As you’re probably aware, we’re working with some new tax laws as of January 1st, 2018. The tax change that will have the most impact for many business owners out there – particularly owners of pass-through businesses – lies in section 199a.
Section 199a specifies that qualified business income is eligible for a 20% across the board deduction on the owners’ personal tax returns. 20%! This is a big deduction, and falls in line with all the political rhetoric about making the country a more business friendly environment.
Unfortunately, not every business owner will be able to claim it. One of the more controversial aspects of section 199a is that the deduction phases out at certain levels of taxable income, if your business is considered a “specialized service business” (SSTB). In 2019, this phaseout range is $315,000 to $415,000 of taxable income for married people filing jointly, and $157,500 to $207,500 for everyone else.
What exactly is a specialized service business, you ask? It’s one whose principle asset is the skills or experience of one or more professionals. This includes medicine, law, accounting, financial services, athletics, and several others.
With the introduction of section 199a & the QBI deduction, there are a number of tax planning opportunities for business owners. Qualifying for the deduction and maximizing its benefit could easily have a significant impact on business owner’s total tax liabilities. This post will explore three different types of tax planning strategies owners of specialized service businesses may consider to maximize the benefit of the 199a deduction.
Income Reduction Strategies
The first, most logical way to maximize the QBI deduction is to find ways to reduce your taxable income. The lower you are in the phaseout range, the greater portion of the deduction you’ll qualify for. Note here that the phase out isn’t based on your adjusted gross income or modified adjusted gross income (which is common for most other phaseouts, like IRA/Roth IRA contributions). The QBI deduction phases out based on your taxable income, which is after you take itemized or standard deductions. Here are a couple ideas to consider.
Qualified Retirement Plan Contributions
Establishing & funding a qualified retirement plan is usually the low hanging fruit for owners of specialized service businesses. The best plan structure and form for your situation will depend on a number of factors, of course. And if you have employees, chances are you’ll need to make contributions on their behalf as well.
The usual suspects here are SEP-IRAs & solo 401(k) plans for those without employees, and 401(k) & profit sharing plans for those with employees. You can also tack on a cash balance plan or defined benefit plan if you want to be aggressive (and are comfortable with mandatory contributions each year). In either case, every dollar you contribute to a qualified retirement plan, both as an employee deferral or employer contribution, will be deductible. And, of course, every dollar you deduct gets you one dollar closer to the beginning of the phaseout range.
Hire Your Kids
A second method to reduce your taxable income would be to shift some it to your kids. By “shift”, I mean paying your kids to do bona fide work in your business, rather than paying yourself. Doing so has a couple different benefits:
- Their wages won’t show up in your taxable income. Compensation paid to employees is deductible!
- Their wages may not show up in theirs, either. Dependents that you claim on your tax return don’t even need to file a return of their own if their earned income is less than the standard deduction ($12,000). If your kids make less than that amount, not only could it help you qualify for more of the 20% QBI deduction – it could potentially come into the family entirely tax free.
- It’s earned income. This is important, as it allows for your kids to make contributions to a Roth or traditional IRA. Better yet, they don’t even need to be the one making the contribution. The fact that they have earned income means that you could fund the account for them, which could be extremely beneficial long term.
Hiring your kids should not be done frivolously. This is a hot topic for the IRS under audit, so you’ll need to make sure that your kids are doing actual work, and that they’re being compensated appropriately. If they’re cleaning your office a couple times a month it’ll be hard to justify paying them $50 an hour. Make sure they’re being paid appropriately for the tasks they’re completing and for their experience level.
You’ll also want to make sure there’s a job description in place and that you’re taking all the typical workplace compliance steps. Give them an offer letter. Track their hours. Conduct performance reviews. And save everything, in case you’re challenged on it in the future.
Bunch Your Deductions
Between business expenses and personal itemized & above the line deductions, most business owners have a good number of deductions that show up on various parts of their tax returns. Another way to reduce taxable income is to think long term, and bunch deductions together in certain years.
Consider this: you’re a charitable family that makes a significant gift on an annual basis. You also take a deduction every year for random equipment purchases, and are planning a big office renovation in a year or two.
If your taxable income is anywhere near the top of the QBI phaseout range, it’s very possible you’d hover there consistently, every single year. You could see the QBI deduction, but it’d be just out of reach because your taxable income was too high.
