When to take the new QBI tax deduction
The hallmark of good tax planning is to pay taxes when your rates are the lowest. All too often, however, people simply look at their taxable income, compare it to a chart showing the tax brackets and assume that any additional income will be taxed at that rate.
That’s not always true.
Case in point, one of the most significant pieces of tax legislation passed in 2017 was the creation of IRC Section 199A, allowing small business owners to deduct up to 20% of the profits of their business. This qualified business income, or QBI, deduction presents taxpayers with a significant tax planning opportunity. By accelerating income, a portion of the tax liability that would normally be attributable to the increased income can be covered by a corresponding increase in the taxpayer’s 199A QBI deduction.
Ultimately this can lead to so-called deduction production income being taxed at just 80% of the otherwise applicable tax rate. And insofar as tax planning is first and foremost about trying to pay taxes at the lowest possible rate, that becomes much easier to do when 20% of your income is effectively tax-free thanks to a deduction that increases in tandem with your income.
Much of IRC Section 199A pivots around what exactly constitutes combined qualified business income. At its most basic, it’s an expression of the net profits of all a taxpayer’s businesses, plus net profits from REIT dividends and publicly traded partnerships. For those who aren’t investing in those vehicles, determining combined qualified business income simply comes down to one question: What was the qualified business income generated by the business itself?
In many cases business owners have more total income than just their combined QBI, e.g., other investment income, a spouse’s W-2 wages, etc. Consequently, even after deductions are considered their total taxable income is greater than their qualified business income.
This simply means the QBI deduction itself is limited to 20% of their qualified business income, since that would be less than 20% of their total taxable income, even after all other deductions.
However, if a business owner’s total personal income is entirely or even just mostly comprised of qualified business income from the business, then their various personal and other deductions will end up applying directly against their business income on their personal tax return — such that 20% of their taxable income is less than 20% of their qualified business income. In other words, when a business owner’s income is too concentrated in the business alone, they may not be able to receive the otherwise-maximum QBI deduction that might have been available based on their business income alone.
Example 1: Sally is a single, sole-proprietor CPA who has $100,000 of net profit on her 2019 Schedule C. After subtracting $7,065 from Sally’s Schedule C net profit to account for the deduction for one-half of her self-employment tax as required by the 199A Final Regulations issued by the IRS on January 18, 2019, Sally’s qualified business income for 2019 is $92,935. Thus, the maximum potential QBI deduction that Sally could receive for the qualified business income generated by her CPA practice is $92,935 x 20% = $18,587.
Suppose though that Sally’s business income is her only income for the 2019 tax year, and that she claims the minimum amount of additional deductions: the $12,200 standard deduction for a single filer in 2019. Based on these facts, Sally’s 2019 taxable income prior to the application of the 199A deduction will be $80,735. This would produce a QBI deduction of only $80,735 x 20% = $16,147.
Since the QBI deduction is ultimately limited to the lesser of 20% of qualified business income ($18,587) or 20% of taxable income ($16,147), the final QBI deduction for Sally will be only $16,147.
Even though Sally would normally get a QBI deduction of $18,587 based on 20% of her qualified business income, owing to the fact that Sally’s only income is from the business and her personal deductions — in this case, the standard deduction — effectively applied against her business income on her personal tax return, Sally only sees a QBI deduction of $16,147.
Thus, as a result of the taxable income limitation, her potential QBI deduction is reduced by $18,587 potential deduction – $16,147 actual deduction = $2,440.
If a taxpayer’s only source of income is qualified business income — i.e., net profits from a sole proprietorship on Schedule C or net profits from a partnership, as reported in Box 1 of Schedule K-1 — taxable income will always be less than qualified business income.
If the individual’s sole income is the business income and any level of personal-return deductions are applied against it — generally, at least the standard deduction, or if greater their itemized deductions — then taxable income will simply be the business income reduced by personal deductions, which is always lower than the business income itself. Accordingly, this will limit the QBI deduction.
So in order to avoid the 199A taxable-income-limitation, a taxpayer must effectively have other income equal to or greater than their below-the-line deductions — e.g., the greater of their applicable standard deduction or itemized deductions — such that even after deductions their taxable income is still at least as much as their original qualified business income.
