IRC 199A Final Regulations Part I – Specified Services Trade or Business

Take-Away: The Final Regulations for IRC 199A were published on January 18, 2019. These Final Regulations carry forward most, but not all, of the same limitations to planning strategies that were provided in the Proposed Regulations of August, 2018. The Final Regulations will be of interest to clients who own specified services trades or businesses and who are, generally speaking, ineligible for the IRC 199A deduction. Unfortunately, the Final Regulations seem to broaden the scope of what constitutes a specified service trade or business at least when it comes to performance of services in the field related to health.

Specified Service Trades or Businesses: A taxpayer’s IRC 199A deduction on income from a specified services trade or business will begin to be limited if the taxpayer’s 2019 taxable income exceeds $160,700 if single, and $321,400 if married filing jointly. The IRC 199A deduction will be completely lost if the taxpayer’s 2019 taxable income exceeds $201,700 if single, or $421,400 if married filing jointly.

Spreading the Wealth?: While the IRC 199A deduction is either limited or lost for these high-earning professionals, part ownership in these entities can be held by related individuals who have less than $160,700/$321,400 income, so that the income from a specified services trade or business can still qualify for the income tax deduction. Unfortunately, many states, like Michigan, prohibit an ownership interest to be held by non-licensed individuals in professional practices, thus making this co-ownership opportunity with family members illusory.

Management Service Organization (MSO): It is possible, however, to create a MSO that will provide arm’s-length management services to the specified services trade or business and receive reasonable compensation for those services, thus generating a profit against which the IRC 199A tax deduction can be claimed, and which also indirectly lowers the salaries or compensation of the professionals prior to their payment of a management fee to the MSO. Often an MSO is created to provide marketing, HR, intellectual property monitoring, IT, and related services, so long as the MSO is appropriately capitalized. The MSO, not the professional practice, employs the managerial and other workers directly, to assure that the MSO is treated as a separate legal entity. Sometimes if the professional individual enters into a long-term employment agreement containing non-competition covenants with a MSO, personal goodwill of the professional can also be held in the MSO, which might warrant an even larger share of the specified serve trade or business’ profits received by the MSO. An MSO is one way where a professional might lower his/her compensation to become eligible to claim the IRC 199A tax deduction, and also ‘shift’ taxable income to an MSO owned by other family members to enable those other family members to also claim an IRC 199A tax deduction.

MSO with Less than 50% Common Ownership: One change made in the Final Regulations clarified the ability of professionals to form their own MSO, again to reduce their own reported taxable income to enhance their IRC 199A deduction eligibility, and to enable them to ‘shift’ qualified business income to an MSO of which they are also owners. The proposed Regulations had provided that an MSO having at least 50% common ownership with the specified service trade or business and which provided 80% or more of its property or services to the specified services trade or business would be considered to be aggregated with and a part of the specified services trade or business, and thus would not be eligible for the IRC 199A deduction if the owner’s taxable income exceeded the threshold amounts. The Final Regulations simplify this rule by providing that an MSO that provides property or services to a specified services trade or business with 50% or more common ownership will be treated as a separate specified services trade or business but only to the extent that such property or services are actually provided to the specified services trade or business,e. not all of the MSO’s income is aggregated with the specified services trade or business, just the income attributable to that specified services trade or business. If property or services are provided by the MSO to entities that are less than 50% commonly owned, regardless of whether they are specified services trades or businesses or not, then the income that is attributable to the MSO’s activities will not be treated as specified services trade or business income. In short, if the MSO is owned 49% or less by a family member of a specified services trade or business owner, the MSO will pass muster and its owner(s) will be able to claim an IRC 199A tax deduction.

50% Common Ownership: The 50% common ownership test is measured based on the common ownership between the two entities, not simply a 50% ownership ‘test’ for one owner. Example #1: Three physicians equally own their medical practice. The three physicians also equally own a separate MSO that provides office management and billing services to their medical practice. Thus, each physician owns 33.3% of both the medical practice and the MSO. Despite each physician owning only 33.3% each, the common ownership test is satisfied, since the two entities, i.e. the medical practice and the MSO, are 100% commonly owned by the same three physicians. Example #2: Three physicians each own their own medical practice. These physicians form an MSO that is equally owned by them to provide medical billing and collection services to each of their respective medical practices. Each physician’s common ownership would not exceed 50%, and their MSO would not be considered a specified services trade or business. Consequently, a reasonable management fee can be paid by each of the three physician medial practices to the MSO in exchange for the MSO providing billing and collection services to the three medical practices, and as owners of the MSO the three physicians will qualify for the IRC 199A tax deduction associated with their distributions from the MSO.

Health Services: One other change in the Final Regulations was to apparently expand what constitutes performance of services in the field related to health. Under the proposed Regulations this was defined to include services that were provided directly to a patient. In the Final Regulations, that phrase, directly to a patient was dropped. Example: A radiologist ‘moonlights’ reading x-ray readings for a small hospital, where the radiologist works as an independent contractor. The radiologist does not provide services directly to a patient but to a hospital that pays the radiologist on a per diem basis. Under the proposed Regulations the radiologist independent contractor probably would not be treated as providing medical services directly to a patient, but will now be included under the Final Regulations. The result is that a lot more individuals who work in a health care related jobs may find that they are unable to claim the IRC 199A income tax deduction.

Conclusion: Not much changed from the proposed Regulations to the Final Regulations with regard to specified services trades or businesses other than expanding that concept for those who work in health care positions. The use of a MSO is still possible in order to be able to redirect some of the qualified business income generated by the professional to the MSO and thus claim the IRC 199A tax deduction, but the planning opportunities are narrow with the simplified interpretation of Final Regulation’s ‘50% common ownership’ test.