The Tax Cuts and Jobs Act (TCJA) gives business owners new ways to save significantly on federal income taxes, but there are obstacles to getting the full benefits. Here's a primer on tactics to get around some of the barriers.
TCJA permits business owners to deduct 20% of the income passed to them through an S-Corp, LLC, sole proprietorship, and other business forms — excluding C-Corporations.
Section 199A of the tax code makes it harder to qualify for the 20% deduction for businesses that perform services, such as healthcare, law, accounting or consulting. For them, the deduction was phased out above $157,500 for an individual filer and $315,000 for a married couple in 2018, and that will be adjusted for inflation in 2019 (to $160,700 for a single, $321,400 for a couple). The deduction was entirely eliminated for a single-filer on taxable income of more than $207,500 in 2018 and for married taxpayers with more than $415,000 (rising to $210,700 and $421,400 for 2019). Earning more than that means you can't take any 199A deduction whatsoever.
How can service-business owners avoid such impediments? By whittling income down below the thresholds.
As an example, let's take Lisa, a dentist, whose profession is definitely in the service business. Her husband contributes no income, as he is retired. She receives $400,000 in pass-through income from her practice, the profit after she meets all her overhead. Beyond her pass-through income, she pays herself a salary of $150,000. So, her taxable income ($550,000, adding the pass-through and the salary money) exceeds the $410,000 ceiling — with the result that she is not eligible for the 20% deduction.
But Lisa can make moves to lower her reported income. First, she can start her own defined contribution plan for herself and her employees — a receptionist, hygienist, and bookkeeper. That usually means establishing a 401(k) retirement plan in her business qualified under the tax code and it would involve research, services and liability to a business owner as well as added costs.
Since Lisa is 55, she can contribute a maximum $25,000 yearly to the plan — the standard $19,000 maximum contribution, plus a $6,000 additional contribution permitted those over-50 to encourage them to catch-up on retirement savings, and that would reduce her taxable income to $525,000.
Lisa also can open a defined benefit plan for herself and employees. This is a traditional type of pension plan qualified under the tax code to allow participants and their beneficiaries an annual payment for life based on their earnings and life expectancy. In Lisa's case, she can contribute up to $150,000 annually to a defined benefit plan, as that is the average of her past three years' salary. That shaves her taxable income to $375,000, and she now is below the $415,000 ceiling.
Should she wish to pare it further, perhaps to below $315,500 to nab the full 20% pass-through tax deduction, Lisa has additional options: She could make charitable donations or invest in oil and gas ventures that may allow deductions on intangible costs of drilling a well.
For business owners, this is a complex area of tax and financial planning and requires expert advice. Please contact our office with any questions about this specialized advice.