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August 27, 2018

Setback: Your Knack to 'Crack and Pack' Under Attack (article)

Man holds building blocks that spell reform.

The IRS released long anticipated proposed regulations on August 8 for the new Qualified Business Income (QBI) deduction created by the Tax Cuts and Jobs Act (TCJA). These Section 199A regulations resolve numerous ambiguities in the taxpayers’ favor; however, several popular strategies designed to maximize the QBI deduction were targeted and eliminated.

QBI deduction benefits are denied to taxpayers who crack their businesses into “good” and “bad” segments, and to other taxpayers who pack small disqualified businesses with large qualified businesses. A number of other strategies are curtailed in the regulations.


The QBI deduction provides owners of a pass through entity (PTE) or sole proprietorship a deduction of 20 percent against qualified items of taxable income from the business. These qualified items generally include ordinary income from a business, and exclude interest and investment income and amounts subject to capital gains tax rates (such as certain types of Section 1231 gains).

The 20 percent QBI deduction is limited to the lesser of 20 percent of a taxpayer’s adjusted taxable income, or the amount that is the greater of:

  • 50 percent of W-2 wages (hereinafter the wage limitation), or
  • 25 percent of W-2 wages plus 2.5 percent of the unadjusted basis of qualifying property (the wage plus property limitation).

Furthermore, certain Specified Services Trades or Businesses (SSTBs) are not eligible for the QBI deduction at all. Taxpayers with income below threshold amounts are given reprieves from the wage limitation, the wage plus property limitation, and the SSTB restriction. The bulk of the recently released regulations aim to further define and explain these terms.

Establishing Trade or Business Status

The law provides that income must arise out of a trade or business other than performance of services as an employee to be eligible for the QBI deduction. The regulations adopt the existing rules for determining when an activity is a trade or business, incorporating existing case law and administrative positions along with the ambiguities that exist. However, two important modifications are made to the existing rules to determine trade or business status. To avoid abuse, the regulations provide that employees who attempt to reclassify as independent contractors will fail to be regarded as independent contractors for QBI deduction purposes. Additionally as a pro-taxpayer measure, the rental or licensing of tangible (including real property) or intangible property that might not otherwise constitute a trade or business will be classified as a trade or business if the rental/licensing is to a commonly controlled entity.

SSTB Definitions

In addition to trade or business guidance, the regulations provide detailed information on when an activity is an SSTB, which is ineligible to claim the QBI deduction. The specific exclusions or additional clarification provided for each of the categories are as follows:
Health – does not include those who provide services that are not directly related to medical services, such as research or testing, the operation of health clubs or spas, and those involved in the manufacture or sale of pharmaceuticals or medical devices.

Law – critical question is whether the activity requires skills unique to the field of law.

Accounting – no exclusions; includes those who are CPAs, Enrolled Agents, and those without any designation who are providing bookkeeping, accounting or tax preparation services.

Actuarial Science – does not include analysts, economists, mathematicians, and certain statisticians.

Performing Arts–- This category excludes those whose skills are not unique to the creation of the performing arts such as theater operators, producers, and broadcasters.

Athletics – Covers individuals involved in athletic competition, including coaches and team managers, while excluding broadcasters, those who operate and maintain facilities, and team or franchise owners.

Consulting – Unfortunately, this remains a broad and vague category, focused on providing advice and counsel to assist clients in achieving goals and solving problems.

Financial Services – Much like the consulting category, focuses on those who provide advice and counsel to help their clients achieve specific goals, but bankers and real estate managers are specifically excluded.

Brokerage Services – Limited to those who arrange transactions related exclusively to securities, so it does not include real estate or insurance agents and brokers.

In addition to these categories, there is a catch-all category that includes any trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owners. Fortunately, the IRS took a limited approach and restricted this catch-all provision to three categories:

  • A trade or business where the taxpayer receives fees, compensation, or other income for endorsing products or services;
  • A trade or business where a taxpayer receives income for the use of their name, image, likeness, signature, voice, trademark, or any other symbol associated with the taxpayer’s identity; and
  • An activity where the taxpayer receives fees, compensation, or other income for appearing at an event, on television or radio, or another media format.

