Last Friday, Treasury finalized its regulations for the special 20-percent tax deduction for income from pass-through businesses, which was added by the 2017 Tax Cuts and Jobs Act (TCJA). Treasury largely retained its guidance from last August, which significantly expanded the scope of eligible businesses. But the final rules did not go further. Thus, while many business owners will enjoy a tax windfall, not all businesses that requested access to the 20 percent deduction got it.
Pass-through businesses include sole proprietors, partnerships, limited liability companies, and S corporations. In contrast to C corporations, the earnings of pass-throughs are not subject to a business-level tax but, instead, are taxed at their owners’ ordinary income tax rates. While people often confuse pass-through businesses with small businesses, pass-throughs include large multistate pipelines, logging companies, real estate developers, and some manufacturing enterprises, all of which may be eligible for the deduction.
Congress expressly denied the 20-percent deduction to the high-income owners of specified services businesses, including health, law, accounting, brokerage, performing artists, athletics, and consulting, which often are small enterprises. But for unknown reasons, it allowed some service businesses such as architecture and engineering firms to claim the deduction.
Congress also excluded any business where the principal asset is the reputation or skill of its owners, but Treasury effectively overrode that exclusion. Treasury instead barred from taking the deduction only those businesses that earn endorsement, licensing, or appearance fees based on their owners’ reputation or skill. This will make it possible for many pass-through owners to claim the deduction (for example, professional gamblers), if Congress did not explicitly exclude their businesses.
The owners of many other pass-through enterprises also asked Treasury to extend the 20 percent deduction to them by, for example, lowering the level of activity to qualify as a business. But Treasury rejected these requests, most notably for owners of real estate who devote relatively little time to managing their properties. Instead, Treasury adopted the definition of business used in other parts of the Tax Code, relying on a Supreme Court decision that someone who engaged in continuous and regular gambling activity met the definition of a business. In a separate notice, Treasury said that owners of rental real estate who devote at least 250 hours annually to managing their property and maintain detailed records generally will qualify automatically for the deduction.
Congress is ultimately responsible for the hodgepodge nature of the 20-percent deduction. But Treasury has done relatively little to restrain its use.