The Tax Cuts and Jobs Act of 2017 (Tax Act) got a lot of press during negotiations and passage, but there are particular aspects of the law that are worth a deeper dive. One such aspect of the law is the 20-percent deduction in Section 199A intended to benefit pass-through entities. The deduction is much-discussed in the circles that discuss such things, and perhaps the reader has referred clients to the deduction as a benefit worth pursuing. But this article intends to discuss the deduction in the context of health care, where the news is not so good.
The early headlines surrounding the Tax Act focused heavily on the tax rate change for non-pass-through corporations (i.e., “Subchapter C corporations,” so named because the general rules governing such entities are codified at Subchapter C of Chapter 1 of the Internal Revenue Code; see, e.g., 26 U.S.C.A. Section 301) from a progressive rate scheme (and, in the case of personal services corporations, a flat 35 percent) to a flat 21 percent. Though widely welcomed by the business community, that rate change meant little to the pass-through entities.
Many medical and dental practices around the country are organized as professional corporations or professional limited liability companies. While the latter entity type is, by default, a pass-through entity for taxation purposes, the organizers of the former entity type may file with the Internal Revenue Service (IRS) a Form 2553 to elect pass-through status. These Subchapter S corporations (so named for the same reason as are Subchapter C corporations; see 26 U.S.C.A. Section 1362) are taxed—along with PLLCs—at a single level.
However, the physicians and dentists who own such pass-through entities should temper their celebrations of the Section 199A deduction. This is because it is only available for those pass-through entities engaged in a “qualified trade or business.” This is defined in the Tax Act so as to exclude the professions listed in 26 U.S.C.A. Section 1202(e)(3)(A)—including those that perform services in the health care field and those “where the principal asset of such trade or business is the reputation or skill of one or more of its employees.” For you readers, it is worth noting that law is an excluded profession, as well. It is also worth noting that the Section 199A specifically carves out architecture and engineering from the list of excluded professions.
There has been some confusion around the qualified trade of business exclusion, mostly regarding the apparent application of the skill and reputation exclusion to any service company whose providers have either skill or a somewhat positive reputation. In response, the U.S. Department of Treasury released nearly 200 pages of proposed regulations in August aimed at clarifying the confusion and providing some guidance to pre-empt anticipated avoidance tactics. The proposed regulations did assist lawyers and accountants nationwide with the skill and reputation exclusion by clarifying that same should be read narrowly. For those professions left out in the cold, the guidance is unlikely to provide much relief.
The proposed regulations at Section 1.199A-5(b)(2)(ii)—which provides guidance for the meaning of services performed in the health care field—takes its cue from temporary IRS regulations regarding methods of accounting. That regulation, found at 26 C.F.R. 1.448-1T(e)(4)(B)(ii), provides as follows: … the performance of services in the field of health means the provision of medical services by physicians, nurses, dentists, and other similar health care professionals. The performance of services in the field of health does not include the provision of services not directly related to a medical field, even though the services may purportedly relate to the health of the service recipient. For example, the performance of services in the field of health does not include the operation of health clubs or health spas that provide physical exercise or conditioning to their customers.
The proposed regulations for the Tax Act largely mirror the foregoing, except that they add after dentists, “veterinarians, physical therapists, psychologists …” and clarify that the services provided by those professionals be “in their capacity as such who provide medical services directly to a patient (service recipient).” The proposed regulations also clarify that such services as “payment processing, or the research, testing, and manufacture or sale of pharmaceuticals or medical devices.” That final addition is a rather large and counterintuitive gift to those of your health care clients engaged in drug or durable medical equipment businesses.
The proposed regulations also provide helpful examples that may assist counsel in determining whether a particular client is eligible for the Section 199A deduction. One such example involves a dermatology practice that sells skin care products to its dermatology patients. The products are sold in the same space as the dermatology practice is located and by the same employees who work for the dermatology practice. In the example, the gross receipts for the skin care products are only 5 percent of the entity’s overall gross receipts. The proposed regulations clarify with this example that, though the sale of skin care products is not “the performance of services in the field of health,” such sales are “incidental” to the practice of dermatology and therefore excluded from the 199A deduction all the same. The Tax Act and the proposed regulations include a more detailed discussion of the rules, definitions, and exclusions related to specified service trades or businesses (SSTBs) that requires more ink (digital or otherwise) than is available in this article.
Though nearly all pre-exist the Tax Act, it may be beneficial to look to IRS letter rulings for additional guidance. Such rulings have concluded that, in certain circumstances, companies that provide products and services primarily to the pharmaceutical industry or companies that sell proprietary IT to health care providers are, despite their customers, qualified trades or businesses, see IRS letter ruling 201436001. This may offer some hope for your health care clients who exist on the periphery of the field. Ultimately, eligibility for the Section 199A depends on the unique facts at issue. For that reason, it is worth directing your clients, regardless of their professions, trades, or businesses, to a qualified tax attorney or accountant who can walk them through the Tax Act to find the good news.
—Andrew Stein, an associate at Lamb McErlane, who focuses his practice on health and business law, assisted in the preparation of this article.
Vasilios J. Kalogredis is chairman of Lamb McErlane’s health law department. He represents many medical and dental groups and thousands of individual physicians and dentists.