While many small businesses may consider taking advantage of the new 20% tax deduction introduced by the Tax Cuts and Jobs Act (TCJA), the Internal Revenue Service (IRS) is looking to set limits on certain strategies for claiming the deduction.
The TCJA introduced IRC Section 199A, which generally provides a 20% tax deduction for pass-through business income (certain rental income, sole proprietors, partnerships, LLCs, S Corps). Typically, these are small businesses whose net business or partnership income is taxed at rates and brackets applicable to individual taxpayers.
In recent weeks, the IRS has proposed new regulations for claiming the deduction. These proposals are subject to a 45-day comment period, with a possibility that there could be further modifications before being finalized.
Some of the key proposed regulations include:
- Additional clarification on the definition of a “specified service or trade business” (SSTB) in areas such as law, health, finance, and accounting. These types of businesses face limitations (based on household taxable income) in claiming the deduction.
- Restricting professional service businesses — such as a law firms — from splitting out administrative functions into a separate entity just to take advantage of the 20% deduction on that portion of their business (the so-called “crack and pack” strategy).
- Eliminating the 20% deduction in certain cases where employees are reclassified as independent contractors.
- Prohibiting the use of similar multiple trusts to secure the 20% deduction.
Regardless of the outcome of the proposed regulations, small business owners can still consider tax-planning strategies to reduce, avoid, or defer income in order to optimize use of the 20% small business tax deduction.
Because this new area of the code is complex, it is critical for clients to consult with a qualified tax professional about their own situation, especially given uncertainty around the future of the proposed regulations.