If your small business qualifies for the Section 199A deduction, your financial life just became much, much more complicated. I'm so sorry. If it makes you feel any better, I'm in the same boat.
There was a major business tax cut that went into effect in January 2018. Of course, the IRS didn't really issue all their regulations about it until January 2019, so we have all been guessing about how it would really affect us for over a year. Now we know and it is time to scramble to make changes that could reduce your current and future tax bills substantially.
The corporate income tax brackets were dramatically lowered. In order to keep other business structures (S Corp, partnership, sole proprietorships) on a competitive footing, a new deduction was added for those types of “pass-thru businesses.” This is the Section 199A or Qualified Business Income (QBI) deduction. The deduction is basically 20% of qualified business income plus REIT and Publicly Traded Partnership income. So if the business has $500K of qualified business income, that's a $100K deduction. In my case, I have a 42% marginal tax rate, so a $100K deduction is $42K back in my pocket. That's obviously a HUGE tax break. That's larger than what I get from maxing out my partnership 401(k) and defined benefit plan (a mere $31K tax break). Because it is such a huge tax deduction, one should be willing to bend over backward in an attempt to qualify for it and make it as large as possible.
In case you're not aware, Congress and the IRS seem to hate financially successful doctors and similar high-income professionals like the target audience for this blog. That's the only explanation I have for why they were excluded from this deduction compared to other small businesses. Thus many professionals who own businesses will find that their business does not qualify for this deduction at all. If that is the case, be consoled with the fact that your financial life did not become any more complicated. If you know you are in this category (only business income is from specified service businesses and your taxable income is over $207,500 ($415,000 married) you can ignore the rest of this post. Those without business income can also ignore the rest of this post.
For the rest of you, grab your beverage of choice, sit down, and prepare to wrap your mind around all the ways your financial life is about to change.
The 199A Deduction Explained in Simple Terms
Let's start with the basics of this deduction:
- The deduction is the lesser of 20% of qualified business income plus REIT/Publicly Traded Partnership income or 20% of your taxable income reduced by capital gains and qualified dividends (usually the first)
- If your taxable income is LESS than $207,500 ($415,000 married) for 2018 (goes up with inflation each year), your business income can come from any business you like and you do not need any employees to get the deduction.
- If your taxable income is MORE than $207,500 ($415,000 married) for 2018, there are three rules that will limit your deduction:
- Your business income cannot come from a specified service business and
- Your deduction can be no larger than 50% of the salaries paid by your business or
- Your deduction can be no larger than 25% of the salaries paid plus 2.5% of the original basis of property owned by the business. (this one is for real estate investors to still be able to get a big deduction even if they don't have many employees, named the Corker Kickback for Senator and real estate investor Bob Corker who changed his vote once this provision was added to the bill.)
- REIT and publicly traded partnership income is also eligible for the deduction (including mutual fund REIT income)
What is Qualified Business Income?
See page 51 of Pub 535 for the IRS interpretation of Qualified Business Income (QBI). I'll reproduce the most important parts here:
Determining your qualified business income.
Your QBI includes items of income, gain, deduction, and loss from any trades or businesses….within the United State. This includes income from
- partnerships (other than PTPs),
- S corporations,
- sole proprietorships,
It also includes other deductions attributable to the trade or business including, but not limited to,
- deductible tax on self-employment income,
- self-employed health insurance, and
- contributions to qualified retirement plans.
QBI doesn’t include any of the following:
- Items that aren’t properly includible in income
- Investment items such as capital gains or losses, or dividends
- Interest income, other than interest income properly allocable to a trade or business (interest income attributable to an investment of working capital, reserves, or similar accounts is not properly allocable to a trade or business)
- W-2 income.
- Amounts received as reasonable compensation from an S corporation.
- Amounts received as guaranteed payments.
There are some important things to understand here.
First, only profits count. You have to subtract all of the business deductions, including salaries, health insurance premiums, and retirement account contributions.
Second, interest doesn't count. So income from money left in the business and invested doesn't count.
Third, guaranteed payments don't count. That apples to MANY physician partnerships including mine. Essentially all the pay to the partners in our partnership are guaranteed payments. Many times that can be changed by changing the structure of the partnership and its agreement. In our case, it turns out it can't.
What Are Specified Service Businesses?
IRS Publication 535 also clarifies this.
Specified service trade or business excluded from your qualified trades or businesses
Specified service trades or businesses generally are excluded from the definition of qualified trade or business income if the taxpayer's taxable income exceeds the threshold. Therefore, no QBI, W-2 wages, or UBIA of the qualified property from the specified trade or business are taken into account in figuring your QBI deduction.
Exception 1: If your taxable income before the QBI deduction isn’t more than $157,500 ($315,000 if married filing jointly), your specified service trade or business is a qualified trade or business, and thus may generate income eligible for the QBI deduction.
