“Reputation or Skill” in the New Pass-Through Regulations:

Reading “Skill” (and “Principal Asset”) Out of the Law

The proposed regulations governing the 20-percent pass-through deduction under Section 199A are rightly garnering attention, and there is already significant commentary focused on the fact that Treasury chose to interpret the “reputation and skill” catch-all narrowly. As I explained in my earlier post, I think that’s a mistake because of the wide-open door that leaves for many high-income service providers. Here, I discuss exactly how narrow the definition is — which seems to be extremely narrow, at least based on the examples given — and how the regulatory definition seems to conflict with the text and potentially purpose of the restriction.

Specifically, and despite the language in the law, the regulation seems largely focused on excluding returns that are explicitly and exclusively based on “reputation” from the deduction, and it allows a deduction for returns to “skill” associated with labor services, despite the plain language of the statute. The regulation then has no way of dealing with the mixing of the two in most circumstances, other than to grant the full deduction. So, if the star chef simply lends her name to a business in exchange for a share of profits, she doesn’t get the deduction according to the regulation but, if she also provides services to the business too in exchange for that profit share, she apparently does on all her income from the restaurants.[1] And that helps illustrate the extremely narrow reach of the catch-all and how people can plan around it in its current iteration.

The alternative: Give “skill” meaning in the regulation and restrict returns to that too, which would deny the deduction to many more business owners and reduce some of the haphazard distinctions. I’m not saying that’s easy, but I am saying that’s a better reading of the statute and probably a better outcome in terms of the policy.

The Catch-All

As I explained in my post yesterday, high-income service providers — those making over $315,000 in taxable income for a married couple (and half that for a single individual) — face certain restrictions in taking the 199A deduction. Namely, they don’t get the deduction if their business is in certain listed sectors (law, health, consulting, etc.) or if the principal asset of their business is the reputation or skill of the owners or employees of the firm. It’s this latter catch-all that the IRS explicitly chose to interpret narrowly. That then leaves a lot of room for high-income service providers to take the deduction — so long as they make sure they’re not in the specifically prohibited categories.

How Narrow Is Narrow?

In reading that catch-all narrowly, the IRS seems to have largely ignored the word “skill” and focused exclusively on “reputation” and, specifically, those situations in which there are returns to reputation alone. In fact, I worry that the IRS’s definition of “reputation or skill” may be relatively easily avoided even by those who rely significantly on what seems to be reputation by simply mixing that reputation with skilled labor.

I’m pasting below in full the proposed regulation’s definition of “reputation or skill.” There are three types of activities listed, and income from these three activities is considered in the bad category:

(1) “[E]ndorsing products or services.”

(2) “[U]se of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity,” OR

(3) “[A]ppearing at an event or on radio, television, or another media format.”

Here’s the problem with these definitions and especially the first two: Those first two categories seem to be trying to separate out returns to “reputation” (bad) from other returns to skilled, highly-paid labor (good — so long as not in the other specifically listed sectors). That is inconsistent with the text of the statute which also discusses “skill.” And, further in many situations, it’s not so easy to draw the line between “reputation” and “skill,” and the regulation provides no guidance on how to do so other than apparently granting the full deduction.

The same problem doesn’t exist with the last category — of appearances. There, even if you labor and do so with skill (you’re good at appearing on TV!), you don’t get the deduction because, apparently, appearing on TV or elsewhere is always bad.

The two examples given by the IRS help illustrate the dilemma and how even returns to reputation can often get the deduction if they’re just mixed with services (and so long as those services aren’t simply appearing somewhere).

The first example in the regulations covers the “well-known chef.” The celebrity chef owns a bunch of restaurants, the profits of which flow through to her. She also receives an endorsement fee (of $500,000) for the use of her name a line of cookware. According to the proposed regulation, the $500,000 is attributable to her reputation or skill and so not eligible for the deduction. However, the restaurant income is eligible because “owning restaurants” is not on the list of “bad” businesses.

Here’s the problem: It sure seems like the profits from those restaurants are at least partially attributable to the fact that the celebrity chef is associated with the restaurants. Her “name” — and her listing as the owner and likely executive chef of those restaurants — is probably helping to bring in the customers. There’s not a separate payment labeled “payment for your name being associated with the restaurant,” but the return to her name is in there.

