One of the major provisions of the Tax Cuts and Jobs Act (TCJA) was the addition of Internal Revenue Code (IRC) section 199A. It provides up to a 20% deduction for qualified business income (QBI) received by taxpayers from a pass-through entity. Pass-through entities include sole proprietorships, S corporations, partnerships or limited liability companies taxed as a partnership.
It’s important to note that this deduction may be limited for taxpayers who receive pass-through income from a specified service trade or business (SSTB), which includes performing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business in which the principal asset is the reputation or skill of one or more of its employees.
But let’s dive into the deduction and how it can benefit you:
When the QBI deduction phases out
First, we’ll talk about when the deduction phases out.
For single taxpayers, the deduction is phased out beginning at $160,700 of taxable income and is completely phased out at $210,700 of taxable income for 2019. For those taxpayers married and filing jointly, the deduction is phased out beginning at $321,400 of taxable income and is completely phased out at $421,400 of taxable income for 2019.
For most taxpayers whose pass-through income is not from an SSTB, the deduction is generally the lesser of: 1) 20% of QBI or 2) the greater of 50% of W-2 wages paid or the sum of 25% of W-2 wages paid plus 2.5% of the unadjusted basis in “qualified property.” This deduction is further limited to 20% of a taxpayer’s taxable income in excess of any net capital gain.
How retirement plans help leverage the deduction
Given the potential tax benefit for taxpayers whose income is from an SSTB, the goal is to reduce taxable income below the threshold for phase-out of the 20% QBI deduction.
When you take into account the new limitation on the deduction for state and local taxes under the TCJA, taxpayers (especially those in high-tax states) will need to look to other deduction sources to reduce their taxable income. Tax qualified retirement plans — both defined contribution (including 401(k) plans) and defined benefit plans (including cash balance plans) — represent a potential source of substantial tax deductions for taxpayers.
While retirement plans usually are most beneficial for owners of entities with less than 50 employees, all affected business owners should ask their advisors whether they can increase their contributions to retirement plans in a sufficiently cost-effective manner to help them to take advantage of the QBI deduction.
Defined contribution plans
A large percentage of SSTBs already sponsor either a simplified employee pension plan (SEP) or a 401(k) profit-sharing plan. The first step to reducing your taxable income is to ensure that you are making the maximum deductible contributions to your existing defined contribution plan (assuming you have one).
In the case of defined contribution plans, this translates to $56,000 for a SEP plan for 2019 and, for 401(k) profit sharing plans, a maximum deduction of $56,000 for taxpayers under age 50 and $62,000 for taxpayers 50 or older through any combination of employee contributions, employer matching contributions and employer profit-sharing contributions (aka non-elective contributions).
In the case of both a SEP and a 401(k) profit-sharing plan, the taxpayer will need to weigh the cost of additional contributions to employees compared to the tax savings from the 20% QBI deduction.
Defined benefit pension plans
Looking for substantial deductions?
Defined benefit pension plans, including cash balance plans, require annual contributions. The current maximum annual pension payable at retirement that may be funded for in 2019 is $225,000. In order to fund this maximum annual pension benefit, taxpayers in their late thirties and early forties may be able to contribute close to $100,000 annually, those in their fifties may have annual contributions up to $200,000, and those in their sixties may have annual contributions in excess of $300,000. Thus, the deductions can be large — and that is good news if you’re looking for substantial deductions to meet the threshold for the 20% QBI deduction.
The trade-off for the potentially large tax deductions is that defined benefit plans are complex, resulting in higher annual administration costs. They require annual actuarial calculations to determine the contributions required to be made to the defined benefit plan to fund the annual pension benefits and (if also maintained) the maximum contribution to the employer’s defined contribution plan, which may be reduced as a result of having a defined benefit plan.
Contributions to a defined benefit plan are required to be made each year under the minimum funding requirements of IRC section 412. So if the employer has a down year, they will still need to have the cash available to fund the defined benefit plan. Plus, non-highly compensated employees (generally those earning less than $125,000 in 2019) will need to receive a total contribution of about 7.5% of their compensation in either the defined benefit plan, the defined contribution plan or a combination of the two in order for the taxpayer to make the maximum contributions allowed.
Additionally, if the taxpayer’s business currently sponsors a SEP plan, it may not be able to also contribute to a defined benefit plan, depending on whether it is a model SEP or an individually designed SEP.
Finally, it’s important to note that the plan sponsor, not the plan participants, invests the assets held by the defined benefit plan. Thus, because the annual pension benefits are guaranteed, the plan sponsor bears the risk for the investment results of the plan trust.
Despite the complexity and costs, when properly designed by a competent actuary, a defined benefit plan alone or combined with a defined contribution plan can help high-income taxpayers in an SSTB reduce their income sufficiently to meet the threshold for the 20% QBI deduction.
Coming up in part 2: Planning strategies
All SSTB owners fall within one of three categories. Stay tuned for part 2, where we dive into what these three categories are and which strategy you can use, depending on which category you fall into.
In the meantime, consult with your tax advisor or retirement plan consultant on how you can best leverage the 20% QBI deduction.
Read part two here.