Business owners — and their accountants — can rest a bit easier: The IRS has given them the long-anticipated final word on how they can claim one of the biggest perks in the 2017 Republican tax overhaul.
The regulations detailing the new 20% deduction for pass-through business owners are of critical importance to the operators of such entities, who range from mom-and-pop convenience store owners to private equity investors.
The guidance, issued on January 18, 2019, despite a four-week partial government shutdown that has many IRS employees on furlough, can cut those business owners’ tax bills by as much as one-fifth. The rules would govern what many say is one of the most complex changes in President Trump’s tax law.
The IRS made a series of changes to make it simpler for businesses to determine if they can or can’t get the tax break, a senior Treasury official said on a call with reporters.
Veterinarians, for example, don’t qualify for the deduction, but rental real estate owners who spend at least 250 hours a year involved with the business can get the deduction, according to the IRS guidance.
Lobbyists had wanted Treasury to make the rules easier for taxpayers who own multiple pass-through entities. That didn’t happen, according to Brian Reardon, president of the S Corporation Association.
“Disappointed,” he wrote in an email. “They had a chance to broaden the tax benefit while making it much simpler for businesses to comply with, but they chose not to.” He added that for larger pass-through businesses, “these rules are going to be very complex and require a lot of planning.”
The rules make it clear that income from originating and selling mortgages is eligible for the deduction, said Alan Keller, first vice president of legislative policy at Independent Community Bankers of America, a trade and lobbying group. “That is favorable,” he said.
Taxpayers had been worried that they wouldn’t see final rules in time for the filing season due to the partial government shutdown, and that confusing parts of the original provision could leave them exposed to penalties plus interest on improperly reported income.
The agency on Friday also released a proposal clarifying that shareholders of mutual funds with real estate investment trust investments can get the deduction. That change will affect about 15 million investors, according a trade group representing REITs. The IRS is still considering whether publicly traded partnership investments held through a mutual fund will qualify for the deduction.
An official with the National Association of Real Estate Investment Trusts, or Nareit, said the IRS guidance was welcome news confirming that individual REIT investors through mutual funds are eligible for the same 20% deduction as direct investors with respect to their qualified REIT dividends.
The proposed regulations also provide guidance for taxpayers who hold interests in regulated investment companies, charitable remainder trusts and split-interest trusts, the IRS said in a statement.
The agency also put in a test for rental real estate owners to know if they can get the tax break. Property owners can get the tax break if they — or someone they hire, such as a contractor — spend at least 250 hours a year on the business and keep records of their activities.
The pass-through deduction was included in the overhaul to give a tax break to businesses whose owners pay the taxes on their personal tax returns — partnerships, limited liability companies, and S corporations. Trump and Republican leaders have said that middle-class Americans and small businesses would be the biggest beneficiaries under the $1.5 trillion tax cut.
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All taxpayers who earn less than $157,500, or $315,000 for a married couple, can deduct 20% of the income they receive via pass-through businesses from their overall taxable income. If taxpayers earn above those amounts and aren’t service professionals — such as lawyers or accountants; they must meet certain tests to take the full deduction — the size of their deduction depends on how much they pay in employee wages or how much they’ve invested in capital like real estate.
For service professionals, the break fully phases out if they earn more than $207,500 if they’re single, or $415,000 if they’re married.
The rules make clear that companies can’t use a tax planning technique called “crack and pack” to avoid limits on the new tax break. Professional service providers had eyed the break to get around the income limits set for owners of pass-through businesses.
The strategy would have allowed them to split their firms into different entities to lower their tax bills. For example, a law firm could have put all of its secretarial staff into one entity and its lawyers into another to get the full deduction on the income tied to the administrative work.
But companies with some income that qualifies and some that doesn’t can still delineate those different activities, such as through separate accounting books, to get the deduction on the eligible income. For example, banking activities qualify for the deduction but wealth management advising doesn’t, so a bank with some investment advising can separate the bookkeeping for those two units and still get the deduction on the qualifying income.
The deduction is limited for employers who pay low wages or hire few workers. The rules make it easier for related pass-through businesses to maximize their deduction by allowing companies to combine at the entity level or at the owner level. For example, two related businesses — one with a lot of employees but little profit, and another with a lot of profit but few wages — could aggregate their payroll and income to get a bigger tax break.
The rules retain a provision meant to simplify record-keeping if companies only have a small amount of income from ineligible activities, such as health or law. If less than 10% of the income is from ineligible sources, the company can still get the full deduction on all its profits.
Despite Treasury rules making it more clear how the law is implemented, the deduction isn’t available evenly, even within industries, said Mike Greenwald, a partner at accounting firm Friedman. A long-time building owner may not be able to get the tax break, while newer buyers might be able to get the deduction because they’ve invested more capital in the building, he said.
To prepare for questions — and their own filings — planners should note these tips.
“We’re seeing a lot of anomalous results,” said Greenwald.
Donald Susswein, a pass-through tax specialist who’s a principal in the Washington National Tax unit of RSM US, said the final rules allow taxpayers to choose whether to use prior proposed regulations or the final regulations when preparing their returns.
Ordinarily, final rules supersede earlier rules, but this time the Treasury Department made an exception because many taxpayers had already put their accountants to work for the filing season. “It’s unusual,” he said.
One thing the final rules didn’t clarify, Susswein said, concerns taxpayers with multiple trades and businesses held within the same entity.
For example, he said it’s not clear how much of a deduction would be available to an optometrist who sees patients, a service business subject to the cap, and also grinds lenses, a manufacturing business that is not.
Howard Wagner, a national tax services partner at Crowe, said the final rules deal a blow to real estate owners involved in a popular type of lease known as a triple net lease. The term refers to property owners who lease a building to an investor but require the investor to pay for repairs and maintenance. Those property owners aren’t eligible for the deduction, he said.
