By Adam Cmejla, CFP®
Oct. 31, 2018
The Tax Cuts and Jobs Act (TCJA) that was passed at the end of 2017 was one of the biggest pieces of tax reform legislation that has been passed by this country in decades. The new legislation brings a multitude of planning opportunities for small business owners, most notably under new Section 199A, which introduces a new 20 percent deduction on “Qualified Business Income” (QBI) for certain pass-through business entities.
However, as with most pieces of tax code, it’s anything but simple. Important components of the 199A deduction apply to optometry, and there are strategies you can use to help minimize your tax bill. Here are tips to help you get started planning now to reduce your tax bill.
Definition and Limitations
Simply stated, the 199A deduction allows a 20 percent deduction on “qualified business income” for owners of any business entity other than C-Corporations. This includes LLCs, Partnerships, Sole Proprietors and S-Corporations.
One of the most important provisions in this tax code was determining who qualified to use this deduction and the formula used to determine if and/or how much of the deduction they would be able to claim on their tax return. The best way to determine whether and how much of the deduction that you can take is to answer this series of “if, then” questions.
Does your business generate specified service business income (SSBI)?
Optometrists are almost unilaterally going to answer this question “yes.” The definition of a “specified service
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business (SSB)” is “…any trade or business involved in the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principle asset of such trade or business is the reputation or skill of one or more of its employees…”.
Is my income above the threshold?
Assuming that everyone reading this is an OD, and thus qualifies as a SSB, we now have to look at an important number: income limitations.
If the OD’s taxable income is under $157,500 (individual) or $315,000 (married filing joint: MFJ), they qualify for full use of the 20 percent deduction on QBI.
One important point that I’d like to emphasize about these calculations: they are based on taxable income, not adjusted gross income (AGI). Most people are used to using AGI to determine whether they are able to use a variety of tax and investment planning strategies (i.e. student loan interest deduction, Roth IRA eligibility, miscellaneous deduction calculations, etc.).
Taxable income, on the other hand, includes the application of either your standard or itemized deduction, which was another area of the tax code that underwent a big overhaul as a result of the TCJA.
Another important component of this calculation is that taxable income will include, in a married filing jointly household, the income of both individuals. What this means is that even though the deduction is based on the business’s income, the eligibility to use the deduction is based on the business owner’s personal tax return. Having a high-income earning spouse in a completely unrelated profession could tip the scales out of favor of the business owner, leaving them not much (if any) opportunity to plan for the use of the QBI deduction.
Is my income above the full phase in?
If your taxable income is above the full phase-out amount ($207,500 individual or $415,000 MFJ), then you do not qualify to use any of the QBI deduction on your tax return.
If you answered “Yes” to #2 but “No” to #3, you will find yourself in an interesting quagmire that is open to a variety of planning opportunities. While there are a variety of strategies, they can all be distilled down into about three different “themes” as listed below.
Let’s dive into a few common strategies that might be applicable for ODs for the remainder of 2018 and into 2019.
In situations like I mentioned above, where a spouse may be a high-income earner outside of the business owner’s business, running the calculations on whether it makes sense to file tax returns as “married filing separately” is worth the effort.
In addition, this is one of the few instances where associate doctors that are W-2 employees of a practice may benefit from being classified as a 1099 contractor, since W-2 wages are not considered QBI, but sole proprietor income does meet the definition for QBI.
Charitable Lumping/Gifting Strategies
Depending on the relationship to how much you give per year to charities and the amount over the threshold you are, it may make sense to think about accelerating your gifting strategies into this year to reduce your income below the threshold. If you would like to accelerate gifting all at once, but control how much is allocated to the charity per year, utilizing Donor Advised Funds is a solution we’ve seen being adopted by individuals.
Revisit Income Ratio
For practices that are set up as S-corporations, it’s prudent to revisit your YTD W-2 wages and determine if you’ve paid yourself “enough” already this year to meet IRS “reasonable compensation requirements” so that you can maximize the net profits of the practice.
Remember, for every dollar that you pay yourself in W-2 wages, you reduce the net profits of the practice, and the net income of the practice is what determines how much of a QBI deduction you can take on your tax return! Of course, modifying your income has other implications, including profit sharing and 401k match calculations, so be sure you’re weighing the options with your advisor(s) to determine what’s in your best interest.
Convert from S-corporation to a Partnership
If you’ve been structured as an S-corporation and your salary has been at or close to the maximum amount of earnings subject to Social Security, you may consider looking at switching to a partnership filing status.
Remember, W-2 wages paid to an owner do not count as QBI. So, a doctor paying herself $110,000 in wages per year with a $10,000 profit means that only the $10,000 is QBI. Since partnerships cannot pay themselves a salary, all income from the partnership passes through as partnership income and thus qualifies as QBI (as long as it’s not “guaranteed payments” from the partnership).
If she restructured her entity as a partnership, she could have all $120,000 qualify as QBI. Regardless of whether she was married or single, 20 percent of $120,000 is a $24,000 deduction. If we assume she is in the 24 percent tax bracket (adding in other income from a spouse, capital gains, dividends and interest income, etc.), restructuring her entity and reclassifying her income could potentially be a $5,760 tax savings.
Keep in mind that this is not a net tax savings as we would have to calculate what the additional Social Security tax that she would pay on the difference between $120,000 (subject to Social Security and Medicare payroll taxes) and her $110,000 S-corp salary. Doing that math, we come to $3,060. So, $5,760 – $1,530 = $4,230!
These are just a few of the strategies that one could consider. As mentioned, this is one of the biggest pieces of tax reform passed in decades. Because of the complexities of these strategies, please consult with your qualified planners and advisors before making any decisions, as all of the information provided above is for educational purposed only, and should not be taken as personalized tax advice.
Click HERE for the IRS’s FAQs section for the 199A Qualified Business Income Deduction.
Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life—personally, professionally, and financially. For a free copy of his “Top Five Tips to Financial Freedom” visit https://bit.ly/2Mo3NV8.