Yesterday I went for a full day of continuing education aimed at CPAs regarding the Qualified Business Income Deduction. I came away trying to change my focus from the multi-variable linear equations I got there into actual tax planning strategies to bring up with my clients.
I’m going to write up my notes here. This will be long. I’ll highlight the actual planning opportunity, though.
REITs and MLPs are superstars of this new tax bill. That means we need to stop and consider whether we wish to own REITs inside taxable accounts. I’ve always put these inside tax-deferred accounts because I don’t want the K-1s to hold up the tax returns AND to have to file in multiple states AND because they kicked off ordinary income so I figured they were best located in something that would be taxed as ordinary income. But now they qualify for a 20% deduction without limitation, as far as I can see.
The two thresholds to use in planning are $157,500 “Tentative Taxable Income” for singles (with a 50K phase-out, so all phased out at $207,500) and double that for MFJ, so $315K to $415K. “Tentative Taxable Income” is your taxable income before this deduction is factored in. So other adjustments and deductions count towards this, meaning we can dive towards safety with traditional methods like workplace retirement plans and charitable gifts (including things like DAFs and CRTs.) The planning piece to this is to consider this threshold when doing tax planning for contributions, etc.
If you are below these thresholds then a business owner optimize things by having only enough wages and Non-REIT investment income on the tax return to sponge up the adjustments and deductions. So a sole proprietor/LLC member married to a wage earner should stay as they are. The tax attorney leading the course referred to this as the “poor attorney” exception.
If you are going to come in over $415K as a MFJ with a service-based business, good news: you can skip the rest of this discussion. You’re simply not eligible. So sad, too bad you aren’t a real estate mogul instead. (There’s a lot to be said about what means a “Specified Service Trade or Business” (SSTB), but that’s not a planning issue for the most part. Maybe it’s possible to separate out the manufacturing wing of a service business, maybe, but that’d be a really bespoke situation.)
If your income is over the initial threshhold, $315K for MFJ, that’s when things get interesting in terms of planning. In fact, the tax attorney teaching my course called it the “Good Planner Exception”. For the SSBTs (like financial advisors, for example), all this planning is only useful for that next $100K of income. I’m not sure how far we want to go in terms of entity changes to optimize for this. But there are some easier options to consider.
First off do general tax planning to stay under these limits. Also, pay attention to having retirement money come out of the NON-business-owning spouse’s income first. I’m going to check today to make sure we’re maximizing my husband’s workplace retirement contributions. I think we were doing a mix between me and him, trying to get our assets more evenly distributed for vague medicaid planning strategies someday far down the road. But reducing his salary (that isn’t associated with my business) is a total win, whereas contributions into tax-deferred money for the business owner have a reduced value under this law.
Once you are over the initial threshold, the limits that pop up are associated with both wage base of the business and/or property base. Basically, no service-based business is going to have property base large enough to be useful in this conversation, so we can skip this entirely (which is wonderful, because the property base requires creating brand new depreciation schedules that are weirder and harder than the AMT depreciation schedules. Skip doing this if you possibly can, it’s an accounting nightmare of epic proportions.) There are capital intensive businesses that will need this, though. If any of you are doing planning for people who make over $415K/year in a capital-intensive business you need to know that we have to have new depreciation schedules and there are planning opportunities involving buying equipment that intermingle with Section 179 strategies and the recursive Section 199 deduction. None of my clients are, so I’m going to skip this whole thing.
In some situations we should advice clients to get married. Simply put, it’ll save them something like $20K/year while this law is in place. Every year. They go from being over the phase-out to under the phase-out if they marry someone with a modest (or no) salary. We’ve got a lot of unmarried couples in our roster. This needs to be brought up for discussion.
Some of our clients might benefit from filing MFS. It looks like the QBI isn’t disqualified if you file that way. Some people may want to rejigger ownership of companies so they can file MFS, getting, say, real estate out of a spouse’s name that has an SSBT. (This is a pain in the ass as it involves entity changes and possibly retitling. Also, when I owned an office building with my spouse, he considered it my folly and would have objected to me putting that LLC entirely into his ownership. He didn’t want it!) CPAs get to suggest things that CFP®s know would never work.
