Planning for the New Qualified Business Income (Pass-Through) Deduction
The new qualified business income deduction provision in the Tax Cuts and Jobs Act (TCJA) gives a 20% deduction for qualified business income. is It’s goal is to improve the benefits for flow-through entities and sole proprietors, who do not receive the major tax cuts that were given to C corporations.
Whether the rule meets the goal remains to be seen. Any strategies you consider should be given a good dose of caution, because there is still a lack of clarity and guidance into the definitions and how these deduction rules are to be applied.
In the meantime, you can review the basic rules and strategies and see how they may apply to you, and what questions you may want to explore further.
Basic Rules for the 20% Deduction for Qualified Business Income, or Also Section 199A Deduction:
- A qualified business is any business except those “specified service businesses” and the income earned an employee, from guaranteed payments or personal interest, dividends or capital gains.
- The specified service businesses can be in health, law, accounting, consulting, brokerage services, financial services, and others, but exclude architects and engineers.
- Available to sole proprietors and owners of pass-through entities such as S-Corps, LLCs, and partnerships.
- Subject to limitation based on the taxpayer’s income and the type of business.
- The deduction reduces your taxable income, but not your adjusted gross income and can be taken regardless of whether you itemize deductions.
- To get the full benefit of the deduction, and not be subject to further wage and capital limitations, taxable income must be no greater than $315,000 for married filing jointly (phases-out through $415,000); and $147,500 for single or married filing separately (phases out through $207,500).
- If the pass-through entity owner is over the dollar threshold and a specified service business, it does not get the deduction; but if it’s a qualified trade or business it does, although it is subject to wage and capital limitation.
- The deduction is the lesser of: 20% of the taxpayer’s qualified income, and a wage and capital limitation. The wage and capital limitation is the greater of: 50% of the W-2 wages; or 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property. In addition, there is 20% deduction of REIT dividends and distributions from publicly traded partnerships.
The W-2 Wage Limit
The W-2 wage limit minimizes the deduction if the business does not employ a substantial number of people relative to its size, or invest in a substantial amount of property under the “wage-and-property limit.” Specified service businesses that rely primarily on the efforts of their owners, or those with limited employee or capital investments will struggle to take advantage of the new qualified business income deduction.
In addition, there is an overall limitation on the deduction. The limitation is the lesser of: the combined qualified business income, and 20% of any excess taxable income minus the sum of any net capital gain plus any qualified cooperative dividends.
The total amount cannot exceed the taxpayer’s taxable income (minus the taxpayer’s net capital gain) for the tax year.
Here Are Some Strategies to Optimize the Availability of the Pass-through Deduction:
- If some portion of the qualifying business income comes from a “specified service business” could you consider spinning off portions of the business (separating the specified service business portion from the other qualified trade or business portion) in order to maximize the use of the pass-through deduction?
- Consider operating as a real estate investment trust (REIT), which do especially well. There is only one level of tax, and shareholders are entitled to a 20% qualified business income deduction for ordinary distributions with no W-2 basis limitation. However, REIT compliance and maintenance rules are onerous.
- Consider operating as a publicly traded partnership (PTP), which are not subject to the W-2 wage limit and qualified property cap.
- For S corporations, it may be beneficial to take advantage of reasonable compensation. For the new pass-through deduction rules, you would want the 50% of wages limitation to be higher.
- Consider rearranging an employer-employee relationship to one in which there is a partnership under an agreement in which the individual’s income from the partnership could be eligible for the deduction.
- Consider “multiplying” the $157,500 per person threshold by gifting business ownership interests to children or non-grantor trusts.
- For partners, consider switching from guaranteed payments, which don’t qualify, to preferred returns, which do.
- Consider increasing the W-2 limit by switching from 1099 independent contractors to W-2 employees. However, also consider that you may have to provide W-2 employees fringe benefits as well.
- Consider managing taxable income so it is below the phase-out thresholds in order to qualify for the deduction.
- Consider increasing a pension contribution to reduce taxable income. If the taxpayer is over the income limit, salary could be reduced and a mandatory pension contribution, such as a contribution to a cash balance plan, could be increased. No part of the pension contribution would be included in income, so the deduction could apply.
- Make tax-deductible qualified retirement plan contributions to reduce an individual’s taxable income in order to qualify for the deduction.