New Tax Deduction Might Favor Life Agents Over Retirement Advisors

(Photo: Allison Bell/TA)

The details are hazy, and the final outcome is uncertain, but the Internal Revenue Service may make the new, 20% “pass-through deduction” more generous for insurance agents who sell products such as life insurance, disability insurance, voluntary benefits and property-casualty insurance than for financial professionals who classify themselves as “wealth planners” or “retirement planners.”

IRS officials have raised that possibility in a new draft of proposed regulations for part of the new Tax Cuts and Jobs Act, the “qualified business  income” (QBI) deduction provision.

(Related: The New 20% Pass-Through Tax Deduction: An Advisor’s Guide)

The QBI deduction part of the new tax act added Section 199A to the Internal Revenue Code (IRC).

IRC Section 199A creates a complicated 20% business income deduction for owners, or part owners, of the kinds of business that small business owners typically own: sole proprietorships, partnerships, S corporations, limited liability corporations and limited liability partnerships.

The deduction is set to last from the 2018 “taxable year” through 2025.

IRC Section 199A could lead to a financial professional stampede to tax advisor offices, because the section sets much tougher rules for owners of “specified service, trade or business” (SSTB) firms than for  than for owners of other types of businesses.

If the final regulations look something like the new draft regulations, financial professionals may suddenly have a strong financial incentive to identify themselves as something other than a financial advisor, a retirement planner, or an actuary.

SSTB Maze

Eligible taxpayers are supposed to apply the 20% deduction to either their eligible business income (“qualified business income”) or to 20% their overall taxable income, minus capital gains — whichever calculation produces the smaller number.

Tax Cuts and Jobs Act drafters reportedly wanted to give business owners a tax break, but they also wanted to avoid giving the impression they were creating a loophole to help rich people.

Drafters added a number of limitations to use of the deduction.

One limitation that directly affects financial professionals is a cap on use of the deduction by owners of SSTB firms.

For the owner of an SSTB firm, the deduction starts to phase out when the owner’s overall taxable income reaches a “threshold amount,” and goes away entirely when overall income gets too higher.

The “phase-in range” limits will be adjusted for inflation.

The range will start out at $157,500 to $207,500 for a single filer, and at $315,000 to $415,000 for a married couple filing jointly.

Tax law drafters defined an SSTB firm as “any trade or business” described in IRC Section 1202(e)(3)(A) (applied without regard to the words ‘engineering, architecture,’)” or “which involves the performance of services that consist of investing and investment management, trading, or dealing in securities (as defined in [IRC] Section 475(c)(2)), partnership interests, or commodities (as defined in section 475(e)(2)).”

IRC Section 1202(e)(3)(A) states that other tax provisions for “certain activities” apply to “any trade or business involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or 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.”

The next section, IRC Section 1202(e)(3)(B) defines a class of businesses that includes “any banking, insurance, financing, leasing, investing or similar business.”

In the new draft regulations, IRS officials say they believe the tax law drafters meant to apply the SSTB business income deduction limits only to the kinds of professionals described in Section 1202(e)(3)(A), such as lawyers and actuaries, and not to people involved in insurance.

In an introduction to the draft regulations, IRS officials describe their approach this way:

[The draft limits the ] definition of financial services to services typically performed by financial advisors and investment bankers and provides that the field of financial services includes the provision of financial services to clients including managing wealth, advising clients with respect to finances, developing retirement plans, developing wealth transition plans, the provision of advisory and other similar services regarding valuations, mergers, acquisitions, dispositions, restructurings … , and raising financial capital by underwriting, or acting as the client’s agent in the issuance of securities, and similar services. This includes services provided by financial advisors, investment bankers, wealth planners, and retirement advisors and other similar professionals, but does not include taking deposits or making loans.”

David Kamin, a tax law professor at New York University, talked about the SSTB definition at a Senate Finance Committee hearing in April.

He took note of congressional Joint Committee on Taxation projections that about half of the tax savings resulting from IRC Section 199A may go to taxpayers earnings over $1 million per year.

The provision also “draws very, very haphazard lines in the sand as to who gets [the deduction] and who doesn’t,” Kamin said.