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The 20% deduction on qualified business income (QBI) for pass-through businesses in the new tax law creates many planning opportunities for dental practice owners. The IRS is expected to issue more guidance on this deduction, but I will outline some thoughts on the role financial planning can play in this new deduction.
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What are pass-through businesses?
Simply put, a pass-through business is any business entity other than a C corporation. Sole proprietors, LLCs, partnerships and S corporations are all pass-through businesses. Even independent contractors qualify.
What is qualified business income (QBI)?
QBI is ordinary business income minus ordinary business expense, basically, your net income from your practice. Currently, QBI specifically excludes guaranteed payments from partnerships and reasonable compensation from S corporations.
As a service-related business, dentist owners fall into one of three categories.
1. Full QBI deduction—If you are the owner of a pass-through dental practice with taxable income below $157,500 (single) or $315,000 (married filing jointly), then you will receive the 20% qualified business income (QBI) deduction on the lesser of your QBI or taxable income.
Example: The dental practice owner (married filing jointly) has QBI of $250,000 and taxable income after deductions of $210,000. The QBI deduction would be 20% of $210,000, which equals $42,000. At a 24% tax rate, this couple would save $10,080 in federal taxes.
Tax deduction: 20% of taxable income
Planning opportunity: Because you qualify for the full QBI deduction on taxable income, it might be to your advantage to contribute to a Roth 401(k) vs. a Traditional 401(k). Traditional 401(k) contributions lower your taxable income and QBI deduction. By contributing to a Roth 401(k) account, you would maintain the full QBI deduction and build retirement funds in an account that can be withdrawn tax-free in retirement. Additionally, current tax rates are historically low and set to expire at the end of 2025.
2. Partial QBI deduction—The QBI deduction starts phasing out with taxable income above $157,500 (single) or $315,000 (married filing jointly). The deduction is completely phased out with taxable income above $207,500 (single) or $415,000 (married filing jointly). This means it is possible to receive part of the 20% deduction if your business income is between the income limit and the phase out.
Example: The dental practice owner (married filing jointly) has QBI of $400,000 and taxable income after deductions of $360,000. The QBI deduction would be phased out by 55%, which equals $44,000.* At a 32% tax rate, this couple would save $14,080 in federal taxes.
Tax deduction: 12.2% of taxable income
Planning opportunity: Income reduction strategies are important to this group. Here are several actions you can take to reduce your income: (1) start or increase your retirement plan contributions to IRA, 401(k), or pension plan; (2) purchase equipment; (3) hire children as employees; (4) consider implications of filing married filing separately if your spouse has high income; (5) make charitable contributions; and (6) minimize taxable investment income (use tax-efficient investments).
3. No QBI deduction—The QBI deduction is completely phased out with taxable income above $207,500 (single) or $415,000 (married filing jointly). This means if your taxable income is above these limits you will not get to participate in the 20% QBI deduction.
Example: The dental practice owner (married filing jointly) has QBI of $500,000 and taxable income after deductions of $460,000. The taxable income of $460,000 is above the $415,000 income limit. Therefore, the person would not qualify for the QBI deduction.
Tax deduction: 0% of taxable income
Planning opportunity: This group could consider the same income reduction strategies as those in the partial QBI deduction group but in larger amounts. A more complicated consideration might be to spin off certain assets and operations as a separate non-service business. For example, have your office building and equipment owned by a separate entity and leased back to your dental practice. In the same way, separate administrative functions of your practice such as billing and accounting into a non-service entity. Non-service businesses are not subject to the income threshold in obtaining the QBI deduction. However, they are subject to additional rules related to W2 wages and qualified property of the practice. These would be advanced strategies that would need to be fully reviewed with a CPA or tax preparer to determine if they would be beneficial.
We are now almost halfway through the calendar year. There will be many changes on your 2018 tax return. You should schedule a meeting with your CPA or tax organizer soon to ensure you are doing everything you can to take full advantage of the new tax law.
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*QBI phase out and deduction calculations
$415,000 income limit - $360,000 taxable income = $55,000 / $100,000 phase-out range = 55%
$400,000 QBI * 55% phase out = $220,000 reduced QBI
$220,000 reduced QBI * 20% = $44,000 QBI tax deduction
For simplicity, this example assumes practice wages of $330,000
Disclaimer: Eaglestrong Financial is a Registered Investment Advisor (RIA) with the state of Tennessee. The information contained herein is not intended to be used as a guide to investing or tax advice. This material presented is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
