Federal Tax Reform – Traps for the Unwary

Last week, I listened to a webinar about the effect of the 2017 tax reform legislation on independent insurance agents.  It was put on by the Independent Insurance Agents and Brokers of America and contained a lot of useful information (click here to see the slides from the webinar).   The focus of the webinar was on the 20% deduction that is available to individuals who receive income from a pass through entity (a subchapter S corporation, a limited liability company, or a partnership).  That deduction only applies to distributions, not wages, received from such entities and is subject to income limits if the business being conducted by the pass through entity is a “specified service trade or business.”

FIRST TRAP FOR THE UNWARY

What constitutes a “specified service trade or business” has been the subject of an intense lobbying campaign by the IIABA because approximately 80% of its members conduct their business activities using a pass through entity.   As you might expect in a tax law, the statutory definition of a “specified trade or business” is a long and involved one that includes references to consulting and financial and brokerage services.  Whether an insurance agency, which could be said to provide one or more of such services, is included in that definition has been an open question.  That question was recently answered in a draft regulation issued by the Internal Revenue Service.  In that regulation, the IRS specifically excluded insurance agents and brokers from the definition of brokerage services and limited financial services to those typically provided by financial advisors and investment bankers.  That leaves consulting, which the draft regulation states does not include consulting services “embedded in, or ancillary to, the sale of goods or performance of services on behalf of a trade or business”  that is not otherwise a “specified service trade or business.”  However, creating a trap for the unwary, the IRS added the condition that there must be “no separate payment for the consulting services.”

Under the draft regulation, an insurance agency owner whose agency is not paid a separate fee for risk management or other similar services would be able to deduct 20% of the distributions paid to the owner by his or her pass through entity agency regardless of how much total income the owner receives.  If the owner’s agency receives only commissions for the sale of insurance and related products, they have no worries.  However, if the agency also receives a separate fee from the insured for services related to the sale of such products, there are some conditions that have to be met before its owners will be entitled to the 20% deduction regardless of their total income.

Those conditions concern the total percentage of the agency’s income received from fees.  If the agency has $25 million or less in gross annual income, it can receive up to 10% of its gross annual income in consulting fees and still not be considered a “specified service trade or business.”  For agencies with gross annual income above $25 million, the cap for consulting fee income is 5%.  If these caps will present a problem for an agency owner, the owner could create a separate entity to perform the consulting services for which a fee is charged.  The owner would not get a 20% deduction for any distributions paid by this entity, but would be able to take the 20% deduction on distributions made by their agency, because it would receive only commissions for the sale of insurance and related products.

SECOND TRAP FOR THE UNWARY

One other trap for the unwary found in the IRS draft regulation is its treatment of former employees who perform a similar service for their former employer as still being an employee for purposes of the 20% deduction.  This provision will prevent a producer from leaving an agency and forming a pass through entity, which then contracts with the agency to perform the same or substantially similar services for the agency as the producer had been performing.  In other words, becoming an independent contractor for the agency will not entitle the producer to the 20% deduction.

The draft regulation is not yet final, so things could change before that happens.  However, the IRS has said that the draft regulation can be relied on by taxpayers for tax planning purposes until a final regulation is issued.  This implies that the IRS does not think significant changes will be made to it.

The IIABA will repeat the webinar on October 3, 2018 from 1:30 to 2:30 p.m. EDT and questions can be submitted.  Click here if you are interested in registering for it.

 

 

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