filers and $50,000 for individuals), so that where a married filer has over $415,000 in taxable income or an individual filer has over $217,500 in taxable income, the 20% deduction is lost. Thus, there is no benefit here to higher-paid service providers.

For most pass-through business owners, the deduction is the lesser of (1) the "combined qualified business income" of the taxpayer, or (2) 20% of the excess of taxable income over the sum of any net capital gain. The term "combined qualified business income" is then defined as the lesser of (1) 20% of the business owner's "qualified business income" (QBI) or (2) the greater of (A) 50% of the W-2 wages of the business allocable to the owner or (B) 25% of the W-2 wages of the business plus 2.5% of the unadjusted tax basis in property of the business (generally the original cost of certain depreciable assets) allocable to the business owner.

Under the new Section 199A, any pass-through business owner can potentially receive the new deduction provided his or her taxable income is below the above thresholds. However, if the business owner has taxable income above these income thresholds and the business is a "service business" the deduction is lost. Even if the business is not providing services, if the business owner has higher income - income exceeding the above taxable income thresholds, the business must be paying W-2 wages to employees or have a significant depreciable assets to qualify.

For Jane and her court reporting business, the issue of whether Jane and her business are providing "services" is important to whether Jane can qualify for the deduction. If so, Jane's taxable income of $300,000 is above the deduction threshold and she can qualify for the deduction only is she can satisfy the W-2 wage/depreciable property requirements of the new law.

Under Section 199A, and the new IRS Proposed Regulations, there are certain "listed" types of businesses that are automatically deemed to be "service" businesses. This includes "services performed in the field of law." In addition to these "listed" service fields, a "service" also includes "any trade or business where the principal asset of such trade or business is the reputation or skill or one or more employees or owners."

Applicable to the "field of law," the new Proposed Regulations define this "service" to include:

"the performance of services in the field of law means the performance of services by individuals such as lawyers, paralegals, legal arbitrators, mediators, and similar professionals performing services in their capacity as such. The performance of services in the field of law does not include the provision of services that do not require skills unique to the field of law, for example, the provision of services in the field of law does not include the provision of services by printers, delivery services, or stenography services." [emphasis added]

The new IRS Proposed Regulations certainly help Jane and her business. The court- reporting/stenographic services provided in her business are not considered services provided in the "field of law" and are therefore not one of the "listed" services. However, court-reporting services such as those provided by Jane and her business must also be evaluated under the "catch-all" area for "any trade or business where the principal asset of such trade or business is the reputation or skill or one or more employees or owners."

Initially, an argument could certainly be made by Jane that what she and her court reporter employees do is not a "service" and instead is the stenographic transcription in physical form of recorded voice/testimony. However, the new Proposed Regulations provide Jane and her business now with clear guidance that what she does is not a service. Under the new Proposed Regulations, the phrase "any trade or business where the principal asset of such trade or business is the reputation or skill or one or more employees or owners" is defined to be: (A) a trade or business in which a person receives fees, compensation, or other income for endorsing products or services; (B) a trade or business in which a person licenses or receives fees, compensation or other income for the use of an individual's image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual's identity; or (C) receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.

Under the new Proposed Regulations none of what Jane and her employees do in providing court reporting/stenographic services is considered a prohibited "service" under Section 199A. So, getting back to Jane and her business, and the applicable test for the 20% profit deduction, Jane's business has $100,000 profit, 20% of this profit would be $20,000, and Jane has taxable income of $300,000. She paid W-2 wage income of $120,000 and 50% this amount is $60,000. $60,000 is greater than $20,000, so Jane gets the full $20,000 deduction to claim on her tax return and which reduces her $300,000 taxable income down to $280,000.