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Strategies for Business Owners to Maximize your New 20% Pass-Through Deduction
This is part two of a two-part series on the new IRC Section 199A deduction (also known as the pass-through deduction) for business owners. For part one, How Business Owners Can Qualify for the New 20% Tax Deduction, click here.
As discussed in part one of our series, the new IRC Section 199A deduction (also known as the pass-through deduction) will allow some businesses to be taxed on only 80% of their income. Understanding what the pass-through deduction is and how to qualify for it, your next step is to take possible action to maximize your tax-savings. Here are three possible strategies that might provide the biggest tax break for your business.
#1 Lower Your Taxable Income with Retirement Plans
Many physicians, attorneys and other high-earners in the “specified-service” business will lose their pass-through deduction due to the $207K/$415K income limits. The good news is that increasing contributions to a retirement plan can help business owners who don’t qualify for the 20% deduction to become re-eligible. This is especially effective when layering a cash balance plan that allows for far higher contributions than the $19,000 limit on top of a traditional 401(k).
Because retirement plan contributions reduce your taxable income, additional plan contributions can help you fall below the $315,000 phase-out limit, thus making you eligible for the 20% pass-through deduction. This means that plan contributions not only reduce your tax dollar for dollar, but also can trigger an additional 20% deduction on your income.
The example below shows a business owner earning $200K in salary and an additional $300K profits before and after making a $185k contribution to a cash balance 401(k) plan. Without the retirement plan contribution, the owner makes too much and is not eligible for the deduction. Because the pass-through deduction is triggered in scenario #2, a $185,000 contribution creates a $208,000 reduction in taxable income.
#2 Adjust Your Salary or Partnership Payments
The salary you pay yourself as an owner of an S Corporation is not considered business income and therefore not eligible for the QBI deduction. Same goes for guaranteed payments from a partnership. So, if you are eligible for the 20% deduction, the after-tax value of income paid to you via QBI profit distributions will be greater than that paid via salary or guaranteed payments, because with profits the deduction gets applied.
Overall, paying yourself less in salary or making a simple “revision” of a partnership agreement to adjust guaranteed payments can increase the amount of your 20% deduction. Of course, in the case of an S Corporation, make sure that you are paying yourself a “reasonable” salary as to steer clear of any issues with the IRS.
If you are in a non-service business, it may make sense to actually pay yourself more (see #3 below). So much for simplifying the tax code.
#3 Revisit Your Business Entity
While the Section 199A pass-through deduction is available to all businesses operating as S Corporations, Partnerships, LLC entities, and sole proprietors, your personal ability to maximize the benefit may be closely related to which entity you use.
Recall that if you are in a non-service business with a high-income, your 20% deduction is limited by the wages you’re paying yourself (or others). This is an example where having the right business entity can create new tax savings.
Consider a sole-proprietor with a retail business earning above the $415K income limit (remember it’s $415K on the family tax return, not just this business). Because this is not a specified service business, you could still qualify for the 20% deduction despite earning above the income limitation. However, you are limited by how many wages are paid (see the 50% wage rule described in part one of this series). With no wages as a sole proprietor, 50% of $0 = $0, and the deduction is eliminated. By converting into an S corporation and paying yourself a reasonable salary, the 20% deduction is now allowed, possibly providing significant tax savings above and beyond any costs of restructuring.
Given that we are dealing with the IRS, there’s also a scenario where the opposite action could be advised, demonstrating both the complexity of the new tax law and the fact that planning around Section 199A needs to be a highly personalized strategy.
A change from a S Corporation to a Partnership or LLC could result in a lower tax bill for a business owner in some circumstances. This is because, as stated above, the salary you pay yourself as an owner of an S Corporation is not considered business income and therefore not eligible for the QBI deduction. Taking all income as profits via a LLC or Partnership and none as salary could maximize your tax savings, as long as there is no need to navigate any wage limitation tests (i.e., if you earn under the high-income limit, this could be an option to explore). Changing the nature of your payment will also affect your FICA and self-employment taxes, so you should certainly seek the guidance of your tax-professional.
We Can Help
The new IRC Section 199A pass-through deduction can provide business owners with large tax breaks and tremendous planning opportunities. However, it is highly complicated and demands a personalized strategy. If you would like to discuss any options that are specific to your situation, you can reach us at Windgate Wealth Management by calling (844) 377-4963 or emailing firstname.lastname@example.org. You can also book an appointment online here.