That said, not just any type of income will be eligible to lift taxable income for purposes of the QBI deduction.
GAINS AND DIVIDENDS
One important caveat for those subject to the 199A deduction taxable income limitation is that not all taxable income actually counts as such for 199A deduction purposes.
Specifically, IRC Section 199A(a)(2) states that for the purposes of the 199A deduction, the term “taxable income” does not include “the net capital gain (as defined in section 1(h)).” And IRC Section 1(h)(11(A) states:
“In general, for purposes of this subsection, the term ‘net capital gain’ means net capital gain (determined without regard to this paragraph) increased by qualified dividend income.”
Thus, for purposes of the 199A taxable income limitation, taxable income really means taxable income minus net capital gains — regardless of whether those gains are long- or short-term — minus qualified dividends but not ordinary dividends.
Of course, below-the-line deductions are not the only ways that taxpayers can reduce their taxable income. In addition to their standard deduction/itemized deductions, many taxpayers also claim one or more above-the-line deductions on their personal tax return — another way to reduce both taxable income and adjusted gross income. Thus, determining whether above-the-line deductions will have the same QBI deduction taxable-income–limiting impact for a business owner is more complicated.
While it might seem odd that deductions taken on a personal income tax return could reduce qualified business income, the Final 199A Regulations released by the IRS on January 18, 2019, make this oddity explicitly clear. Specifically, Treasury Regulation Section 1.99A-3(b)(vi) reads in part:
For purposes of section 199A only, deductions such as the deductible portion of the tax on self-employment income under section 164(f), the self-employed health insurance deduction under section 162(l), and the deduction for contributions to qualified retirement plans under section 404, are considered attributable to a trade or business to the extent that the individual’s gross income from the trade or business is taken into account in calculating the allowable deduction, on a proportionate basis to the gross income received from the trade or business.
In other words, some above-the-line deductions will reduce both taxable income and qualified business income, which also indirectly means some above-the-line deductions reduce taxable income but not qualified business income.
As a result, not all deductions on the personal return are necessarily problematic, as only the latter exacerbates the impact of the taxable income limitation on the QBI deduction — because they increase the difference between QBI and taxable income — whereas deductions of the former do not have the effect because they also reduce QBI itself by an equivalent amount.
Example 2a: After accounting for her $7,065 deduction for self-employment taxes, Sally’s qualified business income was $92,935, and after accounting for both her $7,065 above-the-line deduction for self-employment taxes and $12,200 standard deduction, her taxable income prior to the application of the 199A deduction was $80,735.
Thus, her maximum potential QBI deduction was limited to $16,147, or 20% of her taxable income, instead of $18,587, which represented 20% of her qualified business income — effectively reducing her QBI deduction by 20% of the amount by which her taxable income prior to the application of the 199A deduction was less than her QBI, or ($92,935 – $80,735) x 20% = $2,440.
Suppose, however, that Sally decides to make a $10,000 SEP IRA contribution. Per Treasury Regulation Section 1.99A-3(b)(vi), Sally must reduce her QBI by $10,000. Thus, as a result of the contribution her QBI drops to $82,935, reducing her maximum potential QBI deduction to $16,587.
At the same time, the $10,000 SEP contribution will also reduce Sally’s taxable income prior to the application of the 199A deduction by $10,000, to $70,735. This in turn reduces her actual QBI deduction to $14,147. Not coincidentally, the difference between this amount and Sally’s potential QBI deduction after her SEP contribution is $2,440, exactly the same amount by which her QBI deduction was reduced due to the 199A taxable income limitation before the SEP IRA contribution.
As the above example highlights, while the SEP IRA contribution reduced the value of Sally’s SEP IRA contribution, it at least did not amplify the adverse impact of the 199A taxable income limitation. That’s because SEP IRA contributions reduce both the business’s income and taxable income at the same time.
Example 2b: Imagine that Sally also makes a $2,000 contribution to an HSA for 2019, and thus is entitled to a $2,000 above-the-line deduction for her contribution. This $2,000 deduction does not further reduce QBI, but it would reduce her taxable income by another $2,000.
