By John Markely, As seen in Plan Consultant Magazine – Summer 2020
Here are examples of how the new deduction affects the deductibility of four businesses’ retirement contributions.
I am writing this article in the midst of the Coronavirus shutdown. It is challenging to think about the time in the future when the world returns to normal. The Tax Cuts and Jobs Act (TCJA) may seem like it was enacted a long time ago, but it has been less than 3 years—and Section 199A was part of the TCJA.
Let’s take a look back to when the tax structure was about to change. It was late 2017 and the most pressing item on my to-do list was to follow up on cash balance designs that we had prepared during the year. That year was going to be more complex than most— not only did potential clients have to consider their future economic budget, but a new tax law was on the horizon.
The new law would not be applied for 2017, but there was nothing worse than setting up a plan and then having to amend or terminate it because of different consequences that were not known when the plan was implemented. Details about the new tax law were beginning to be revealed, and a clearer picture of what the new law was going to look like became clear.
A new concept would be introduced by the TCJA that became part of the Internal Revenue Code as Section 199A. Generally, a tax deduction would be permitted equal to 20% of the qualified business income with respect to a qualified trade or business as long as 50% of payroll exceeded the credit.
Of course, the devil is in the details. What is a qualified business? A qualified business is generally a business where capital, such as machinery, is the primary income producer of the business. A qualified trade or business does not include professional service business, such as medical services, law offices, dental offices or financial advisory offices.
What is qualified business income? Qualified business income would generally be the taxable income of a business, but exclusive of reasonable compensation paid to the taxpayer for services rendered with respect to the business. A straightforward example would be an S Corporation profit after reasonable compensation is paid the owners. C Corporations are not eligible for this deduction.
However, if the taxpayer is the owner of a business that is not a qualified trade or business and has income below certain limits, the Section 199A deduction would become available.The limit for 2018 was $157,500 or double that amount for a joint tax return. For 2018, there was a phase-out of the 199A deduction in this situation for income amounts $50,000 over $157,500 for a single return and $100,000 over double that amount for a joint return.
Here are four of our 2017 potential clients and illustrations of how the Section 199A deduction would apply and how the 199A deduction impacts the tax deductibility of the retirement contributions of their business.
The second potential client was an attorney with no employees. His 1099 income was approximately $400,000 and his wife earned $50,000 at her job. Based on his age, a cash balance contribution of $150,000 was possible and deductible. As an attorney, his business was not a qualified business. Without a contribution to a cash balance plan, the combined taxable income would be $450,000, and their combined income would exceed the limits for a 199A deduction without a qualified business. However, with a contribution of $150,000 to a cash balance plan, the combined taxable income on their joint return would be $300,000, and they would become eligible for the 199A deduction.
The attorney was taxed as an S Corporation. For 2018, he could have earned income from his business of $100,000, make a cash balance contribution of $150,000 andhave qualified business income of with his W-2 compensation.What if a cash balance plan were implemented with a contribution of $200,000?
The cash balance contribution counts toward reasonable compensation, so the issue of reasonable compensation is eliminated or at least greatly reduced. Reasonable compensation is also an issue for a qualified business. Reducing W-2 compensation of a business owner would increase qualified business income and increase the 199A deduction. However, compensation must be reasonable for this purpose.
The fourth example was a business that is a qualified business.The profits of the business that were under consideration for contribution to a profit sharing plan were $100,000. The contribution of $100,000 would reduce the qualified income of the business and eliminate a $20,000 Section 199A deduction for the business.The business decided not to implement the profit sharing plan.
The first is a dental specialty office with qualified income over $500,000. While the tax rate reductions at the upper limits resulted in some tax savings for this client, he was very aware that his business was not eligible for the Section 199A deduction. His office had significant sophisticated dental equipment, but because his business was as a professional, his business was not a qualified business. He remained very interested and implemented a cash balance plan. His business would receive a tax deduction for employer contribution to qualified retirement plan(s), similar to before the TCJA.
$150,000. He would be eligible for a 199A deduction of $30,000 (20% of $150,000).To review, the joint return showed income of $450,000 without the cash balance plan and $270,000 with the cash balance plan.Taxable income is reduced by $180,000 with a cash balance contribution of $150,000 that made the joint return eligible for the 199A deduction!
The third client was a doctor with no employees.With his S Corporation, his W-2 compensation was $90,000 with additional profits of over $1 million.The issue here is reasonable compensation.There could be an issue of payroll taxes for this business owner
By example, I hope that you now better understand the Section 199A of the TCJA. Now, let’s all get back to normalcy!