Now that small business owners have the 20% deduction available for their pass-through income in 2018, as a business owner, you will need to begin to position your business to take full advantage of the new tax deduction. However, the Qualified Business Income (“QBI”) deduction has taxable income thresholds. Once the owner’s personal taxable income begins to exceed specific dollar amounts, the 20% deduction with either phase out or it will trigger an alternative calculation that could lower the deduction.
First: Understand The 20% Deduction
If you are not already familiar with how the new 20% deduction works, I encourage you to read our article:
If you are already familiar with how the Qualified Business Income deduction works, please continue reading.
The Taxable Income Thresholds
Regardless of whether you are considered a “services business” or “non-services business” under the new tax law, you will need to be aware of the following income thresholds:
These threshold amounts are based on the “total taxable income” listed on the tax return of the business owner. Not “AGI” and not just the pass-through income from the business. Total taxable income. For example, if I make $100,000 in net profit from my business and my wife makes $400,000 in W-2 income, our total taxable income on our married filing joint tax return is going to be way over the $315,000 threshold. So do we completely lose the 20% deduction on the $100,000 in pass-through income from the business? Maybe not!!
The Safe Zone
For many business owners, to maximize the new 20% deduction, they will do everything that they can to keep their total taxable income below the thresholds. This is what I call the “safe zone”. If you keep your total taxable income below these thresholds, you will be allowed to take your total qualified business income, multiply it by 20%, and you’re done. Once you get above these thresholds, the 20% deduction will either begin to phase out or it will trigger the alternative 50% of W-2 income calculation which may reduce the deduction. The phase out ranges are listed below:
Inidividuals: $157,500 to $207,500
Married: $315,000 to $415,000
As you get closer to the top of the range the deduction begins to completely phase out for “services businesses” and for “non-services business” the “lesser of 20% of QBI or 50% of wages paid to employees” is fully phased in.
What Reduces “Total Taxable Income”?
There are four main tools that business owners can use to reduce their total taxable income:
- Standard Deduction or Itemized Deductions
- Self-Employment Tax
- Retirement Plan Contributions
- Timing Expenses
Standard & Itemized Deductions
Since tax reform eliminated many of the popular tax deductions that business owners have traditionally used to reduce their taxable income, for the first time in 2018, a larger percentage of business owners will elect taking the standard deduction instead of itemizing. You do not need to itemize to capture the 20% deduction for your qualified business income. This will allow business owners to take the higher standard deduction and still capture the 20% deduction on their pass-through income. Whether you take the standard deduction or continue to itemize, those deductions will reduce your taxable income for purposes of the QBI income thresholds.
Example: You are a business owner, you are married, and your only source of income is $335,000 from your single member LLC. At first look, it would seem that your total income is above the $315,000 threshold and you are subject to the phase out calculation. However, if you elect the standard deduction for a married couple filing joint, that will reduce your $335,000 in gross income by the $24,000 standard deduction which brings your total taxable income down to $311,000. Landing you below the threshold and making you eligible for the full 20% deduction on your qualified business income.
The point of this exercise is for business owners to understand that if your gross income is close to the beginning of the phase out threshold, somewhere within the phase out range, or even above the phase out range, there may be some relief in the form of the standard deduction or your itemized deductions.
Depending on how your business is incorporated, you may be able to deduct half of the self-employment tax that you pay on your pass-through income. Sole proprietors, LLCs, and partnership would be eligible for this deduction. Owners of S-corps receive W2 wages to satisfy the reasonable compensation requirement and receive pass-through income that is not subject to self-employment tax. So this deduction is not available for S-corps.
The self-employment tax deduction is an “above the line” deduction which means that you do not need to itemize to capture the deduction. The deduction is listed on the first page of your 1040 and it reduces your AGI.
Example: You are a partner at a law firm, not married, the entity is taxed as a partnership, and your gross income is $200,000. Like the previous example, it looks like your income is way over the $157,500 threshold for a single tax filer. But you have yet to factor in your tax deductions. For simplicity, let’s assume you take the standard deduction:
Total Pass-Through Income: $200,000
Less Standard Deduction: ($12,000)
Less 50% Self-Employ Tax: ($15,000) $200,000 x 7.5% = $15,000
Total Taxable Income: $173,000
While you total taxable income did not get you below the $157,500 threshold, you are now only mid-way through the phase out range so you will capture a portion of the 20% deduction on your pass-through income.
