2018 brought a bundle of joy for business owners & self-employed people. They could not get a 20% deduction as per the Tax Cuts & Jobs Act enacted in December 2017.
Well, ignorance is bliss they say, for the joy lasted only for a short period. As the details of the final regulations trickled in, the complexity unraveled. Lo & behold, it was not going to be that simple.
We try to shed some more light on the regulations that we know so far. We also try to present some other opportunities for large tax deductions if you do not qualify for the 20% deduction.
The initial process starts with determining ‘qualified business income’. Simple speaking, qualified business income is defined in IRC 199A (c )(1) as the ordinary income from a qualified trade or business net of ordinary deductions from a sole-proprietorship, S-Corp or Partnership.
Qualified business income does not include (I) ‘reasonable compensation’ paid to the tax payer by the business for the services rendered for the business, (II) guaranteed payments, (III) payments described in section 707(A) to a partner for services rendered with respect to the business, (iv)amounts not included in QBI.
The pass through deductions are the lesser of:
- 20% of qualified business income,
- 50% of W-2 wages from the business,
- 25% of W-2 wages from the business plus 2.5% of the unadjusted basis of all ‘qualified property’.
The TCJA divides business into two classes and business owners are divided into three groups based on their income.
Division based on type of business:
The two classes are:
- Professional Service Industry: Businesses that fall in the following category will see their deductions completely phased out at $415,000 – health, law, accounting, performing arts, consulting, athletics, financial services, brokerage services, investing and trading.
In addition to this, there is a broad category as follows: the deductions will phase out for a business if the business benefits due to the skill or reputation of any one individual.
- Non-professional service industry: For all other industries not included above, the TCJA encourages businesses to hire employees or invest in depreciable business property.
Division based on income of business owners:
- Income below $315,000 ($157,500 for singles): If your income is below $315,000 you will get the full 20% deduction.
- Income above $415,000 ($207,500 for singles): If your income is above $415,000 the deduction will be limited to the lesser of:
- 20% of your Qualified Business Income
- 50% of W-2 employee wages paid by the business or
- 25% of W-2 employee wages or 2.5% of the unadjusted basis of all qualified property
- Income between $315,000 and $415,000 ($157,500 to $207,500 for singles): If your income is between these two limits, you are stuck in a sweet spot. It is best to let your accountant calculate the deduction amount as the calculations can be very complex.
Now you have some basic idea of the deductions!
But what if you don’t qualify for the 20% deduction or if you are a part of the professional service group?
If this is your case, you just need another provision that can provide you a large tax deduction. Such a provision has been in existence for a long time and you have likely heard about it. This is a defined benefit plan or commonly referred to as a cash balance plan.
A defined benefit plan can provide a tax deduction in the range of $100,000 to $250,000 based on your age, compensation and years of service.
Below is an example of how a defined benefit plan works for a self-employed individual:
Employment status: Self employed
Three-year average income: 100,000 as W-2 compensation/Schedule C income/K-1 Income
Participant’s age: 50
A participant with the above mentioned parameters can accumulate $1,248,535.08 till s/he reaches an assumed retirement age of 62. In the first year, a maximum contribution of $100,000 can be made to the defined benefit plan.
Employment status: Self employed
Three-year average income: More than $265,000 as W-2 compensation/Schedule C income/K-1 Income
Participant’s age: 50
A participant with the above mentioned parameters can accumulate $2,621,923.68 till s/he reaches an assumed retirement age of 62. In the first year, a maximum contribution of up to $200,000 can be made to the plan.
If you need a tailored estimate, please email us at email@example.com
Please refer to this page for learning more about setting up a defined benefit plan when you have employees: Floor Offset Plans
Defined benefit plan for high income individuals
A defined benefit plan is the only plan that will permit large contributions as desired by high income individuals. If the business has been established for several years, the defined benefit plan can be based on past service and annual contributions can be bumped up even further. It is common for someone above the age of 50 and making more than $300,000 each year to be able to contribute $150,000 to $250,000 to the defined benefit plan.
How to set up a defined benefit plan?
Setting up a defined benefit plan requires a certain amount of ground work that needs to be put in before you can actually start contributing to the plan.
At first a calculation needs to be performed about how much you can actually contribute to a defined benefit plan. Unlike 401(K) and profit sharing plans, contributions to a defined benefit plan vary from person to person. They are typically based on the age of the individual and the compensation history. You can calculate an estimate using our online defined benefit calculator on this page. A final calculation needs to be performed by an actuary though.
Once you have a final estimate from the contributions, you will need to collaborate with your CPA to ensure that you have sufficient cash flow to contribute to the defined benefit plan. Once the amount has been decided between you and your CPA, the actuary will need to draft the plan document for you.
For examples, your actuary may calculate that you can contribute $200,000 in the defined benefit plan in the first year. However, you might want a lower contribution amount and your actuary needs to be informed of that. Once you, the actuary and your CPA agree on a contribution amount, you are all set to go ahead with the next steps.
Every defined benefit plan requires a plan document which will list all assumptions of the pension plan and ensure compliance with all IRS rules and regulations. This document has to be drafted by an actuary before you can set up the investment accounts for the plan. A new TIN also needs to be registered for the pension plan as it is a distinct legal entity. The actuary will customize a plan document based on the contributions you need. Make sure your actuary provides you a plan document that is pre-approved by the IRS so you don’t need to go through the hassle yourself. You can read more about a pension plan document here.
After the plan document has been drafted, you are all set to open the investment account for the plan. You should reach out to your financial advisor or a broker to set up the accounts. Make sure you tell them to open a ‘qualified account’ so that the investment gains are not taxed at source.
You can start making contributions to the plan as and when free cash flow is available once the investment accounts are open. For the first year, the contribution will be what was decided between you and the actuary. The actuary will calculate a range for each subsequent year along with a recommended contribution amount. You are required to contribute within the range to avoid over funding or under funding the plan. The deposits can be made until you file the tax returns for your business.
All qualified plans are required to file annual returns with the IRS. Note that these returns are different from the company tax returns and your personal tax returns. Also note that the CPA or financial advisor cannot file these returns since these are required to be certified by an actuary.
The actuary will prepare a form called the Form 5500SF and certify another form called the Schedule SB. You will need to sign the form as the plan sponsor and the actuary will file it electronically. The penalties for not filing these forms run in to hundreds of dollars and the pension plan could end up getting disqualified.
If you are a self-employed individual and interested in exploring the idea of a defined benefit plan for yourself please email us at firstname.lastname@example.org. We specialize in this area and can provide you with valuable advice and services that could end up saving thousands of dollars and giving a boost to your retirement planning.
Advantages of a defined benefit plan
- Substantial benefits (read money) can be provided and accrued within a short time – even with early – retirement
- Employers may contribute (and deduct) more than is permissible under other retirement plans such as Defined Contribution Plans
- Plan provides a predictable and guaranteed benefit, and the benefits are not dependent on asset returns
- Plan can be used to promote certain business strategies by offering subsidized early retirement benefits
- The Defined Benefit Plan favors older participants as they are closer to retirement and need to accrue benefits at a faster rate than younger participants.