The New 20% Pass-Through / Qualified Business Income (QBI) Deduction May Offer Tax Relief for Your Small Business Client
The StageInitially, the Tax Cuts and Jobs Act of 2017 allowed for generous tax cuts for larger corporations but provided few incentives for the owners of smaller businesses (owners of Partnerships, S-Corporations, and Sole Proprietorships). This new deduction aims to levelize the income tax rates of small company owners with the new lower corporate rates.
The BasicsThe new 20% Pass-Through / Qualified Business Income (QBI) Deduction is an income tax deduction of 20% of QBI reduced by §179 depreciation deductions. This deduction is passed through to an individual owner who pays any tax due.
The Magic NumberWhen an owner’s preliminary household taxable income is less than $315,000 and the pass-through income is less than $315,000, the owner deducts 20% of the lesser of these two.
The OpportunityWhen a pass-through business contributes to a retirement plan, the owner’s preliminary household taxable income decreases. Business owners wanting to structure retirement plan contributions to get below the $315,000 limit may consider a profit sharing contribution. However, a Cash Balance Plan may be the best fit for those needing to make larger retirement plan contributions. See Example Strategies below for additional plan design ideas. And know we are here to assist you.
The Savings CalculationWhen an owner’s preliminary household taxable income is less than $315,000 and the pass-through income is less than $315,000, the owner deducts 20% of the lesser of these two.
Above $315,000 the calculation is more complex. Specified Service Trades or Businesses (SSTBs) over $315,000 are stricter in allowing deductions than other pass-through businesses. Details on this calculation are attached.
The pass-through deduction is a permanent 20% tax savings. Unlike retirement plan contributions, for which tax is deferred (they will generally be taxed when funds are later withdrawn or converted to Roth), this deduction is permanent.
Examples of Strategies to ConsiderExample 1: A pass-through business owner for whom preliminary household taxable income and pass-through income are both $415,000 (all taxable income comes from this pass-through source). By causing the business to adopt a retirement plan, especially a cash balance plan, if the business funded a retirement plan contribution of $100,000, preliminary household taxable income would now be $315,000, and 20% of pass-through income could be deducted. (This may not exceed 20% of the owner’s preliminary household taxable income reduced by capital gains). For a cash outlay of $100,000, taxable income would drop $163,000, which is calculated as the $100K cash balance contribution + (20% of $315K being passed through).
When the pass-through business income is in the $315K – $415K range (less if not married filing jointly) this principal applies on the income in the $315K – $415K range. When the presence of a new retirement plan deduction could get a higher business income figure down into this range this also applies.
Example 2: A business owner with $140K of pass-through business income and $124K of preliminary household taxable income could deduct only 20% of $124K. This person could increase taxable income by with a $20,000 in-plan Roth conversion, raising taxable income to $144,000. While this initially increases income $20K, the increased 20% deduction means that taxable income increases only $16K.
A person with pass-through business income but lower household taxable income can deduct only 20% of preliminary household taxable income. In this case the QBI deduction can be increased by increasing income. A common way to consider doing this is to make an in-plan Roth conversion, increasing taxable income, and thereby allow the full 20% QBI deduction. The in-plan Roth conversion would normally be fully taxable. This allows a 20% deduction on the conversion.
When an owner’s pass-through income is relatively low, as could easily happen for a person with a regular job but also some consulting or freelance on the side, helpful steps may include ensuring any deferrals are Roth, considering after-tax (rather than pre-tax) contributions, and considering an in-plan Roth conversion. Either of these would normally boost pass-through income and taxable income, pushing the QBI deduction upward.
For more information contact your Tax Advisor or your JULY Client Service Manager.
This article is for general information and does not constitute tax or legal advice. Those needing such advice should contact those who provide such services.