Now that the IRS has released its proposed regulations interpreting the new IRC Section 199A deduction for qualified business income (QBI) of certain pass-through entities, small-business clients should be advised to perform an end-of-year checkup focused on action steps that could potentially allow the client to maximize the value of the QBI deduction.
For many small-business clients, it’s not too late to take steps to minimize taxable income to qualify for the full deduction. Despite the fact that the proposed regulations eliminated several anticipated planning avenues, several potential strategies still remain to help small-business clients minimize taxes by maximizing the QBI deduction value for 2018—and some of these options can provide powerful long-term benefits that extend far past maximizing the QBI deduction.
QBI Deduction Basics
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). Despite this, “service businesses” (including attorneys, accountants, doctors, financial advisors and certain other service-related professionals) 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.
Maximizing the QBI Deduction Value; Planning for the Future
For small-business clients who may have put off saving for retirement, the Section 199A income limits now create a dual incentive for these clients to take steps to establish a retirement plan that accepts pre-tax contributions in order to reduce taxable income and take advantage of the new 20 percent QBI deduction in 2018—all while planning to ensure sufficient postretirement income.
A SEP IRA can allow a small-business owner to reduce taxable income by up to $55,000 (or 25 percent of compensation) in 2018 (the same limits that apply to 401(k)s also apply here). Because contributions are not required to be made to the account every year, a small-business client could establish the plan primarily to take advantage of the QBI deduction in 2018-2025, and simply stop contributing (or reduce contributions) if the deduction is allowed to expire after 2025.
SEP IRAs will likely appeal to business owners with no employees (or those who primarily employ a spouse or family members) because while contributions are not required each year, if the employer contributes any amount to a SEP IRA during any given year, contributions to the accounts of all employees who have performed services for the employer during that year become mandatory and contributions must be uniform among eligible employees (certain employees who are under 21, earn less than $600 during the year or have not worked for the employer for three of the five preceding years may be excluded from participation).
Any employer can establish a SEP IRA as long as that employer does not maintain any other retirement plan—there is no maximum number of employees, as is the case with SIMPLE IRAs. SEP IRAs are retirement savings accounts that only allow employer contributions (employee contributions are not permitted).
Small-business clients with a substantial number of employees may choose to establish a traditional 401(k), which does not require the employer to contribute to each employees’ account, and allows the employer to contribute up to the same $55,000 cap in 2018. The primary disadvantage of these plans is the expense of administering the plan and the nondiscrimination testing that may be required of the employer (safe harbor designs can reduce this burden in certain circumstances).
For business owners with higher income levels, SEP IRAs and 401(k)s may prove insufficient to help these clients reduce their taxable income to take advantage of the QBI deduction. These clients may wish to establish a defined benefit plan or cash balance plan, which can allow for much larger contributions to reduce higher income levels to below the applicable thresholds.
The end of the year is swiftly approaching, and it’s especially important to encourage small-business clients to perform a post-reform year-end tax checkup this year. The small-business retirement planning checkup can encourage clients to maximize the value of the Section 199A deduction while minimizing taxable income to take advantage of a myriad of other tax benefits.