Tax reform and retirement plans: The QBI deduction

By David J. Kupstas, FSA, EA, MSPA

As third-party administrators, we can get very anxious when we learn that Congress is thinking of tinkering with the retirement plan rules in the tax code. We wonder, will this help our clients? Will it hurt them? We also wonder how our own business will be affected.

When retirement plan law is changed, it is usually easy to decide whether a given change is good or bad:

•  Allowing companies to make bigger contributions to defined benefit plans: Good!
• Reducing the compensation that may be taken into account when determining benefits: Bad!
•  Introducing safe harbor 401(k) plans so the Actual Deferral Percentage (ADP) test may be avoided: Good!

Then along came the much-anticipated Tax Cuts and Jobs Act of 2017 (TCJA), a.k.a. “tax reform,” a.k.a. “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.” Yes, that last one is actually the real name of this law, but that’s a story for another day. Anyhow, they might as well have called it the Accountants and Actuaries Full Employment Act, because all of us in these professions are going to be working night and day trying to figure out what this law means to us and our clients.

There were ‘NO changes’ to the 401(k) limits

In his presidential campaign, Donald Trump promised us tax reform. As summer turned to fall in 2017 and it appeared tax reform stood a good chance of becoming reality, a couple of concerns emerged in the retirement plan industry. First, rumor had it that the limit on pre-tax 401(k) deferrals might be lowered from $18,000 to $2,400. Salary deferrals exceeding the new lower threshold would be subject to “Rothification,” meaning they would be after-tax, a la the Roth IRA. This change would clearly fall under the “bad” category. In response to these reports, President Trump tweeted, “There will be NO change to your 401(k). This has always been a great and popular middle class tax break that works, and it stays!” Indeed, the 401(k) limits, as well as pretty much everything else directly related to qualified retirement plans, were not touched.

This doesn’t mean the retirement-plan industry got off scot-free. Another proposal called for capping the tax rate on pass-through income from entities such as S corporations,

LLCs, partnerships and sole proprietors. Why is that so bad? The concern was that small businesses would be less likely to sponsor retirement plans. If a business owner could take income today and pay tax at a reduced rate, why should he adopt a retirement plan and pay a higher rate in the future when the distributions from that plan were taxed as ordinary income?

Unlike the 401(k) limit changes, a reduction of sorts in the pass-through income tax rate did make its way into the final tax reform bill. Did this kill the incentive for a small business to adopt a qualified retirement plan? We think not — and we certainly hope not, or else we will put on our third-party administrator hat and unequivocally declare this to be a bad law!

QBI deduction keeps pass-throughs on par with c corps

The Section 199A, or Qualified Business Income (QBI) deduction, has gained significant attention in the retirement plan world, so we will spend the remainder of this article discussing that provision and its possible impact on qualified retirement plans. Here are a few facts to get us started:

•  TCJA reduced the C corporation tax rate from 35 percent to 21 percent. The QBI deduction was designed to give pass-through entity owners a tax break on par with that given to C corporations.
• Generally, the QBI deduction is 20 percent of the lesser of qualified business income and the taxpayer’s taxable income as reduced by net capital gains and qualified cooperative dividends. The QBI deduction is not used to compute Adjusted Gross Income (AGI), but rather is a “below-the-line” deduction.
• It matters whether the pass-through entity is a “specified service trade or business.” Specified service trades or businesses are health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners. Engineering and architecture are specifically excluded from the list of occupations.
• There are limitations and phase-outs for this deduction. We will discuss these briefly as we go on.

Let us look now at a few examples.

Small business with owner below the income threshold

The full 20 percent QBI deduction is available to any pass-through entity owner whose total taxable income is below $157,500 (single filers) or $315,000 (married joint filers). The taxable income for this purpose is computed without regard to the QBI deduction. Consider these facts about Adams, who is married and the 100 percent owner and sole employee of an S corporation:

• Qualified business income: $140,000
• W-2 wages: $100,000
• Other income: $10,000
• Taxable income: $250,000
• 20 percent QBI deduction (20 percent × $140,000): $28,000
• Net taxable income ($250,000 - $28,000): $222,000

We haven’t said what occupation Adams is in, but it does not really matter. Because his taxable income is below the $315,000 threshold, he is eligible for the QBI deduction.

Now assume Adams adopts a defined benefit (DB) plan and contributes $60,000. The numbers now look like this:

• Qualified business income: $80,000
• Taxable income: $190,000
• 20 percent QBI deduction (20 percent × $80,000): $16,000
• Net taxable income ($190,000 - $16,000): $174,000

Without the plan, Adams’ net taxable income is $222,000. With the plan, it is $174,000. That’s a $48,000 reduction. In that sense, the $60,000 contribution is 80 percent deductible [($222,000 - $174,000) ÷ $60,000]. Adams may not think it is worth it to contribute to the retirement plan. Indeed, under TCJA, it is pass-through entity owners whose taxable incomes fall below the $157,500/$315,000 threshold who are most likely to eschew a retirement plan.

Still, it must be noted that the $60,000 will grow tax-deferred in the qualified retirement plan. Moreover, there is an underlying assumption when deciding to contribute to a retirement plan that the owner will be in a lower tax bracket when the contributions are ultimately withdrawn than during the high-income working years. The incentives to contribute may be higher if Adams resides in a state with high state and local income taxes (SALT) and itemizes deductions. The retirement plan contributions could reduce income subject to state income tax so that no SALT deduction is lost due to the new $10,000 limit.

There are very good reasons to adopt a retirement plan besides the tax benefits. Having a plan helps attract and retain talent, contribute to the financial well-being of employees and owners and perhaps protect assets from creditors, among other things. Perhaps Adams will sponsor a retirement plan for these reasons.

