Editor: Valrie Chambers, CPA, Ph.D.
The Sec. 199A qualified business income (QBI) deduction is a game-changer in many ways, both obvious and not-so-obvious. In the latter category are a potential pitfall and a potential treasure for small businesses that can benefit from the QBI deduction that could easily be overlooked in their tax planning.
Retirement plan contributions may be a pitfall
Contributing to a retirement plan has been the primary means of achieving significant tax deferral for small business owners. Self-employed taxpayers can make tax-deductible contributions to a wide variety of plans including simplified employee pension individual retirement arrangement (SEP-IRA), Keogh, SIMPLE, 401(k), and cash balance plans. Traditional IRAs are also a tax-deferral vehicle. The objective is to push income from current, higher-tax-bracket years into post-retirement, presumably lower-tax-bracket years.
The QBI deduction is a great boon for small businesses owners who can claim it. However, the interplay with small business retirement plan contributions now requires more timely analysis by the CPA. Because the QBI deduction is reduced by the business retirement plan contribution, the tax-deferral benefit of the retirement plan contribution is substantially reduced in many instances. It may not make sense to make a retirement plan contribution if the current-year tax savings are insignificant compared with the tax liability that could be incurred in the future distribution year.
Example: In 2019, a couple with $100,000 of QBI, other income of $90,000, and no self-employed health insurance deduction have a choice of making a maximum of $12,000 in traditional IRA contributions or a maximum SEP contribution of $18,587.A traditional IRA contribution of $12,000 saves $2,735 in tax. The traditional IRA contribution does not reduce QBI. Due to the reduction of QBI by the total amount of the SEP contribution, the maximum SEP contribution, which is $6,587 higher than the maximum IRA contribution, saves only $3,389, or $654 more than the IRA contribution. This makes the effective tax saving rate on the additional $6,587 less than 10%. Even considering the time value of money, the couple could pay income tax of much more than 10% on the SEP contribution in the year it is included in taxable income.
In this example, a better alternative might be to make traditional IRA contributions of $12,000 and invest the $6,587 in assets producing long-term capital gain because, historically, returns on stock market portfolios have been 7%-10%, and the long-term capital gain tax rates have been lower than ordinary income tax, which, hopefully, will be true in the future as well.
Of course, other factors can affect the ability to make deductible IRA contributions, such as the April 15 deadline in the following year and retirement plan coverage by either spouse. SEP-IRA, 401(k), and Keogh plans also must consider whether other employees of the business qualify for plan contributions. State income tax laws may also affect the decision. Importantly, SEPs can be funded through the extended due date of the tax return, while IRAs must be funded by the original due date of the individual income tax return.
In general, the lower QBI is, the less beneficial small business retirement plan contributions are, compared with deductible traditional IRA contributions. In the right situation, a Roth IRA coupled with a SEP-IRA or Keogh plan could be a tax-advantageous choice. Once the CPA knows how much the taxpayers have available to contribute to any combination of retirement plans, many more options now need to be considered than in the past, due to the QBI deduction. In addition, if traditional IRA or Roth contributions are to be made, the planning must be completed in time to make the contribution by the April 15 deadline.
While this example targets middle-income taxpayers, higher-income taxpayers also need to reconsider retirement plan contributions, including company 401(k) contributions that are not matched by the employer. The tax code currently has a top bracket that is historically relatively low. The maximum bracket of 37% is set to expire after 2025, but with the political winds, it is possible it will not last even that long. The question is whether high-wealth individuals should make tax-deferred retirement plan contributions at a maximum 37% tax savings rate when their expected top bracket post-2025 could be 40% or higher. Another consideration is that the tax-deferred appreciation and earnings in the IRA will also be taxed at ordinary rates when withdrawn. The same after-tax money invested in capital assets could produce tax-favored long-term capital gains and qualified dividends.
Hidden QBI treasures
PTP hot-asset ordinary income: Publicly traded partnerships (PTPs) and real estate investment trusts (REITs) have specific benefits under Sec. 199A. A percentage of their business income is added to the QBI deduction. The qualifying income is reported to each partner on the PTP's Schedule K-1, Partner's Share of Income, Deductions, Credits, etc., line 20 with a code of AD. What is not reported on line 20 of Schedule K-1 is any Sec. 751(a) hot-asset ordinary income recognized upon sale of PTP units. Under Regs. Sec. 1.199A-3(b)(1)(i), Sec. 751(a) ordinary income is added to other qualified PTP income in computing the QBI deduction. The Sec. 751(a) information is found in the Schedule K-1 attachments. This hidden treasure is easily overlooked.
Sec. 481(a) adjustments: Post-2017 Sec. 481(a) adjustments are included in computing QBI. Both positive and negative adjustments affect the calculation. Sec. 481(a) adjustments are the result of accounting method changes requested by the taxpayer. Any time a Form 3115, Application for Change in Accounting Method, is filed, the QBI effects must also be considered.
Planning for QBI
Tax planning is even more complex than expected under the law known as the Tax Cuts and Jobs Act, P.L. 115-97, particularly Sec. 199A. Searching for hidden treasures and avoiding pitfalls makes CPAs into pirates of a different sort.
Contributors Valrie Chambers, CPA, Ph.D., is an associate professor of accounting at Stetson University in Celebration, Fla. Janet C. Hagy, CPA, is a shareholder of Hagy & Associates PC in Austin, Texas. Ms. Hagy is a member of the AICPA Tax Practice and Procedures Committee. For more information on this article, contact firstname.lastname@example.org.
Valrie Chambers, CPA, Ph.D., is an associate professor of accounting at Stetson University in Celebration, Fla. Janet C. Hagy, CPA, is a shareholder of Hagy & Associates PC in Austin, Texas. Ms. Hagy is a member of the AICPA Tax Practice and Procedures Committee. For more information on this article, contact email@example.com.