Photo by Netania Moore
Raphael Moore, JD, LLM, is general counsel of the Veterinary Information Network.
The Internal Revenue Service recently issued final regulations to implement the Tax Cuts and Jobs Act, which makes new rules on pass-through deductions for 2018 tax filings.
The tax reform law, passed in December 2017, amended Internal Revenue Code Section 199A to permit a new 20 percent pass-through deduction to certain individual business owners, as well as some trusts and estates.
The IRS proposed draft regulations last August for the new law, prompting many questions from the veterinary profession. Among them: Do veterinarians fall under the "health services" provision of the law? Can a veterinarian avoid losing the deduction if they don't directly treat patients?
The answers can be found in the IRS's final rules, which clarify or confirm a number of critical items:
1. As I anticipated in my first VIN News Service commentary on the topic, published in March 2018, the IRS has confirmed that veterinarians are included in the agency's definition of "health" and as such, their practices fall under the definition of "specified service trade or business," or SSTB. As an SSTB, veterinarians qualify for a deduction but are subject to limitations different from those in non-specified services.
2. In the IRS's draft regulations, the term "health" as related to an SSTB included "other similar healthcare professionals who provide medical services directly to a patient." In a second commentary, published in August, I suggested this could open a loophole via these possible scenarios: "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?"
Apparently, I was not the only one who identified this open issue, because the final regulations remove this concept, thereby broadening the scope of the field of health. The referral clinic that works only with other DVMs, or radiologists who never see patients, now squarely fall within the SSTB definition.
3. The IRS also clarifies its interpretation of a catch-all phrase that defined an SSTB as "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its owners or employees." Arguably, that could include just about any business. In its final rule, the IRS opts to narrowly define the concept. As promulgated, only the following businesses can be defined as SSTBs because their principal assets are the "reputation or skill" of an owner or employee:
• A business that earns compensation or other income for product or service endorsement
• A business that earns income from the use of one's image, name, trademark, or the like
• A business that makes money from appearing at events or in some sort of media format
4. A question existed about how the IRS would handle businesses with a mix of an SSTB (i.e. performing of services in a disqualified field), coupled with non-disqualified product sales. The final regulations confirm a de minimis exception to SSTB classification. Specifically, for a business with gross receipts of less than $25 million, if 10 percent or less of the gross receipts are attributable to the performance of services in a disqualified field, the service income is ignored and the entire business is not an SSTB.
The regulations do not address whether this de minimis rule is a cliff. In other words, it's unclear whether the entire business is disqualified if its income exceeds the threshold or if its SSTB-based income can be treated as earned in a separate trade or business while the remainder of the income forms the non-SSTB part of the business and still is available for a deduction. Support can be found for both arguments in the regulations, so it remains an open question to be addressed with tax professionals if relevant.
5. Another loophole I discussed in the August commentary was the idea of a veterinarian who owns a clinic building, charging rent to the clinic for the usage. By doing so, the income generated by the SSTB veterinary clinic would be reduced. The final regulations greatly reduce the utility of this concept, known as "cracking," by determining that if rents or other charges are passed to a commonly controlled SSTB, the income generated from the SSTB likewise is treated as SSTB income. The IRS states that "common control" means one or more folks own 50 percent or more of both businesses.
The final regulations do provide a small victory for cracking. The IRS originally proposed that if a business rented more than 80 percent of its property or provided more than 80 percent of its services to a commonly controlled SSTB, then all of the income was deemed SSTB income. But in the final regulations, the agency removed the 80-percent threshold. So if some of the income is generated from unrelated parties, it won't fall into the SSTB category.
6. What happens if you get it wrong and take a deduction that you shouldn't? An accuracy-related penalty on underpayments exists in Internal Revenue Code Section 6662(a). The 6662 penalty sets a threshold at which an understatement of tax is deemed substantial enough to impose an extra penalty on the taxpayer. In most instances, there is a substantial understatement of tax if the amount of the understatement exceeds the greater of 10 percent of the tax required to be shown on a tax return, or $5,000. However, for deductions made under the new section 199A, the threshold is the greater of 5 percent, or $5,000.
The new law still can provide practice owners with sizable tax savings. To best determine how your situation falls within the complex regulations, folks should consult with knowledgeable tax professionals.
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.