Exception 2: If your taxable income before the QBI deduction is more than $157,500 but not $207,500 ($315,000 and $415,000 if married filing jointly), an applicable percentage of your specified service trade or business is treated as a qualified trade or business.
It then names some specified service businesses:
- Health, including physicians, nurses, dentists, veterinarians, physical therapists, psychologists, and other similar healthcare professionals. However, it excludes services not directly related to a medical services field, such as the operation of health clubs or spas; payment processing; or the research, testing, manufacture, and sale of pharmaceuticals or medical devices;
- Law, including lawyers, paralegals, legal arbitrators, mediators, and similar professionals.
- Accounting, including accountants, enrolled agents, return preparers, financial auditors, and similar professionals;
- Actuarial science, including actuaries, and similar professionals;
- Performing arts, including actors, directors, singers, musicians, entertainers, and similar professionals.
- Athletics, including athletes, coaches, and managers in sports such as baseball, basketball, football, soccer, hockey, martial arts, boxing, bowling, tennis, golf, snowboarding, track and field, billiards, racing, and other athletic performance.
- Financial services….including services provided by financial advisors, investment bankers, wealth planners, retirement advisors, and other similar professionals. However, it excludes taking deposits or making loans, but does include arrange lending transactions between a lender and borrower
- Brokerage services, including services in which a person arranges transactions between a buyer and a seller with respect to securities for a commission or fee including services provided by stock brokers and other similar professionals. However, it excludes services provided by real estate agents and brokers, or insurance agents and brokers;
- Investing and investment management, in which a fee is received for providing investing, asset management, or investment management services, including providing advice with respect to buying and selling investments. However, it excludes the service of directly managing real property;
- Trading, including the trade or business of trading in securities, commodities, or partnership interests;
- Any trade or business where the principal asset is the reputation or skill of one or more of its employees, as demonstrated by: – Receiving fees, compensation, or other income for endorsing products or services; – Licensing or receiving fees, compensation or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbols associated with the individual’s identity; or – Receiving fees, compensation, or other income for appearing at an event or on radio, television, or another media format. De minimis rule 1—If your gross receipts from a trade or business are $25 million or less and less than 10% of the gross receipts are from the performance of services in a specified service field, then your trade or business is not considered specified service trade or business, and thus may generate income eligible for the QBI deduction for the tax year.
So obviously, docs, dentists, attorneys and basically the main business for my entire target audience is specifically excluded. The only exception is if you have a taxable income below the limit. However, this is all about your personal taxable income, not the business itself, which is kind of wacky. So if there are two docs in a partnership making $200K each and one of them is married to a radiologist and the other is married to a stay at home spouse, the one married to the stay at home spouse gets this deduction and the other does not! It doesn't seem fair, but that's the way the law is written. Like I said, Congress and the IRS hate financially successful doctors.
The good news is that many docs have a side gig that qualifies. The White Coat Investor, LLC certainly qualifies for this deduction. You might think it does not because “the principal asset is the reputation or skill of one of its employees” but if you look at the de minimis rule 1, you can see that since less than 10% of WCI income is from appearing at events (most is ad and product sales), it still qualifies.
How Do You Actually Claim the Deduction
The deduction is a below-the-line (the line is now line 7-AGI) deduction on your 1040 that is calculated concurrently with the itemized vs standardized deduction. As you can see, it plugs in at line 9 on the second page of your 1040.
So where does line 9 come from? Take a look at the 1040 instructions for line 9. It all starts on page 34 of the instructions. The simplified worksheet is found on page 37 (instructions for it on page 35). This is for those whose income is below the phaseout limits. It looks like this:
QBI goes on 2 and is multiplied by 20% on line 5. Your REIT dividends go on 6 and are multiplied by 20% on line 9. Add them together on 10. Make sure that deduction is more than 20% of your taxable income less capital gains and dividends on lines 11-14, and your deduction is on line 15. Take that to Line 9 of the 1040. No big deal. Of course, I don't get to use that super easy worksheet to calculate mine. I have to use this one in Publication 535, on page 55. Just to keep things interesting, this two page form also has four schedules that go along with it which you may have to fill out too.
- Schedule A- For those with Specified service businesses in the phaseout range
- Schedule B- For those with multiple businesses who need to aggregate them to maximize the deduction
- Schedule C- For those with a business that lost money
- Schedule D- For those in agricultural businesses
Here is part I and II.
List the businesses in part 1. Your QBI goes on line 2. You multiply it by 20% on line 3. Line 4-11 is where you apply the 50% of salaries (or 25% of salaries plus 2.5% of basis) rule. Schedule A plugs into line 12. Line 14 is where Schedule D plugs in. Line 16 is the QBI component total. Now let's look at part III.