Consequently, Sally’s maximum potential QBI deduction would continue to be $82,935 x 20% = $16,587, but as a result of the taxable income limitation her actual QBI deduction would now be reduced to ($70,735 – $2,000 = $68,735) x 20% = $13,747.
The end result is that Sally’s actual QBI deduction is now $2,840 less than her maximum potential QBI deduction, as compared to $2,440 in Example No. 2a. Thus, there is a $400 increase in the amount of lost QBI deduction due to the taxable income limitation resulting from Sally’s non-QBI-reducing deduction for her HSA contribution.
Viewed another way, the HSA deduction was less valuable than it would have been because the HSA deduction itself effectively reduced the QBI deduction, given Sally was already subject to the taxable income limitation.
Putting it all together, if an individual’s taxable income prior to the application of the 199A deduction falls below their applicable phaseout range, then their QBI deduction will be reduced by the taxable limitation when the following formula is true:
That is, if non-QBI–reducing, above-the-line deductions plus the standard deduction/itemized deductions is greater than other, non-QBI ordinary income, the QBI deduction will be limited to 20% of taxable income.
This difference between the way the QBI-reducing deductions and non-QBI–reducing deductions impact the ultimate QBI deduction calculation is a critical concept to understand in order to maximize 199A deduction planning — specifically in scenarios where the taxable income limitation comes into play.
Notably though, the impact that QBI-reducing deductions have on the ultimate QBI deduction calculation cannot be offset by other planning, as they reduce QBI itself. By contrast, the impact that other, non-QBI–reducing deductions have on the QBI deduction calculation can be offset by having — or generating — more taxable income.
THE INCOME IMPACT
When a person’s QBI deduction is limited by their taxable income — e.g., as opposed to their QBI, or due to wage/depreciable property phaseouts — their QBI deduction can be increased up to a point by adding more taxable income that doesn't arrive in the form of a capital gain or qualified dividend. While this does increase the overall tax bill, a portion of the tax attributable to the increase in income is offset by an increase in the QBI deduction. This means, in essence, that this income is taxed at an unusually low rate.
Example 3: Al and Peggy are married and file a joint return. Al is a partner in Harry’s Shoes and Accessories, a very successful local business. In 2019 Al’s share of net profits from the partnership are expected to be $275,000. This will be the couple’s only income for the year.
As such, after accounting for the couple’s $11,923 deduction for self-employment tax, their QBI will equal $263,077.
However, suppose that in addition to the deduction for self-employment taxes, the couple also has $45,000 of itemized deductions — e.g., from a substantial mortgage on the recent new home they purchased for their family. As such their taxable income prior to the application of the 199A deduction is $218,077. And since this amount is less than the couple’s $263,077 QBI, their 20% 199A deduction will equal $218,077 x 20% = $43,615.
After accounting for the QBI deduction, Al and Peggy have taxable income of $218,077 – $43,615 = $174,462, which gives them a income tax liability, excluding self-employment taxes, of $23,881, putting them squarely in the 24% bracket for 2019. Given this reality, one would expect that if Al and Peggy were to add additional income to their return, they would pay tax at a 24% rate, but that’s not necessarily what happens.
Now that the couple’s children are a bit older and in school, Peggy decides she wants to go back to work part time. If Peggy were earning $30,000 in W-2 wages for her part-time work, it would be logical to expect that the couple’s federal income tax bill would increase by $30,000 x 24% = $7,200. But run the numbers and you’ll find that when you add the $30,000 salary, the couple’s taxable income increases by just $24,000, resulting in an increase in federal income tax of just $5,760. How can this be?
In short Peggy’s $30,000 of W-2 wages are partially offset by the production of more 199A deduction. More specifically, the additional $30,000 of wages increases the couple’s taxable income prior to the application of the 199A deduction to $248,077. This amount is still less than the couple’s QBI of $263,077, but is much closer than before, and results in an actual QBI deduction of $49,615. That’s $6,000 more than the couple’s QBI deduction would have been before Peggy went back to work and earned more income.
The increase in the QBI deduction is the reason why adding $30,000 of actual income only increases final taxable income by $24,000. And by the same token, it’s also why the couple’s tax rate on the actual $30,000 was a very favorable 19.2% and not 24%.
