Are You Maximizing the new 20% Qualified Business Income Deduction?
In addition, the deduction cannot exceed 20% of your taxable income above net capital gains.
The Tax Cuts and Jobs Act, the most sweeping federal tax law change in 30 years, has brought with it a myriad of provisions significantly impacting the business community. Many of these provisions, which have an effective date of January 1, 2018, can impact a firm’s economic situation but perhaps none more materially than the Section 199A deduction for qualified business income (QBI).
The Section 199A deduction, which represents a deduction equal to 20% of QBI, should provide a substantial tax benefit to many individuals with “qualified business income” from pass-through entities including sole proprietorships, LLCs, partnerships or S-corporation. This deduction is a below-the-line deduction based on 20% of an individual’s qualified business income.
An individual’s qualified business income does not include income related to business conducted outside of the U.S., wages from an S-corporation, guaranteed payments received from a partnership or most capital gains or losses, dividends or interest income. In addition, the deduction cannot exceed 20% of your taxable income above net capital gains.
In addition, there are certain thresholds established by section 199A which defer certain taxpayers from attempting to reclassify earnings from personal services to income eligible for the deduction.
Threshold #1: Specified Service Trade or Business Threshold
The first threshold relates to pass-through entities with “Specified Service Trade or Business Income”. Households will begin to experience a phase out of the 20% deduction when their individual taxable income exceeds $157,000 (or $315,000 for joint filers). The 20% deduction will be fully phased out at $207,500 and $415,000. Specified service trades or businesses are trades or businesses involving the performance of services in the fields of health, law, consulting, athletics, financial or brokerage services, or where the principal asset is the reputation or skill of one or more employees or owners.
Threshold #2: Wages and Capital Threshold
If a taxpayer’s taxable income exceeds the thresholds mentioned above, a limitation is imposed on the amount of the deduction based on either on wages paid or wages paid plus a capital component. In this situation, the deduction for QBI cannot exceed the greater of (1) 50% of your allocable share of the W-2 wages paid with respect to the qualified trade or business, or (2) the sum of 25% of such wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of tangible depreciable property used in the business (including real estate). For taxable incomes that are between the threshold amounts and the $207,500/$415,000 amounts, a phase-in of the limitation applies.
This deduction has been embraced by the business community, however, this excitement has been balanced with much uncertainty due to the lack of issued regulations and the seemingly endless complexity associated with these provisions.
On August 8, 2014 the Internal Revenue Service issued 184 pages of proposed regulations which taxpayers may rely on the rules in these proposed regulations until final regulations are published in the Federal Register. These regulations solidify countless planning opportunities for small business owners to consider when navigating these complex provisions. The remainder of the article will outline a few of these more impactful planning considerations.
“Top 10” Section 199A Tax Planning Opportunities
The opportunities within this code section are endless and are dependent upon each individual’s facts and circumstances. However, we have outlined our “top 10” tax planning strategies designed to maximize the value of the Section 199A deduction. These strategies are designed to either lower your taxable income and avoid the 199A phaseouts or recharacterize your income into the Qualified Business Income bucket eligible for the deduction.
Avoid Taxable Income Phase-Outs
- Filing Status – married couples should consider filing separately in certain circumstances where the combined income of the couples exceeds the phaseout threshold of $415,000. In certain cases, there may be opportunities to realize some of the 20% deduction if one member of the couple has income below $157,000 and has QBI.
- Retirement Plan Deductions – in periods where a taxpayer exceeds the QBI threshold, it may be beneficial to maximize contributions to an individual’s retirement plan in order to receive a “double deduction”. The retirement plan deduction has historically been a powerful way to reduce taxable income, however, this deduction (and all other deductions) are more impactful when the deduction brings a taxpayer below the QBI threshold phase-out thus triggering the additional 20% QBI deduction.
- Use of Trusts – trusts are eligible to receive the QBI deduction thanks to the language in the code that allows all “non-corporate” entities to participate in the deduction. This provides a tax planning opportunity for an individual that has taxable income that has exceeded the QBI threshold and therefore cannot fully take advantage of the QBI deduction. Essentially, a taxpayer may consider transferring ownership interests in a business with QBI in order to “spread” the income over multiple entities all subject to the same individual threshold allowing the entities individually realize the benefit of the deduction.
- Optimize Portfolio Income – in order to optimize “taxable income” and avoid the QBI phase-out rules, individuals should consider the appropriate use of portfolio income in years where individuals might be on the bubble of crossing over the QBI threshold. Careful consideration should be given to asset basis, loss harvesting opportunities, the use of qualified, non-qualified and non-taxable (Roth) assets.
- Optimize Depreciation Deduction – the use of bonus depreciation, which was extended as part of the Tax Cuts and Jobs Act, has been a significant lever pulled by many business owners to minimize taxable income and pull cash forward. This allows the business owner to tax a deduction now as opposed to over the tax life of the asset. While this provides cash in the pockets today, it will reduce taxable income and in certain cases reduce the maximum benefit of the QBI deduction. In this new era, the pros and cons of bonus deprecation should be considered on a case by case basis.
- Choice of Entity – because the Section 199A deduction is applicable to all entities, other than C-corporations, closely held C-corporation shareholders should compare the benefits of both the C-corporation and the pass-through entity in order to understand the most optimal choice of entity. This analysis can be complex and includes the consideration of multiple assumptions and factors. For further discussion on choice of entity, see “Avoid Leaving Value on the Table: Choice of Entity Post-Tax Reform”.
- Employee versus Contractor – because wages are not eligible for the 199A deduction, employees may consider changing altering their relationship with their employer to be classified as a contractor rather than as an employee. This would allow employees to take advantage of the 199A deduction and write-off certain business expenses that otherwise may not have been eligible. This reclassification will avail the contractor to self-employment taxes that otherwise would have been paid for by the employer, therefore, the employee would ideally negotiate a contract that would take these facts into consideration.
- Partnership Agreements – Because guaranteed payments are determined without regard to the income of the partnership, proposed regulations under 199A provide that such payments are not considered attributable to a trade or business, and thus do not constitute QBI. Therefore, a review of the partnership agreement in order to determine if the guaranteed payment levels are appropriate. Any reduction in guaranteed payments would provide for a greater opportunity to take advantage of the 199A deduction.
- Leasing Entities – for a specified service business that exceeds the taxable income threshold and is thus not eligible for the 199A deduction, it could be beneficial to set-up asset leasing entities which would have the ability lease certain assets and employees to the specified service business therefore shifting income to the leasing companies who could take advantage of the 199A deduction.
- Real Estate Investments – one of the benefits of the Tax Cuts and Jobs Act for real estate investors is that real estate investment activity that qualifies as a trade or business will qualify for the 20% 199A deduction. However, this deduction is subject to the phase-out limitations discussed above. However, Section 199A also provides for a 20% deduction on qualified Real Estate Investment Trust (“REIT”) dividends and this deduction is not limited by the phase-out limitations described above. This distinction, should be considered by real estate investors when comparing real estate investment options.
How Can We Help
The changes born from the Tax Cuts and Jobs Act provides individuals a once in a lifetime opportunity to take advantage of these unique tax savings opportunities. At Midcoast, our team of expert advisors can assist you with the development and implementation of a game plan to maximize your savings and take advantage of these considerable tax incentives.