Are you confused by the IRS’s Section 199A deduction? It can actually be quite beneficial— up to a point. Read on as we dissect the language of the code and provide suggestions for planning.
The Internal Revenue Code Section 199A deduction for qualified business income is one of the most generous parts of the 2017 Tax Cuts and Jobs Act. It is also one of the most complex, which can complicate strategies for contributions to retirement plans.
The Section 199A deduction allows taxpayers to deduct up to 20% of their qualified business income (QBI). QBI is business income that:
1. comes from a qualified domestic trade or business, and
2. is passed through to the taxpayer from a sole proprietorship, partnership, S corporation, or LLC.
Once taxable income exceeds a threshold amount, however, the taxpayer must begin excluding service business income from QBI. There are 13 types of service businesses, including health, law, accounting, consulting, and some investment and trading activities – basically, a laundry list of professional (and generally financially successful) businesses.
The threshold amounts for 2019 are:
1. $160,700 for single filers and heads of households,
2. $160,725 for married taxpayers filing separate returns, and
3. $321,400 for joint filers.
When taxable income exceeds the applicable threshold amount, service business income begins to phase out as QBI. Once taxable income exceeds the threshold amount by $50,000 (or $100,000 for joint filers), the phase-out is complete, and service business income is completely excluded from QBI.
Section 199A affects retirement planning because a self-employed (i.e., owner of a pass-through entity) worker’s deductible retirement plan contributions reduce both taxable income and QBI. This is because the contributions are a business expense that is attributable to QBI in proportion to the taxpayer’s gross income from the qualified business.
For lower-income taxpayers, the fact that retirement plan contributions reduce QBI means that the taxpayer effectively loses 20% of the tax deduction for the contribution. For higher-income taxpayers, however, once taxable income exceeds the threshold amount, deductible retirement plan contributions that reduce both taxable income and QBI can make a lot of sense. The 20% reduction in the contribution deduction may be useful if the contribution brings taxable income back below the threshold amount or the phase-out ceiling.
While a qualified retirement plan should only be implemented if it makes sense absent the tax advantages, the Section 199A planning outlined above can make it more attractive given the right set of facts. For a professional service business with a small number of older, higher-earning owners, this can supercharge the benefits of adopting a cash balance defined benefit plan in addition to or in conjunction with a traditional 401k.