If you have a business (other than a C Corporation) and you haven’t heard of the 20% Pass-Through Deduction under Section 199A, we’d like to introduce ourselves to you as your new CPA. The quick and dirty explanation is that, starting in 2018, you can reduce the taxability of income from your business by as much as 20% without actually spending money. You read that correctly: if you would have otherwise been taxed on, for example, $100K of net income from your business, it could be taxed as if it were $80K, even though there is not actually $20K in expense you have to come out-of-pocket for. The reason this was written into the Code via the Tax Cuts & Jobs Act was to put small business on parity with the lowered tax rates for C Corporations.
What’s the catch? Well, there are a lot of criteria here that can lower the amount of the deduction that you can take or disallow it entirely. The first and most important criterion is whether your business is a Specified Service Trade or Business (SSTB). For the most part, if your business generates income from the services of “professionals,” then your business is likely an SSTB. This would include the fields of 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. This post will focus on the strategies for businesses that find themselves in the less tax-favored SSTB bucket.
To begin, the easiest workaround is to get the entire amount of the 20% pass-through deduction is to get your total taxable income below $321,400 if you’re married or $160,700 if you’re unmarried (these are the new thresholds for 2019). You will get the entire 20% deduction if your taxable income on your personal tax return is below these amounts. The deduction begins to phase out as you exceed those amounts. If you’re married, the deduction is totally phased out at $421,400 and if you’re unmarried the deduction is totally phased out at $210,700.
You might be thinking, “that’s great, Dark Horse, but I make a lot of money and getting below those thresholds is going to be difficult…what can I do to reduce my income?” Astute question! We would start by looking at maximizing retirement contributions. If you’re an S-Corp owner, this means paying yourself enough via W-2 wages (which you already SHOULD be doing, as discussed here) to be able to max out both the EE and ER contributions, which could allow you to deduct up to $56K ($62K if you’re older than 50) or double both of those amounts if you are married and your spouse is employed by the business.
Next, consider buying fixtures, furniture and equipment which can be financed to ease cash flow considerations. Remember, you can use 100% bonus depreciation to fully deduct the cost of the asset when placed in to service, even though you might not be paying the loan off for another couple years.
On the personal front, make an extra mortgage payment, consider being extra charitable, push forward a large medical expense, pay points on a new mortgage, fund your HSA, deduct your health insurance premiums (if they are paid by the business and not sponsored by a spouse’s employer). There are many ways to help yourself out here and we can share a few additionally advantageous moves that can work out very well for certain types of clients.
When you do any of the above, you’re actually deducting more than a dollar for every dollar you put in for that additional deduction since you are unlocking part or all of the Pass-Through Deduction.
After you’ve exhausted all of the above options, if you find that you’re still partially or fully phased out, you should look at your revenue streams to see if any of those revenue streams would constitute qualified business income that could be carved out separate from the restricted income from your SSTB revenue streams. This area is beyond the scope of this post, but there are opportunities to deploy a strategy of separating these revenue streams and related expense so that not all of your business’ income is treated less favorably for tax purposes. You’ll want to talk to us if you’re interested in exploring this. Whatever taxable income become qualified business income via this effort would still have a different set of rules that would need to be considered to maximize the 20% deduction
The bottom line here is that your total taxable income on your personal tax return is going to affect the amount of the Pass-Through Deduction you’re able to take from SSTB income, so you best plan wisely.
If your business is not an SSTB, or a portion of it isn’t (via a strategy loosely outlined above), there are a separate set of rules you’ll want to make sure you understand to maximize your deduction. That will be the topic of our next blog post.
About Dark Horse CPAs
Dark Horse CPAs provides integrated tax, accounting, and CFO services to small businesses and individuals across the U.S. The firm was founded to save small businesses (and their owners) from subpar accounting and tax services and subpar client experiences. These small businesses are Dark Horses among their larger and more well-known competition. Being a Dark Horse CPA means advocating for small businesses by bringing them the tax strategies and accounting insights previously reserved for big business. Get a quote today.