The Tax Cuts and Jobs Act of 2017 was the single biggest tax reform the US has seen in decades. There is so much in this legislation that it will take industry professionals a few years to fully digest it. Not to mention the IRS has yet to issue guidance on several issues that require clarification. This article is designed to give some guidance to owners of Pass-Through Service Businesses on how to benefit the most from the 20% Qualified Business Income Deduction (QBI).
What is a Service Business?
A service business typically provides intangible products by an expert or team of experts. Examples are Attorneys, Doctors, Accountants, Consultants, Insurance Agents, IT Professionals, Entertainers, Professional Athletes, and Financial Advisers. If you own a service business and want to understand how you can reduce your taxes this article is for you! If your business is not a service business there are a completely different set of rules for getting the QBI deduction that are outside the scope of this article.
What is a Pass-Through Business?
A Pass-Through Business does not pay income tax at the corporate level, but instead passes through taxation to the owners of the business. For purposes of this rule examples of Pass-Through businesses are partnerships, S-corps, Sole proprietors, or LLCs that are taxed as one of the previously mentioned business types.. The main business type that is not considered a Pass-through entity is C-corporations. Most C-corporations did receive a tax reduction from “The Tax Cuts and Jobs Act” through lowered corporate tax rates, so they were excluded from the QBI deduction.
How does the QBI deduction work for Pass-Through Service business owners?
If the owner of a Pass-Through Service business has a taxable income on his/her tax return of $157,500 or less for an individual or $315,000 or less for a married couple they are allowed to deduct 20% of their QBI. Individuals who have income between $157,500 and $207,500 ($315,000 and $415,000 for married) will receive only a portion of the deduction. If an individual or couple has income above these levels they do not qualify and therefore will not receive a QBI deduction.
Let’s look at a couple examples:
Example 1: Steve and Betty are married. Steve is a dentist, owns his own practice, and is the sole owner. His business is a LLC that is not taxed as a corporation. Let's assume that the only income they have for the year is the net profit from the business, which is $300k. Steve and Betty would only pay federal income tax on $240k because the $300k in earnings is considered QBI and they receive a 20% deduction on that income. At their top marginal tax bracket of 24% (for 2018) the QBI deduction would account for approximately $14,400 in federal income tax savings ($60,000*.24%).
Example 2: Nancy and Bob are married. Bob is a school teacher who earns around $60,000/year. Nancy is the sole owner of XYZ Insurance Agency Inc. XYZ is taxed as an S-corp. Nancy takes a salary of around $100,000 and receives profit from the business of $100,000 this year. Bob and Nancy’s salaries are not QBI so they would not qualify for the 20% deduction but the $100k of profit from the business would qualify. Their savings would be approximately 24% (their top marginal tax bracket) of 20% of the QBI (24% of $20k) or approximately $4,800.
Example 3: Joe is a Cardiologist who is not married. He is the sole owner of his company which is an LLC not taxed as a corporation. He makes around $450,000 per year from his business. Joe would not qualify for the QBI deduction because his income exceeds the $207,500 limit for an individual.
What are my options if my income is too high?
Simply put, “Reduce your income.” This may sound like an unattractive option but it does not have to be.
Spend some money: If you are a successful business owner you likely have had end of the year conversations with your accountant about purchasing equipment, supplies, etc to reduce your tax burden for that year. The same concept applies here. Spending money just to save on taxes does not make sense; however accelerating the purchase of necessary business equipment and supplies can make a great deal of economic sense. Not only do you reduce your tax consequences by reducing your income that reduction of income could also cause you to qualify for the QBI Deduction.
Defer Income through a Retirement Plan: This can be a really powerful option in the right situations. Most of us are aware of deferral of income through a 401k plan. In 2018 the max contribution to a 401k plan is $18,500 with an additional catch up amount of $6,000 if you are over 50 years old. If you are not maximizing these contributions and you are in or just above the phase out income level you will want to give it serious consideration.
If you want to take deferral to the next level you can implement a Profit Sharing Plan (PSP) in conjunction with 401k deferrals. The maximum combined amount you can put into a 401k and a PSP in 2018 is $55,000 with an additional $6,000 catch up amount if you are over 50. If that still isn’t quite enough you can also set up a cash balance pension plan. The maximum contribution varies depending on your age but in 2018 a 50 year old can have $148,000 contributed to this plan. This is in addition to the $61,000 that can be contributed to the 401k/PSP. You will want to review this option carefully with a professional as all of the above mentioned plans need to meet non-discrimination rules. Meaning you will have to include eligible employees in these plans which of course increases costs. Whether you have employees or not you may want to take a closer look.
Let’s say you are married and are the sole owner of a service business (LLC not taxed as a corporation) which is your family's sole source of income. In 2018 your taxable income is $415k. You could set up a cash balance pension plan and make a contribution of $100k. Not only would you avoid federal and state income tax and payroll taxes on the $100k you are now also below the income phase out for the QBI deduction. If you live in a state with high income tax it is possible for you to receive around $50,000 in tax savings for your $100k contribution!
What other options do I have?
Re-classify Income: If you own a service business that owns equipment or real estate you could start a separate entity that owns the equipment or real estate and lease it back to your service business. This would allow the income derived from the leasing business to not be considered service business income and therefore the taxable income thresholds ($315k-$415k for married) would not apply. (work with a CPA to find out if this is right for you)
Convert from an S-corp to a partnership or LLC: Since the salary that an S-corp pays the owner is not considered QBI it does not qualify for the deduction. Partnership income, outside of guaranteed payments, on the other hand is considered QBI. (work with a CPA to find out if this is right for you)
Revisit Married Filing Separately: When one spouse has QBI but the amount of income the other spouse brings into the household causes them to be over the income thresholds then filing separately could make sense. (work with a CPA to find out if this is right for you)
What to do next?
As your have probably realized already the QBI deduction has complicated taxes for a lot of business owners. Believe it or not the strategies listed in this article are only the beginning and certainly not a comprehensive list. There are another set of rules and strategies for non-service businesses. I would encourage you to have proactive conversations with your accountant and financial advisor before implementing any of the above mentioned strategies. They should be able to guide you towards the right path. Choosing the wrong strategy for your situation or poor execution of the strategy can be very costly. If you really like learning about these strategies and want to read more check out this article by Michael Kitces.
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This article is written by Brandon Carter.