The Tax Cuts and Jobs Act (the “TCJA”) cut corporate income taxes to a flat 21%, down from as high as 35%. To level the playing field for pass through entities (a “PTE”) (i.e., LLCs, S-Corps, Partnerships, and Sole Proprietors), the TCJA offered another tax cut in the form of IRC Section “199A” which allows a 20% deduction on an individual’s qualified business income (“QBI”) received from a PTE.
One of the limitations for 199A, however, is that the deduction can phase out for businesses that perform certain types of activities, which 199A terms as a “specified service trade or business” (“SSTB”). An SSTB can include a business in the field of health, law, accounting, consulting, and other professions where the “principle asset of [the business] is the reputation or skill of one or more of its employees or owners.”
At first glance, an SSTB owner may think they can avoid the SSTB limitations by simply restructuring their business operations. A medical professional, for example, may reserve the existing entity for clinical operations (the “Clinic”) (which is unquestionably an SSTB) but then form other entities (“Supporting Entities”) to handle its activities which involve administration, real estate, non-professional staffing, or equipment. For those familiar with management services organizations (an “MSO”), they may have noticed that the Supporting Entities from the example are services that can typically be utilized in an MSO structure. The owner might think that the SSTB limitation no longer applies to income from the Supporting Entities, and that they now have a significant portion of their business activities that qualify for 199A without limitation.
To prevent this workaround, the Treasury issued Regulation 1.199A-5(c)(2)(i) (“Reg 5”), which states that “if a trade or business provides property or services to an SSTB … and there is 50 percent or more common ownership … that portion of the trade or business of providing property or services to the … commonly-owned SSTB will be treated as a separate SSTB with respect to the related parties.” Therefore, for tax purposes, the restructuring in the example would not move the owner any closer to avoiding the SSTB limitations because he owns 50% or more of each entity.
The good news, however, is that an MSO arrangement which involves separate owners can still avoid the SSTB limitation. For example, if a chiropractor forms/owns an MSO that provides support services for a clinic that is owned/operated by a nurse practitioner (the “NP Clinic”), then the MSO’s income from the NP Clinic is not subject to Reg 5, assuming the MSO does not perform any other services that make it an SSTB. The MSO still “provides property or services to an SSTB” but there is no longer common ownership between the entities.
A common issue is that the chiropractor in this situation may be tempted to simply structure his chiropractic clinic (the “Chiro Clinic”) as the MSO to the NP Clinic, as shown in the diagram below, in which case the MSO will be classified as an SSTB. The temptation can be great when the Chiro Clinic already has a competent administration staff, support staff, or is the named party for the office space; and the chiropractor may not want to undergo the short-term “hassle” that comes with a more comprehensive restructuring.
If maintaining a consolidated support staff/services structure is the issue (i.e., to simplify payroll), the MSO can serve both entities (the NP Clinic and the Chiro Clinic), as shown in the diagram below, and only the portion which comes from the Chiro Clinic will be treated as SSTB income. Even if developing this structure is indeed a short-term “hassle,” a structure that keeps the MSO separate from SSTB services can be worthwhile to the tune of a 20% deduction on the MSO’s QBI.