'Crack and Pack' Strategy Largely Eliminated

The regulations also contain anti-abuse provisions that attempt to implement perceived Congressional intent, which invalidate strategies designed to avoid the effects of being an SSTB.

The “crack and pack” strategy involved separating the “good” activities of an SSTB from the “bad.” The concept is to quarantine the “good” activities from a SSTB so that a QBI deduction is possible on the separated “good” business activity.

One common example involves a law firm that owns its own building and retains its own administrative staff. Prior to the release of the regulations, common wisdom suggested the firm could separate the law practice (which is clearly an SSTB, or “bad” activity) from the building and from the administrative staff. If successful, income from the law firm income would still have been ineligible for the QBI deduction, but the building rental and administrative services income would have been eligible for the deduction to the extent each was operated as a separate trade or business.

The regulations effectively killed this strategy.  Now, if there is 50 percent or greater common ownership between an SSTB and a business that provides property or services to the SSTB (Related Entity):

  •  The Related Entity will be an SSTB if it provides more than 80 percent of its property or services to the SSTB, or
  • If less than 80 percent, the actual percentage of property or services provided to the related SSTB will be treated as SSTB income.

Using the law firm example, if the law firm and the building rental and administrative services businesses meet the 50 percent common ownership test and the 80 percent test, then they will each be considered part of the law firm SSTB and all of the income from each will be ineligible for the deduction. Thus, the only successful cracking strategy under the new regulations requires that 50 percent or more of the Related Entity be owned by persons different than the owners of the SSTB.

For those who were thinking of avoiding the SSTB restriction through packing “good” and “bad” activities together in order to ignore the “bad” activities as de minimis, the regulations contain a bright line test. Businesses with gross receipts of $25 million or less can treat the “bad” activity as de minimis if the gross receipts are less than 10 percent of total gross receipts from the combined business. If total gross receipts exceed $25 million, then gross receipts from the “bad” activity must comprise no more than 5 percent of total gross receipts to receive this de minimis treatment.

The regulations also permit eligible taxpayers to aggregate multiple trades or businesses for QBI deduction purposes. While beyond the scope of this article, aggregation is beneficial when the wage limitation or wage plus property limitation might curtail the QBI deduction on a stand-alone basis for each business. Similar to its position on packing, the IRS prohibited aggregating any business classified as a SSTB with other qualified businesses.

Other Strategies Curtailed

The regulations cut off another planning idea regarding the use of multiple trusts as a strategy to avoid the QBI deduction limitations. The multiple trust strategy involved spreading ownership of a single business across multiple trusts to limit each trust’s income, thereby exempting it from the wage limitation, wage plus property limitation, and SSTB restriction. The regulations state that if two or more trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and a principal purpose for establishing such trusts or contributing additional cash or other property to such trusts is the avoidance of federal income tax, then such trusts will be treated as a single trust for Federal income tax purposes.

The IRS also targeted another strategy involving transitory ownership of property designed to skirt the wage plus property limitation rules. This strategy involved the acquisition of property shortly before the end of a tax year and the subsequent disposition of such property shortly after the end of a tax year, designed to increase the amount of property taken into consideration for the wage plus property limitation. The regulations do not permit such property to be considered unless it was used in the business for a minimum amount of time (generally 45 days).


The IRS has worked to define, and in some cases, limit the scope of the SSTB designation, to provide some clarity on when an activity is an SSTB, and to provide guidance on some of the early tax planning ideas and strategies. In some cases these rules represent “wins” for taxpayers, particularly the narrow scope of the catch-all SSTB category. While in others, like the near elimination of the cracking strategy, taxpayers may not see the favorable result that they anticipated. In any case, taxpayers must gauge SSTB status with the help of the regulations to ascertain the amount of the QBI deduction for 2018 and beyond. For more information on these new regulations and how they will affect your business, please contact your local CBIZ MHM Tax Professional.

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