With the end of the year rapidly approaching, now is an ideal time for small-business clients to take stock and plan to maximize the value of the Section 199A deduction for qualified business income (QBI).
2020 and 2021 have both been tumultuous years for most individual and small-business clients. Many may have overlooked basic planning strategies that can help them take advantage of the Section 199A deduction — which, technically, is still set to expire in just a few short years absent congressional action.
For many small-business clients, it's not too late to take steps to minimize taxable income to qualify for the full 20% QBI deduction — and some of these options can provide powerful long-term benefits that extend far past maximizing the QBI deduction.
Section 199A QBI Deduction: The Basics
The 2017 tax reform legislation allows pass-through entities (such as partnerships, S corporations and sole proprietorships) to deduct 20% of "qualified business income" (QBI) in 2018 through 2025. Despite this, "service businesses" (including attorneys, accountants, doctors, financial advisors, and certain other service-related professionals) are not entitled to the full benefit of the 20% deduction if the business owner's taxable income exceeds certain threshold amounts.
The applicable threshold levels for 2021 are $329,800 (married filing jointly) or $164,900 (single filers), and the deduction is phased out for service business owners with income between the threshold levels plus $50,000 for individual filers or $100,000 for joint filers. This means that clients who own service businesses and have taxable income that exceeds $429,800 (married filing jointly) or $214,900 (single filers) will not receive the benefit of the new deduction.
Fortunately, many business owners have significant opportunities to reduce overall taxable income — all while taking steps to secure their own retirement.
Pretax Defined Contribution Plan Strategies
Many higher-income clients are already making the maximum contributions to traditional retirement plans, health savings accounts and other savings vehicles. Small-business clients, however, can opt to establish a SEP-IRA or fund a 401(k) from both the employee and employer side of the aisle.
A SEP-IRA can allow a small-business owner to reduce taxable income by up to $58,000 (or 25% of compensation) in 2021 (the same limits that apply to 401(k)s also apply to SEPs). Because the client isn't required to contribute to the account every year, a small-business client could establish the plan primarily to take advantage of the potentially temporary QBI deduction, and simply stop contributing (or reduce contributions) if Congress allows the 199A deduction to expire after 2025.
SEP-IRAs will likely appeal to business owners with no employees (or those who primarily employ a spouse or family members) because while contributions are not required each year, if the employer contributes any amount to a SEP-IRA in any given year, contributions to the accounts of all employees who have performed services for the employer in that year become mandatory and contributions must be uniform among eligible employees (certain employees who are under 21, earn less than $600 during the year or have not worked for the employer for three of the five preceding years may be excluded from participation).
Any employer can establish a SEP-IRA as long as that employer does not maintain any other retirement plan — there is no maximum number of employees, as is the case with SIMPLE IRAs. SEP-IRAs are retirement savings accounts that allow employer contributions only (employee contributions are not permitted).
