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Maximization of Tax Reduction

Hi You All,

Here we are in late December and the holidays are upon us and tax planning may not be the first thing on your mind.  But without effective tax planning and execution in just the few weeks we have left before the end of the year, you and/or your clients will suffer the consequences.  Last year, I wrote several articles on Code Section 199(a) and how the 20% deduction would apply.

Below I have tried to focus on specific trade or businesses rules and a couple of late year-end tax planning opportunities.  I have presented a case study on one of my clients to show how applying several strategies can provide tremendous tax savings.

First what is a qualified trade or business? 

Code Section 199(a) defines a qualified trade or business as any business other than the business of performing services as an employee (W-2).

Second, what is this thing called a specific trade or business? 

Specified trade or businesses are businesses that cannot take advantage of the 199(a) deduction. These businesses involve performing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investing and investment management, trading or dealing in securities, or where the principal asset of the business is the reputation or skill of one or more employees or owner.

Even though specified trade or businesses are excluded from the deduction, the law provides an exception to the owner if the owners’ taxable income is below certain threshold amounts.  This provides the tax planning opportunity. The threshold amounts are $315,000 for Married Filing Joint (MFJ) and $157,000 for individuals, with phaseouts for income up to $415,000 for MFJ and $207,500 for individuals.

Third, what is qualified business income?

Qualified Business Income (QBI) is computed on the U.S. sourced income (revenues), deductions and losses with respect to any qualified business of the taxpayer.  The items below are not included in QBI:

  • Reasonable compensation paid to the taxpayer by the qualified business for services rendered;
  • Guaranteed payments paid to a partner for services rendered;
  • Passive-type income such as capital gains, dividend income, interest income, and certain investment income; and
  • Qualified REIT dividends, qualified cooperative dividends, qualified publicly traded partnership income.

Below is an example of how a qualified trade or business computes their Code Section 199(a) 20% deduction.

Once we have quantified the QBI, we have to apply certain limiting criteria.  These criteria do not apply if taxable income is under $157,500 individual filers or $315,000 for MFJ—the specific trade or business thresholds.  Whether you are a qualifying business or a specific trade or business, you have the same magic thresholds.

The limiting criteria for the 20% deduction are the lesser of:

a) 20% of the qualified business income of the pass-through entity, or

b) The greater of:

(i)  50% of the allocable W-2 wages or

(ii)  25% of the allocable W-2 wages plus 2.5% of the unadjusted basis of all qualified real and tangible property on hand at year end (excluding land) used in the business.

The above computation cannot exceed 20% of the excess of taxable income over net capital gains.

Pass-through entities that have large W-2 wages or large amounts of fixed assets have a tremendous benefit from their deduction.  Remember, there is no cap on the deduction.

Now let’s get back to those of us in specific trade or business—we get the crumbs but some just get air.

Below is the chart showing the specific trade or business exception.

Now how can we help our clients reduce their taxable income to maximize the 20% deduction and minimize the tax burden?  For married filing jointly, we try and get as close to $315,000 as possible.

Case Study

Last year, I had a client whose taxable income before any planning strategies was $950,000.

Based upon the client’s profile, we recommended two strategies.

First, we suggested installing a Defined Benefit Plan.  The actuarial completed deduction was $350,000 ($330,000 for the client and $20,000 for a younger employee).

Next, we recommended investing in a real estate partnership with a conservation option.  The client invested $60,000 in the real estate partnership, which resulted in a non-cash charitable contribution of $300,000.

The cost to the client was $20,000 for the employee’s part of the Defined Benefit Plan and $60,000 for the investment in the real estate partnership or $80,000.

The tax savings to the client was $284,535 making his return on investment 355%.

Now, not all of your clients have an old Dude who qualifies for a Defined Benefit Plan, but let’s think about how we can be proactive and help our clients reduce their tax burdens.

Don Deans CPA/PFS