How revised tax code treats veterinary practices, part II

Highlights of IRS proposal on pass-through deductions

August 23, 2018 (published)
By Raphael Moore

Photo by Netania Moore
Raphael Moore, JD, LLM, is general counsel of the Veterinary Information Network.

Late last year, President Trump signed into law the "Tax Cuts and Jobs Act," which, among other things, allows certain business owners to deduct up to 20 percent of the income earned by their business. The law created more questions than answers. The Journal of the American Veterinary Medical Association published an article that attempted to explain implications of the new law to veterinarians. In the process, however, the article incorrectly noted that veterinary practices might not be entitled to the pass-through deduction, and questioned whether veterinarians would fall under the "health services" provision of the new law.

In response, I wrote a commentary, published by the VIN News Service, arguing that not only do veterinarians fall into the health-services field, they would indeed be eligible for the full 20 percent deduction, subject to threshold rules. Since then, the AVMA requested and received confirmation from the U.S. Treasury Department that veterinarians will be able to take advantage of the new law. Unfortunately, in a blog post on Aug. 14, they erred again, saying that a deduction could be taken "for the salaries" that veterinarians pay themselves. While the salary a veterinarian earns is a component of their household income, and thus used to determine whether they meet the deduction threshold requirements (see chart in the article I wrote in March), they cannot take a deduction on it. Rather, the deduction is based on the income of the business itself. The tax code specifically states that the wages reported on Form 1040 are not eligible for the 20 percent deduction. For example, if you are a 100 percent owner of an S-corp that shows income of $500,000 and you report a salary of $125,000, your deduction is based on a starting figure of $375,000.

In any event, after months of uncertainty on the part of business owners, the IRS recently issued proposed regulations meant to provide guidance on the pass-through deduction, which is in section 199A of the new law. The draft rules confirm that veterinarians are eligible, provided their household income is within certain limits. The 184-page document still leaves open issues, but a number of elements have been clarified. The following highlights aspects that could affect veterinary professionals.

What is a 'specified service trade or business'?

Of major concern to the profession was whether veterinary practice owners could take advantage of the new law. As written, the law treats a "specified service trade or business" (SSTB) differently from non-specified services or businesses. For SSTBs, basically, no deduction is allowed once the owner’s taxable income exceeds a set threshold, subject to a phaseout adjustment. (For the 2018 tax year, married couples making up to $315,000 and individuals making up to $157,500 may take the full deduction.)

The regulations help clarify what is considered an SSTB. While we knew that a company providing services in the "health" field would be an SSTB, it was unclear exactly who fell into that category. The draft regulations specify that veterinarians and other health-care professionals "who provide medical services directly to a patient" are in the "health" field. Those who provide services that merely "relate to the health of the service recipient" (e.g., pharmaceutical sales, or lab testing), on the other hand, are not SSTBs.

Second, the regulations address the situation in which a business sells both services in a specified field (making it an SSTB) and products (so not an SSTB): Where less than 10 percent of the gross receipts come from the service component in a disqualified field, the business will not be deemed an SSTB. The 10 percent figure drops to 5 percent if a business has gross receipts greater than $25 million.

A veterinary business that offers boarding might want to consider whether it is worthwhile to separate its services into two distinct holdings: One business would offer boarding services (non-SSTB), and the other would offer veterinary services (an SSTB). Similarly, a practice could analyze whether spinning off its sale of pharmaceuticals into a separate business could be beneficial.

This idea of separating services and products can go only so far, however. In another clarification, the regulations deal with the situation where services or property is provided to an SSTB. Essentially, when the new law came out, we "tax-loophole types" started exploring ways of reducing an SSTB income by moving it to non-SSTB origins. For example, a veterinarian could own the clinic building in a separate entity, and charge the clinic rent for its usage. Doing so would reduce the income of the SSTB veterinary clinic and instead, pass it to a rental business, which is a non-specified service. The regulations address this by broadening the definition of an SSTB to include any business that provides at least 80 percent of its property or services to another SSTB, as long as the two businesses share at least 50 percent common ownership. So in the rental example, the rental income would be treated as being earned by an SSTB nevertheless.

