Separating SSTB and Non-SSTB Activities Into Separate Trades or Businesses

Note - this is being posted for discussion purposes only as we try and understand how the SSTB de minimis rules and separate trade or business rules work.  I'm not yet totally convinced the examples come to the proper conclusion.

The proposed regulations clearly indicate that a single individual or entity can conduct more than one trade or business.[1]  But these regulations do not provide for a test to divide up a single trade or business.

However, such a test does exist at Reg. §1.446-1(d) for the use of different methods of accounting, even if it’s not quite a “bright line” test for what is a separate trade or business.  That regulation provides:

(d) Taxpayer engaged in more than one business.

(1) Where a taxpayer has two or more separate and distinct trades or businesses, a different method of accounting may be used for each trade or business, provided the method used for each trade or business clearly reflects the income of that particular trade or business. For example, a taxpayer may account for the operations of a personal service business on the cash receipts and disbursements method and of a manufacturing business on an accrual method, provided such businesses are separate and distinct and the methods used for each clearly reflect income. The method first used in accounting for business income and deductions in connection with each trade or business, as evidenced in the taxpayer's income tax return in which such income or deductions are first reported, must be consistently followed thereafter.

(2) No trade or business will be considered separate and distinct for purposes of this paragraph unless a complete and separable set of books and records is kept for such trade or business.

(3) If, by reason of maintaining different methods of accounting, there is a creation or shifting of profits or losses between the trades or businesses of the taxpayer (for example, through inventory adjustments, sales, purchases, or expenses) so that income of the taxpayer is not clearly reflected, the trades or businesses of the taxpayer will not be considered to be separate and distinct.

Absent some additional guidance in final regulations on how applying “trade or business” to §199A would be different, the above regulation would appear to provide the best guidance.  Note that the regulation has two key requirements to respect the trade or business:

• A complete and separate set of books must be kept for each trade or business of the taxpayer/entity and
• Shifting of income between the entities through sales, purchases or expenses will be fatal to a finding of two businesses.

In Chief Counsel Advice 201430013 the IRS National Office looked at a case where a subsidiary converted to a single member LLC disregarded entity.  The memorandum concludes that, in fact, there are two distinct trades or businesses in this organization.

The activities undertaken by the LLC and its corporate owner were summarized as follows:

Company’s activities include sales, marketing, distribution, sale support, research and development, and administrative and headquarters functions. LLC primarily manufactures products but does provide some research and development services to the purchaser of its products, Purchaser A. Purchaser A will subsequently sell these products to Purchaser B, who will ultimately sell the products to Company.

Company and LLC have separate books and records. These books and records are prepared at Company’s location. Company and LLC are in different geographical locations. Further, Company and LLC do not share employees, but, do share the highest-level executives. Company and LLC use the same accounting method, presumably, that method is an accrual accounting method.

The memorandum concludes:

Deciding whether Company and LLC are separate and distinct trades or businesses requires a factual determination. The currently available information fails to convince us that Company and LLC are not separate and distinct trades or businesses. The fact that LLC has failed to make an election to be taxed as a corporation and is thus, disregarded as an entity separate from Company for federal income tax purposes, does not mean that LLC can never be a separate and distinct trade or business. Accordingly, based on the available information, our view is that Company and LLC are separate and distinct trades or businesses within the meaning of IRC § 446(d).

So does that mean that a single entity can be divided into multiple trades or businesses—likely yes, but they need to be truly distinct.

Example 1

A & B, Inc. is an S corporation.  A & B is a licensed CPA firm that provides auditing, accounting and tax services to individuals and businesses.  As well, A & B offers seminars on tax, technology and business topics that qualify for professional continuing education for CPAs, EAs and various other professionals.  The seminars are conducted by a specific group of individuals in the corporation.  There is no overlap between the customers of the accounting services performed by A&B (businesses and individuals seeking tax planning and preparation) and those that purchase seats at the seminars (tax professionals seeking to obtain education).  65% of A&B’s revenue for the year came from seminar fees and 35% came from accounting services.

A&B records all activity in one set of books to record revenue and expenses for all revenue and expenses of the company.  All administrative functions are performed by the same employees for both the accounting services and the seminars.  The accounting services and seminars are both operated in the same physical location.

Due to the fact that separate books and records are not kept and the operations are begin run on an integrated basis, it appears that A&B may have a difficult time showing that there are truly two separate trades or businesses being conducted.  In that case, it seems likely that all income from A&B will be tainted as coming from an SSTB.

Example 2

Assume the same facts except the accounting firm and seminars operate out of offices located in separate offices.  Each office has its own administrative staff and maintains its own set of books.  However, the officers of A&B, who are also the shareholders, both conduct all of the seminars and are lead members of the engagement teams on accounting and tax engagements.  They carefully account for their time, and their salaries are divided between the two divisions based on time expended.

In this case, it seems likely that A&B can show it is operating two distinct trades or businesses.  The accounting business is clearly still an SSTB.  But the seminar business would appear to be in the business of education, which is not an SSTB.  As such, the income related to the education business would appear not to be subject to the restrictions on claiming a §199A deduction from a specified service trade or business.

[1] See, for instance, Proposed Reg. §§1.199A-3(b)(5) and 1.199A-4(a).