By Richard Rubin and Ruth Simon 

The Trump administration set final rules for a new deduction that will provide significant savings for many business owners, providing more clarity for real-estate owners and service-industry businesses.

The government also offered a cushion for many owners of rental real estate to claim the deduction if they meet certain tests, but declined to allow the looser definitions some wanted.

The Treasury Department rejected requests from real-estate settlement agents, Major League Baseball team owners, writers and physical therapists, who all wanted more favorable rules for their specific industries.

The rules for the new 20% deduction for so-called pass-through businesses -- which include partnerships, S corporations and sole proprietorships -- will be crucial as business owners begin filing their first returns under the new system in coming months. Citing that urgency, the government released the rules during a partial government shutdown affecting Treasury and the Internal Revenue Service.

Congress created the pass-through deduction as part of the sweeping 2017 tax overhaul to give a rate cut to businesses that wouldn't benefit from the cut in the top corporate tax rate.

The 20% deduction lowered the top rate on business income that qualifies for the break to 29.6%, down from the 37% top rate that applies to individuals' wage income. The 2017 tax law reduced the top corporate tax rate to 21% from 35%.

The final rules make some changes from proposed regulations released last year, and they will guide business owners and tax preparers in determining what income qualifies for the deduction. Each case will be different, and lawyers expect frequent disputes between the IRS and business owners over who is eligible.

Typical corporations pay corporate taxes and then a second layer of tax on dividends. For pass-through businesses, by contrast, the net income flows directly to the owners' personal returns and is only taxed once, at the owners' individual rates. Many pass-through businesses are small, but some large closely held businesses use this structure, too.

Democrats and some tax experts have warned that the pass-through deduction will distort business decisions, add complexity and help high-income households. More than half of the benefit of the deduction goes to the top 1% of households, according to a Tax Policy Center estimate.

Not every owner of a pass-through business can claim the deduction. Once income reaches $157,500 for individuals and $315,000 for married couples, some restrictions apply. For instance, above those levels, certain service businesses -- including those in medicine, law, athletics and consulting -- start losing the break. That restriction was designed partly to prevent people from turning higher-taxed labor income into lower-taxed business income. Businesses that don't meet specified levels for assets and wages paid can also lose the break.

When it passed the 2017 tax law, Congress didn't directly answer many questions about the deduction, including whether all owners of rental real estate could qualify.

Friday's rules provide a cushion for real estate owners, letting them claim the deduction if they keep adequate records, have at least 250 hours of activity per year on the business and avoid lease structures that make tenants responsible for many expenses. The hourly requirements don't include time spent arranging financing or other financial and investment-management activities.

The regulations also spell out what counts as a service business, and when having some service-business income taints an entire business and makes it ineligible for the break.

The rules make it harder for businesses, such as law firms and doctors, to split their operations apart on paper and pack income into an entity that would qualify for the more favorable tax treatment. The government removed one proposal that would have penalized taxpayers in situations where a service business and a nonservice business had common ownership.

The proposed regulations had prompted some resistance.

The IRS had proposed a standard last year 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%. The government rejected requests to loosen those rules.

Small banks had said their trust and mortgage services kicked them over those thresholds, denying them a break they thought they had won. Insurance brokers, pharmacists and owners of assisted-living centers, among many others with narrow concerns, found themselves in similar predicaments.

In many of those cases, the government declined to provide specific exceptions requested by those service industries, specifically rejecting the concerns of real-estate settlement agents, writers and physical therapists. It said assisted-living centers and skilled nursing facilities would likely have to be judged case by case.

The final rules give an example of a senior-citizen facility that contracts with health-care providers who provide medical services and bill patients directly. In that case, the facility itself wouldn't be considered to be providing health care. That's a helpful example, Emily Murphy, an accountant at Plante & Moran PLLC, said at a tax conference in New Orleans on Friday.

The government did adjust its proposed rules for businesses that buy and sell commodities, as opposed to those trading financial instruments based on commodities.

Small banks should be helped by a statement in the final rule saying that originating loans doesn't count as a financial service ineligible for the break. But the rules don't reflect some of the banks' broader requests.

The new rules are "on the positive side of mixed," said Alan Keller, a vice president with the Independent Community Bankers of America, a trade group.

Not so for Major League Baseball, which argued that its team owners should qualify for the break, because their income doesn't just come from players' on-field performance -- a service that could render their businesses ineligible.

"While sports club and team owners are not performing athletic services directly, that is not a requirement," the regulations say, noting the question is whether the business involves those services, not whether the owners perform them.

Write to Richard Rubin at richard.rubin@wsj.com and Ruth Simon at ruth.simon@wsj.com

(END) Dow Jones Newswires

January 18, 2019 17:23 ET (22:23 GMT)

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