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Phone:  732-404-1860    
Fax:  732-404-1868

DSO Tax Update – The 20% Pass Through Deduction – Final Regulations

nTreasury announces Final Regulations on Tax Deduction

In January 2019, the Treasury issued final regulations that adds some clarity in determining how DSO’s and it’s investors can benefit from the 20% Pass Through Deduction.

This is our third post on this ever evolving matter.

Here’s What We Knew (Thought)

If an owner of a dental practice formed as a pass through entity and his or her taxable income exceeded $415,000, such owner would not be able to obtain this special deduction equaling 20% of the net income of the practice. This is because certain professional service firms were deemed specified service trade or businesses (SSTB) and would not eligible to claim this deduction.

In business relationships involving DSO’s and dental practices, whereby common ownership of 50% or more existed among the same group of entities and 80% or more of the revenue from the DSO came from the commonly owned PC’s, the DSO was viewed as a SSTB and was not able to take advantage of the 20% pass through deduction.

Brothers and sisters; children and parents; spouses; and corporations and partnerships that were owned by the same people were viewed as commonly owned.

Here is an example of a commonly owned DSO/PC structure.  Two brothers own a DSO equally, one of the brothers, who is a dentist owns a 100% interest in the PC. The DSO derives 100% of its income from the PC. As a result of this relationship the DSO is viewed as a SSTB and is unable to take advantage of the 20% deduction.

In circumstances where there was an investor/private equity-based DSO and common ownership was less than 50% and/or less than 80% of the revenue of the DSO was received from the PC,  there was an opportunity to take advantage of this 20% deduction.

Let’s look at the following example:

Dr. Jones owns 100% of a PC A and 51% of a DSO. Dr. Smith owns 100% of PC B and 0% of the DSO. Each PC generates 50% of the DSO’s revenue. The net income earned by the DSO on PC B’s practice is eligible for the 20% deduction while the net income earned on PC A’s practice is not eligible due to common ownership.

There were a few more caveats.

To the extent that the DSO provided consulting services to any practice whereby such services consisted of providing professional advice and counsel to assist the practice in achieving its goals and solving its problems, such services were considered disqualified from claiming the 20% deduction due to the nature of this type of service.

Other disqualified services affecting DSO’s included accounting and bookkeeping services.

The good news is that payment processing and billing analysis is not deemed a disqualified service.  

Thus it is critical for the DSO to maintain accurate records so that it can properly track the revenues and expenses of these disqualified services.

However, to the extent that these disqualified services are less than 10% of the total combined revenue of the combined businesses (5% for businesses whose combined revenue exceeds 25 million dollars), such income is considered incidental and does not need to be carved out for purposes of calculating the pass through deduction.

Here’s What We Learned

In addition to excluding the revenue and cost attributes for service lines that are disqualified due to it’s SSTB nature, to the extent that these disqualified services represent at least 10% of the total combined revenue of the combined businesses (5% for businesses whose combined revenue exceeds 25 million dollars) such businesses are disqualified even if they meet the common ownership test.

Thus if in the prior example, 11% of the DSO’s revenue came from accounting, bookkeeping and consulting services, the DSO would be unable to benefit from the pass through deduction even though no common ownership existed with the  PC and Dr. Smith.

Is there a work around?

In situations where less than 80% of the revenues comes from PC’s that have more than 50% common ownership with the DSO, one can still take advantage of this deduction.  

Here’s How:

The regulations state that one entity can maintain multiple trades or businesses without having to create separate entities as long as;

  • Each business unit can stand on it’s own both operationally and financially
  • The DSO maintains accurate records so that it can properly track the revenues and expenses of the various business units

Thus as long as less than 5 or 10% of the revenues (depending on the size) of a particular business unit has SSTB services, that business will not be disqualified from qualifying for the pass through deduction.

Here’s an example:

USA DSO is 90% owned by non-dentists and 10% owned by the owners of the PC’s. 100% of the revenue received by the DSO comes from the PC’s.  

USA’s sources of revenue were as follows:

Marketing $300,000  
Call Center 200,000  
Employee Leasing 1,500,000  
Procurement and Payment Processing 400,000  
Billing 600,000  
Financial Reporting 400,000  
Human Resources 200,000  
Total Revenue $3,600,000  

Although financial reporting is considered a disqualified service and represents more than 10% of the overall revenue of the DSO, the entire DSO will not be disqualified, only the income related to financially reporting will be excluded as long as it meets the tests above.

If the revenue from financial reporting was $300,000, instead of $400,000 the entire DSO would qualify as the service would be considered incidental given that it would represent less than 10% of total revenue.

How does the deduction work?

If your DSO qualifies for this benefit your deduction can not exceed the greater of:

  1. 50% of the W-2 wages with respect to the qualified trade or businesses (W-2 wage limit), or
  2. The sum of 25% of the W-2, wages paid with respect to the qualified trade or business plus 2.5% of the unadjusted basis, immediately after acquisition, of all “qualified property”. Qualified property is defined as meaning tangible, depreciable property which is held by and available for use in the qualified trade or business at the close of the tax year. The property must be used at any point during the tax year in the production of qualified business income, and the depreciable period has not ended before the close of the tax year.

As you can see, there are various complications in analyzing and evaluating these relationships in order to determine whether one can claim this valuable benefit while the interpretation of this new law will continue to evolve. 

DSO CPAS is here to help navigate this new regulation. For more information please feel free to contact us.