Let Your Retirement Plan Help You Get the Most Out of Your Qualified Business Income Deduction by Ilene Ferenczy
The Qualified Business Income Deduction enacted as part of The Tax Cut and Jobs Act (TCJA) was one of the many tax rule changes for 2018. This change, which permits many owners of unincorporated business and S-corporations to deduct up to 20% of their business earnings, should provide good news at tax time. Business owners with taxable income in the $200,000-$500,000 range may find that their retirement plan is of indispensable assistance in qualifying for this new deduction.
The 20% Qualified Business Income (QBI) Deduction applies to income from business operations from a sole proprietorship, partnership, LLC, LLP, or S-corporation. It does not apply to employee earnings shown on a Form W-2, S-corporation distributions are shown on a Schedule K-1 or guaranteed payments to a partner.
The QBI Deduction is subject to limitations at certain income levels. If you are married filing jointly, and your taxable income exceeds $415,000 ($207,500 for other filers), the QBI Deduction is decreased significantly or, if you are engaged in certain types of business, eliminated entirely. The businesses subject to the elimination of the QBI Deduction at higher income levels (called “specified service trades or businesses” or SSTBs) are generally professionals — those engaged in health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services. (Note that the proposed regulations to these rules broadly define several of these categories. For example, “accounting” includes bookkeepers and other people engaged in accounting-related services, not just CPAs.)
If your taxable income is below $315,000 ($157,500 for filers other than married filing jointly), even if you are an SSTB, the 20% QBI Deduction is fully available. Between those two income levels, there is a phase-out, which applies more harshly to SSTBs than to other businesses.
Business income and taxable income are both decreased for business owners by the amount contributed to the retirement plan. Therefore, making a company contribution to a retirement plan can not only provide the deduction associated with that contribution but also preserve the QBI Deduction.
For example, suppose that Dr. Jones, a sole proprietor anesthesiologist with no employees, has QBI and taxable income of $425,000. Without further action, Dr. Jones is not eligible for the 20% QBI Deduction, because his income exceeds $415,000 and he is in the medical profession, which is an SSTB.
However, Dr. Jones may contribute up to $55,000 ($61,000 if over age 50) to a 401(k) plan on his own behalf. When that deduction is subtracted from his taxable income, the taxable income is reduced to $370,000, which is in the “phase-out” range for the QBI Deduction. The net result is that he gets the $55,000 retirement plan deduction PLUS a QBI deduction of $33,300.
The result is even better if Dr. Jones adopts a cash balance plan. Assuming Dr. Jones is age 49, he could contribute for himself approximately $135,000 to a cash balance plan in addition to the $55,000 to the 401(k) plan. Those contributions reduce his taxable income to $235,000 so that he now qualifies for a QBI Deduction of $47,000.
It is a good idea for business owners to use retirement plans to help their employees save for retirement. It is a better idea to use them to enable the owners to save on a tax-favored basis for their own retirement. But, the value of the retirement plan becomes even better when it helps the owner preserve an otherwise unavailable QBI Deduction.
The Qualified Business Income Deduction is available for 2018 and later years. Therefore, you should get together with your retirement plan advisor soon to make sure that you are set up for a proper tax result before the end of the year.
Ilene Ferenczy is the Managing Partner of Ferenczy Benefits Law Center, an employee benefits law firm in Atlanta, Georgia. She advises clients on all types of employee benefit plans, particularly focusing her practice on qualified retirement plans, benefits issues in mergers and acquisitions, and advising third-party administrators of employee benefit programs on technical and practice issues. See full Bio here.
