The new Tax Cuts and Jobs Act effective for the 2018 tax year creates a significant tax benefit for pass-through entities including partnerships, limited liability companies (LLCs), S corporations, trusts, estates, and sole proprietorships. Eligibility for this deduction is subject to some income limitations; however, a retirement plan and/or other employee benefits plans can be a good tax planning tool to help mitigate the limitations.
Qualified Business Income (QBI)
If you are the owner of a one of these pass-through entities, you may be able to take advantage a deduction of up to 20% of QBI. QBI is defined as the net of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business. QBI does not include certain investment-related income.
QBI is calculated separately for each eligible business, such that the partner/owner’s respective share of income and expenses can be calculated for each business.
QBI Exclusions and Limitations
Wage and Guaranteed Payments Exclusion from QBI
Salaries to S corporation owners and guaranteed payments allocated to partners in a partnership or members of an LLC are excluded from QBI. In addition, the owner taxpayer must take wages that are considered the going rate for their position.
W-2 Wage and Capital Limitation on QBI
If the owner taxpayer’s taxable income is below a threshold of $157,500 or $315,000 if filing a joint return, then the 20% of QBI deduction can be taken unhindered. If the owner taxpayer’s taxable income is above this threshold, the QBI deductible amount is subject to a limitation based on W-2 wages and/or capital (the unadjusted basis of certain business assets in Sec. 199A(b)(2)(B)). In this instance, the deductible QBI amount for the business is equal to the lesser of:
- 20% of the business’s QBI, or
- the greater of:
- 50% of the W-2 wages for the business, or
- 25% of the W-2 wages plus 2.5% of the business’s unadjusted basis in all qualified property.
Specified Service Trade or Business Limitation
In addition to the wage and capital limitation, there is an additional limit based on specified service trades or businesses. Specified services defined under IRC Section 1202(e)(3)(A) include any trade or business involved the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees, any banking, insurance, financing, leasing, investing, or similar business, any farming business (including the business of raising or harvesting trees), any business involving the production or extraction of products of a character with respect to which a deduction is allowable under section 613 or 613A, and any business of operating a hotel, motel, restaurant, or similar business.
The specified service trade or business exclusion does not apply to the extent the taxpayer’s taxable income does not exceed certain thresholds: $207,500 or $415,000 for joint filers. Application of this exclusion is phased-in for income exceeding $157,500 and $315,000 for joint filers. In computing the QBI with respect to a specified service trade or business, the taxpayer takes into account only the applicable percentage of qualified items of income, gain, deduction, or loss, and of allocable W-2 Wages and qualified property.
How a Retirement Plan and Other Employee Benefits Can Help Maximize the QBI Deduction
Pretax deductions for a retirement plan or certain employee benefits can reduce the taxable income below exclusion thresholds.
In addition, W-2 Wages are also reduced. W-2 wages are the total taxable gross wages less any pretax deductions from an employee’s pay including employer-sponsored retirement plan contributions, such as 401(k) contributions, flexible spending accounts, dependent care, parking (if tax-exempt) and medical premiums.
For 2018, the contribution limit for employees for a 401(k) is $18,500 and participants who will be age 50 and older by the end of 2018, have an additional the catch-up contribution amount of $6,000. This limit does not include other contribution sources like employer matching contributions, non-elective deferrals, or allocations of forfeitures. Including all sources, the 2018 contribution limit for these plans is $55,000 plus the $6,000 catch-up contribution, for a possible overall maximum 2018 contribution of $61,000.
Of course, there are additional benefits to a retirement plan. Income grows tax deferred to retirement when presumably the owner taxpayer would be in a lower tax bracket. A retirement plan is part of total employee compensation and can help attract and retain talent.
AEPG® works with business owners and their CPA on tax planning issues. AEPG® can design a retirement plan that can balance all the benefits and restrictions to maximize the benefits to you. There are many nuances to the QBI deduction and the calculation can be complex. This article is not intended to cover all the nuances of the rule and we recommend checking with your CPA to perform a calculation prior to the end of the year to see if you may be eligible for the deduction and plan accordingly.
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