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IRS Nixes Anticipated Pass-Through Tax Deduction Workarounds

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IRS headquarters in Washington. (Photo: Bloomberg)

The IRS and Treasury have finally released the long-awaited regulations interpreting the new Section 199A deduction for qualified business income (QBI) that is available to pass-through entities under the 2017 tax reform legislation. While the regulations answer many questions and provide good news for certain service-related businesses, they also impact several important strategies that many businesses and employees had been counting on to maximize, or even access, the Section 199A deduction. The regulations provide important restrictions that must be analyzed to comply with the new rules, both for service business owners hoping to access the deduction through spin-off or “cracking” transactions, and for employees hoping to turn independent contractor.

(Related: 2 Ways the New Tax Law Hurts Financial Planners and Investors)

Specified Service Businesses: The Good News

One of the more confusing aspects of new IRC Section 199A was the limitation on the ability of specified service trades or businesses (SSTBs) to claim the deduction. The regulations provided clarity as to which types of businesses qualify as SSTBs that were specifically enumerated in the statute itself (for example, with respect to the field of law, lawyers, paralegals, arbitrators and mediators are specifically included as SSTBs, while other services related to law, such as printing, stenography and delivery services, are specifically excluded).

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Importantly, the regulations provided clarity with respect to the catch-all phrase “any trade or business where the principal asset of the business is the reputation or skill of one or more employees or workers” contained in the IRC Section 199A definition. The IRS chose to interpret this phrase very narrowly, providing that it generally only applies with respect to individuals or businesses that receive compensation for endorsing products or services, for licensing an individual’s image/likeness, or appearing at an event or on radio, television, or another media format.

(Related: New Tax Deduction Might Favor Life Agents Over Retirement Advisors)

A “de minimis” exception will apply to further reduce the impact of the SSTB limitation for businesses where only a small portion of revenue stems from service-like activities. If the business has gross receipts of less than $25 million for the year, it is not considered an SSTB if 10% or less of its gross receipts are derived from performing services that would otherwise cause the business to be characterized as an SSTB (the threshold is lowered to 5% for larger businesses).

IRS Limits Potential Workaround Strategies

Prior to release of the regulations, many SSTBs had contemplated spinning off separate business units that would not be SSTBs, such as administrative and nonprofessional functions, in order to take advantage of the QBI deduction. The proposed regulations limit this strategy by providing that if (1) the “spun off” business provides more than 80% of its property or services to an SSTB and (2) the two businesses share 50% or more common ownership, the “spun off” entity will be characterized as an SSTB. In other words, the separate entity will be ignored for Section 199A purposes.

Further, employees generally will not be able to simply ask their employers to reclassify them as independent contractors to take advantage of the QBI deduction. QBI specifically excludes income that is earned from the trade or business of being an employee. Because of this, many employees would now rather be characterized as independent contractors in order to access the deduction.

The proposed regulations limit the viability of this potential workaround by providing that if an individual was classified as an employee for tax purposes and, while continuing to perform the same services for the employer, was reclassified as an independent contractor, the IRS will presume that the individual remains an employee for Section 199A purposes. However, the presumption contained in the proposed regulations is a rebuttable presumption — if the individual can show that he or she is, in fact, properly classified as an independent contractor, Section 199A will be available.

Employees should note that this presumption only applies in cases where the individual continues to perform the same job for the same employer. Employees who obtain new positions with different entities, and are properly classified as independent contractors, are not subject to the presumed employee status.


The newly proposed regulations are complex enough that they leave many questions unanswered, and it is widely anticipate that the IRS will further clarify the rules as a result of the comments received prior to finalizing the rules.  For now, however, business owners should be advised that the IRS has already identified and prohibited several potential strategies for maximizing the Section 199A deduction, meaning that further scrutiny could be forthcoming.

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