Recently, the IRS issued nearly 300 pages of final regulations on the new pass-through deduction. In general, the regulations are taxpayer friendly and will make it easier for restaurants to claim the deduction. Although the regulations generally apply to tax years ending after February 8, 2019, taxpayers may rely on them for tax years ending in calendar year 2018.
A Brief Review
Many restaurant businesses are structured as pass-through entities, such as sole proprietorships, partnerships, S corporations or limited liability companies whose income is taxed directly to their owners at their individual rates. Owners were likely pleased that tax reform legislation added Sec. 199A to the tax code. That section allows pass-through owners to deduct up to 20% of their “qualified business income” (QBI) for tax years beginning after 2017 and before 2026.
Sec. 199A contains two important limits that kick in when an owner’s taxable income exceeds $157,500 ($315,000 for married persons filing jointly). First, the deduction is capped at a percentage of the business’s W-2 wages and/or fixed asset investments. Second, the deduction is eliminated for owners of specified service trades or businesses (SSTBs). Both limits are phased in beginning at the above thresholds and fully applicable once taxable income reaches $207,500 ($415,000 for joint filers).
Related read: “New Pass-Though Tax Provisions: The Devil is in the Details“
Higher income restaurant owners were concerned that these limits would create roadblocks to claiming the deduction. Although restaurants are not specifically excluded, SSTBs include “any trade or business where the principal asset . . . is the reputation or skill of one or more of its employees or owners.” Would this “catch-all” provision eliminate the deduction for restaurants with celebrity chefs? Also, what if a restaurant hires workers through an employee leasing company or professional employer organization (PEO) or otherwise is structured in a way that limits its W-2 wages or fixed assets?
For the most part, the regulations alleviate these concerns.
SSTB interpreted narrowly
The regulations limit the “reputation or skill” classification to income from endorsements, licensing of one’s image or likeness and appearance fees. An example involves a well-known chef who owns multiple restaurants and receives a $500,000 endorsement fee for lending his name to a cookware line. According to the regulations, the chef is engaged in two businesses—being a chef and owning restaurants. Owning restaurants is not considered an SSTB, and receiving endorsement income is considered an SSTB.
For chefs that receive significant income from endorsements, image licensing or appearance fees, it is a good idea to keep separate books and records for these activities and otherwise treat them as a separate business.
Additionally, what if a restaurant generates endorsement or licensing income based on the reputation or skill of a celebrity chef who is deceased? Arguably, this activity would not be an SSTB because the income is not derived from the reputation or skill of an employee or owner, but the answer is not clear.
Aggregation of businesses permitted
The regulations allow owners of multiple non-SSTB businesses to treat them as a single business to maximize pass-through deductions, provided certain requirements are met. This can be an advantage for related businesses if one generates substantial QBI, (but little or no W-2 wages or fixed assets), while the other generates minimal QBI, but has significant W-2 wages or fixed assets. Keep in mind that once you choose to aggregate businesses, you must continue to do so in future years, absent a significant change in circumstances.
The regulations also provide that:
- In applying the W-2 wage limit, a business may count wages paid to its workers by third parties, including PEOs, that meet certain requirements.
- Entities that lease real estate or other property to commonly controlled businesses are eligible for the pass-through deduction. This is helpful for restaurant businesses that use a separate entity to lease property to one or more operating companies.
The regulations are complex and this alert only scratches the surface. We can help you sort through the details and determine how these rules will affect your business.