We previously blogged about the final Section 199A regulations confirming “cliff” treatment for the de minimis aggregation rule. However, the final regulations did delete a different cliff in the rules designed to defeat the so-called “crack and pack” strategy of segregating various activities of a specified service trade or business (“SSTB”) into SSTB and non-SSTB elements. Since the enactment of Section 199A as part of the Tax Cut and Jobs Act late in 2017, tax practitioners have been devising ways to take an SSTB, such as a physician group, and segregate the parts of the business that are a specified service trade or business from the parts that are not. For example, there has been speculation as to whether an S corporation operating a physician group that provides medical services (an SSTB), owns its building, and employs administrative and billing staff could be divided into three S corporations. S corporation 1 would provide medical services to patients, S corporation 2 would own the medical office building and lease it to S corporation 1, and S corporation 3 would employ the administrative and billing staff and provide its services to S corporation 1 in exchange for fees. The hope would be that the common owners of the three S corporations would be eligible for a 199A deduction with respect to S corporation 2 and S corporation 3 (they would generally not be eligible for a 199A deduction if all of the components of the physician group were contained within one entity).
The proposed regulations address this issue by providing that an SSTB includes any trade or business that provides 80% or more of its property or services to a specified service trade or business if there is 50% or more common ownership of the two trades or businesses. If a trade or business provides less than 80% of its property or services to a specified service trade or business that has 50% or more common ownership, then the portion of the trade or business providing property or services to the commonly-controlled business will be treated as part of the specified service trade or business. For example, if a dentist owns a dental practice and a building used in the practice in separate entities, and 40% of the real estate is leased to the dental practice and 60% of the real estate is leased to an unrelated tenant, then 40% of the real estate business will be treated as part of the dental SSTB, but the remaining 60% of the real estate business will not be treated as an SSTB. But, if 85% of the real estate was leased to the dental practice, then all of the real estate business (including the 15% leased to the unrelated tenant) would be treated as part of the dental SSTB. Thus, this rule creates an “80% cliff” for the unrelated portion of the real estate business.
In response to criticism of this 80% cliff, Treasury removed the 80 percent rule in Section 1.199A-5(c)(2) of the final regulations. Therefore, if a non-SSTB provides property or services to a 50 percent or more commonly controlled SSTB, the portion provided to the SSTB would be treated as a separate SSTB, and the remaining portion will be treated as a non-SSTB. Using the example above, if 85% of the real estate was leased to the dental practice, then only 85% of the real estate activity would be treated as an SSTB, and the other 15% of the real estate activity would be treated as a non-SSTB.
This post is one in a series of posts on the 199A regulations.