The Tax Cuts and Jobs Act (TCJA) offers a 20% tax deduction to owners of pass-through entities, such as sole proprietorships, S corporations, or partnerships, provided they meet certain conditions. Contributions to a qualified retirement plan can help entities qualify for the deduction under the new Internal Revenue Code Section 199A (Section 199A) that would otherwise be phased out or eliminated. The new Section 199A provides up to a 20% deduction for Qualified Business Income (QBI). QBI is essentially the entity’s profit after wages reflected on a Schedule C or Form K-1.
The deduction is subject to a phase-out for specified service businesses, such as “health, law, accounting, actuarial science, performing arts, consulting, athletics, financial, brokerage, or any business where the principal business is the reputation or skill of one or more of its employees.” Architecture and engineering have been removed from the list of eligible professions subject to the phase-out. The phase-out applies to taxable income between $157,500 – $207,500 for single taxpayers and $315,000 – $415,000 for married taxpayers filing jointly.
Since contributions to retirement plans are considered deferred compensation, they do not count as QBI. Business owners can, therefore, utilize a qualified retirement program, such as a profit sharing plan, to qualify for the tax deduction, while at the same time saving for their own retirement.
Example 1: Kathleen, a 40-year-old single consultant, owns an S corporation. She pays herself $225,000 in 2018 W-2 wages and has an additional $210,000 in QBI K-1 distributions. Without a retirement plan, she would pay income tax on the entire $210,000 pass-through amount and would not qualify for the 20% deduction because her QBI is above the phase-out limit. However, if she contributed $55,000 to a profit sharing plan, her QBI falls below the phase-out threshold to $155,000. She would receive a tax deduction for the contributions and qualify for the 20% Section 199A deduction for a total deduction of $86,000.
A defined benefit plan is another type of retirement vehicle that is limited by the amount accumulated at retirement, rather than on the amount of annual contributions. These plans can have an even more dramatic impact on the Section 199A deduction for older business owners who can generate enhanced deductions under such programs.
Example 2: Bob is a 55-year-old married attorney who operates as a sole proprietor. His 2018 net Schedule C income is $500,000, which has been his historical average. Without a plan, his income is beyond the joint filer phase-out. By adopting a defined benefit plan before the end of 2018, Bob can make a $190,000 tax deductible contribution to the plan, which would lower his QBI to $310,000. He would now qualify for the 20% Section 199A deduction, resulting in a total tax deduction of $252,000.
The rules for determining QBI and deductions are complex. We are awaiting further IRS guidance on the application of the rules and clarification of certain contradictory provisions in the new law. For taxpayers who might otherwise have limited or eliminated deductions, a retirement plan may offer an excellent solution.
For questions or more information, please contact Richard Green at firstname.lastname@example.org or 844.4WINDES.