The Qualified Business Income Deduction (QBI deduction) entered the calculus of taxation for pass-through entities (including sole proprietorships) as a result of last year’s Tax Cuts and Jobs Act (TCJA). The TCJA allows individual taxpayers who are owners of pass-through entities to take a deduction of up to 20 percent of their qualified business income, effectively reducing their effective tax rate by up to 7.4 percent. Unfortunately, not all taxpayers are eligible for the full benefit. Individuals who work in certain service businesses are prohibited from receiving the full deduction once their incomes reach a certain level. However, these taxpayers may be in luck; they may be able to leverage a qualified retirement plan to obtain a deduction from a business that would otherwise be ineligible.
Summary of the Limitation
As we discussed in our introductory piece on the QBI deduction here, individuals who are owners of a specified service trade of business (SSTB) are generally ineligible for the benefit. If their taxable incomes exceed a certain threshold, their deduction will be limited, and once they reach an upper threshold, their deduction will disappear. For the 2018 tax year, the lower thresholds are $157,500 for single filers and $315,000 for married filers, and the upper thresholds are $207,500 and $415,000, respectively. For taxable income between the two thresholds, the benefit is phased in.
Under Section 199A, SSTBs are defined as a trade or business that performs services in one of the following fields:
- Health
- Law
- Accounting
- Actuarial science
- Performing arts
- Consulting
- Athletics
- Financial services
- Brokerage services
- Any business involving investing or investment management services, trading, or dealing in securities or partnership interests or commodities
- Any trade or business where the principal asset is the reputation or skill of one or more employees or owners
Recently, the IRS released a set of proposed regulations that confined the SSTB definition for the potentially expansive definition involving an employee’s or owner’s reputation or skill to include only certain situations where an individual is paid for his or her presence, image, voice or similar characteristics, for example:
- For endorsing the company’s products and services.
- For appearing at an event in person, online, on a podcast, etc.
- For the use of his or her personal attributes (e.g., name, voice, signature, or photo).
The definitions of SSTBs will require taxpayers above the income thresholds to consider carefully whether the nature of a trade or business qualifies for the QBI deduction, and as a result, whether planning opportunities are available to qualify all or party of the business.
How to Boost the Deduction – Two Options
Retirement plans offer unique planning opportunities in conjunction with the QBI deduction. There are two ways taxpayers can use retirement plans to their advantage, and both rely on the fact that retirement plan contributions are eligible business deductions.
A contribution to a retirement plan in an S corporation, for instance, will be reported on the S corporation’s tax return as shareholder-employee wages, or as a pension expense – both of which are eligible entity-level deductions. These deductions may lower a shareholders’ qualified business income below the threshold, making the remaining income eligible for the benefit. Let’s look at one example.
Option 1
The taxpayer owns a physician practice, is married, and has taxable income of $420,000. His S corporation salary is $300,000, and his remaining income from his physician practice is $150,000. He is ineligible for a QBI deduction because his taxable income exceeds the $415,000 threshold.
If the S corporation contributes $55,000 to an eligible retirement plan, the remaining income from the taxpayer’s physician practice will fall to $95,000 and his taxable income will fall to $365,000. He will then be eligible for a partial $9,500 QBI deduction (after application of the phase-in rules).
In this example, the retirement plan contribution lowered the individual’s taxable income enough to qualify him partially for the QBI deduction. However, it also lowered the business income upon which the deduction is calculated, thereby lowering his ultimate deduction. Luckily, there is a way around this.
Option 2
The taxpayer owns a physician practice, is married, and has taxable income of $420,000. His S corporation salary is $300,000, and his remaining business income from his physician practice is $150,000. If he decides to convert $55,000 of his $300,000 salary into retirement plan contributions, he will reduce his taxable income from $420,000 down to $365,000, and his remaining business income from his physician practice will remain unchanged at $150,000. He will be eligible for a partial $15,000 QBI deduction (after application of the phase-in limitation)
By converting his existing salary into retirement plan contributions, he was able to reduce his taxable income without touching the tax base off of which the deduction is calculated. For a $55,000 contribution to his retirement plan, he was able to reduce his overall taxable income by $70,000, resulting in maximum additional tax savings of over 10 percent of his $55,000 investment. In other words, by making his $55,000 contribution in the most tax-advantaged method, he not only saved $20,350 at a 37 percent maximum tax rate, but another $5,550 by creating a $15,000 qualified business income deduction. His net cost for contributing $55,000 to his retirement plan drops to only $29,100!
Consider Retirement Plans Carefully
Using a retirement plan as a mechanism for taking advantage of the pass-through entity deduction will require careful planning and an evaluation of a taxpayer’s unique circumstances. There are many qualifications and traps having nothing to do with tax that require the knowledge and experience of retirement plan professionals. For more information about the techniques we have discussed, or about the QBI deduction in general, please contact your local CBIZ MHM tax advisor.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).