- Why is this relevant?
The Tax Cuts and Jobs Act, passed in December 2017, includes a new deduction for owners of pass-through businesses. When a pass-through business adopts a retirement plan, contributions into that plan generally reduce the owner’s preliminary household taxable income. Depending on this income, and depending on the type of business, an owner may be able to deduct more than 100% of a retirement plan contribution. In other cases, the deduction could be less than 100%. Deductions over 100% occur as an owner’s income moves through income ranges where the deduction is phased in, and deductions under 100% occur in other ranges where it’s phased out.
- What is the Sec. 199A deduction?
It’s an income tax deduction of 20% of Qualified Business Income (QBI) reduced by §179 depreciation deductions. This deduction is passed through to an individual owner who pays any tax due. QBI does not include W-2 income, guaranteed payments to partners or investment income. If the owner’s preliminary household taxable income is less than QBI, that lower figure is deducted instead. (This can happen when virtually all of a person’s income is from the pass-through business). A person does not need to itemize deductions to benefit from the pass-through deduction.
This deduction is referred to as the Sec. 199A deduction, the Qualified Business Income deduction, the QBI deduction and the 20% pass-through deduction. For consistency this paper will call it the QBI deduction.
- Why was the QBI Deduction adopted?
To levelize income tax rates on pass-through businesses with corporations. The deduction allows pass-through entities to generally be taxed at the same rates as the new lower 21% rate for C Corporations.
- Who it is for?
Owners of Partnerships, S Corporations, and Sole Proprietorships, and Beneficiaries of Trusts and Estates issuing K-1 forms. While Sole Proprietorships are generally not thought of as pass-through entities, their income qualifies for purposes of this deduction. IRS Tax Statistics show that this group represents 95% of all business tax returns and 55% of all private employment, so this covers a major part of the overall private workforce. The deduction is calculated by each individual owner as part of Form 1040. It is not calculated or deducted on K-1 forms or Schedule C.
Is there a simple way to estimate tax savings? – There is when an owner’s preliminary household taxable income is less than $315,000. The simplified estimate is that the owner deducts 20% of the lesser of:
- Qualified Business Income (QBI, or pass-through income), or
- Preliminary household taxable income minus any capital gains.
Above $315,000 the calculation is more complex.
The rules for calculating the QBI deduction depend on whether the pass-through business is a Specified Service Trade or Business (SSTB). The calculation is also impacted by the preliminary household taxable income of the business owner. (“Preliminary” refers to income before the QBI deduction has been subtracted).
- What is an SSTB?
Any trade or business involving the performance of services in the fields of health (including doctors, nurses and dentists), law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of the owners or employees.
- What is not an SSTB?
Engineers and Architects are specifically excluded from being SSTBs. Personal trainers, health club (gym) owners, bankers, real estate brokers, and property managers are also specifically excluded. Performing services as an Employee (receiving a W-2 Form) cannot be an SSTB.
The Regulations prohibit former employees from reclassifying themselves as independent contractors so as to make themselves eligible for the QBI deduction. An employee who becomes an independent contractor but continues to provide substantially the same services for his former employer will be presumed to continue to be an employee for Sec. 199A purposes and will thus be not entitled to the deduction. IRS guidance prohibits renting, or providing services, to a commonly controlled SSTB, by ruling that this will cause the rental or service entity to be treated as an SSTB.
While it may not affect large numbers of business owners, qualified Real Estate Investment Trust (REIT) dividends and qualified Publicly Traded Partnership (PTP) income also qualify for the QBI deduction.
To enable business owners to make required calculations, pass-through businesses will be required to report on K-1s or other tax forms the amounts of QBI (pass-through income), W-2 wages, Unadjusted Basis immediately after Acquisition (UBIA) of qualified property owned, and other less common information a business owner might need to figure the deduction.
The QBI 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), the QBI deduction is permanent. It does not reverse and lead to tax later.
- Step-by-Step Calculation of QBI Deduction
Regardless of whether a business is an SSTB, when the owner’s preliminary household taxable income is less than $315,000, the owner deducts 20% of the lesser of:
- Qualified Business Income (QBI, or pass-through income), or
- Preliminary household taxable income minus capital gains.
When the owner’s preliminary household taxable income is more than $315,000, QBI deductions are larger for non-SSTBs than for SSTBs. Over $415,000 there is no QBI deduction for SSTB pass-through income, but there is still a potential limited deduction for non-SSTBs.
The attached AICPA flowchart walks through the calculation for each situation.
- Examples of Strategies to Consider with these Rules
Example 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.