Tax Cuts and Jobs Act (TCJA) was signed into law by President Trump in December 2017. While the TCJA affects almost every single individual taxpayer to some degree, the changes also significantly affect corporations and small businesses. In some areas, the impact was purposeful and directed. However, in other ways, the TCJA will have both positive and negative secondary effects. One such area that could see an unintended boost due to a new tax deduction for pass-through businesses is retirement plans with small business employers.
The TCJA added a significant deduction for millions of taxpayers who operate a pass-through business like a sole proprietorship, S corporation, or partnership. The new provision, under IRC 199A, provides up to a 20% deduction for Qualified Business Income. However, depending on the type of business, if it is a “Specified Service” business, as defined in Code § 1202(e)(3)(A). A specified service business includes:
any trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees [TCJA removed architecture & engineering ]
If you are in a specified service business, the deduction will start to phase out for single filers at $157,500 of taxable income and be completely gone after $207,500. For married-filing jointly, the deduction begins to phase out at $315,000 and is fully gone at $415,000.
For all other non-specified service pass through entities, the deduction does not phase out after $157,500 for individuals and $315,000 for married filing jointly. Instead, the deduction is limited to the 1) lesser of 20% of Qualified Business Income (QBI), or 2) the greater of 50% of W-2 wages or the sum of 25% of W-2 wages plus 2.5% of unadjusted basis in qualified property.
Taxpayers operating a specified service business who earn over the phase out ranges will lose the 20 percent deduction. As such, it will be helpful for them to bring their income down below the thresholds in order to qualify for the deduction.
One way to bring the income down is by setting up a tax-advantaged employer sponsored retirement plan, like a SEP, SIMPLE, 401(k), or a defined benefit plan. This allows business owners to defer compensation into the retirement plan, grow the savings, and bring down their income to qualify for the 199A deduction.
Here at Capital Advisory Group Inc., we specialize in tax strategies like defined benefit and cash balance plans for high income pass-through entities. Since so many deductions have been eliminated in 2018, our retirement plan strategies offer one of the few remaining large deductions for reducing the business owner’s Adjusted Gross Income (AGI) which can help them qualify for the 20 percent deduction and in many cases, move them into lower tax brackets. It is also important to note that a retirement plan could be valuable for a non-specified service business to help bring income back down below the ranges because the deduction can be limited above the ranges. These plans also work for individuals with side-incomes that might push their total income above the new thresholds.
For example, let’s say John is a single individual, who runs an S Corporation as a health care provider. Let’s say his qualified business income from that business is $225,000, which is all of his income for the year. As such, he is over the threshold amount and isn’t able to take the 20% deduction of the $225,000 of QBI. However, John could set up a 401(k), SEP, or profit sharing plan and defer $55,000 into the plan for his retirement, bringing his income down $55,000 (2018 contribution limit for under age 50 in 2018), under the threshold, and thereby allowing him to at least take part of the 20% QBI 199A deduction. Using this strategy, John is able to lower his tax liability and save for retirement.
While most small employers tend to lean towards SEPs, SIMPLEs, and 401(k)s, in some cases, a defined benefit plan might be even more beneficial. A defined benefit plan is not subject to the $55,000 annual contribution limit for 2018 for someone under age 50. Instead, a defined benefit plan could shelter $100,000 in the right situation for a small business owner. So if John, from our example above, instead made $265,000 a year, the 401(k) or SEP deduction wouldn’t be enough to get her the 20 percent deduction. But, if he set up a defined benefit plan, he could get a deduction large enough to bring his income down below the threshold and take the full 20% QBI deduction. This larger potential deduction with defined benefit plans will be able to help a lot of people save for retirement and maximize their tax deductions under the new tax law.
Tax-advantaged retirement plans have always been a valuable and efficient way to save for retirement. However, many small business owners have stayed away due to the perceived complexity and cost. Under the new tax laws, it could be more expensive to not have a retirement plan in place. As such, any small business owner with significant income should sit down with his or her tax strategy advisor to discuss the benefits of setting up a tax-advantaged retirement plan. Even if the plan is not required to help you qualify for the new 20% QBI 199A deduction, it can still be a great way to lower your taxable income, get tax-deferred investment growth, save for retirement, and protect assets from creditors.
The Tax Cuts and Jobs Act of 2017 represents the most significant changes in tax law in over 30 years! Don’t pay more in taxes than you’re required. Give us a call today at 636-394-5524 and let us help guide you through the complexities of these new rules.