Qualified Plan Tax Savings Could Be Greater for Some Plan Sponsors Post-TCJA
The Tax Cuts and Jobs Act (TCJA) passed at the end of 2017 made significant changes for tax year 2018 and beyond. One such change was enactment of Section 199A which provides a deduction to non-corporate taxpayers based on certain qualified business income (QBI) generated by sole proprietorships, S corporations, and partnerships. This deduction, combined with other changes in the TCJA, may have the effect of reducing the tax advantages of making qualified plan contributions. However, for some plan sponsors, a qualified plan contribution may be more valuable now than ever.
As it relates to Section 199A it is important to cover a few of the basic rules before diving into how plan sponsors may benefit from enactment of this new deduction.
First, Section 199A may provide a deduction of up to 20% of QBI. It is important to distinguish QBI from net business income. While net business income may provide a reasonable starting point for the determination of QBI, a number of exclusions must be considered. For example, non-US sourced income and capital gains and losses are excluded from QBI. Determining a taxpayer’s QBI can be complicated and it is important to understand that QBI may not be the same as net business income.
Second, the ability of a taxpayer to claim the Section 199A deduction may be limited to W-2 wages and qualified property associated with the generated QBI. For taxpayers filing joint tax returns with taxable income in excess of $415,000 ($207,500 for non-joint filing taxpayers) the Section 199A deduction will be limited to the lesser of (A) 20% of QBI or (B) the greater of (i) 50% of W-2 wages or (ii) 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of qualified property. It is important to note that this limitation is subject to a “phase in,” and joint filing taxpayers reporting taxable income of less than $315,000 ($157,500 for non-joint filing taxpayers) are not subject to this limit. For taxpayers with taxable income between the upper and lower ends of the ranges, the limit is applied based on how far into the range taxable income falls.
Finally, the ability to claim the Section 199A deduction may be further limited to the extent the QBI is generated from a Specified Service Trade or Business (SSTB). Recently proposed regulations published under Section 199A provide much needed guidance intended to assist in determining whether or not a trade or business is an SSTB. However, oftentimes the determination of whether a trade or business will be considered an SSTB requires significant analysis. Once determined to be an SSTB, the rules will operate to disallow the deduction under Section 199A similar to the limitation previously described. Consequently, joint filing taxpayers with taxable income exceeding $415,000 ($207,500 for non-joint filing taxpayers) will not be able to claim any Section 199A deduction for QBI attributable to an SSTB. For joint filing taxpayers with taxable income below $315,000 ($157,500 for non-joint filing taxpayers) will not be subject to this SSTB exclusion. Taxpayers within the respective income ranges ($315,000 - $415,000 for joint filing taxpayer and $157,500 - $207,500 for all other taxpayers) will be subject to a similar phase in as described above.
With that background, we can now address determining whether a plan sponsor will benefit more, the same, or less from increasing qualified plan contributions under TCJA. To a large degree, the potential benefit of increasing qualified plan contributions is dependent upon the taxable income ultimately being reported on the individual’s income tax return. Consequently, determining the extent these increased qualified plan contributions may create benefit can be difficult.
Broadly:
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Plan Sponsors whose owners report taxable income below the threshold levels described above will not see incremental benefits from increased qualified plan contributions, and will likely see a decrease in tax savings from the qualified plan contributions they are already making. For these sponsors, other reasons for funding a qualified plan will become more important, such as employee retention or accelerated retirement savings for business owners and executives.
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Plan Sponsors whose owners receive very high levels of QBI are unlikely to fund sufficient additional qualified plan contributions to reduce taxable income to a level that will create an incremental benefit. These sponsors will see little change in the tax savings of a qualified plan contribution.
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Plan Sponsors whose owners report taxable income moderately in excess of the threshold levels and generate QBI from an SSTB (or QBI that generated from an activity having an insufficient amount of W-2 wages and/or qualified property) may realize significant benefits from increased qualified plan contributions. This is because in addition to the normal reduction of taxable income, the deduction of the contribution may also trigger an increase in the allowable Section 199A deduction. If an advanced plan design is used, there are more sponsors who fall in this third group than one might initially think.
BDO Insight: What New Section 199A Rules Mean for Plan Sponsors
As described above, certain owners of Plan Sponsors may see an additional benefit from increased qualified contributions. Let’s look at two examples.
Example 1. Consider a single sole proprietor with Form 1040 taxable income of $208,000 and QBI of $208,000 (so no adjustments needed to determine QBI). This is above the $207,500 threshold limitation, so the Section 199A deduction may be limited (depending on whether the QBI is generated from an SSTB or has insufficient W-2 wages or qualified property associated with it)., For the sake of example, let’s assume the Section 199A would be limited to zero. Now let’s assume this sole proprietor makes a $50,500 qualified plan deduction. Now taxable income and QBI are reduced to $157,500. The Section 199A deduction is limited to the lesser of 20% of taxable income or 20% of QBI. Consequently, the Section 199A deduction would be 20% * $157,500, or $31,500. Net taxable income is now $126,000. Assuming a 24% marginal tax rate, the Section 199A tax savings is $31,500 x 24% = $7,560, and the regular tax savings is $50,500 x 24% = $12,120. Total tax savings from the $50,500 contribution is $19,680 for a 39% effective tax savings.
Example 2. Consider a married sole proprietor taxable income of $555,000 and QBI generated from an SSTB of $555,000. This is above the $415,000 limit, and QBI is generated from an SSTB, so the Section 199A deduction would be zero. Now assume this client makes total contributions of $240,000 to their qualified plans. This would bring their income and QBI down to $315,000 and allow a 199A deduction of $63,000. Net taxable income would now be $252,000. Assuming a 24% marginal tax rate, the Section 199A tax savings is $63,000 x 24% = $15,120, and the regular tax savings is $240,000 x 24% = $57,600. Total tax savings from the $240,000 contribution is $72,720 for a 30.3% effective tax savings.
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