With the ink barely dry on the 2017 Tax Act, professional service businesses are already looking for ways to wedge their way into the new 20 percent deduction for income of pass-through entities, including sole proprietorships, partnerships, LLCs and S corporations.
There's a reason why these professionals and their accountants are so active: The act seems to invite some strategies for disfavored businesses to salvage a deduction.
Favored and Disfavored Services Businesses
Somewhat arbitrarily, Congress has virtually excluded from the 20 percent deduction any businesses providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any other business centered on the reputation or skill of one or more employees.
In a last-minute modification, Congress removed engineering and architecture firms from the favored list. Also, in spite of the apparent reach of the term “financial services,” there is good reason to think that the disfavored financial sector excludes banking, insurance, financing, leasing and the investment businesses.
The effective exclusion of the disfavored businesses is brought about through a phase-out of the deduction for higher-income taxpayers. The phase-out starts at $157,500 of taxable income ($315,000 for joint return filers). It is completed at $207,500 of taxable income ($415,000 for joint return filers).
Dividing Strategies
Planning for disfavored businesses likely will involve a divide-and-conquer strategy—spinning off activities that had been part of the disfavored business operation into a separate entity that qualifies for favorable treatment.
Many advisors are already suggesting a possible spin-off and leaseback of business real estate. S corporations might find the tax costs of a spin-off of real estate to be prohibitive. It generally should be pretty workable for other pass-through entities.
The idea of a separate real estate entity won’t help any professional practices that operate out of rented premises. A larger proportion of professional practices have employees, and payroll is often their biggest expense item.