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Taxes and the Government Contractor:
PASS-THRU DEDUCTION FOR SPECIFIED SERVICE TRADE OR BUSINESS
By Mark Vieno, MBA, CPA
January 2, 2018
Starting in 2018, pass-thru entities may be eligible for the Section 199A deduction of 20% against taxable income under the Tax Cuts and Jobs Act. Pass-thru entities are LLCs, partnerships and S corporations. Many small government contractors providing services and products to the federal government are pass-thru entities and may be eligible for the Section 199A deduction. However, there are several important rules that may limit or entirely eliminate the available deduction and require a change in your accounting system.
One such rule that limits or entirely eliminates the Section 199A deduction applies to a "Specified Service Trade or Business". It will be important for government contractors to classify their business income as either "Specified Service Trade or Business" income or "Qualified Business" income. It is possible that your "Qualified Business" income may receive a higher deduction than your "Specified Service Trade or Business" income.
Treatment of income as "Qualified Business" income may be preferred over "Specified Service Trade or Business" income because the Section 199A deduction is not entirely phased out for "Qualified Business" income. Instead of a phase out, for "Qualified Business" income, a limitation is phased in based on W-2 wages and investment in certain depreciable property. However, for a "Specified Service Trade or Business", the Section 199A deduction is phased out beginning at $315,000 in taxable income for a joint filer and is entirely eliminated for taxable income over $415,000 ($157,500/$217,500 for other filers) and therefore receives no tax deduction at all.
DEFINITION OF A SPECIFIED SERVICE TRADE OR BUSINESS
For this reason, it is very likely that the Internal Revenue Service will challenge many small government contractors that claim the Section 199A deduction based on "Qualified Business" income rather than "Specified Service Trade or Business" income. To prepare yourself for any challenges from the IRS, it is important to understand the definition of "Specified Service Trade or Business".
The Tax Cuts and Jobs Act defines a "Specified Service Trade or Business" as follows:
"SEC. 199A(d)(2) SPECIFIED SERVICE TRADE OR BUSINESS. The term 'specified service trade or business' means any trade or business - (A) which is described in section 1202(e)(3)(A) (applied without regard to the words 'engineering, architecture,') or which would be so described if the term 'employees' therein,".
Section 1202(e)(3)(A) reads as follows:
"QUALIFIED TRADE OR BUSINESS. For purposes of this subsection, the term “qualified trade or business” means any trade or business other than - (A) any trade or business involving the performance of services in the field of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees,".
The Tax Cuts and Jobs Act also exempts from the definition of a "Qualified Trade or Business" and thereby includes as a "Specified Service Trade or Business":
"SEC. 199A(d)(1)(B) the trade or business of performing services as an employee".
It is important to note that engineering and architecture are not considered to be a "Specified Service Trade or Business".
QUESTIONS FOR YOUR TAX ADVISOR
There are many questions you should be asking your tax advisor. Many of the questions have not been addressed in the Tax Cuts and Jobs Act and are likely to be addressed later through IRS Revenue Rulings, the Tax Courts, and additional congressional legislation.
1. Is my business a "Specified Service Trade or Business"?
2. If my business has revenue from both products and services, can I segregate my business income between the two, to maximize the Section 199A deduction?
3. If I am able to segregate my product and service income, how do I allocate expenses to determine the profit related to each?
4. My business provides staffing services. Am I in the trade or business of performing services as an employee and therefore a "Specified Service Trade or Business"?
5. To be excluded from a "Specified Service Trade or Business" as an engineer or architect, are there any licensing requirements for my business to qualify for the exclusion?
WHERE WE CAN HELP
Although we are not in the business of providing individualized tax advice or preparing tax returns, we can help you with the following:
1. Prepare an annual forecast of your revenue, expenses, and income, to included projected indirect rates, which can be used by you or your tax advisor for tax planning.
2. Advise you on changes to your Quickbooks accounting system to segregate income and expenses in a way that allows you to maximize your deductions through coordination with your tax advisor.
TAX AND LEGAL ADVICE DISCLAIMER
Govcon Accountants LLC does not provide tax or legal advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for tax or legal advice. Your individual tax and legal situation should be carefully reviewed by consulting with your own tax and legal advisors regarding these matters.