You only have to fill this section out if your taxable income is in the phaseout range ($157,500-205,000 single, $315,000-$415,000 married for 2018.) It's where the phaseout is calculated. Then we'll move on to section four where you add in any REIT or Publicly Traded Partnership income.
Line 27 is your QBI component. Lines 28-31 is your REIT and PTP income. Total them up on 32. Make sure it's more than 20% of taxable income less LTCGs/dividends on lines 33-36. The deduction is on line 37 which goes to line 9 of the 1040. Not the worst worksheet I ever saw. Way easier than doing your own direct real estate property taxes. And if your K-1s are correct, Turbotax handles this with ease.
The Section 199A Deduction and Your Retirement Accounts
Okay, we're over 2000 words into this post already and I haven't yet gotten to the point of the post–what those who qualify for the deduction should do with their retirement accounts. The fact that employer contributions to retirement accounts are specifically excluded from QBI (they're an expense, not income) means that tax-deferred retirement account contributions are now much less valuable than they used to be, unless they lower your taxable income to a place where you now qualify for this deduction. Read that sentence again. It's the whole point of this post:
Now, let's talk about all the ways this fact can affect you.
Using Tax-deferred Contributions to Get the Deduction
The first way to use retirement account contributions is to lower your taxable income. For example, if two married self-employed doctors have a taxable income of $430K but have the option to contribute $130K to tax-deferred retirement accounts like individual 401(k)s and defined benefit/cash balance plans, they should do so. By doing so, they lower their taxable income from $430K, where they don't qualify for any 199A deduction at all to $300K where they will qualify for a deduction. Obviously, the amount of the employer contributions to those retirement accounts is subtracted from the QBI before the deduction is taken, but any deduction beats no deduction.
Using Roth 401(k) Contributions to Increase QBI Deduction
A sole proprietorship or partnership (or an LLC filing as either of those) may be able to increase their QBI deduction by making their “employee contribution” to the business 401(k) a Roth contribution instead of a tax-deferred contribution. This is because this deduction is taken on Form 1040 Schedule 1 Line 28 where employee and employer contributions are lumped together. Since this line is subtracted from QBI, having a smaller number on that line makes for more QBI and a larger deduction.
Note that this does not matter for an S Corporation (or an LLC filing as an S Corporation) since employee contributions to retirement accounts show up on the W-2 and employer contributions show up on the 1120S (Corporate return). Also keep in mind that although employee contributions can be Roth (tax-free), tax-deferred, or after-tax (not the same as Roth because earnings are fully taxable upon withdrawal), employer contributions are always tax-deferred.
The Mega Backdoor Roth IRA
So in reality, if your business qualifies for a QBI deduction, tax-deferred contributions to retirement accounts (except tax-deferred employee contributions for S Corps) are not as valuable as they used to be because they reduce your QBI deduction. They are essentially 80% as good as they used to be. They're still good, but not AS good. Because they're not as good, it is possible you should not be making them.
For most high-income professionals in their peak earnings years, tax-deferred retirement contributions are a no brainer. They are MUCH more likely to be able to take out their retirement savings at a lower marginal tax rate than they saved putting the money in. It takes unusual circumstances (like being a super saver, having pensions, and having a lot of rental income) for that to not be the case. You just have to have a ton of side income in retirement or an absolutely monstrous IRA for this to work out badly for you. And even if it works out badly, you still win because you have tons of money in retirement. It's the old “economic utility” argument. If you end up with very little income in retirement, contributing to tax-deferred accounts was the right move. If you end up with tons of income in retirement then the additional taxes you end up paying over your lifetime didn't affect how you lived your life.
Let's look at my case to illustrate why you might not want to make tax-deferred retirement contributions anymore. Katie and I are in the 37% federal tax bracket and used to be in the 39.6% bracket. In 2017 when we contributed to the WCI individual 401(k), we saved 39.6% of the contribution in taxes. However, those same contributions in 2018 are only going to be worth a 37% * 80% = 29.6% deduction. While it is no big deal if we contribute at 37% and pull the money out at 37%, it would really suck to contribute at 29.6% and then pull the money out at 37%, or 40%, or 45% if the top marginal tax rate goes up. In fact, it would kind of stink to put money in at 29.6% and pull it out at 32%. In 2019 the 32% bracket starts at a taxable income of $321,450. While we would have nowhere near that much taxable retirement income if we retired today, we don't plan to retire today. If we stick with this WCI thing for another decade and it continues to be very successful and we continue to save a ton of money each year, it is entirely possible for us to have that much taxable income in retirement. Obviously, there are a lot of variables in the equation:
- how much we continue to make,
- how well our investments do,
- how many Roth conversions we do going forward,
- how long we work for,
- how much we spend,
- how tax rates change, and
- how that money is invested in retirement.
