Can a taxpayer restructure their business to avoid specified service trade or business limitations?
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A taxpayer may attempt to restructure their business to avoid the specified service trade or business (SSTB) limitations under section 199A, but the ability to do so is subject to significant legal restrictions, anti-abuse rules, and practical limitations. Below is a comprehensive analysis of the relevant legal framework, IRS guidance, and the practical effectiveness of such restructuring.
1. Background: SSTB Limitation under Section 199A
Section 199A provides a deduction of up to 20% of qualified business income (QBI) from a qualified trade or business (QTB), but specifically excludes income from an SSTB for taxpayers whose taxable income exceeds certain thresholds. SSTBs include fields such as health, law, accounting, consulting, financial services, and any business where the principal asset is the reputation or skill of one or more employees or owners.
The deduction is fully available for SSTB owners with taxable income below the threshold, partially available within the phase-in range, and completely disallowed above the upper limit.
2. Common Restructuring Strategies
A. “Crack and Pack” (Spin-Off) Structures
One frequently discussed strategy is to separate (or “crack”) non-SSTB activities (such as real estate ownership or administrative services) from the SSTB (e.g., a law or medical practice), and “pack” them into separate entities. The SSTB would then pay rent or service fees to the new entities, which, if respected as non-SSTBs, could generate QBI eligible for the deduction.
B. Use of Non-Grantor Trusts
Another approach is to divide business income among multiple non-grantor trusts, each with its own income threshold, to maximize the amount of income eligible for the deduction.
3. IRS and Treasury Anti-Abuse Rules
A. Related-Party and Common Ownership Rules
The IRS anticipated these strategies and issued regulations to address them. Under Reg. §1.199A-5(c)(2), if a business provides property or services to an SSTB and there is 50% or more common ownership (direct or indirect, including related parties under sections 267(b) or 707(b)), the portion of the business providing property or services to the SSTB is treated as a separate SSTB with respect to the related parties. This means that, for example, if a law firm spins off its office building into a separate entity owned by the same partners, the rental income paid by the law firm to the real estate entity is treated as SSTB income and is subject to the same limitations.
Key points:- The anti-abuse rule applies to both direct and indirect ownership.- The rule applies regardless of whether the owner is passive or active.- The rule is designed to prevent taxpayers from disaggregating SSTB and non-SSTB activities solely to avoid the SSTB limitation.
B. Multiple Trusts
The regulations also address the use of multiple non-grantor trusts. Under Reg. §1.643(f)-1, two or more trusts with substantially the same grantor(s) and substantially the same primary beneficiary(ies), and a principal purpose of avoiding federal income tax, will be aggregated and treated as a single trust for purposes of section 199A. This is intended to prevent taxpayers from creating multiple trusts to multiply the income threshold.
4. Facts-and-Circumstances and Substance-Over-Form
The IRS applies a facts-and-circumstances test to determine whether a business is an SSTB, including the nature of services, the skills of the workforce, and the type of clients served. If a business is restructured in form but not in substance—meaning the economic reality is unchanged and the principal asset remains the reputation or skill of the same individuals—the IRS may disregard the restructuring.
5. Potential for Successful Restructuring
While the anti-abuse rules are broad, there may be limited circumstances where restructuring is effective:- If the non-SSTB entity is not 50% or more commonly owned with the SSTB, and the arrangement is not principally for tax avoidance, the non-SSTB may be respected as a separate QTB.- If the non-SSTB entity provides substantial, independent services to unrelated parties, and not just to the SSTB, it may avoid SSTB taint.- If the restructuring is motivated by bona fide business purposes (e.g., risk management, operational efficiency) and not primarily for tax avoidance, and the facts support this, the IRS may respect the separation.
However, these are narrow exceptions, and the burden is on the taxpayer to demonstrate that the restructuring is not principally for tax avoidance and does not run afoul of the anti-abuse rules.
6. Practical Considerations and Risks
- The IRS has signaled it will scrutinize arrangements that appear designed to circumvent the SSTB limitations.
- The regulations do not provide a bright-line test for all situations, and the outcome may depend on the specific facts and circumstances.
- If the IRS determines that a restructuring lacks economic substance or is primarily for tax avoidance, it may disregard the structure and deny the deduction.
7. Conclusion
In summary: While a taxpayer may attempt to restructure their business to avoid the SSTB limitations under section 199A, the IRS has implemented robust anti-abuse rules that generally prevent such strategies when there is 50% or more common ownership or when the principal purpose is tax avoidance. Only in limited, fact-specific situations—where there is not substantial common ownership, the restructuring has a bona fide business purpose, and the non-SSTB entity is not tainted by SSTB activities—might a restructuring be effective. Taxpayers considering such strategies should proceed with caution, maintain thorough documentation, and be prepared for IRS scrutiny.
Bottom line: The IRS and Treasury have made clear that most restructuring efforts to avoid SSTB limitations will not be respected if they are primarily for tax avoidance or involve substantial common ownership. Any restructuring must be carefully analyzed under the regulations and the facts-and-circumstances of the case.
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