Section 199A Separate Trade or Business
By Joseph Bassett (edited by Jason Watson, CPA)
Posted August 22, 2019
The Section 199A deduction was derived from the Tax Cuts and Job Acts and, thanks to our Congress, is one of the more complicated business tax deductions. Our website has a multitude of posts to help you understand the Section 199A deduction, but it is essentially the lessor of 20% of your net business income, or 50% of the W-2 wages paid by the business. Yeah there are some granular details, but those are the big rocks… one of the pebbles in your shoe is defining a Section 199A separate trade or business.
One of the biggest limits associated with the Section 199A deduction involves your occupation. If you are a specified service trade or business (SSTB), not only will you be referred to around the office by a cool acronym, but you will also be potentially phased out of the Section 199A deduction based on taxable household income (which starts are the top of the 24% marginal tax bracket, indexed annually). You might be under the assumption that there is no wiggle room if you have been classified as an SSTB and that you are stuck; however there is some wiggle room in the tetris blocks that compose your business life. Final regulations for the Section 199A deduction may allow you to treat parts of your business separately from your SSTB activities, while also providing a de minimis rule.
Specified Service Trade or Business
As a reminder, the following trades or businesses are considered an SSTB for purposes of calculating the Section 199A deduction:
- Health Professionals
- Actuarial Science
- Brokerage Services
- Dealing in Securities or Commodities
- Financial Services
- Performing Arts
- Investing and Investment Management
The final nail in the coffin for determining if you are an SSTB is if your business relies on the reputation or skill of one or more of the employees or owners. If people rely on your advice (consultant), or if you have a special set of skills (Liam Neeson), then you will most likely be considered an SSTB. Don’t get too hung up on the reputation or skill concept; of course your business relies on your skill. We get it! The reputation or skill concept as defined by the IRS is much deeper. Are you the only one who provides this amazing service? Do people come in from all over on horse and buggy to see the amazing you? While licking stamps is fairly pedestrian, are you an exceptional stamp-licker in high demand? We know no one licks stamps anymore… we get that too!
Once you have been classified as a specified service trade or business, and your taxable income for 2019 is over $210,700 for single filers and $421,400 for married filing joint (again, top of the 24% marginal tax bracket plus $50,000 for single and $100,000 for married), then you would normally be completely phased out of the Section 199A deduction. However, if your business is engaged in multiple operations, then you can possibly justify that you have a separate business that should not be classified as an SSTB.
One Business, Multiple Operations
You wear many hats as a small business owner. Whether it is being a janitor at night, closing deals during day or making CEO level decisions in between, small business owners have a lot going on! For example, you might have a consulting business (SSTB) where you also sell software. The consulting side of your business is considered an SSTB, but your software sales could be potentially considered a separate business. If the software sales are run by separate employees, maintain separable books and invoice your customers separately, then it could potentially be classified as a separate business for purposes of the Section 199A deduction.
What’s the big deal?
The big deal is that we want to allocate as much business income towards the non-specified service trade or business side of the tax return… safely and within the confines of the rules. This “side of the tax return house” is now only limited to the basic Section 199A concept of 20% of net qualified business income or 50% of W-2 wages (or the depreciation limit), whichever is most restrictive. In other words, there is not a household income limitation like there is on the SSTB side.
As a side note, the example of a consultant whose business also sells software is razor thin, which is why we mentioned it. If the software sales are inextricably connected to the consulting business, you might have a more difficult argument to prove. The Section 199A separate trade or business concept is designed for those businesses that can be split into separate “containers” and remain operable.
Operating Your Separate Business
While maintaining separate employees, maintaining separable books is a less robust challenge. Separable books are different from separate books. You do not need to keep separate books, with a” t;” however, you need to be able to clearly separate the income and expenses of your software business from your SSTB. But! We highly encourage you to keep not just separable books, but separate books. Try to truly run your separate businesses separately. Just think of any big business such as Amazon. Each of their business units or wholly owned entities maintain separate books, and are then later compiled into consolidated financial statements for the annual filings and tax returns.
In determining whether a separate business exists, the IRS will also consider whether a different accounting method could be used for each business. In the case of our consulting business that also sells software, the software business will have inventory, which could be recorded using an accrual or modified cash basis. This would be separate from our cash basis consulting business (who the heck wants to recognize income at invoice which might or might not get paid… recognize income with cash baby!).
Cash basis accounting reports income when received, while the accrual basis reports income when earned. If that was not boring enough for you, the IRS goes into an even deeper dive on accounting methods, and our small business accounting method blog post makes it a slightly more bearable read (since Jason wrote the accounting method blog post, he takes slight offense to Joseph’s “slightly more bearable” comment… and needs a nice IPA to repair the love).
De Minimis SSTB
If your business offers a minor amount of SSTB services, or a de minimis amount, you can bypass the SSTB classification for the Section 199A deduction. While it might be difficult to say ten times fast, de minimis is still one of an accountant’s favorite sayings! It allows us to deduct 100% of donuts bought for the office, but more importantly, it allows you to escape the entrapping SSTB designation. While you might be afraid of labeling yourself as a “consultant”, if your business only provides a small amount of consulting services, then you will not be classified as an SSTB under the de minimis rule.
Unlike determining if you have a separate business, which is a facts and circumstances argument, the de minimis rule provides a bright-line nexus. If less than 10% of your gross income is earned from SSTB services, and your total receipts are less than $25 million, then your business will avoid the SSTB classification.
So, going back to our consultant who also sells software. If the software sales constitute the bulk of the overall revenue (as in 90% or more), the side hustle consultant stuff is not considered an SSTB activity of all your business income is eligible for the Section 199A deduction (provided you clear the other hurdles such as wages and depreciation).
As from the de minimis rule above, there is no safe harbor for determining if you have a separate business. Keep in mind that de minimis and safe harbor are separate concepts; de minimis is the IRS basically telling you while you might be getting away with a business tax deduction, it is too small or immaterial to worry about. The juice isn’t worth the squeeze. On the other hand, safe harbors are bright lines where the IRS is stating “if you check these boxes, we automagically check the OK box.”
While this might be frustrating to some, we see it as more room to maneuver. We are not encouraging you to ask for forgiveness instead of permission (although that isn’t always a bad thing either like leaving wet towels on the floor), but the lack of a Section 199A separate trade or business safe harbor allows a greater percentage of taxpayers to justify that they have a separate business through a facts and circumstances argument.
The best way to win an argument with the IRS is to never have one in the first place. If you are not sure if you can justify that you have a separate business, give us a call and we will help you decide! Here are some additional Section 199A resources including a safe harbor for rental property owners (this is a great example of where the safe harbor might not be that great, and relying on a facts and circumstances argument is preferred… see what you think!)
Joseph Bassett is a tax professional for the Watson CPA Group, a business consultation and tax preparation firm, and is part of the business development team.