In other words, the QBI deduction production process effectively created a tax rate equal to 80% of the original bracket rate (24% x 80% = 19.2%). Viewed another way, Peggy didn’t have to pay taxes on 20% of her new employment income because her salary increased the household’s taxable income limitation enough to produce an extra $6,000 of QBI deductions on Al’s shoe store business profits.
LIMITS OF QBI
In situations where the QBI deduction is being limited by taxable income in the first place, producing more income can actually increase the QBI deduction, and in the process such deduction production income is taxed at only 80% of the otherwise applicable rate.
A real federal income tax rate that is just 80% of the stated federal income tax rate probably sounds rather appealing. But it’s important to remember that the QBI deduction production income process is not one that continues forever.
Rather, once taxable income prior to the application of the 199A deduction equals QBI, the deduction production effect stops, and additional income will not result in an increased QBI deduction. Thus, such income will simply be taxable again at the retail rate of a taxpayer’s applicable tax bracket(s) — or ultimately, the taxpayer’s marginal tax rate after considering the potential phaseout of key deductions and/or credits.
Example 4: Recall Al and Peggy from Example No 3. Imagine Peggy decides to go full-time instead of part-time, and her salary doubles from $30,000 to $60,000. Would that result in another $6,000 of QBI deduction production — i.e., the same as was generated from Peggy’s first $30,000 of salary — for the couple, reducing their effective tax rate on the income?
The answer is no.
After accounting for Peggy’s $60,000 salary, the couple would have taxable income prior to the application of the 199A deduction of $278,077, while QBI would remain at a portion of $263,077. Here, the limiting factor would no longer be taxable income, but rather the lower QBI amount itself.
Therefore, the couple’s QBI deduction would be $263,077 x 20% = $52,615, which is only $3,000 higher than before earning the extra $30,000 of income — i.e., not 20% x $30,000 = $6,000 of additional deductions.
As Example No. 4 shows, once Peggy’s salary — e.g., the couple’s only non-QBI eligible taxable income — reaches $45,000, equaling the couple’s non-QBI reducing deductions, the maximum QBI deduction is achieved and an additional 199A deduction production for additional income is no longer available. Further increases in taxable income are no longer subsidized by a growing 199A deduction.
THE ROTH EFFECT
While there are certainly exceptions to the rule, in general taxpayers whose 199A deductions are restricted by the deduction’s taxable income limitation should give serious consideration to finding ways to accelerate taxable income. By doing so, the resulting 199A deduction production will cover the tax cost of some of that income, such that the income will only be taxed at 80% of its otherwise-applicable rate.
Taxpayers may have a variety of options at their disposal when attempting to engage in some good old-fashioned deduction production income strategies, but the best option for many will be to engage in Roth IRA conversions.
Not only are Roth conversions that create 199A deduction production subsidized by the corresponding increase in the 199A deduction, but such conversions also offer the benefit of protecting future growth from taxation as well — at what will likely be a favorable current tax rate, especially when that rate is only 80% of the otherwise-applicable tax bracket.
Roth conversions also offer other, more practical deduction production benefits as well. For instance the income produced by a Roth conversion is easy to control: Simply decide how much to convert. Conversions are also easy to initiate, can generally be processed quickly and, perhaps most importantly, can create income in relatively short order.
Indeed, depending on an individual’s IRA custodian, a Roth IRA conversion request might be able to be submitted up to and including December 31 of the year. Thus, even if a tax projection is completed on the final day of the year, presuming that projection suggests the taxpayer would benefit from the acceleration of income to trigger a 199A deduction production, it’s possible that a Roth IRA conversion can still be done in time to achieve the goal.
Example 5: Jack and Sandra are a married couple who file a joint tax return. Jack is 60 years old and retired, while Sandra continues to work in her sole proprietorship medical practice. As 2019 comes to a close, the couple meet with their advisor and CPA. Sandra estimates that she will net a $240,000 profit from her sole proprietorship, and Jack thinks they will have $38,000 in itemized deductions. Finally, Sandra intends to make a traditional IRA contribution for the maximum deductible amount of $7,000 for 2019 — including a catch-up contribution for being over age 50 — plus an additional $7,000 for Jack as a spousal IRA contribution.
