It’s time to call your clients. The IRS has finally released an explanation of the tax rules for claiming the 20% deduction for qualified business income. These are the proposed regulations for the 199A deduction (named for a section of the tax code) that was included in the Tax Cuts and Jobs Act.
The new rules are largely directed at closing loopholes for higher earners who seek the deduction by separating entities and income, a strategy some are referring to as “crack and pack” schemes.
Here’s what advisors need to know:
The deduction is 20% of qualifying business income, but not every business qualifies. That would be too easy. It is geared toward small business owners with pass-through income (partnerships, S Corporations and LLCs) or sole proprietorships (those who file Schedule C). The rules were added to the tax law to create more fairness compared to the regular corporations whose tax rates were dramatically slashed from 35% to 21%.
Keep in mind that this provision, like many others from the new tax law, is set to expire after 2025 unless renewed by Congress. This point alone, along with possible future changes to these rules, should be a warning for advisors not to make knee-jerk permanent changes based on what may be temporary tax benefits. For example, advising a client to change a business entity should be done because it’s good long-term planning for the client.
Every business owner, including a financial advisor, qualifies if their taxable income does not exceed $315,000 (for married, filing jointly) or $157,500 (for a single filer). If taxable income exceeds these amounts, the deduction phases out based on these ranges: $315,000 to $415,000 (married, filing jointly), and $157,500 to $207,500 (single).
After these limits, then certain businesses will qualify and others won’t. Real estate professionals make out well, for instance, as do architects and engineers. But not financial advisors, accountants, doctors or lawyers.
Once income exceeds these limits, complex rules apply to see who qualifies based on skill and reputation rules, as well as wage and capital investment tests. The rules are meant to thwart attempts by wage earners to turn themselves into qualifying businesses in order to claim the deduction.
Other things to know: The deduction is a “below-the-line” deduction. That means it does not reduce adjusted gross income. The deduction will not reduce taxes on Social Security or Medicare surcharges. The deduction can be taken even if the taxpayer does not itemize, which will be many more taxpayers this year due to the increased standard deduction available. For those who can still itemize, the deduction can be taken in addition to itemized deductions. And it is a deduction from business income only. It does not reduce income for self-employment tax.
Advice financial planners can offer now:
These rules are effective retroactive to the beginning of 2018, so there’s not that much time or ability to gain a full benefit for this year, unless plans were put in place earlier in the year or the business already qualified.
Identify your clients who might benefit from these rules and see how you might help them qualify.
Focus on clients who may be close to the phase-out thresholds and see how you might help them keep other income lower this year by taking losses or deferring income.
Look at the timing of Roth conversions. Remember that under the new tax rules, Roth conversions are permanent. They cannot be undone. Roth conversion income can push clients who might otherwise qualify for the deduction over the limit. But again, planning has to be with a long-term view.
A Roth conversion now (even if it means losing out on the 20% deduction for the year of the conversion) may benefit clients in future years by having future sources of tax-free retirement income and avoiding taxable required minimum distributions. This may be worth losing out on the 20% deduction for the year of the Roth conversion.
Older business owners subject to required minimum distributions on their IRAs (after age 70½) can benefit from using qualified charitable distributions to help qualify for the 20% deduction, if they might be close to the income threshold. RMDs could otherwise push them over the limit.
Increasing tax deductible retirement contributions can lower income and help clients qualify for the deduction, for example with a solo 401(k).
Bunching heavy medical or charitable deductions (with donor advised funds) could allow a client to itemize deductions and reduce taxable income to gain the 20% business income deduction.
To help keep investment income lower for future years, consider gifting using the newly expanded gift tax exemptions ($11,180,000 per person). But again this has to be for all the right reasons, not limited to only qualifying for the 20% deduction.
Financial advisors can get involved quickly and make a difference. Start contacting your clients.
To read more valuable tax insights from Ed Slott, please click here.