In some cases, it pays to start a retirement plan even if the current benefits are not apparent. Maximum contributions and benefits can be achieved in a defined benefit plan if the owner participates in the plan for at least 10 years. Having more years of participation “expands the bucket” into which contributions may be made. Often, when assisting with the startup of a new defined benefit plan, we wish the plan had been set up a year or two earlier with modest contributions. Having those additional years of participation would have paved the way for larger contributions once the business started to flourish. Oh, well. Hindsight is 20/20.

Specified service business owner above income threshold

Now we will move on to Baker, Adams’s old nemesis from high school. Baker always wanted to outdo Adams — on the football field, in the classroom, in dating — and almost always did. These days, Baker owns a business just like his old buddy Adams, except his income is double that of Adams. We will mention here that Baker is a prominent local attorney. Here are Baker’s numbers:

• Qualified business income: $280,000
• W-2 wages: $200,000
• Other income: $20,000
• Taxable income: $500,000

The QBI deduction is not listed. Did you guess that it is $0? You guessed correctly. Baker’s taxable income is too high to qualify for the QBI deduction. When there is a specified service trade or business, like Baker’s law firm, the QBI deduction starts to phase out once you hit the $157,500 or $315,000 taxable income thresholds. The deduction goes down on a sliding scale for the next $50,000 of income after $157,500 for single taxpayers and for the next $100,000 of income after $315,000 for married taxpayers filing jointly. When there is taxable income exceeding $207,500 (single) and $415,000 (married filing jointly), the QBI deduction is lost.

Stop for a moment and digest that. Usually when an income threshold or other limit is reached in the tax world, the relevant deduction or benefit is capped, but you still get the deduction or benefit on the dollars up to the limit. In this case, anyone exceeding the taxable income threshold loses the QBI deduction completely. Baker gets zippo for a QBI deduction. Adams must be laughing hysterically.

But, as he did throughout high school and even into their adult years, Baker is going to have the last laugh. How? He is going to adapt and contribute $200,000 to a defined benefit retirement plan. Now let’s see how those numbers look:

• Qualified business income: $80,000
• Taxable income: $300,000
• 20 percent QBI deduction (20 percent × $80,000): $16,000
• Net taxable income ($300,000 - $16,000): $284,000

Voila! On the strength of a $200,000 defined benefit contribution, Baker’s taxable income is now comfortably below the $315,000 threshold for taking the full QBI deduction. In Adams’s case, it was questionable whether a retirement plan should be funded. For Baker, the choice makes more sense. The $200,000 contribution reduces his net taxable income by $216,000.

If you’re thinking that $200,000 sounds like a lot for one person to be contributing to a plan, you’re right. Unlike defined contribution plans where annual contributions may not exceed $55,000 or $61,000, it is definitely possible for a business owner to be able to contribute $200,000 to a defined benefit plan under the right circumstances.

Sole proprietor with huge income

Finally, let’s move on to Carmen, a sole proprietor with $500,000 in net Schedule C income and QBI. Assume she is married and files a joint tax return. Carmen is a medical-device salesperson who works by herself.

Since medical device sales is not a specified service trade or business, Carmen would seem to qualify for the 20 percent QBI deduction with ease. She is not subject to those pesky income thresholds. While that is true, there are wage and capital limits she is going to have to contend with. Specifically, the deductible amount for a trade or business is the lesser of

1. 20 percent of the qualified business income, or

2. The greater of

a. 50 percent of the W-2 wages with respect to the qualified trade or business, or

b. 25 percent of the W-2 wages with respect to the qualified trade or business, plus 2.5 percent of the cost of qualified property.

This is a lot to chew, but let’s make it easy on ourselves by assuming Carmen has no qualified property. And, of course, she has no employees, so there are no W-2 wages. As such, item 2 is $0. The QBI deduction is the lesser of item 1 and item 2. Since item 2 is $0, it must be the lesser item. Therefore, there is no QBI deduction available for Carmen.

Here again, a large retirement plan contribution will save the day. If Carmen can afford to contribute $200,000 to a defined benefit plan, this contribution will be deducted on the front of Form 1040 as an “above-the-line” deduction, offsetting the $500,000 in Schedule C income. If she can keep her other income at $15,000 or less, she’ll be below the $315,000 taxable income threshold for taking the full 20 percent QBI deduction.

Here are the relevant numbers:

• Taxable income without DB plan: $500,000
• Qualified business income with DB plan: $300,000
• Taxable income with DB plan: $300,000
• 20 percent QBI deduction (20 percent × $300,000): $60,000
• Net taxable income ($300,000 - $60,000): $240,000

As with Baker, Carmen’s defined benefit contribution reduces her net taxable income by more than the amount of contribution ($200,000 contribution vs. $260,000 reduction in taxable income).

Conclusion

As others have said, TCJA may or may not have been “tax reform,” but it certainly was not “tax simplification.” Unfortunately, space does not permit us to give an exhaustive review of the QBI deduction with more complex examples and discussion about the finer points. (We didn’t even attempt to define “qualified business income.”) In addition, we are operating without the benefit of regulations and other guidance. When such guidance is issued, our interpretations may change.

That being said, it does not appear the fears of a major decline in retirement plan sponsorship or contributions will come to fruition. Some businesses may choose to scale back their plans, while others will look to ramp them up further. As was the case before tax reform, plan sponsors will wish to consult with their advisors for a thorough analysis of how a qualified retirement plan fits into the business’s and the owner’s overall financial picture.

David J. Kupstas, FSA, EA, MSPA, is ACG’s chief actuary. He possesses an intricate working knowledge of ERISA, as well as U.S. Internal Revenue Service (IRS) and U.S. Department of Labor (DOL) regulations as they pertain to plan administration and compliance, and is a CPE instructor for CPAs.