Tax Cut and Jobs Act (TCJA); short for “An act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for fiscal year 2018.” What a mouthful! I think we will stick with TCJA. One of the major areas of complexity in this new law, is its application to pass through entities.
Corporate Tax Rates
As you may be aware, the top corporate tax rate has been reduced from 35% to 21%. However, with sole proprietors, partnerships, “S” corporations, and pass through LLC’s there is a 20% deduction on adjusted gross income. The complexity arises in how and when the 20% deduction is applied. If the client has an “S” Corporation, only the distributive share is eligible for the 20% deduction. W-2 wages paid to principals are not eligible nor are guaranteed payments to the shareholders.
To add to the complexity of this act, congress chose to limit the benefits of the 20% deduction for “service” organizations. If the business derives its income from personal service, the deduction is phased out at certain levels of adjusted gross income; so doctors, accountants, attorneys, financial professionals, real estate agents, and consultants must deal with the phase-out of the 20% deduction.
Single vs Joint Filing
For service organizations where the taxpayer is filing singly, the deduction is available up to $157,500 of adjusted gross income. There is a pro rata reduction up to $207,000 of Adjusted Gross Income (AGI) and over that amount the deduction is completely gone. If the taxpayer is married filing jointly, the threshold is $315,000 and the deduction is gone at $415,000 of AGI. If filing jointly, the spouse’s income is also included in determining the phase-out.
Obviously affluent service business owners need help. Keeping income below the $315,000 threshold could provide a $63,000 deduction and save $17,640 in taxes for a pass through service business owner with and AGI of $315,000.
Two Strategies for Reducing Income
How can a service business owner reduce taxable income below the threshold? Most have fewer than five employees or may work alone. The ability to reduce income by buying a substantial depreciable asset is often limited. The only alternatives for reducing income are a qualified retirement plan or deductible interest payments on a loan based split dollar plan.
Qualified Retirement Plan Options
In the qualified retirement plan space, two options stand out. The most flexible option for a business that may have fluctuating profits is the SOLO K plan, which can allow deductions of up to $61,000 for owners over age 50. For businesses with stable profits, the defined benefit plan is a top choice. Deductions for this type of plan can easily exceed $170,000 each year for an owner participant. Several carriers like Lafayette Life, National Life Group, and American National offer plan design, plan administration, and funding media specifically designed for these plans. Options include annuities and life insurance.
Loan Based Split Dollar or Dual Loan
With the loan based split dollar or dual loan strategy, the business takes a commercial loan and loans the proceeds to the owner to pay premiums on a personal life insurance policy. The policy is collateral for the loan and the owner pays interest at the applicable federal rate. The owner receives a higher level of protection for family and higher retirement income potential than with a traditionally funded plans. The business interest deduction often amounts to between $30,000 and $60,000.
These strategies can mean the difference between being able to benefit from the 20% deduction and not seeing any tax relief. To learn more about how these strategies work, and how they can benefit your clients, contact the Partners Advantage Advanced Markets Department by visiting our website.