By bunching your deductions together in the same year, you may be able to break through that threshold in one year, making yourself eligible for the QBI deduction. You may not be able to claim the deduction every year, but one year is certainly better than nothing.
Income “Swapping” Strategies
The second type of strategy revolves around income “swapping”. Jeff Levine calls this income “alchemy” in his description on the Nerd’s Eye View. (Which is an excellent post that you should definitely read). The idea here is that you may be able to segregate parts of your business that would not be considered a specialized service business as standalone entities. The tax community has affectionately named this the “crack and pack” strategy.
The “Crack & Pack”
Here’s a quick example. Let’s say a physician’s office with one owner produces $1,000,000 in business profits. With medicine clearly being classified as a specialized service business, $1,000,000 of profits would prevent the owner from claiming any portion of the QBI deduction.
But let’s also say that the owner of the practice purchased the building in which the business resides a few years ago. The business owns the building, pays the mortgage & maintenance expenses, claims depreciation, and rents out the available space.
Being in the medical field, none of the business’s profits will be eligible for the QBI deduction if the owner’s income is above the phaseout thresholds. With the crack & pack strategy, the owner would essentially spin off the building into a separate entity. Rather than having one specialized service business, the owner would have two businesses: a medical practice (SSTB) and a property management company (not a SSTB). The property management company then leases the space back to the medical practice at fair market value, which is a deduction for the medical practice.
This could also be accomplished with employees. Rather than have the medical practice hire the employees directly, the owner could set up a staffing agency. They’d then lease the employees from the staffing agency, producing non-specialized service business income for the owner.
Limitations to “Crack & Pack”
In the final regulations, the IRS decided that the “crack” & “pack”, at least as described above, was too large of a loophole. To limit use of this practice, they imposed a rule stating that income from related entities will be classified as specialized service business income if the two businesses share 50% or more common ownership. Which would basically wipe out the benefit of the “crack & pack”.
Note though that the limitation isn’t on the entire secondary business itself (in this example the property management company). It’s on the rental income coming from the original medical practice. So, the property management company could still produce non-specialized service income. It’d just need to be involved in other activities.
Another thought here would be to team up with a few owners of similar businesses. If the physician could find two owners of similar practices, he/she could combine efforts to launch a property management company between the three of them. The 33% ownership share would fall below the IRS threshold, potentially carving out rental income from the SSTB limitation.
Finally, specialized service businesses may want to rethink some of their prior business decisions in light of section 199a. Entity selection, how you staff the business, and how aggressively you reinvest can all impact your ability to capture the 20% QBI deduction. Whereas the income reduction and income “swapping” ideas listed above will be helpful if your taxable income falls above the phaseout ranges, the business strategy ideas I’ll suggest have more to do with adjusting corporate structure for the purpose of making more business profit “qualified business income” in the first place. This is list is in no way exhaustive – there are many other strategies and opportunities out there. Nevertheless, here are two thoughts to consider.
Converting from an S-Corporation to an LLC
Whereas owners of S-Corporations pay themselves through a mix of w-2 compensation and profit distributions, only the profit distributions are eligible for the QBI deduction.
For example, let’s say you own a business that produces $150,000 in profit. You pay yourself a w-2 wage of $120,000, and distribute the remaining $30,000 as profits. You may be eligible for a QBI deduction on the $30,000 profit (if your income isn’t too high). If the business were an LLC instead, the entire $150,000 would be eligible for the deduction. You’d be responsible for a greater amount of payroll tax, but it’s likely in this scenario that it’d be outweighed by the benefit of the QBI deduction.
Converting from an S-Corporation to a C-Corporation
On top of that, owners of S-Corporations may want to consider converting to C-Corporations – especially if their income if it appears that the tax law will sunset in 2026. If the law does sunset, the 20% deduction on pass through business profits goes away. That tax cut on C-Corps does not, as it was made permanent in the bill. Even if the law sunsets in 2026, C-Corps will continue enjoying lower tax rates across the board.
All in all, there are a good number of planning opportunities within section 199a, and maximizing the 20% QBI deduction will probably have a big impact on business owners’ tax liabilities. There’s a good deal of nuance in the tax law though, and the IRS is still in the early stages of providing guidance. For those reasons, this is a really good topic to discuss with a tax advisor. As they say, don’t try this at home.