So, the IRS seems to be saying that so long as reputation — here in the form of a name — is mixed with actually working in a place, it’s ok. In that case, the income is not because of the name alone but also because of the other things that the celebrity chef does.

However, given the text of the statute, why should the celebrity chef get the deduction on the profits if most of that is attributable to some combination of her reputation or skilled labor as the owner and executive chef? The statute explicitly addresses the latter point (no deduction if the primary asset is reputation or skill of owners or employees), but the IRS seems to let it go — and, in doing so, also lets go returns to reputation when mixed with skill.

This brings us to our second example, involving a “well-known actor,” which helps further illustrate the limitations. In exchange for the use of her “likeness” and “name,” she’s given 50 percent of a shoe company. To be clear, this is a situation in which she actually owns the company, and its success or travails affect her income. Still, the IRS rules that the returns she earns won’t be eligible for the deduction presumably because this is based on “reputation.”

However, let’s change the fact pattern a little and show how this restriction can be avoided, following the lesson learned based on the celebrity chef. Let’s say that this wasn’t an actor but instead a famous athlete. And let’s say the famous athlete provided not just a name but also input on the design of the shoes. She is, after all, particularly expert on how shoes like this perform. Call her the “chief development officer.” She then is given a 50 percent stake in profits of the company, and the shoes she helps develop will carry her name.

Does she get the deduction? You might think the answer should, at least, be in part “no.” She is after all putting her name on the shoe. But, then let’s look back at the celebrity chef. Why is the celebrity chef getting the full deduction on her restaurants, where her name is almost certainly a draw?

We’re not just talking celebrity chefs and athletes. Take the star architect or ad executive, whose names are probably on their firms. Other partners get smaller shares of the firm because they are not the “star.” This star in fact tends to swoop in and swoop out and isn’t working the late nights of the other partners. Reputation and not just skill are playing a role here. o they get the full deduction? The proposed regulations seem to say that the answer should be “yes.” Well…how different is that from athlete and the shoes?

You get the idea. The basic problem here is that the IRS has come up with a rule that seems to largely ignore “skill” and only works cleanly where “reputation” isn’t mixed with skilled services and is instead disaggregated. The IRS seems to have no idea what to do if the two are mixed: well, other than give the deduction (except for people making appearances). In that case, you can begin to imagine what people will be encouraged to do. Mix reputation and labor and voila.

The perversity here is that the actual law says it restricts the deduction when it comes to returns to both “reputation or skill.” “Skill” seems to involve provision of services, and the IRS — in writing the regulation — has focused only on reputation.

While the drafters of Section 199A have much to answer for, they here actually have a better idea than the IRS — namely, that reputation can’t easily be disaggregated from labor when the two are mixed and so a restriction has to apply to returns to both. The proposed regulation doesn’t do that, and seems to throw up its hands when the two come together.

What Are Alternatives?

The better alternatives to this involve IRS giving meaning to the word “skill” and trying to bar returns to that from getting the deduction. In that case, mixing reputation and skilled labor wouldn’t get far.

I believe this is in fact the better reading of the statutory language. In justifying its very narrow approach, the IRS argues that surely service businesses — not specifically listed — were meant to get the deduction under section 199A, because “there would have been no reason to enumerate specific types of businesses in section 199A(d)(2); that language would be pure surplusage.”

However, the IRS reading itself creates surplusage; the word “skill” is given basically no meaning in the catch-all under the proposed regulation. Further, giving “skill” meaning — and broadly limiting service businesses — does not create surplusage in the way the IRS suggests. Rather, the specifically listed categories would then be read to be per se prohibited service businesses, which would be a simplifying administrative move on Congress’s part. That has real effects for those businesses and the IRS — those businesses could never be considered something other than service businesses that don’t get the deduction. If they’re in those categories, no further tests are needed. In that case, the specifically listed categories aren’t surplusage, but rather examples of the kinds of businesses that aren’t allowed the deduction and that, because of their listing, necessarily don’t get it.

