Congressional Republicans created a juicy new tax break for business owners when they rewrote the U.S. tax code late last year. Three months later, hundreds of thousands of U.S. employers still don't know if they qualify.
The Internal Revenue Service has said it will provide guidance detailing exactly who's allowed to take the so-called pass-through deduction. With billions of dollars at stake, business groups are lobbying for the agency to open the doors to the deduction as widely as possible.
Some high-earning proprietors — such as construction contractors, massage therapists, executive headhunters and restaurateurs — could be excluded if the IRS writes the rules too narrowly. The agency plans on issuing guidelines by June. But that deadline has been questioned by a former top Treasury official given the vagueness of the legislation and complexity of the task.
The 20% deduction is aimed at pass-through businesses, whose income is reported on their owners' personal tax returns. Congress tried to bar wealthy owners of service businesses from getting the break — leaving out many doctors, lawyers and hedge fund managers unless they can find a loophole.
By trying to exclude those service businesses, though, Congress ended up asking the IRS to settle some rather absurd philosophical and semantic conundrums. What, for example, is an entertainer? Are humans the only species who get "health care," or do animals count too? How do you tell a broker from a salesperson, or an interior designer from an interior architect?
"We want to make sure that real businesses that are generating real economic activity get to take advantage of the deduction," said Chris Smith, executive director of Parity for Main Street Employers, a new group formed to lobby the IRS and Congress on behalf of pass-through businesses. "You should be able to organize your business for business reasons, and not have to restructure because of quirks in the tax code."
The challenge ahead for the IRS, which has been struggling with limited resources and faces a possible restructuring by Congress, is monumental. The agency must write coherent rules, and then be ready to make judgments on every business in the U.S. And the IRS can be challenged by taxpayers and second-guessed by courts, a process that could take years to play out.
A spokesman for the IRS didn't respond to a request for comment.
A lax interpretation of the pass-through rules would please businesses, but also could blow a hole in the U.S. Treasury. The nonpartisan Joint Committee on Taxation estimates that the pass-through deduction, which expires at the end of 2025, would cost about $415 billion over the coming decade. The tax break could be even more expensive if IRS regulations can't keep gamesmanship to a minimum.
Tax professionals are pleading with the IRS for details as soon as possible. The American Institute of CPAs asked for "immediate guidance" on the pass-through provision in a Feb. 21 letter to the IRS. "Taxpayers and practitioners need clarity" to comply with their tax obligations and "make informed decisions regarding cash-flow, entity structure, and other tax planning issues," the AICPA said.
This much is clear: If you're a pass-through business owner who earns less than $157,500, or $315,000 for a married couple, you get full access to the deduction no matter what you do.
Above those thresholds, the deduction fades for certain "service" industries specified in the law including health, law, consulting, athletics, financial and brokerage services. (The break is completely eliminated for service business owners earning more than $207,500 if they're single, or $415,000 if they're married.)
Each term raises questions. Veterinarians, for example, can't know for sure whether their work qualifies as "health care" in the tax code. Even if it does, vets do lots of things that probably don't fall in that service category, from boarding pets to selling drugs and dog food.
The American Veterinary Medical Association "is working with the IRS and Congress to explore all options to improve tax provisions impacting veterinary medication," said Kent McClure, the AVMA's chief government relations officer.
"Consulting" and " brokerage" are two catch-all terms that could ensnare many unsuspecting businesses. The function of a consultant is to give advice: So how does the IRS legally distinguish a management consultant, who advises a CEO on restructuring, from a tattoo artist who tells you what might look good on your shoulder?
"What does it mean to be a broker? It could be very narrow or it could be big," said Troy Lewis, a CPA and professor at Brigham Young University who chairs an AICPA task force on the topic. "There are a lot of people who are in the information business, who get paid to put two people together."
Reputation or Skill
Just as puzzling to tax advisers is another phrase in the law. Any firms where the "principal asset" is the "reputation or skill of one or more employees or owners" are also excluded by the law as service businesses.
This makes many businesses nervous. Contractors, for example, can live and die based on their reputations.
For "a lot of the big names in construction, it's their name that is the company," said Matt Turkstra of the Associated General Contractors of America, which represents more than 27,000 firms in the construction business. The law's wording on reputation and skill is "broad enough that it could be concerning if it was taken out of the context," he said.
What does the law mean, Lewis asks, for businesses that advertise their skill or reputation? If you brag you're the "best baker in the tri-city area," will the IRS use those claims against you? Will restaurants owned by celebrity chefs get taxed differently from other restaurants?
'One Big Problem'
Tax professionals are poring over old IRS regulations and rulings looking for clues. Lobbyists aren't consultants, according to a 1988 IRS memo. Another obscure regulation tries to distinguish brokers, consultants and salespeople based on how they get paid.
The final version of the bill took "engineers and architects" off the list of service professionals. Professions like interior decorators and designers could be caught up in disputes over whether they're more like architects or consultants.
"You can see how fine the line is," said Megan Lisa Jones, a tax attorney at Clark & Trevithick in Los Angeles. "The IRS can decide one thing and the court can decide another." Individual IRS examiners could end up disagreeing with each other, she said.
The American Society of Certified Public Accountants and the U.S. Chamber of Commerce, a trade group representing businesses, have sent letters to federal tax officials seeking clarification on a number of pass-through provisions.
The AICPA, for example, is recommending that individuals be able to aggregate or group business activities together if the taxpayer's activities are "managed as one trade or business."
Jamie Hopkins, associate professor of taxation at The American College of Financial Services, said the question of aggregation is important for determining the amount of the pass-through deduction.
"For individuals running partnerships and pass-through entities, it is very possible that they operate multiple trades or businesses," Mr. Hopkins said, adding that even inside a sole-proprietorship or partnership, a few separate businesses might be operated. "But, it is not clear if you can aggregate the income from these separate lines of business together in one business or if each needs to be treated as separately within an entity."
The result of not being able to aggregate could be "unnecessarily complex business arrangements and calculations," Mr. Hopkins said.
Further, while investors in real estate investment trusts can get the 20% deduction on REIT income, there's a question as to whether shareholders of mutual funds that own REITs will benefit, too. The chamber recommends in a March 7 letter that the Treasury Department and IRS clarify that these shareholders also get the deduction.
Even some defenders of the tax overhaul find fault with the pass-through provision.
University of Michigan law professor Reuven Avi-Yonah said in a recent paper he supports most of the tax law's provisions such as the doubling of the standard deduction, reduced corporate tax rate and international changes.
But he cited the pass-through deduction as the "one big problem" that creates "an unworkable, unadministrable mess."
InvestmentNews reporter Greg Iacurci contributed to this story.