By Richard Rubin 

WASHINGTON -- For Extraco Banks of central Texas, the 2017 tax law that promised a 20% deduction is turning into something of a headache.

S-corporation banks such as Extraco technically qualify for the break. But under proposed IRS regulations, Extraco might lose out, because it gets too much revenue from managing trusts and selling mortgages into the secondary market. Those activities may be ineligible -- and taint the ability of the whole business to qualify.

"There's a difficult situation placed upon us late in the tax year that gives us few alternatives to manage around it," said Chief Financial Officer Gary Miller.

Situations like Extraco's will be a crucial part of an IRS public hearing Tuesday, as the agency prepares to finish the rules for the new 20% deduction for pass-through businesses such as partnerships and S corporations, closely held companies that don't pay standard corporate taxes. Companies, accountants and the government are struggling over who is eligible for the tax break.

In last year's law, Congress created the 20% deduction for pass-through businesses, which pay taxes through their owners' individual tax returns. The break shaves their top tax rate from 37% to 29.6%. Lawmakers were trying to cut rates for millions of closely held businesses like they did for corporations.

But Congress aimed to prevent lawyers, doctors and similar professionals from turning high-taxed labor income into lower-taxed business income. It named which specified service businesses are ineligible, listing industries such as law, medicine, consulting and athletics.

In those industries, once taxable income hits $157,500 for an individual or $315,000 for a married couple, the break starts phasing out.

Congress left part of the problem for the Treasury Department and the Internal Revenue Service. How much of a specified service can a business perform before it becomes a specified-service business? Once a business crosses that level, does it lose the whole deduction?

Besides banks, insurance brokers worry that consulting services could make them lose the deduction. Pharmacists offering direct health care are on the bubble, too. Assisted living centers say they might provide too much health care to qualify.

"We don't know what direction to go," said Steve Fogg, chief financial officer of Marquis Companies, which runs 24 long-term-care facilities or similar operations in Oregon, Nevada and California.

The pleading leaves the government in a pickle. Give companies what they want and the U.S. could lose more revenue to the deduction, beyond the $48.6 billion estimated for fiscal 2019. Tight rules would mean fewer companies qualify for benefits and encourage economically unproductive tax avoidance.

The IRS proposed a standard to help companies with minimal service income. For businesses with $25 million or less in revenue, 10% of receipts from specified services is the magic number that causes them to lose the entire deduction. Above $25 million, the threshold drops to 5%.

A $30 million manufacturer can get the full deduction, even with a $1 million consulting arm that helps customers use its products. Extraco Banks, however, is over the $25 million threshold and says 5.98% of its revenue comes from the services in question, putting its whole deduction at risk.

The IRS rule can be especially messy for businesses around the $25 million threshold. Imagine a retailer with $24 million in revenue and $1.7 million, or 7.1%, from consulting. That retailer would get the full deduction. If the core business outside of consulting grew by $2 million, the percentage would decline to 6.5%. But it would tip over the $25 million threshold and could lose the entire break because of the 5% standard.

"You won't know if you've exceeded that $25 million threshold until the end of the year, and then it's too late to self-correct," said Rick Grafmeyer, a lobbyist at Capitol Tax Partners.

Companies are pressing for leniency in defining a service business, a higher percentage threshold and leeway in what happens to businesses that trip over that threshold. Some argue against a hard cap, so a business that's 25% specified services could lose part of the break, not the whole thing.

The IRS rules could force companies to account separately for services that are now commingled so specified-service revenue can be isolated.

To insulate a core business eligible for the deduction, companies could put service businesses into entities paying higher tax rates.

Those separate businesses would need to meet the tax code's definition of "trade or business," itself the subject of audits, court fights and fact-dependent disputes.

"We're going to need an understanding of what comprises a trade or business," said Tony Nitti, an accountant at Withum Smith & Brown in Aspen, Colo. "We're trying to close one door of questions but opening two more."

Once the rules are final, the IRS will argue with taxpayers one at a time.

"It will be hard for the IRS to audit," said Steve Rosenthal, senior fellow at the Tax Policy Center, a Washington group run by a former Obama administration official. "If a business is close, they'll fudge it, and this is a difficult thing for the IRS to pursue."

Write to Richard Rubin at richard.rubin@wsj.com

(END) Dow Jones Newswires

October 16, 2018 05:44 ET (09:44 GMT)

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