For all other businesses, the IRS would then apply a test to determine whether the principal asset of the business is “reputation or skill.” This then brings us to another phrase in the statute that the proposed regulation turns into surplusage. Namely, the deduction is not intended to go to businesses where “the principal asset of such trade or business is the reputation or skill of one or more employees or owners.” (emphasis added)

As it is, the regulations appear to read out “principal asset.” They instead treat the listed returns to reputation as always a separate trade or business and never getting the deduction, but everything else does.

That’s not actually what the statute says for better or worse. Instead, the law recognizes that returns to reputation and skill can be mixed together with other returns in a single trade or business and often are. The section then denies the deduction for the entire business if reputation or skill represent the principal asset of the business. If they are not, then those returns apparently are meant to get the deduction (assuming the business is not in one of the other listed categories).

So, applying that language would seem to involve actually determining what are the assets of the firm. As Lily Batchelder has suggested, one way of doing that would be to have people track their capital investments in the firm (i.e., not labor services or reputation) and then assume a rate of return in order to compare to the actual income being produced by the firm. If a majority of the income is attributable to non-capital (i.e., skill and reputation) investments, then the firm does not get the deduction.

There surely must be other ways as well to give meaning to the words “skill” (and “principal asset”) and broaden the catch-all beyond its very narrow current iteration.

Taking this broader reading is not just supported by the text of the statute but also a policy goal that at least some in Congress might have had in mind: Not allowing high-income service providers to take the deduction. There was quite a bit of concern expressed at the time Section 199A was designed that high-income service providers in the form of pass-through businesses could take advantage, and the “guardrails” put in place arguably were meant to prevent that. Giving meaning to the word “skill” would help effectuate that goal.

To be sure, none of this is clean. None of this is optimal. Congress should not have enacted Section 199A to begin with, and Treasury was handed a mess to implement. However, in setting the catch-all, Treasury should endeavor to catch a lot more, consistent with the text of the statute.

[1] Perhaps the IRS envisions differentiating the profit share in the partnership attributable to the star chef’s services and reputation in that case, with only the former being allowed the deduction. But, as I explain below, the IRS provides no mechanism for doing so, and suggests there’d be no such splitting apart when the celebrity chef wholly owns the restaurant. In that case, everything is eligible for the deduction despite considerable profits presumably deriving from reputation.

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Proposed Regulations: Definition of “Reputation or Skill”

(xiv) Meaning of trade or business where the principal asset of such trade or business is the reputation or skill of one or more employees or owners. For purposes of section 199A(d)(2) and paragraph (b)(1)(xiii) of this section only, the term any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners means any trade or business that consists of any of the following (or any combination thereof):

(A) A trade or business in which a person receives fees, compensation, or other income for endorsing products or services,

(B) A trade or business in which a person licenses or receives fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity,

(‘C) Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format.

(D) For purposes of paragraph (b)(2)(xiv)(A) through © of this section, the term fees, compensation, or other income includes the receipt of a partnership interest and the corresponding distributive share of income, deduction, gain or loss from the partnership, or the receipt of stock of an S corporation and the corresponding income, deduction, gain or loss from the S corporation stock.

Proposed Regulations: The Two Examples Given

Example 8. H is a well-known chef and the sole owner of multiple restaurants each of which is owned in a disregarded entity. Due to H’s skill and reputation as a chef, H receives an endorsement fee of $500,000 for the use of H’s name on a line of cooking utensils and cookware. H is in the trade or business of being a chef and owning restaurants and such trade or business is not an SSTB. However, H is also in the trade or business of receiving endorsement income. H’s trade or business consisting of the receipt of the endorsement fee for H’s skill and/or reputation is an SSTB within the meaning of paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.

Example 9. J is a well-known actor. J entered into a partnership with Shoe Company, in which J contributed her likeness and the use of her name to the partnership in exchange for a 50% interest in the capital and profits of the partnership and a guaranteed payment. J’s trade or business consisting of the receipt of the partnership interest and the corresponding distributive share with respect to the partnership interest for J’s likeness and the use of her name is an SSTB within the meaning of paragraphs (b)(1)(xiii) and (b)(2)(xiv) of this section.