Tax Magic: 199A & Retirement Plans for Business Owners
Tax reform enacted at the end of 2017 (aka the "TCJA") created a new tax deduction under Section 199A for qualified business income ("QBI"). The 199A deduction targets business owners who operate so-called pass-through entities (sole proprietorships, partnerships, limited liability companies, or S corporations), which pass income directly through to owners without paying a corporate level tax. This article explains the 199A deduction as applied to owners of specified service businesses and offers one method to otherwise qualify for the deduction.
Primer on 199A
The TCJA markedly lowered the tax rate of C corporations from 35% to 21% - permanently. By comparison, the marginal tax rate for individuals under the TCJA went from 39.6% to 37% - temporarily. In theory, 199A attempts to reconcile a tax rate discrepancy between C corporations and pass-through businesses through a deduction of up to 20% of qualifying business income. The 199A deduction is only temporary and will sunset at the end of 2025. Sounds great until 2026?
Perhaps. The complications of 199A are quite astounding for a law purportedly aimed at simplifying the tax code. Nevertheless, the potential benefit to obtaining the full 199A deduction is quantifiable and significant: the effective tax rate for QBI is only 29.6% for those eligible to claim the full 20% deduction. For example, if you are a single business owner, with $150,000 of QBI, then your deduction is $30,000.
Exclusion of Specified Service Trades or Businesses from 199A Deduction
Unfortunately, not all pass-through income is qualifying business income under 199A. More unfortunate is the fact that not all business owners are treated equally under the new law. The 199A deduction applies to income from a qualified trade or business. A qualified trade and business includes any and all trades or businesses except…. a "specified service trade or businesses" ( a "SSB"). Congress determined these types of businesses should not be similarly entitled to the 199A deduction. SSBs include: any business or trade involving the performance of services in health, accounting, law, consulting, athletics, financial services, etc. etc. Are business owners of SSBs out of luck?
Service Business Owner's Income & 199A
The prohibitions excluding service business owners from claiming a deduction under 199A are, in reality, limitations on the business owner's taxable income. Congress lets SSB owners claim the deduction to varying degrees so long as they do not make too much money.
Above certain income thresholds, $415,000 (joint filers) and $207,500 (single and other filers), the deduction is entirely excluded. Below certain thresholds, $315,000 (joint filers) and $157,500 (single and other filers), the deduction is entirely available. The SSB exclusion is phased-in for income levels between the those levels.
Retirement Plans & 199A
In that light, many owners of specified service trades and businesses stand to benefit if their taxable income falls below the aforementioned 199A thresholds whenever possible and practicable. Be reasonable. Do you want to forgo $1 million of SSB income just to claim the 199A deduction? Not a chance! However, tax planning can prove essential for those business owners that are only missing out on the deduction more narrowly (e.g. tens of thousands of dollars).
Two tools available to owners of specified service trades or businesses are the Solo 401(k) or SEP IRA. For all business owners, setting up a solo, aka individual, 401(k) or SEP IRA can provide an efficient means by which to reduce taxable income - while saving for retirement. For the SSB owner, these retirement vehicles can open the backdoor into a valuable 199A deduction.
Each plan certainly comes with various rules and restrictions. Suffice to say, a SEP IRA generally permits employer or self-employed contributions up to $55,000 in 2018. The solo 401(k) likewise permits combined employer and employee contributions up to $55,000. Depending upon your structure, employee or employer contributions will reduce your taxable income. Remember, we are talking business owners who are may be both the employer and employee and contribute accordingly. Feeling greedy?
Many SSB owners will want to know whether it is possible to have both types of retirement plans. Yes, but the limitations on contributions generally washes out to a combined $55,000. There is limited opportunity for greater retirement savings when combined with a separate employer's 401(k), i.e. another company and not your own. However, do note that individuals have their own contribution limits. This may prove useful for couples and closely held family businesses. A couple or family unit can potentially multiply their tax benefits through an appropriate ownership structure and savvy selection of retirement vehicles.
Ultimately, It is true that the TCJA disadvantages SSB owners to the point of outright denying them the pass-through 199A deduction at certain income thresholds. There are, however, ample opportunities to still maximize the available deduction through restructuring or even simply committing to a retirement savings plan. Pass-through owners of all trades should determine how to keep more of their income until this valuable deduction sunsets.
Just FYI Travis Scales is a tax attorney focused on efficient wealth accumulation and preservation strategies.