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Good to Know: Tricks, Traps and Opportunities in the 20% Qualified Business Income Deduction

Today, we conclude our 4-part series with insights into tricks, traps and planning opportunities in the 20% Qualified Business Income Deduction (QBID) under Internal Revenue Code Section 199A, brought to us courtesy of the Tax Cuts and Jobs Act. But first, here’s an uber quick refresher of key concepts from the previous three QBID blogs:

  • Show me the money! How much is the tax deduction?
    • Generally: 20% of the lesser of  a qualified business’s adjusted net income (revenue less expenses – with adjustments) OR adjusted personal taxable income of the business
      owner
    • Adjusted personal taxable income is personal taxable income LESS capital gains and qualified dividends.
    • You cannot claim the QBID on capital gains or qualified dividend income
    • No expenses are required to claim the deduction – it’s a free deduction!
  • What does “Qualified Business Income” look like?
    • Must be from a pass-through business or sole proprietorship
      • Most business structures (except C Corporations) generally qualify
    • Generally EXCLUDES compensation paid to the owner/employee
    • Must have adjusted net income from domestic U.S. business operations
      • Net income = Revenue – expenses (any W2 compensation or guaranteed payments made to the owner are generally deducted as part of expenses)
      • Adjusted net income is net income reduced by any non-operating income such as capital gains, qualified dividends & investment interest income.

Tricks, Traps, and Opportunities

  • Trick

    Not all “pass-through” or sole proprietorship businesses are qualified businesses! For example, a Specified Service Trade or Business (SSTB) is not a qualified business. SSTBs include most professional service businesses (e.g., health care, financial, consulting, legal, accounting and other services). However, by exception, certain SSTBs may be eligible for the QBID – see Opportunity #1 below.
  • Trap

    Your client’s contributions or deferrals into his or her business retirement plan, such as a 401(k) Plan, may REDUCE the 20% QBI deduction if your client owns an S Corporation or (generally) an LLC, making the S Corporation tax treatment election. How is that possible? Here’s one example:

Your client Mamie files as married filing jointly with her husband. The couple’s adjusted personal taxable income is $250,000 in the current year. Mamie owns and operates an S Corporation with net income in the current year of $231,000, after deducting Mamie’s W2 compensation of $75,000 and a $19,000 contribution to Mamie’s 401(k) pre-tax plan account. The business had only operating income and did not receive income from capital gains or qualified dividends. Hence, the S Corporation’s adjusted taxable income is $231,000.

  • Her QBID given this fact pattern will be $46,200 (20% of the lesser of $250,000 or $231,000).

But what if she contributed $19,000 to a non-deductible 401(k) Designated Roth Account instead? In that case, her qualified business income would have been $250,000 instead of $231,000.

  • Here’s the impact – her QBID increases to $50,000 (20% of $250,000). Her personal taxable income and adjusted qualified business income are $250,000 each).

CAVEAT – The decision to make pre-tax or Roth contributions is a complex issue. The impact of the 20% QBID is just one of a number of factors, including current and future income tax rates, that should be considered.  

  • Opportunities

    #1 – Unlock the QBID for SSTBs

    Even though your client’s SSTB may not be considered a “qualified business,” he or she may yet be eligible for the QBID deduction. Specifically, if your client’s adjusted personal taxable income is less than a phase-out range, the QBID amount is 20% of the lesser of the owner’s adjusted personal taxable income or the adjusted net income of the business. Phase-out ranges vary by filing status. The phase-out range for a client who owns an SSTB and files as married filing jointly is illustrated in the chart below:

    Specified Service Trade or Business Phase-Out Range (2019)
    20% Qualified Business Income Deduction (QBID)
    Taxpayers Filing Married Filing Jointly
    ADJUSTED PERSONAL TAXABLE INCOME BEFORE THE 20% QBID IMPACT ON THE 20% QBID
    Up to $321,400 QBID = 20% x lesser of adjusted personal taxable income or adjusted qualified business income
    From $321,400 to $421,400 A prorated deduction is generally available
    Over $421,400 The QBID is generally not available.  The SSTB owner is “too successful” to qualify.

    #2 – Cut the Tax Cost of a Roth Conversion

    If the 20% QBID is limited by adjusted personal taxable income, consider increasing personal taxable income. One approach is converting a Traditional IRA to a Roth IRA. Noteworthy – Increasing capital gain or qualified dividend income will NOT work because such gains and income do NOT qualify for the QBID. The income tax saved by a higher QBID could offset a portion of the income tax liability from the Roth IRA conversion. For example:

Your client Jim files as married filing jointly with his wife. The couple has adjusted personal taxable income of $225,000 from Form 1040. He has qualified business income of $250,000 from a sole proprietorship. Independent of the 20% QBID, he determined that a Roth conversion of his traditional deductible IRA would be appropriate.

  • If Jim converts $25,000 of his traditional deductible IRA to a Roth IRA, his married filing jointly adjusted personal taxable income rises from $225,000 to $250,000.
  • What is the impact to his 20% QBID? Before the Roth conversion, Jim’s 20% QBID was $45,000 (20% of the lesser of $225,000 or $250,000). After the Roth conversion, Jim’s 20% QBID becomes $50,000 (20% of $250,000).

The net result is that Jim saves income taxes. He can reduce the $25,000 in added income from the Roth IRA conversion by the $5,000 increase in the QBID.

Caveat – The Roth IRA conversion decision should be based on a number of factors such as marginal income tax rates today vs. income tax rates in retirement.  The QBID is a factor, but NOT the only factor, in a Roth IRA conversion.

The Section 199A deduction – the QBID – has been called one of the most complex sections of the Internal Revenue Code.  How complex?  In early 2019, the IRS released a 247-page document with clarifying  regulations. While many questions were answered by these clarifications, new questions are posed to the IRS weekly, if not daily.

Our goal in this blog series is to raise your awareness of common 20% QBID questions so that you may recognize clients that could benefit and then refer those clients to their professional tax advisor for additional information. The scope of this blog series does not permit complete coverage of all aspects of this deduction or a discussion of all potential client applications. As but one example, pass-through business owners with taxable income above the phase-out ranges may be eligible for the QBID as long as the business is not an SSTB.

Disclaimer – Our blogs are NOT intended as specific tax advice for clients. Each client presents unique needs and financial situations. The variables in the QBID are both numerous and, to some degree at least, yet to be fully clarified by the IRS.