The new Qualified Business Income deduction (QBID) aka "Internal Revenue Code Section 199A" deduction, proved to be a significant help to pass-through entities for the tax year 2018. With one year of the tax overhaul or "Tax Cuts and Jobs Act of 2017" under our belts, we now have a more concise understanding of these changes and have been able to uncover potential tax-saving opportunities. For those of you who are business owners operating as a sole-proprietorship or "pass-through" entity (most entities other than a C-corporation), here are some pro-tips to consider:
To recap my previous article, here is a summary of eligibility for the QBID:
You must be a "pass-through" entity such as a partnership, S-corp, LLC treated like an S-corp, or sole-proprietorship.
A "Specified Service Trade or Business" (SSTB) is not a qualified business and the deduction can be reduced or even eliminated in this case. Unfortunately, this includes many professional services. The IRS lists what they consider an SSTB and what is not, although some are still up for interpretation. That being said, there are exceptions to this rule.
The deduction is generally 20% of the lesser of the qualified businesses adjusted net income, OR adjusted personal taxable income. You must take out any investment interest, qualified dividends, and capital gains as you cannot take the deduction on these. Remember that if you pay yourself W-2 wages those are an expense to the business and are a part of calculating the net income.
Pro Tip #1: Consider implementing a retirement plan
You can allow yourself to qualify for the full deduction, or simply maximize the amount of deduction you get with a retirement plan in place such as a 401(k) or SEP IRA. Any contributions or deferrals into a pre-tax business retirement plan will bring down the net income which may make you fully eligible or reduce your phase-out reduction. However in some situations, a pre-tax contribution can actually reduce the amount of your potential 20% deduction, which is not preferential; In that case a Roth 401(k) contribution can be of great use!
Grab your most recent tax return!
-If you are an SSTB and all your income is business income, and you are over the $321,400 (MFJ) beginning threshold; Thereby reducing or eliminating the potential deduction, you can make a pre-tax contribution to your 401(k) or SEP IRA. This can reduce your business income and potentially qualify you for the full deduction! This is because a contribution can put you closer to or below the $ 321,400 (MFJ), and at that point the fact that you have an SSTB doesn’t matter and you will be treated as having QBI!
-If you are a Sole-Proprietor/Partner making $350,000 as an SSTB (your only income source), you’ll realize that because that is your only income, it also ends up being your personal taxable income (without any deduction adjustments). In this case if you contribute $50,000 to a pre-tax retirement account, you bring your business and taxable income down to $300,000. Therefore, there is now a full (not phased) 199A deduction available of $60,000! Or .20 x $300,000. Not only that but you get a $50,000 deduction for the retirement contribution as well!
-Now let's assume you and your spouse file MFJ and your household adjusted personal taxable income is $200,000. You own and operate an S-corporation with net income of $181,000, after deducting your own W-2 compensation of $65,000 and a $19,000 contribution to your pre-tax 401(k) plan account (for simplicity assume no interest income, capital gains, or qualified dividends).
In this case your S-corporation’s adjusted net income is $181,000 (QBI). The deduction therefore would be 20% of the lesser of $200,000 (adjusted personal income), or $181,000 (QBI) which would have been $36,200 (.20 x $181,000). In this case, making the pre-tax retirement contribution of $19,000 actually reduced your 199A deduction by $3,800 (.20 x $19,000)!
Let's change the fact pattern and instead you simply contributed $19,000 to a Roth 401(k) account (an after-tax contribution). If you contributed to a Roth account instead, your QBI would be $200,000 instead of $181,000. This would have allowed you to take a deduction of $40,000 (.20 x $200,000) opposed to $36,200! Quick caveat, SEP IRAs do not provide for Roth accounts.
A potential hiccup to this strategy is the fact that your business must have a retirement plan that works best for your specific needs (as the owner) and the needs of your employees (if any). The type of plan that is best for your specific business may not be a plan that allows for designated Roth accounts. It is best to consult with your tax and financial advisors to see what type of plan your business should have, and if this strategy would make sense for you.
Pro Tip #2: Reduce the tax implications of your Roth conversions
Remember that the Qualified Business Income deduction is allowed only on the lower of the two figures (personal taxable income vs. net income of the qualified business or QBI). Therefore, if your personal taxable income is the lower figure, you could consider increasing your taxable income via a Roth conversion.
When converting pre-tax retirement dollars to a Roth (after-tax dollars), the amount converted is included in ordinary income. This will increase your personal taxable income (the goal if your personal taxable income is lower than your QBI), thus increasing your deduction! The end result is that you can save tax-dollars on your conversion. Note that it may not completely offset, due to the taxes associated with conversion.
Let's assume your personal taxable income (married filing joint) is $185,000 and your qualified business income is $225,000. Your deduction would be 20% of $185,000 which is $37,000. You determine that a Roth conversion is right for you and convert $25,000 from a pre-tax account like a 401(k) or IRA. This brings your personal income of $185,000 up to $210,000.
In this example your personal taxable income is still lower than that of your business but it is larger than before. Your deduction is now $42,000 vs. the previous $37,000. This additional $5,000 deduction can help offset the taxes owed on the extra $25,000 in income.
This should not be the sole reason for utilizing a Roth conversion. There are many factors that come into play when deciding whether to use that strategy or not. For more tips and insight on Roth conversion strategies refer to my article on retirement tax strategies. Please consult your tax and financial advisors to see if a Roth conversion makes sense for you.
Pro Tip #3: You may still be eligible for the 20% QBID, even if you are an SSTB
If unfortunately your business is considered an ineligible "Specified Service Trade or Business" or SSTB, you may still be able to get the deduction if your personal taxable income is lower than your business' net income. In this case your personal taxable income will be subject to phase-out limits that may reduce or eliminate your potential deduction. The phase-out ranges vary by filing status. Here are the phase-out ranges for married filing joint (and have an SSTB) on personal taxable income, and how they affect the deduction:
- Up to $321,400 | The deduction is the lesser of adjusted personal taxable income or net "Qualified Business Income".
- From $321,400 to $421,400 | The deduction will be prorated.
- Over $421,400 | The deduction is not available. The SSTB owner is "too successful".
Remember that the above phase-out ranges can be changed with tools like retirement plans. Please consult your tax advisor to help you determine whether or not you are eligible for the deduction, as this is a brief summary.
The Bottom Line
These are just some of the planning strategies to consider when it comes specifically to the "Qualified Business Income Deduction" or QBID. Not all of the details and nuances of the deduction were discussed here. Please also note that some of these strategies should not be implemented based solely on the deduction. There are many other factors that should be taken into consideration.
Cameron Valadez is a CFP® Practitioner.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, and CFP® in the U.S., which it awards to individuals who successfully complete CFP Board's initial and ongoing certification requirements.
Waddell & Reed and its representatives do not provide tax advice. This is meant for educational purposes only. It should not be considered advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a tax advisor and other financial professionals regarding your personal situation prior to making any financial related decisions. 05/19