Or, Why it’s definitely better to be an Engineer or Architect (and possibly better to work in SaaS or biotech) than a Doctor, Banker, Accountant or Lawyer
One of the most sweeping changes in the tax reform is the introduction of a new passthrough tax deduction in Section 199A. Now, for the first time, passthrough business income will be taxed at a lower rate than W-2 wages and salary. But the lower rate is only available for certain types of businesses and owners. This new passthrough deduction is full of potential pitfalls for the unwary!
In this article, I focus on the implications of the passthrough tax deduction for services. I review the top four things you need to know: what is passthrough business income, the taxable income limit, what businesses qualify for the deduction above the income limit, and the W-2 wage limit on the deduction.
Passthrough Business Income
To claim the passthrough deduction under new Section 199A, you need to earn qualified business income. If you’re an independent contractor, member of an LLC, partner in a partnership, or shareholder of an S-Corporation, you may earn qualified business income. (See below for important exceptions.) If you’re an employee that earns W-2 wages, you don’t qualify.
As I mentioned in an earlier post, this new deduction creates a potential tax advantage for being compensated as a 1099 contractor rather than a W-2 wage earner. It also creates a potential advantage for members of LLCs, partners of partnerships, and shareholders of S-corporations. All income reported on Form 1099 and Form K-1 potentially qualifies as passthrough business income.
What kind of 1099 and K-1 income doesn’t qualify? Passthrough business income does not include: (i) income earned as an employee (which may include some types of 1099 income), (ii) reasonable compensation paid by the business for services (such as a salary paid to the owner of an S-Corporation), and (iii) guaranteed payments of a fixed dollar amount paid to partners (even if reported on a K-1).
To qualify for the deduction, it won’t be as simple as switching from a W-2 employee to an independent contractor. Expect the IRS to come up with rules to prevent this type of maneuver. But if the change from a W-2 employee to an independent contractor can be justified, it may be possible to qualify.
If you have less than $157,500 (single) or $315,000 (married) in taxable income, you automatically qualify for the passthrough deduction. However, if you earn more, the deduction is phased out until it is completely removed at $207,500 (single) and $415,000 (married).
Note that the income limit is based on your total taxable income, not just your business income. So if you are single and earn $100,000 in qualified business income, but you also have $110,000 of capital gain or W-2 income, then you exceed the income limit.
Once you’re over the income limit, you only qualify for the deduction if you’re not in a specified service trade or business and you satisfy the W-2 wage limit.
Specified Services: List of Prohibited Services
When you exceed the income limit, the passthrough tax deduction is not available if your business is on the list of specified services. Otherwise known as the doctor, lawyer, asset manager, accountant, actor, athlete, and banker discrimination rule, this is an arbitrary list of services that Congress has deemed not worthy of the deduction. The only reason for creating this list seems to be budgetary. Congress was concerned that offering the deduction to everyone would balloon the deficit.
Section 199A starts by referencing a broad list of specific services that don’t qualify: health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. It also includes a catchall category: any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its owners or employees.
But this broad list is only the starting point. To arrive at the actual list of prohibited services, Section 199A modifies the list by (i) excluding engineers and architects, and (ii) adding investment managers and securities dealers. As a result, the list of prohibited services is both narrower (because engineers and architects are excluded) and broader (because asset managers are included). If there was any question that asset managers were already on the list because they are engaged in financial or brokerage services, the specific reference to asset managers serves to remove any lingering doubt!
Manufacturing, retail, farming and agriculture, mining, energy, and technology companies are in. Doctors, lawyers, accountants, and other specified services are out. But many services do not fall into one of the specific prohibited services. For example, software developers, biotech, and marketing professionals belong to this grey area. How broadly should we interpret the various categories in the prohibited list, particularly the consulting and catchall categories?
Grey Areas: SaaS, Biotech, Marketing
There’s good reason to think that the catchall and consulting categories should be interpreted narrowly for the following reasons:
First, the catchall category includes all businesses when the business’s principal asset is the reputation or skill of its employees. Does this mean that service-based businesses that aren’t specifically excluded qualify for the deduction when they’re unknown and lack skills, only to lose the tax deduction when they develop enough skill and reputation? Not likely.
Second, by specifically excluding architects and engineers, it appears that Congress intended this group to qualify for the deduction. It would be illogical for architects and engineers to be removed, only to include them once they improve their reputation or acquire more skills.
Third, assuming the catchall category doesn’t apply to engineers and architects, that seems to bolster the position of other businesses. That is, if Congress did not intend the catchall category to apply to engineers and architects, why should it apply to SaaS and biotech?
Fourth, in the context of a different code section that references the same list of services, the IRS has issued rulings interpreting the list favorably and narrowly for at least two biotech companies. Specifically, in one ruling, a biotechnology company helped to commercialize experimental drugs through research, testing and manufacturing pharmaceuticals. The IRS ruled that the company was not primarily engaged in providing individual expertise. Instead, it provided manufacturing and intellectual property assets to its customers. Therefore, although the company was in the pharmaceutical industry, the IRS ruled that it does not perform health services, nor does it fall under the catchall category.
In another ruling, the company provided a specific diagnostic test for healthcare providers. The IRS ruled that because the company did not diagnose patients or provide patient care, and because the skills of the employees were specific to the company, the company’s business qualified.
Expect the IRS to issue guidance in this area in the future. The passthrough tax deduction potentially applies to myriad various service businesses. At first blush, the catchall seems to prevent virtually all service businesses from qualifying for the deduction. However, it appears that the limitation may be relatively narrow. In any case, the IRS has already announced that it intends to issue guidance in this area so expect developments this year.
W-2 Wage Limit
If you have taxable income above the limit and you’re in the right kind of business, the last limitation is the W-2 wage limit. Simplifying, the passthrough tax deduction is limited to 50% of the W-2 wages paid by the business. So if the business doesn’t pay any W-2 wages, you won’t qualify for the deduction.
Don’t have any employees? You might consider forming an S-Corporation. With an S-Corporation, owners can pay W-2 wages to themselves.
It’s unclear if the IRS will issue guidance limiting the ability of owners to pay themselves salaries to qualify for the passthrough tax deduction. It’s also unclear how W-2 wages will be allocated to partners or shareholders of S-Corporations through different tiers of entities, although Congress provided the IRS with authority to issue regulations for tiered entities.
Summing it Up
Although the new passthrough tax deduction is complex, for many taxpayers it will provide a significant tax benefit. The top individual tax rate is 37% for income greater than $500,000 and 35% for income over $200,000. With the passthrough tax deduction, that rate goes down to 29.6% and 28% respectively. This is an important topic for many business owners and because of the complexity, it’s worth some attention. My next article will feature specific examples. Stay tuned!