And what if less than 80 percent of property or services are provided to an SSTB that is commonly controlled? For instance, say the veterinarian rents only 75 percent of the building to its clinic, and rents the other 25 percent to an unrelated party. While the entire business would not be deemed an SSTB, the income from services or property provided to an SSTB still would be deemed as earned in an SSTB, and thus we end up with the same result.

Some loopholes still remain in defining what business is an SSTB, and unanswered questions persist. On the loophole front, a good tax lawyer or transactional CPA could get creative with the common-ownership element by keeping it below the 50 percent mark and, at the same time, stay away from "related party" provisions of the Internal Revenue Code.

As to open issues, how granular can we get in defining what does and does not fall into the excluded category of "health" services? Could a specialty referral clinic carve out "radiology readings services" because the radiologist does not directly treat patients? How about telemedicine consulting veterinarians, who provide services to other veterinarians rather than to the patient directly? For every drafted regulation, a loophole is waiting to be imagined, and it will take years of court cases and IRS rulings to figure out what does and does not work.

Employee vs. independent contractor

The pass-through law clearly spells out that an employee cannot take the 20 percent deduction. After all, it is intended for pass-through businesses only. But what about your long-time employee associate who comes to you and states they are now an independent contractor and want to get paid as such so that they can benefit from the 20 percent deduction? Or how about the group of associates who suggest the "novel" plan of setting up their own partnership (a pass-through entity, so in theory eligible for the 20 percent deduction), and having that partnership provide veterinary services to your clinic?

The new regulations aim to catch these "converts" by looking at the low-hanging fruit: First, as long as the IRS deems the person to be an employee, they remain an employee (using the standard independent-contractor test of the IRS). Second, if the person was, in fact, an employee, and is providing substantially the same services to the same employer, they also remain an employee.

This second element is only a presumption of employment, which the worker could, in theory, overcome by showing that they are, in fact, providing the services of an independent contractor. This is, however, a high burden to meet, and the worker will likely fail in their attempt. They will then be found to be in the "trade or business of being an employee" of your clinic, and any 1099 payments they received (or partnership distributive share, in the partnership example above), will be deemed a wage not qualified for the 20 percent deduction.

And a loophole for this regulatory clarification? If the employee resigns from your employment and starts working as an independent contractor for another clinic, they just might find themselves qualifying for the 20 percent deduction.

Businesses that are 'commonly controlled'

Instead of requiring that deductions be determined on a "per-business" basis, the regulations offer a creative way to combine businesses that are under common control. The rules are by no means simple, and beyond scope of this commentary. For the veterinarian who owns multiple clinics, however, it provides the opportunity to maximize deductions while dealing with different entities that may perform at various profit/loss levels, as long as they have a good tax professional who understands the new aggregation rules.

How to deal with a fiscal-year business

The new tax law kicked in on Jan. 1. What is a veterinarian to do if they own a business that uses a fiscal tax year straddling that date? Say your fiscal year runs through July 31. Do you claim a deduction only on the income earned by the S corporation from Jan. 1 through July 31? Alternatively, do you total your income from Aug. 1, 2017, through July 31, 2018, and deduct against that?

The proposed regulations provide that you can claim all of the income, as well as all wages, property basis, etc., from your fiscal year, even though some of that was earned and/or incurred prior to this calendar year.

More to come

The proposed regulations have been published in the Federal Register, meaning the public-comment window is open. The deadline for comments is Oct. 1. We still need to wait to see what the final regulations will look like, but at least some elements have been clarified.

About the author: Raphael Moore, JD, LLM, has been general counsel of the Veterinary Information Network since the 1990s. He enjoys figuring out esoteric legal issues and is a frequent contributor to VIN legal and practice management discussions. An avid hiker, he has a knack for being attacked by bears in Yosemite. He lives with his wife and two daughters in their geodesic dome on the outskirts of Davis, California, where he raises alpacas and chickens.

Editor's note: The article has been changed from the original to clarify that the deduction for which SSTBs are eligible is subject to phased threshold limits.

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