Based on the information provided by the couple, Jack and Sandra’s tax advisor calculates that they will have qualified business income from Sandra’s sole proprietorship of $228,546 — i.e., her $240,000, less the $11,454 of deductible self-employment taxes. The couple’s taxable income prior to the application of the 199A deduction is calculated as $176,546. After subtracting the $176,546 x 20% = $35,309 QBI deduction, the couple’s final taxable income is $141,237, giving them a federal income tax liability of $22,789, and putting them right in the middle of the 22% bracket, which spans from $75,951 to $168,400 in 2019.
Suppose now that in the context of the “to Roth or not” conversation, the couple believes that their future tax rate in retirement will be somewhere around 20%. Would it make sense to add more income now, even though they’re in the 22% bracket, which is higher than what they anticipate their future tax rate to be?
In a word, yes.
To illustrate how such a Roth conversion could benefit Jack and Sandra, suppose that they executed a Roth conversion with the intent of maximizing their available bracket space within their current 22% bracket. Since the 24% bracket begins at $168,400 and their current taxable income is $141,237, that might lead one to think that adding another $168,400 – $141,237 = $27,163 of income via a Roth conversion would allow the couple to top off their 22%. But remember, as the couple’s taxable income increases, so too will their QBI deduction.
Thus, a Roth IRA conversion of $27,163 will only increase the couple’s taxable income by $21,730 to $162,967. Instead, it will take a conversion of $33,954 to bring taxable income after the impact of the QBI deduction production up to the $168,400 top of the 22% bracket.
In reviewing the tax impact of the $33,954 conversion, Jack and Sandra’s federal income tax liability increases from $22,789 pre-conversion to a post-conversion total of $28,765. That’s a $5,976 increase, which translates to an effective tax rate on the conversion of $5,976 / $33,954 = 17.6%. Not coincidentally, 17.6% is also equal to 80% times the tax bracket in which the income was taxed.
Armed with this knowledge, if Jack and Sandra are anticipating a future tax rate of 20%, their deduction production Roth IRA conversion should be increased even further, since going into the 24% bracket would also make sense, as 24% x 80% = 19.2%
Thus, Jack and Sandra could fully offset their $38,000 itemized deductions and $14,000 of total IRA contribution deductions’ reduction of their potential 199A deduction by converting a total of $52,000, pushing further into the 24% tax bracket — which is only a net 19.2% tax rate for them, thanks to the 199A Deduction-Production effect. This equalizes the couple’s taxable income before the application of the 199A deduction to their qualified business income of $228,546, allowing them to max out their QBI deduction at $45,709.
As the above example illustrates, income that generates a deduction production effect ends out being taxed at 80% of the otherwise applicable rate. This is not only easy to control via Roth conversions but can actually make Roth conversions more appealing precisely because the current Roth conversion rate is reduced, making it easier to stay below the projected future tax rate.
However, it’s important to bear in mind that any additional ordinary income added beyond the point that taxable income after deductions equals QBI — or alternatively, the point at which other eligible income equals the couple’s various deductions — additional income would not result in any additional QBI deduction, and would therefore simply be taxable at regular, not-necessarily-appealing tax rates.
For individuals who would benefit from adding more deduction production income, but who either don’t have enough traditional, pre-tax retirement funds to Roth convert to maximize its potential — or who can’t access those funds, perhaps because they are locked up in an employer’s 401(k) to which there is currently no access — other potential sources of ordinary income generation should be considered.
One option is to simply earn, or have a spouse earn, additional W-2 wages, as such income is taxable at ordinary rates but is not, in and of itself, qualified business income eligible for the 199A deduction.
This is one reason why owners/employees of S corporations are less likely to benefit from the deduction production strategy than partners or sole proprietors. Unlike the latter, S corporation owner/employees should already be receiving a reasonable (if not QBI-eligible) salary, which also happens to reduce chances that taxable income will be less than qualified business income. That’s owed to the fact that the salary is considered other, non-QBI taxable income to offset against available deductions. And when taxable income, including non-QBI salary, is greater than QBI from the business to begin with, there is no opportunity for deduction production income tax savings at all.
