Have you heard about a new 20% income tax deduction on something called “Qualified Business Income (QBI)” and wondering if it applies to you? If you are self-employed, the answer is maybe. Those self-employed taxpayers fortunate enough to have their business income qualify for this deduction will be receiving this benefit for the first time as part of their 2018 tax filing (the QBI deduction was included in the Tax and Job Cuts Act passed in December 2017).
Unfortunately, many service-oriented professionals may miss out on the significant tax savings associated with this deduction because of the income-based phase-out cap on the QBI deduction. The IRS has ruled that certain types of service-related businesses will not qualify for the full deduction if their taxable income is above $157,500 for individuals and $315,000 for married couples.
With that being said, these households with income above the phase-out thresholds may consider using some tax planning strategies aimed at bringing their taxable income to a level below the thresholds; thereby, qualifying for the maximum deduction.
Certain Service Providers are Capped
QBI is determined by calculating total business income less net capital gains, investment income, and guaranteed payments. Wages do not qualify for the deduction, but self-employment income reported through a 1099 does. The IRS caps the QBI deduction for certain specified service trade or businesses (SSTB) in a variety of fields.
The figure below illustrates the levels at which the SSTB phase-out kicks in and at what level the deduction is completely phased-out.
Planning Strategies if Your Income is above Phase-Out Limits
For those households that are over the limits, here are some effective strategies to consider that can potentially enable a household to qualify for the full QBI deduction:
- Maximize SEP-IRA Contributions to Lower Taxable Income
Consider the following example; a married self-employed attorney (subject to SSTB phase-out) generates $294,000 of business income while her husband receives a salary of $100,000. Their total taxable income after taking the standard deduction is $370,000 (above $315,000 and below $415,000). At that level of income, they are only eligible for a partial QBI deduction (approx. 4%) rather than the maximum 20% QBI deduction.
If this same self-employed attorney maximized her SEP-IRA contributions by contributing $55,000* (dropping the couple’s taxable income to $315,000 and business income to $239,000), the couple would receive the maximum 20% QBI deduction, increasing their deduction to $47,800. This increase in the QBI deduction generates $7,662 more in tax savings in addition to the tax deferment resulting from the SEP-IRA contributions.
If maximizing a SEP-IRA still doesn’t lower your taxable income far enough to receive a full 20% QBI deduction, there are several other strategies that can be utilized in conjunction with the SEP IRA contribution.
- HSA Contributions
If you have a high deductible health insurance plan, you can make a pre-tax contribution to a Health Savings Account (an HSA) for up to $3,500 for an individual plan or $7,000 for a family plan in 2019. An extra $1,000 is available, if you are 55 years old or older.
- Lumping Charitable Giving
Lumping several years of future expected charitable giving into the current year can be advantageous especially if it pushes you over the standard deduction limit and allows you to reap the tax benefits of itemizing a large charitable gift. This can be done directly to a charity or through a donor-advised-fund (DAF).
- Manage your Income and Expenses
If you have some control as to the timing of your business income, you may consider waiting to take on that next project until the next year to keep your income level below the threshold. The same goes for expenses. You might accelerate the payment of some expenses to the current year to reduce your income level.
Non-Specified Service Trade or Businesses
Non-SSTB’s or Qualified Trade or Businesses (QTB) can also get the QBI deduction but are still subject to a phase-out above the lower taxable income threshold based on the amount of W-2 wages paid and property owned by the business.
The new QBI deduction presents an attractive opportunity for business owners to maximize their tax savings, but only for those that qualify. The QBI deduction rules are complicated; therefore, business owners should consult with their financial and tax advisors to evaluate which strategies may be the most effective and appropriate given their unique circumstances.