If you’re over the threshold, running a payroll starts to make a ton more sense. Either a sole prop puts their kids on payroll – a straight up win – or they go S and put themselves or their spouse on payroll. There are a lot of planning situations involving payroll and deferred comp and maximizing these options with linear equations. I confess that I’ll probably run up some Excel workpapers on this, and already have gotten the first part started, but I’m hoping someone (Kitces!) will do it for me. The short version is that having payroll be 2/7 of the gross income works out to be a sweet spot.
LLCs aren’t getting any love in this story. If you’re a rich married service professional making over $500K/year then, sure, stay an LLC. You’re not going to get anything out of the QBI deduction anyway. But if you’re over the initial threshold then you need to be running a payroll to pass the new test they give about 50% of wages being one of the limitations. That’s 50% of the wage base of the company (or your portion of it, if it’s a multi-member firm.) Not your own wages from the business (although that would obviously be part of the wage base.)
There are problems associated with guaranteed payments to partners that need some planning attention: Guaranteed Payments simply reduces the QBI without helping anything. There’s more to say about that but I’m going to keep moving for now. Basically, sole props and LLCs not running payrolls in non-SSBTs over the initial threshold should go S (which was always good advice anyway) and sole props/LLCs in SSBTs should consider if if they’re in the phase-out range ($315 TI to $415 TI). As I said above, we need to consider how much bother we want to go to in terms of entity selection for us SSBTs projecting income in the phase-out range. I don’t have that quantified yet and I ought to. I’ll be using Excel for this, but maybe tax planning software can handle it, not sure. (I can build an Excel spreadsheet faster than I can program a BNA scenario, but that’s just me. I also use my existing preparation software to do proforma modeling, but that’s tricky for new law like this. I’d prefer to wait until November when the new tax software comes out.)
C Corps only shine IF you don’t expect to ever have to sell your business. Basically, turning C works great if your intention is to shove money back into your business and then die and leave it to your kids. Those don’t happen to be my clients. Also, I’m not thrilled about converting people to a C only to find the 21% bracket goes away with the next election, but there is a strategy involving going C for a few years if you really are trying to accumulate earnings in the business. Just check to the box to go back to C. It’s a bit of a lobster trap, though.
Some other notes that came out of this training.
- Chained CPI reduces inflation adjustments, just another way to raise taxes stealthily.
- Apparently there was a provision thrown into this tax law saying the QBI deduction is not eligible to people whose business is dependent on them being famous. The presenter called it the “Steph Curry” law, but I’m not sure what that meant. A couple of my clients are famous. I need to think about the implications and try to figure out how I’d advise them.
- There’s new stuff with carryforward interest that doesn’t apply to my clients but you should notice it.
- This isn’t new, but it’s a new thought to me: how many of our S Corps have their shares owned by their credit shelter trusts? I need to add that to my estate planning implementation checklist.
- Related to that, I need to make sure the S Corp shareholder agreements have some provisions to add a tax distribution to silent partners AND preventing transfer of shares to ineligible owners. (A story came out at this training of a disgruntled S Corp shareholder blowing the S election deliberately after a conflict arose, rather going nuclear on the company.)
- There’s another thing about NOLs not being eligible to put against other income that year if they’re over $250K(S)/$500K(MFJ). I’d say it’s one of my practice goals already to keep my clients from having business losses of over $500K.
Some other resources worth reading:
- The first best article I read about this was Kitces’ Valentine’s Day article, which I interpreted to be written just for me. (Yes, CPAs can be squeeing fangirls, why do you ask?)
- Kitces.com goes into some deeper strategies for high-income small business owners.
- The first pass at this was from Lou Gauthier, at Boston Tax Institute. He explained that the QBI deduction is just the Domestic Production Activities Credit retooled, which I found to be a useful way of thinking about this complex topic.
- Rick Huff at HSC Wealth Advisors did a nice flowchart that I’m asking him for permission to link to.