The new 20 percent deduction for pass-through businesses created a powerful tax reduction tool for clients who operate as partnerships, S corporations or sole proprietorships. Unfortunately, not all business owners are treated equally under the new rules.
This means that higher income clients who own service businesses may need to engage strategies designed to reduce taxable income in order to reap the full benefit of the deduction. For some small business clients, simply maximizing contributions to traditional retirement accounts may be sufficient—but for higher income clients, a multifaceted income reduction strategy will likely be required in order to avoid leaving valuable tax savings on the table.
The New Pass-Through Regime
The 2017 tax reform legislation now allows pass-through entities (such as partnerships, S corporations and sole proprietorships) to deduct 20 percent of “qualified business income” (QBI) (in 2018-2025, unless Congress takes steps to extend the deduction). However, service businesses (including attorneys, accountants, doctors and financial advisors) are not entitled to the full benefit of the 20 percent deduction if the business owner’s taxable income exceeds certain threshold amounts.
The applicable threshold levels for 2018 are $315,500 (married filing jointly) or $157,500 (single filers), and the deduction is phased out for service business owners with income between the threshold levels plus $50,000 for individual filers or $100,000 for joint filers. This means that clients who own service businesses and have taxable income that exceeds $415,000 (married filing jointly) or $207,500 (single filers) will not receive the benefit of the new deduction.
For these taxpayers, taking steps to reduce taxable income in order to take advantage of the full 20 percent deduction can lead to significant tax savings.
Income Minimization Tools
The first (and likely most simple) step that small business clients can take to minimize taxable income is to ensure that they are maximizing contributions to retirement accounts. Small business owners can contribute up to $55,000 in 2018 to a 401(k) (including both the employer and employee portion of the contribution). If the client is age 50 or above, he or she can contribute an additional $6,000 in catch-up contributions to the account.