Take-Away: Prior to the publication of the anti-abuse Final IRC 199A Regulations last summer, one planning idea was for a Specified Services Trades or Businesses (SSTB), i.e. a professional practice,  to ‘break-off’ a feature or aspect of the professional’s business into a separate business entity, e.g. create a separate billing business apart from the professional’s practice. This planning idea was called crack and pack; the existing professional business was ‘cracked’ into separate businesses, and income was ‘packed’ into the new business, which was created in order to qualify for the IRC 199A qualified income tax deduction. The Final IRC 199A Regulations significantly limited the crack and pack strategy for professional practices, while making it difficult to meet the ’less than 50% ownership’ requirement by subjecting SSTBs to the Tax Code’s ownership attribution rules. That said, it is still possible to crack and pack some existing SSTBs.

[Caveat: Not summarized are the benefits derived from claiming an IRC 199A 20% income tax deduction taken against qualified business income. You have read about it, all too oftenin prior missives, so this discussion is limited to the strategy that might be used to qualify for the tax deduction.]

Background: The anti-abuse Final Regulation with regard to IRC 199A that attempts to address to the crack and pack strategy follows:

“If a trade or business provides property or services to an SSTB within the meaning of this section and there is 50 percent or more common ownership of the trades or businesses, that portion of the trade or business providing property or services to the 50 percent or more commonly-owned SSTB will be treated as a separate SSTB with respect to the related parties.” [Treasury Regulation 1.199-5(c) (2) (i).]

Attribution Rules: These Final Regulations also state that for purposes of applying the 50% common ownership test, the Tax Code’s ownership attribution rules will apply to the SSTB. [IRC Sections 267(b) (transactions between related parties) and 707(b) (transactions between partners and with their partnership.) Members of a family, including brothers and sisters, whether whole or half-blood, spouses, ancestors and lineal descendants are considered related. [IRC 267(c) (4).]These attribution rules will not be summarized, but suffice it to say that they are extremely complicated and do not always seem logical.

  • Example: A mother and her daughter are considered to be related parties. Yet the mother’s second husband, who is not the father of the daughter, will not be considered related to his stepdaughter. Similarly, the daughter’s husband, who is not otherwise related to the mother, will not be considered related to his mother-in-law.
  • IRC 267(c): This attribution rule associated with businesses entities can also apply with regard to IRC 199A. Stock that is owned directly or indirectly by or for a corporation, partnership, estate or trust is considered to be owned proportionately by or for its shareholders, partners or estate or trust beneficiaries.

Crack and Pack Example: An example of the crack and pack planning strategy is a physician who owns his own separate billing company that is taxed as an S corporation. His medical practice could pay arm’s-length fees to his billing company so that the net billing company income of the S corporation would be considered non-SSTB income and would thus qualify for the IRC 199A 20% income tax deduction. Under the Final Regulations, the physician’s billing company will be treated as a SSTB and its income will not be eligible to claim the IRC 199A income tax deduction if the physician’s income exceeds the $207,500 (single taxpayer) or $415,000 (married taxpayer) annual income thresholds.

IRC 199A Planning Opportunities:  While the Final IRC 199A Regulations appear to attempt to end the crack and pack planning strategy, a close reading of some of the Tax Code’s technical attribution rules reveal that a few planning opportunities to crack and pack may still exist due to the way some of those ownership attribution rules are defined or applied.

  • Example #1: A physician owns a SSTB who has less than a 50% ownership interest in that medical practice. That physician can set up a management company that is owned 100% by the SSTB minority-owner physician, or by trusts that are created for his/her children and spouse. The income earned by that separate management company will be considered non-SSTB income for IRC 199A tax deduction purposes, because the physician does not own 50% or more of the medical practice.
  • Example #2: Three dentists are equal partners in their dental practice, i.e. 33.3% each. Each dentist sets up a separate business entity. One dentist sets up a management company. The second dentist sets up a billing company. The third dentist sets up a marketing company. The dental practice pays an arms-length fee to each of those three companies. The income earned by management company, the billing company, and the marketing company should be considered non-SSTB income. The IRS might attempt to combine the three companies together through some type of substance-over-form argument (especially if the fee paid to each of the three companies is identical), and if successful, the combined companies would then be considered to be more than 50% commonly owned and thus not eligible to claim the IRC 199A income tax deduction. However, if the companies are properly structured, with arm’s-length compensation paid to each, this separate-company arrangement should withstand an IRS challenge.

Conclusion: The key to avoiding the Tax Code’s ownership attribution rules and to enable a professional to create a separate business that provides arm’s-length services to the professional’s practice is for the professional to be a less-the-50% owner of the professional practice. If that is the situation, then the professional should explore a crack and pack business arrangements with his/her SSTB.