By Dan Packard, CPA, CFE, CVA
Tim Anderson, CPA
Scott Nielson, CPA
Recent tax changes have dramatically impacted the opportunities available to small business owners. One of the largest opportunities now available is the pass-through deduction (Section 199A deduction), by which a taxpayer can deduct up to 20 percent of income from partnerships, s corporations, or sole proprietorships. The availability of the deduction is influenced by your industry, the nature of your income, the structure under which you operate your business, and whether you’ve adequately prepared before year end. Simply put, the deduction isn’t simple. However, your ability to understand the deduction and properly plan can result in substantial tax savings.
Effective for tax years beginning after December 31, 2017 and before January 1, 2026, a taxpayer is entitled to a deduction equal to 20% of the taxpayer’s “qualified business income” earned in a “qualified trade or business.” The deduction is limited, however, to the greater of:
- 50% of the W-2 wages with respect to the qualified trade or business, or
- The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.
The resulting deduction is then subject to a second limitation equal to 20% of the excess of:
- The taxable income for the year, over
- The sum of net capital gains
The purpose of this overall limitation is to ensure that the 20% deduction is not taken against income that is taxed at preferential rates.
“Qualified Business Income” is the net amount of qualified items of income, gain, deduction, and loss with respect to a qualified trade or business that are effectively connected with the conduct of a business in the United States. However, some types of income, including certain investment-related income, reasonable compensation paid to the taxpayer for services to the trade or business, and guaranteed payments, are excluded from qualified business income.
“Qualified trades and businesses” include all trades and businesses EXCEPT the trade or business of performing services as an employee and “specified service” trades or businesses: those involving the performance of services in law, accounting, financial services, and several other enumerated fields, or where the business’s principal asset is the reputation or skill of one or more owners or employees.
The W-2 wage limitation does not apply to taxpayers with taxable income of less than $157,500 for the year ($315,000 for married filing jointly) and is phased in for taxpayers with taxable income above those thresholds. Income from specified service businesses is not excluded from qualified business income for taxpayers with taxable income under the same threshold amounts. Consequently, taxpayers, regardless of the industry wherein they operate, can achieve the pass-through deduction if taxable income is $315,000 or less.
Maximizing the Pass-through Deduction
Given that the pass-through deduction is primarily designed to benefit qualified trades or businesses and those with taxable income less than $315,000 (MFJ), taxpayers should engage early in tax planning to ensure they maximize the benefit. Below are several ideas you should consider and discuss with your CPA during tax planning:
- Retirement Plan Contributions: Increasing retirement plan contributions, especially for the business owner, is a great idea irrespective of the pass-through deduction. Safe harbor 401(k) profit-sharing plans can provide significant benefits to a business owner and their spouses, and also allow staff to contribute to the 401(k) plan at a relatively low cost to the business. Furthermore, the business owner can adopt a defined benefit or cash balance plan that can provide for extreme contributions for the owner, subject to some limitations. Implementation of a pre-tax retirement plan will reduce your taxable income and help you achieve the income thresholds that yield the largest pass-through deduction.
- Employment of Your Children in your Business: Paying your children the highest reasonable amount for the services they render will further reduce taxable income. Thanks to the increased standard deduction, each child can now earn up to $12,000 annually that is free of federal income tax.
- Be Cautious with Capital Gains and Investment Income: Interest, dividends, and capital gains all serve to increase taxable income. Consequently, it is wise to review investment portfolios to ensure capital gains are not needlessly being recognized as assets are moved. Furthermore, when selling real property, 1031 exchanges should be considered whenever possible to defer gains and reduce taxable income. As a reminder, Section 1031 allows a taxpayer who owns real property held for investment or used in a business to exchange property and defer paying taxes if the taxpayer acquires a like-kind replacement property to be held for investment or used in a business. This allows taxpayers to potentially use all of the proceeds from the sale of the relinquished property to leverage into more valuable property, increase cash flow, diversify into other properties, expand business operations, reduce management or consolidate into one larger replacement property. When considering replacement properties, be sure to consider Opportunities Zones and the tax benefits associated with investment in these types of properties.
- Charitable Contributions: Charitable contributions present a highly effective way to reduce taxable income. Charitable contributions can take many different forms: cash contributions to qualified 501(c)3 organizations, non-cash contributions of household items, and contribution of highly appreciated property, such as stock, art, or real property. Taxpayers can specifically take a charitable deduction for qualified conservation contributions, which are contributions of a qualified real property interest to a qualified organization exclusively for conservation purposes. A qualified real property interest for this purpose can be the taxpayer’s entire interest in the property, a remainder interest or an easement that restricts the use of the property in perpetuity. Conservation purposes include (1) preserving land for outdoor recreational use by, or education of, the general public; (2) protecting relatively natural habitats of fish, wildlife or plants; (3) preserving open space (including farmland or forest space) for scenic enjoyment of the general public or under a governmental conservation policy yielding significant public benefit; and (4) preserving a historically important land area or a certified historic structure. This type of donation can be facilitated in many different ways.
- A Dilemma: Real Estate and Business Management Entities: Administrative and management companies provide billing, collection, human resource, and other ancillary services. Intrinsically, administrative and management companies are qualified trades or businesses. Business owners that do not generate qualified business income have been incentivized to establish these types of entities to create intercompany service agreements and generate qualified business income. These separate management companies are commonly owned by the business order, the business owner’s spouse, or the business owner’s children. If your business is utilizing an administrative or management company, the services provided should equate to the fees that are paid. Minutes should be prepared annually to document the services that were performed. Before adding an administrative or management company to your business structure, be aware of the published guidance from the Treasury Department. The Treasury regulations include an anti-abuse rule designed to prevent taxpayers from separating out parts of what otherwise would be integrated with the non-qualified trade or business, such as administrative functions, in an attempt to qualify those separated parts for the pass-through deduction.
If a business owner owns business real estate in a separate entity, he or she may be inclined to increase the rent paid from a non-qualifying business activity to the rental entity to create qualified business income. Unfortunately, if the real estate entity leases only one property (the business real estate), there is authority that the real estate entity isn’t a qualified trade or business. Additionally, paying too high a rent risks having it recharacterized if rent exceeds the fair market value of facilities in the geographic area. In an effort to combat this, the real estate entity may consider hiring maintenance and janitorial staff and require the operating entity to reimburse for those costs.
The new tax bill has created many questions that have yet to be answered. Consequently, it is difficult to know which strategies will provide the most meaningful benefit moving forward. Strategizing with CPAs at Cooper Norman can help you find the best route forward. We encourage you to start tax planning as soon as possible.