It’s not too late for many small-business owners to minimize taxable income for the 2018 calendar year in order to qualify for the full (20%) QBI or Qualified Business Income deduction. Several potential strategies remain to help you minimize taxes by maximizing the deduction for 2018. Some of these options can provide long-term financial benefits that extend far past maximizing the QBI deduction.
With the IRS releasing its proposed regulations interpreting the new IRC Section 199A deduction for Qualified Business Income (QBI) of certain pass-through entities. Small-business owners should perform an end-of-year checkup with their Financial Advisor or Tax Professional.
What is the QBI Deduction and do I qualify?
The 2017 tax reform legislation now allows pass-through entities (such as partnerships, S corporations and sole proprietorship's) to deduct 20 percent of “qualified business income” (QBI) from 2018-2025. Despite this, “service businesses” (including attorneys, accountants, doctors, and certain other service-related professionals) are not entitled to the full benefit of the 20 percent deduction if the business owner’s taxable income exceeds $315,500 (married filing jointly) or $157,500 (single filers) in 2018. The deduction is phased out for service business owners with income between the threshold levels plus $50,000 for individual filers or $100,000 for joint filers. This means that clients who own service businesses and have taxable income that exceeds $415,000 (married filing jointly) or $207,500 (single filers) will not receive the benefit of the new deduction.
Maximizing The 20% Deduction by Establishing a Retirement Plan
For small-business owners who may have put off saving for retirement, the Section 199A income limits now creates a dual incentive to establish a retirement plan that accepts pre-tax contributions in order to reduce taxable income and take advantage of the 20 percent QBI deduction in 2018.
A Self Employed (SEP) IRA can allow a small-business owner to reduce taxable income by up to $55,000 (or 25 percent of compensation) in 2018 and $56,000 in 2019 (the same limits that apply to 401(k)s also apply here). Because contributions are not required to be made to the account every year, a small-business client could establish the plan primarily to take advantage of the QBI deduction in 2018-2025, and simply stop contributing (or reduce contributions) if the deduction expires after 2025.
SEP IRAs will likely appeal to business owners with no employees (or those who primarily employ a spouse or family members). While contributions are not required each year, if the employer contributes any amount to a SEP IRA during any given year, contributions to the accounts of all employees who have performed services for the employer during that year become mandatory. The contributions must be uniform among eligible employees (certain employees who are under 21, earn less than $600 during the year, or have not worked for the employer for three of the five preceding years may be excluded from participation).
Business Owners with a substantial number of employees may choose to establish a traditional 401(k), which does not require the employer to contribute to each employees’ account and allows the employer to contribute up to the same $55,000 cap in 2018 and $56,000 in 2019. The primary disadvantage of these plans is the expense of administering the plan and the nondiscrimination testing that may be required of the employer (safe harbor designs can reduce this burden in certain circumstances). More information about small business retirement plan’s
For business owners with higher income levels, SEP IRAs and 401(k)s may prove insufficient to help these clients reduce their taxable income to take advantage of the QBI deduction. These clients may wish to establish a defined benefit plan or cash balance plan, which can allow for much larger contributions to reduce higher income levels to below the applicable thresholds.
Guidance is needed
Most U.S. companies and Small Businesses are pass-through firms, structured as S-Corps, Limited Liability Companies, partnerships, or sole proprietorship's. For these companies, the tax deduction effectively lowers the maximum tax rate to 29.6% from 37%. Many businesses are seeking additional detail from the Internal Revenue Service about what types of businesses are defined as specified services businesses. It is important for business owners to work with a qualified tax or legal professional to understand the impact of the income restrictions and if they could benefit from these planning strategies around the deduction.
Next Steps if you’re a Small Business Owner
The end of the year is swiftly approaching, and it’s especially important for business owners to schedule a year-end review with a tax checkup. The small-business retirement planning checkup can show you possible ways to maximize the value of the Section 199A deduction while minimizing taxable income. If you would like to schedule a call or meeting please contact us at 207-761-4733 and by email at [email protected]