New Pass-Through Tax Deduction Could Be a Bust for Business Owners

As part of the Tax Cuts and Jobs Acts passed in December of 2017, IRC Section 199-A was created, which allows owners of small businesses — including partners, owners of S corporations and sole proprietorships — a deduction of up to 20% of qualified business income. In general, qualified business income is referring to the profits of the company.

While that sounds like a valuable opportunity, the QBI deduction may turn out to be a deal killer for creating tax savings for small-business owners who make contributions to a pre-tax retirement plan like a SIMPLE IRA, a SEP IRA or a 401(k).

The problem is that the small-business owner who qualifies for this deduction, and makes a contribution to their employer-sponsored retirement plan, will end up with a partial deduction of only 80% of the contribution. But they will pay income tax on 100% of this contribution, plus all future earnings, when it's later withdrawn.

From just $107.88 $24.99 for Kiplinger Personal Finance

Be a smarter, better informed investor.

CLICK FOR FREE ISSUE

Sign up for Kiplinger’s Free Newsletters

Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.

Profit and prosper with the best of expert advice - straight to your e-mail.

Sign up

Meet Bob: An Example to Illustrate the Issue

To understand this better let’s say Bob, a small-business owner, paid himself a salary of $70,000 and had another $80,000 of business profit that qualified for the 20% QBI deduction. This would give him a QBI deduction of $16,000. ($80,000 x 20% = $16,000)

Suppose Bob decides to make a current year contribution of $17,500 to his SEP IRA. Will he receive a $17,500 SEP IRA deduction? It may seem that way, but when you begin to look closer, the end result will be less of a deduction.

This $17,500 contribution to the SEP IRA reduces Bobs company's profits from $80,000 to $62,500. ($80,000 - $17,500 = $62,500)

Now instead of being eligible for a 20% QBI deduction based on $80,000 of profits, Bob is only eligible for the deduction on $62,500 of profit.

If we multiply the $62,500 times the 20% QBI deduction, Bob now has a deduction of $12,500, rather than the $16,000 deduction if no SEP IRA contribution had been made.

The end result is the $3,500 less of QBI deduction ($16,000 - $12,500 = $3,500) translates into the SEP IRA deduction being reduced from $17,500 to $14,000. ($17,500 - $3,500 = $14,000)

This reduced amount of the SEP IRA deduction is sometimes called the 80% deduction, ($17,500 x 80% = $14,000) because you only get to deduct 80% of the contribution.

Now what happens when Bob goes to withdraw the $17,500 from his SEP IRA, plus whatever it's grown to, later on in life? He’s going to owe tax on the “full” $17,500 contribution plus on any growth.

The net result of putting this $17,500 SEP IRA contribution into the plan was Bob was only able to deduct $14,000 of the $17,500 contribution, when putting the money into the plan, but he has to pay tax on the full $17,500 — or 100% of the contribution — when it's withdrawn.

If Bob stays in the same tax bracket or higher when he later withdraws the original contribution amount he will pay more tax than he saved, when he made the original contribution. To say the least, this is not smart tax planning.

Other Possibilities to Consider

A better alternative for small-business owners in this situation may be to consider making contributions to a Roth IRA, a Roth 401(k), or making after-tax contributions to a 401(k).

There may be situations where small-business owners may still want to consider contributing to pre-tax retirement plans.

This would include business owners who can't claim the 20% QBI deduction anyway, which would be for high-income business owners of specified service businesses like health professionals, legal professionals, accountants and financial advisers.

Also, business owners who expect to be in a lower tax bracket in the future may still be better off taking the partial deduction today, even if it means paying tax on the full amount in the future.

It's very important going forward, that small-business owners with the help of financial professionals understand the tax impact of putting money into their particular retirement plan, to make sure it’s not working against them.