Retirement Plans – “The Golden Goose”
Retirement plans will be the undisputed Golden Goose for purposes of reducing your taxable income for purposes of the qualified business income deduction. Take the example that we just went through with the attorney in the previous section. Now, let’s assume that same attorney maxes out their pre-tax employee deferrals in the company’s 401(k) plan. The limit in 2018 for employees under the age of 50 is $18,500.
Total Pass-Through Income: $200,000
Less Standard Deduction: ($12,000)
Less 50% Self-Employ Tax: ($15,000)
Pre-Tax 401(k) Contribution: ($18,500)
Total Taxable Income: $154,500
Jackpot!! That attorney has now reduced their taxable income below the $157,500 QBI threshold and they will be eligible to take the full 20% deduction against their pass-through income.
Retirement plan contributions are going to be looked at in a new light starting in 2018. Not only are you reducing your tax liability by shelter your income from taxation but now, under the new rules, you are simultaneously increasing your QBI deduction amount.
When tax reform was in the making there were rumors that Congress may drastically reduce the contribution limits to retirement plans. Thankfully this did not happen. Long live the goose!!
Start Planning Now
Knowing that this Golden Goose exists, business owners will need to ask themselves the following questions:
- How much should I plan on contributing to my retirement accounts this year?
- Is the company sponsoring the right type of retirement plan?
- Should we be making changes to the plan design of our 401(k) plan?
- How much will the employer contribution amount to the employees increase if we try to max out the pre-tax contributions for the owners?
Business owners are going to need to engage investment firms and TPA firms that specialize in employer sponsored retirement plan. Up until now, sponsoring a Simple IRA, SEP IRA, or 401(K), as a way to defer some income from taxation has worked but tax reform will require a deeper dive into your retirement plan. The golden question:
“Is the type of retirement plan that I’m currently sponsoring through my company the right plan that will allow me to maximize my tax deductions under the new tax laws taking into account contribution limits, admin fees, and employer contributions to the employees.”
If you are not familiar with all of the different retirement plans that are available for small businesses, please read our article “Comparing Different Types Of Employer Sponsored Plans”.
DB / DC Combo Plans Take Center Stage
While DB/DC Combo plans have been around for a number of years, you will start to hear more about them beginning in 2018. A DB/DC Combo plan is a combination of a Defined Benefit Plan (Pension Plan) and a Defined Contribution Plan (401k Plan). While pension plans are usually only associated with state and government employers or large companies, small companies are eligible to sponsor pension plans as well. Why is this important? These plans will allow small business owners that have total taxable income well over the QBI thresholds to still qualify for the 20% deduction.
While defined contribution plans limit an owner’s aggregate pre-tax contribution to $55,000 per year in 2018 ($61,000 for owners age 50+), DB/DC Combo plans allow business owners to make annual pre-tax contributions ranging from $60,000 – $300,000 per year. Yes, per year!!
Example: A married business owner makes $600,000 per year and has less than 5 full time employees. Depending on their age, that business owner may be able to implement a DB/DC Combo plan prior to December 31, 2018, make a pre-tax contribution to the plan of $300,000, and reduce their total taxable income below the $315,000 QBI threshold.
Key items to make these plans work:
- You need to have the cash to make the larger contributions each year
- These DB/DC plan needs to stay in existence for at least 3 years
- This plan design usually works for smaller employers (less than 10 employees)
Shelter Your Spouse’s W-2 Income
It’s not uncommon for a business owner to have a spouse that earns W-2 wages from employment outside of the family business. Remember, the QBI thresholds are based on total taxable income on the joint tax return. If you think you are going to be close to the phase out threshold, you may want to encourage your spouse to start putting as much as they possibly can pre-tax into their employer’s retirement plan. Unlike self-employment income, W-2 income is what it is. Whatever the number is on the W-2 form at the end of the year is what you have to report as income. By contrast, business owners can increase expenses in a given year, delay bonuses into the next tax year, and deploy other income/expense maneuvers to play with the amount of taxable income that they are showing for a given tax year.
One of the last tools that small business owners can use to reduce their taxable income is escalating expense. Now, it would be foolish for businesses to just start spending money for the sole purpose of reducing income. However, if you are a dental practice and you were planning on purchasing some new equipment in 2018 and purchasing a software system in 2019, depending on where your total taxable income falls, you may have a tax incentive to purchase both the equipment and the software system all in 2018. As you get toward the end of the tax year, it might be worth making that extra call to your accountant, before spending money on those big ticket items. The timing of those purchases could have big impact on your QBI deduction amount.
Disclosure: The information in this article is for educational purposes. For tax advice, please consult your tax advisor.
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.