So if one decides that it is no longer a good idea to make tax-deferred contributions (and I'm not sure whether it is or not for us), what should one do? One could just quit using the retirement account and invest in taxable instead. But there is a better option–the Mega Backdoor Roth IRA. For those who are not familiar with the Mega Backdoor Roth IRA, there are several variations but the basic idea behind it is that instead of making tax-deferred employer contributions, you make after-tax (but not Roth) employee contributions to the 401(k). Then, you convert those to either a Roth 401(k) or a Roth IRA. Since you got no deduction going in, there is no tax cost to the conversion.
In order for this to happen, the 401(k) must allow for two things:
- After-tax contributions
- In-service conversions or rollovers
Most plans, including most off-the-shelf individual 401(k)s from places like Vanguard, Fidelity, or eTrade, do not allow both of those to occur. So if you want to do this, you need a customized 401(k). The least expensive individual 401(k) allowing a Mega Backdoor Roth option that I know of can be found at My Solo 401k. However, I have had two very smart people point out that you don't get anywhere near as much support there as you would if you paid thousands to a separate Third Party Administrator and an Advisor. I like the fact that they actually know what a Mega Backdoor Roth IRA is and just incorporate it routinely. I also like the fact that they only charge $795 the first year and $125 every year after that (and they'll even do your 5500EZ for that.) I have no financial relationship with them but am considering using them if we end up going this route.
At any rate, the point of all this is that if you have this option, you just do $37K as an employee after-tax contribution instead of a tax-deferred contribution and then convert it to a Roth IRA. Since that contribution is an employee contribution, not an employer one, it isn't an employer expense and thus doesn't reduce QBI, increasing the QBI deduction.
Consider Dropping Your Defined Benefit Plan
For similar reasons, it may no longer make sense to use a Defined Benefit/Cash Balance Plan (DBP). Those contributions reduce your QBI just like employer tax-deferred contributions to a 401(k). Plus, DBPs are generally less attractive than a 401(k) anyway given their higher costs and other associated hassles. Katie and I had considered starting a personal DBP this year for WCI, LLC but this has certainly given us pause for the reasons discussed above.
The Balancing Act For S Corps
This is all even more of a balancing act for an S Corp. The S Corp needs enough salary paid out so the deduction isn't limited by the 50% of salaries rule. But every dollar of salary is subject to payroll taxes. You also need a certain amount of income to max out a 401(k), and that amount is much higher for making employer contributions rather than employee contributions. I mean, you can max out a $56K 401(k) contribution that is $19K tax-deferred and $37K after-tax on a salary of, well, $56K.
I told Katie if we go down this Mega Backdoor Roth route that we should cut her salary to $56K. We would have to increase mine to stay clear of the 50% of salaries rule, but that would save us $132,900 – $56,000 * 12.4% = $9,536 in Social Security taxes (half of which would be deductible of course). Naturally, you also have to make sure you're paying a salary you can justify to the IRS as reasonable. Set it too low and they'll nail you. Lots of moving parts here. When we did the math last year, we determined that it made sense for our salary to be 28.6% of the total of our salary plus QBI. That allowed us to max out our 401(k)s (actually far more than we needed for that), minimized our Medicare taxes, and maximized our 199A deduction. Bear in mind that number could be very different for you, especially if you have other employees or have less income than us.
What's the Deal with REITs?
REIT income is also eligible for this deduction. One of my private real estate fund investments actually changed its structure to a REIT in 2018 for just this reason. Even REIT income from a REIT mutual fund is eligible for this deduction. It probably isn't enough to justify moving the classically very tax-inefficient REITS out of a tax-protected account into a taxable account, but if you were holding them there anyway, this will boost your after-tax returns a bit.
Not Everyone Needs to Change Their Retirement Plan
I'm sure this post just gave lots of people a ton of anxiety about their retirement plans. Here is a list of people who should not feel anxious and should just keep doing the tax-deferred contributions they have been doing:
- Those who won't qualify for the QBI deduction anyway
- Those who don't own a business
- Those who only have specified service business income and have taxable income way over the phaseout range
- Those whose K-1 income is mostly in box 4 (guaranteed payments)
- Those who will only qualify for a QBI deduction by maxing out their tax-deferred contributions
- Those who get some other tax benefit from lowering their taxable income such as the child tax credit or college tax credits
Everyone else will need to run the numbers, probably with the assistance of a tax professional. Still confused? Try Jeff Levine's post on this topic at Kitces.com. He made a lot of nice graphics that may help explain the concepts better than my words did.
What do you think? Will you be getting the 199A deduction? Do you plan to make any changes to your retirement accounts as a result? What do you plan to do? Comment below!