Of course, for those paying themselves a salary from their own business, earning W-2 wages means actually working, which in and of itself makes it less attractive than other options. A non-working spouse may not have any desire to (re-)enter to the workforce in order to get a tax break, while a QBI-generating business owner may lack both the time and the desire to work another job.
Another potential source of deduction production income could lie in transitioning qualified-dividend–paying investments to ordinary-income–paying investments. Recall that the effect of deduction production is to create an effective rate that is 80% of the actual rate. For instance, a filer in the 22% ordinary income bracket pays tax on qualified dividends at a 15% rate. But if that taxpayer is able to benefit from deduction production income, the ordinary income tax rate effectively drops to 17.6%, while the qualified dividend rate remains unchanged at 15%.
Thus, the after-tax yield calculation shifts, potentially making such a switch in investments more attractive — as the ordinary income yield would only have to be very slightly higher than the available dividend yield to be superior on an after-tax basis.
Other ways to engage in deduction production income include taking taxable distributions from non-qualified annuities, as well as simply adjusting the timing of certain deductions to not claim them in the current year when the taxable income limitation is in effect for a QBI deduction.
For example, instead of making a December contribution to a favorite charity, a taxpayer might wait until January of the following year to make the same contribution in order to allow the QBI deduction to be better maximized in the current year.
When considering whether to engage in deduction production income strategies, it’s important to consider whether taxable income is the only factor limiting the amount of the QBI deduction. That’s because in the end, the total amount of QBI deduction for which a person is eligible can be limited by a number of other factors as well.
Once an owner of a Specified Service Trade or Business, or SSTB, has taxable income that begins to exceed the lower end of the phaseout range — $160,700 for single filers and $321,400 for joint filers in 2019 — they begin to see their QBI deduction phased out regardless of whether taxable income is greater or less than their QBI.
As an SSTB owner’s taxable income approaches the top of their phaseout range — $210,700 for single filers and $421,400 for joint filers in 2019 — it continues to be reduced. And once taxable income reaches the top of the phaseout range, the QBI deduction is eliminated altogether.
In such instances adding more taxable income is not likely to help. In fact, it might even hurt. That’s because in situations where an SSTB owner’s taxable income is less than their QBI, and adding more taxable income would push them further into or above the phaseout range, they may be trading one restriction on the deduction’s benefit for another that’s even worse.
High-income owners of businesses that are not SSTBs may also find themselves in the same position if they don’t have enough wages or depreciable property to cover a full QBI deduction. When such business owners have taxable income in excess of the top of their phaseout range, the maximum QBI deduction that they can receive is equal to the greater of 50% of wages paid, or 25% of wages paid plus 2.5% of the unadjusted basis of depreciable property owned by the business. Note that the testing is phased in for such business owners within the phaseout range.
Thus, for non-SSTB business owners with sufficient wages and/or depreciable property — such that their QBI deduction is not limited by the tests — deduction production income can be implemented in a manner similar to those business owners, SSTB and non-SSTB, with taxable income below the start of their phaseout range. However, for those high-income, non-SSTB business owners whose wages/depreciable property have already been fully absorbed by the wage/wage-and-depreciable-property tests — and thus have already capped the QBI deduction — deduction production income is no longer possible, and the addition of more taxable income for that purpose should be avoided.
WHEN HIGHER ISN’T
Many times, the addition of more income creates a tax rate that’s higher than the stated tax rate because the income is simultaneously eliminating some sort of deduction of credit. Occasionally, however, there’s a quirk in the law that can be exploited, allowing additional income to be taxed at what might be considered an artificially low rate.
The ultimate takeaway here is that the deduction production strategy produces an effective tax rate that is just 80% of the rate that income would otherwise be taxed at. Thus, for this income acceleration strategy not to make sense, a business owner’s future tax rate would have to be at least 20% lower than their current rate.
That’s an unlikely outcome for many successful business owners, making the deduction production strategy today a no-brainer — at least for those who are eligible and whose circumstances are such that they stand to benefit.