Retirement plans always have been an excellent vehicle for creating current tax deductions for businesses. For a business that passes through income to its owners, the business’s retirement plan often is designed to reduce each owner’s personal taxable income by a share of the retirement plan’s contributions.
The Tax Cuts and Jobs Act of 2017 (TCJA) added Section 199A to the federal tax code, which provides for a new personal tax deduction for business owners. Based in part on an owner’s personal taxable income and on the amount of Qualified Business Income (QBI) passed through to the owner, the percentage of the new QBI Deduction available to the business owner goes down as the owner’s personal taxable income goes up.
The bottom line for the vast majority of business owners who are sole proprietors, partners in a partnership, shareholders on an S Corporation or members of a Limited Liability Company (LLC), is that retirement plan contributions can lower the owner’s personal taxable income. This, in turn, can increase the owner’s personal QBI Deduction, which then further reduces the owner’s overall tax bill.
Owners often can exercise some discretion in deciding the size of a business’s retirement plan contributions, including changing the retirement plan design to optimize tax benefits. Retirement plans are highly regulated and owners must take care to be certain the plans comply with all of the rules.
As the end of the 2018 draws near, most retirement plan options remain available as a valuable tool to help owners take advantage of this deduction. Some options will no longer be available for 2018 after December 31, 2018, although they are worthy of consideration for tax planning for 2019 and future years.
Businesses that are eligible for the QBI Deduction are referred to as Relevant Passthrough Entities (RPEs). Note that C Corporation shareholders are not eligible for the QBI Deduction.
Calculating the QBI Deduction
An owner needs to know his or her filing status, taxable income, net capital gains and the amount of QBI that is passed through from each RPE to the owner.
Note that each RPE is responsible for reporting to the owner the owner’s share of QBI. Also note that all QBI Deductions are subject to a limit of 20 percent of the excess of the owner’s taxable income over net capital gains. Generally, an owner with a filing status of married and filing jointly and with taxable income below the threshold of $315,000 will have a QBI Deduction of 20 percent of the owner’s combined QBI. An owner with any other filing status and with taxable income of $157,500 or less also will get the deduction.
When taxable income for an owner is above the threshold amount for calculating the QBI Deduction, the owner needs to know whether the RPE is a Specified Service Trade or Business (SSTB). Note that each RPE is responsible for determining and reporting to each owner whether the RPE is an SSTB or not. The proposed regulations for Section 199A, released August 8, 2018, devote 28 pages to describing how to make this determination.
As examples, businesses in health, law, accounting and financial services, and individuals who are athletes, musicians and consultants likely are SSTBs. The SSTB status determines in part the formula used to calculate the QBI Deduction on taxable income that is above the threshold amount. The calculation of the QBI Deduction reduces the basic 20 percent of QBI amount and adds a deduction that considers W‑2 wages paid to employees and considers basis in certain qualified properties (known as Unadjusted Basis Immediately After Acquisition or UBIA).
Formulas for Owners
The phasing in and out of the formulas for owners with a filing status of married filing jointly occurs over a range of the next $100,000 in personal taxable income up to the end of the range at $415,000. For owners with other filing statuses, the range is the next $50,000 up to the end of the range at $207,500.
Generally, an SSTB is not favored in the calculation of the QBI Deduction, and the QBI Deduction is zero for an owner of an SSTB with taxable income above the end of the range. An SSTB owner could benefit by increasing his or her deductions to lower taxable income below the end of range. A retirement plan contribution may be the best means to achieve this reduction. The effectiveness of this strategy needs to be evaluated for all owners, both collectively and individually. It is up to the owners to decide if or how personal taxation factors into their determination of owner income.
As mentioned, retirement plans covering owners can be designed to optimize plan benefits and taxation for owners based on compensation maximized at the annual retirement plan limit of $275,000 (for 2018). The $275,000 compensation limit is well below the end of the range of $415,000 for filers who are married and filing jointly and well above the end of the range of $207,500 for all other filers, so owners who file as married filing jointly are more likely than other filers to benefit from the QBI Deduction.
As an example of the impact of these ranges, consider two owners of an RPE that is an SSTB. One owner files as married filing jointly and the other owner does not. Both owners earn $275,000. If all other income and deductions on their respective tax returns are identical, the owner who is married filing jointly could enjoy a sizable QBI Deduction of 20 percent of QBI, while the other owner will have no QBI Deduction.
Keep in mind that the QBI Deduction is subject to an overall limit of 20 percent of the excess amount of the taxpayer’s taxable income over the net capital gain of the taxpayer. Aggressively reducing an owner’s taxable income could suppress the amount of the QBI Deduction that is otherwise available.
In part 2 of this article we’ll look at what kind of reporting requirements RPE’s have as well as some timing considerations.
|A. Paul Protos is president and cofounder of ATR Inc., a third-party administration and benefits consulting firm that provides services related to Forms 5500, plan documents, summary plan descriptions, recordkeeping services, and compliance/operational reviews. Protos has more than 40 years of benefits consulting and administration experience. He has achieved the enrolled retirement plan agent (ERPA) designation. Protos is the contributing editor of the Pension Plan Fix-It Handbook.|