8600 / What steps can a pass-through entity take to maximize the value of the 20 percent qualified business income deduction created by tax reform?

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). 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. 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.

The first (and likely most simple) step that small business owners can take to minimize taxable income is to ensure that they are maximizing contributions to retirement accounts. Small business owners can contribute up to $70,000 in 2025 to a 401(k) (including both the employer and employee portion of the contribution). If the individual is age 50 or above, he or she can contribute an additional $7,500 in catch-up contributions to the account.

For business owners who need to reduce taxable income by a more substantial amount, a cash balance plan may be a more viable solution. A cash balance plan is essentially a cross between a traditional defined benefit pension plan and a defined contribution plan (e.g., a 401(k)). Generally, employers will contribute a set portion of a participant’s salary to the plan each year (a “pay credit”; usually equal to between 5 and 8 percent annually), and the participant’s account will also be credited with an interest credit each year. Cash balance plans are technically defined benefit plans, so the annual $70,000 total contribution limit for 401(k) plans (in 2025) does not apply. Instead, the contribution limit for cash balance plans is based on the amount that a participant may receive at retirement (in 2024, a 55-year old could be able to contribute as much as $275,000 to a cash balance plan). An actuary can be used to calculate backward from the benefit amount in order to determine each individual participant’s contribution level.

The business owner is permitted to operate both a 401(k) plan and a cash balance plan at the same time, so that very high income taxpayers can maximize contributions to both types of account. The cash balance plan contribution will lower the taxable income of the business as a whole (rather than at the individual owner’s level, so that the benefit is split among the business owners). However, the business owner will be required to contribute to the accounts of non-highly compensated employees, as well, on an annual basis (meaning that the business owner should ensure that the business has sufficient profits to sustain the cash balance plan over a period of time).

In addition to retirement account planning strategies, small business owners who are charitably inclined should note that the 50 percent AGI limitation on cash contributions to public charities and certain private foundations increased to 60 percent for 2018-2025 (the AGI limit on contributions of capital gains property (such as securities) remained at 30 percent). For 2020 and 2021, the AGI limit was removed entirely under the CARES Act and CAA 2021. This change increases the amount of the contribution that the taxpayer will be able to deduct in order to further reduce taxable income.