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George F. Bearup, J.D. Senior Legal Trust Advisor

29-Nov-18

IRC 199A and Retirement Plan Contributions

Take-Away: The contributions that a small business makes to a retirement plan can impact the size of that business’ IRC 199A qualified business income tax 20% deduction. S corporate shareholders might be better off making Roth contributions, while LLC members and partners in partnerships might be better off making pre-tax contributions to a 401(k) account, as broad generalizations about this planning strategy.

Background: Small businesses that are ‘pass-through’ entities like LLCs, S corporations, and partnerships can qualify for up to a 20% income tax deduction taken against their qualified business income. This tax deduction is taken on the owner’s personal income tax return and not at the entity level. The opportunity to claim this 20% tax deduction may affect the business owner’s decision to contribute pre-tax, or after-tax, dollars to the business’ qualified retirement plan.

IRC 199A Deduction: The qualified business income tax deduction is the lesser of (i) 20% of the qualified business income or (ii) 20% of the owner’s taxable ordinary income.

Contribution Deductions: The key to the decision, i.e. pre-tax or after-tax contributions,  is where the retirement plan contributions are deducted.

  • Sole Proprietors, Partners, and LLC Members: With sole proprietors, LLC members and partners (but not S corporation shareholders), the deductions are taken as an adjustment to income, which reduces the individual’s reported adjusted gross income, but not their self-employment income. Sole proprietors, LLC members and partners deduct profit sharing contributions on their personal income tax returns, so they can claim the qualified business income deduction from their business income as well. As a result, the sole proprietors, LLC members, and partners will normally want to make pre-tax contributions to qualified retirement plans due to their marginal income tax rate, i.e. the income taxes that they will save with their deductible qualified plan contribution. Thus, the decision between a Roth 401(k) contribution or traditional 401(k) contribution is typically the same for a taxpayer who does not have the option to claim an IRC 199A deduction from qualified business income. Example: Assume an LLC member takes a profit sharing deduction on his/her personal Form 1040 income tax return, after he/she has calculated his/her qualified business income deduction under IRC 199A. The LLC member will be able to claim the full 20% IRC 199A deduction.
  • S Corporations: The possible use of the IRC 199A tax deduction will probably influence the retirement contribution choice of an S corporation shareholder. An S corporation deducts profit sharing contributions and any 401(k) ‘match’ at the corporate level, which reduces the qualified business income, and thus the resulting 20% IRC 199A tax deduction on the shareholder’s personal income tax return. Instead of saving income taxes at a 22% or 24% marginal income tax bracket, a deductible retirement plan contribution by an S corporation shareholder would have a current tax benefit of only 17.6% or 18.2%, i.e. 80% of the posted income tax rates. Consequently,  for an S corporation that has qualified business income, S corporate shareholders may be better off by placing some or all of their retirement plan contributions in an after-tax Roth 401(k)  account, because pre-tax profit sharing contributions will effectively reduce their qualified business income deduction. Example: Assume the shareholder of an S corporation is in the 24% marginal federal income tax bracket. A profit sharing contribution by the S corporation reduces the corporation’s qualified business income, so that the real rate of income tax that is deferred through the IRC 199A tax deduction is only 19.2% [80% X the owner’s 24% marginal income tax rate.]

Elective Deferrals: The impact of qualified business income and the IRC 199A tax deduction on the choice between an S corporation and an LLC may be more about profit sharing plan contributions than elective deferrals to a 401(k) plan. That is because elective deferrals come from an employee’s wages, which are not considered a part of the business’ qualified business income.

Planning Strategy With Roth Conversion: As noted, the qualified business tax deduction is the lesser of 20% of the qualified business income or 20% of the individual’s taxable ordinary income. This ‘lesser of’ formula can be manipulated, for example, with a Roth conversion.

  • Example #1: Taxpayer is a sole proprietor. Taxpayer has net business income of $250,000, which is the only income reported on the taxpayer’s Form 1040. The maximum IRC 199A deduction would be 20% of $250,000 or $50,000. Suppose, however,  the taxpayer deducts about $60,000 in self-employment tax, makes a profit sharing contribution, and also the taxpayer, who is married, claims the $24,000 standard deduction. Thus, taxpayer’s taxable income, before the IRC 199A deduction, would be about $166,000 ($250,000 less $84,000= $166,000.) 20% of $166,000 is $33,200. $33,200 is less than the $50,000 (20% times $250,000) following the ‘lesser of’ formula. Accordingly, the taxpayer is able to claim only $33,200 as the IRC 199A tax deduction following the ‘lesser of’ formula.
  • Example #2: The same facts as above. But suppose the taxpayers convert $84,000 of their IRAs to Roth IRAs. That conversion will increase their taxable income from $166,000 back to $250,000. In turn, that Roth conversion allows the full $50,000 qualified business income tax deduction. The additional tax cost from the Roth conversion of $84,000 would be about 18.5%, well below the taxpayer’s initial marginal income tax bracket of 24% (thanks to the larger IRC 199A qualified business income tax deduction.) Obviously not included in this example is the opportunity-cost over the years by paying  the additional income taxes currently caused by the Roth conversion, at the effective marginal income tax rate of 18.5%, balanced against the tax-free income provided by the Roth  over the lifetime of the Roth IRA.

Conclusion: Deductible retirement plan contributions can have an impact on the business owner’s ability to claim the IRC 199A income tax deduction. Some small business owners operating an S corporation may be better off making an after-tax Roth contribution to a retirement plan. Not to be overlooked is the use of a Roth conversion to intentionally increase the business owner’s taxable income to increase the size of the IRC 199A income tax deduction.