IRS Cracks Down on the ‘Crack and Pack’

The sweeping tax overhaul enacted by Congress last year created a special 20% deduction for small-business owners—and left many of them waiting to find out exactly who will benefit.

On Wednesday, the Treasury Department provided some answers. Many high-earning real estate and insurance brokers will get the tax break, but equally-paid doctors, lawyers or financial advisers won’t.

Owners of closely-held companies should be able to claim the new tax benefit even if a small portion of their income doesn’t qualify for the favorable treatment. But it could be hard for high-earning owners to get around the rules’ limits by splitting up a business—a strategy some tax professionals have dubbed the “crack and pack.”

“They did try to address some of the efforts to game the law,” said David Kamin, a law professor at New York University. The rules also “highlight the arbitrary nature of who benefits and who doesn’t,” he said.

As part of its rewrite of U.S. tax rules, Congress created a 20% deduction for owners of a variety of pass-through businesses, including limited liability companies, partnerships, so-called S corporations and sole proprietorships. The tax break effectively lowers their top rate to 29.6% from 37%.

The deduction can be claimed by business owners whose taxable income is $315,000 or less for joint filers. Above that level, the break would be phased out over the next $100,000 of income for service-business owners such as lawyers, doctors and consultants. There are separate restrictions tied to the level of wages paid and capital investment. Owners of National Football League teams and other sports teams wouldn’t get the break, say Howard Wagner, a CPA with Crowe LLP.

The new rules “were tough on the tax-motivated stuff and they were generally quite liberal on making this work for the broad cross-section of taxpayers,” said Dana Trier, deputy assistant secretary of the Treasury during the first part of the Trump administration.

The restrictions had drawn concerns from businesses owners who receive some of their income from services and worry they might not be able to claim the benefit.

Under the Treasury Department’s proposed new rules, business owners with gross receipts of $25 million or less can claim the tax benefit if less than 10% of receipts are from a “specified service business.” Owners with gross receipts of greater than $25 million can claim the benefit if up to 5% of receipts are from such a business.

The rules aren’t final, but taxpayers can rely on them for planning purposes, Treasury officials said.

Another restriction would affect high earners in any business or trade where the “principal asset” is “the reputation or skill of one or more of its employees or owners.” The restriction would apply when a business owner receives “income for endorsing products or services” or licensing fees, or other income for use of their image, voice or other symbols. It would apply to “reality performers” and others who receive “appearance fees or income.”

A senior Treasury official said the restriction wouldn’t “impair the ability of most otherwise eligible taxpayers to claim the deduction.”

Key Takeaways From the New Rules

The Treasury Department released proposed rules for the 20% deduction available to “pass through” businesses.

  • Who gets the break: In general, owners of partnerships, S corporations, limited-liability companies and sole proprietorships with taxable income of $315,000 or less for joint filers and $157,500 or less for single filers. For owners with higher income, the write-off is often subject to phase-outs and limits.
  • Who doesn’t get the break: Many higher-earning owners of “specified service” businesses. People in this category include doctors, dentists and pharmacists; lawyers; accountants and actuaries; consultants; performing artists; financial advisers and investment managers; and athletes and coaches, including team owners. Real-estate and insurance brokers aren’t in this category.
  • The “reputation” exception: The law denies the deduction to business owners whose “skill or reputation” is a principal asset. The new rules interpret this narrowly: A chef who lends her name to packaged foods wouldn’t get the write-off on that income, but she probably would get it on the income from a restaurant she owns and manages.
  • Crack and pack: The rules have anti-abuse provisions meant to prevent firms that are split into pieces from maximizing the 20% deduction.
  • Aggregation: Businesses that operate through different entities with common ownership can sometimes combine their results for purposes of the new write-off.
  • Alternative minimum tax: In a move that will please many people, the rules specify that the 20% deduction is allowed under the AMT. Thus, the write-off can’t help trigger the AMT.

—Laura Saunders

The rules also include “anti-abuse” provisions to address strategies that might allow business owners to circumvent restrictions on who can claim the benefit, a senior Treasury official said, such as the crack and pack, where an owner splits a company apart, reclassifying and re-categorizing activities to get as much income as possible taxed at the lower rate.

An enterprise at least 50% controlled by a law firm or other specified-service business that provides most of its services back to that firm won’t be able to claim the benefit. “You couldn’t do the crack and pack,” a senior Treasury Department official said. But it could claim the benefit if it also sells a product or rents a building to others. A dermatologist could generally claim the tax break for selling skin-care products, provided those sales contribute more than 5% of combined gross receipts, said John Rooney, a director at KPMG LLP.

The proposed rules also include limitations designed to prevent business owners from relabeling certain employees as independent contractors so they can take advantage of the tax benefit.

Business owners with multiple entities will be able to aggregate those companies for tax purposes provided they have common ownership, the same tax year and meet certain other requirements. That move that will make it easier for some larger companies structured as pass-through businesses to take advantage of the benefit.

Among the other winners under the new rules are banks set up as S corporations and real-estate brokers, both of whom will be able to claim the new deduction, said Dustin Stamper, a managing director at Grant Thornton LLP.

One of the outstanding questions, Mr. Stamper added, is whether business owners will be able to claim the deduction on their state income tax returns. “It’s a big question for a lot of taxpayers,” he said. “It will depend on the state.”

Owners of pass-through businesses filed 35.3 million tax returns in 2015, according to the Joint Committee on Taxation. Another 1.6 million returns were filed by C corporations. Pass-through companies have become more common since Congress lowered individual tax rates in 1986.

Read The WSJ Guide to the New Tax Law.

Write to Ruth Simon at ruth.simon@wsj.com and Laura Saunders at laura.saunders@wsj.com

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