The new 20% tax deduction for qualified business income (QBI) provides valuable tax savings for many pass-through business entities—except for those categorized as “service businesses” with income that exceeds certain threshold levels.
Service business owners who earn too much may miss out on the 20% QBI deduction entirely if they earn above the applicable thresholds.
Fortunately, planning strategies have already emerged to allow these business owners to reap the benefits of the new deduction. Using non-grantor trusts can help service business owners sidestep the income restrictions to potentially take full advantage of the QBI deduction—but because future IRS guidance on the application of new Section 199A is expected, business owners must, of course, exercise caution.
The QBI Deduction
The 2017 tax reform legislation now allows pass-through entities (including partnerships, S corporations and sole proprietorships) to deduct 20% of 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%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.
Many expect that the IRS will release additional guidance on what exactly constitutes a service business, but in the meantime, small business clients who may be categorized as such should be advised of potential planning strategies to consider in order to qualify for all or a part of the QBI deduction.
Non-Grantor Trust Strategy
In past years, clients have typically favored grantor trusts because they offer a greater degree of flexibility should circumstances change in the future. However, the tax reform legislation has added new tax appeal to the non-grantor trust. Using a non-grantor trust can now allow a small business owner to separate ownership of the business among the trust entities, allowing each trust/owner to receive up to $157,500 in income annually in order to qualify for the full QBI deduction.
In order to qualify as a non-grantor trust that can benefit from its own tax treatment, the trust must be structured so that distributions from the trust require the consent of an “adverse party,” which is a person with a substantial interest in the trust. This adverse party could be an adult child or other relative (using a spouse would cause the trust to be categorized as a grantor trust, although the spouse could be the trust beneficiary).
Currently existing grantor trusts can typically be converted into non-grantor trusts (even if the original grantor trust is irrevocable).
While this strategy could potentially prove valuable to small business clients in service industries, it is important to note that the IRS has not approved it, so a degree of risk does exist. Further, IRC Section 643(f) provides that multiple trusts created by the same client could be treated as a single trust (but no regulations to this effect have been issued, so until such regulations are released, the trusts should be treated as separate entities).
The client still must be aware that a non-grantor trust can be significantly less flexible than a grantor trust (making it more difficult to transfer or substitute assets), and that the new QBI deduction will technically expire after 2025 absent Congressional action to renew it for future years.
The 20% QBI deduction can generate substantial tax savings for pass-through business entities in 2018-2025—but small service business owners will often need to take fairly involved planning steps in order to fully take advantage of the new tax break.