QBID may alter income v. deductions strategy

Ihave written much about the new tax act, and I’ll push my luck and try one more item. Once again, I want to address the new 20 percent qualified business income deduction, but with a different slant.

While the mechanics of the QBID are fairly complicated, it also produces different approaches to tax planning. We generally view deductions as a good thing, and the QBID can enhance the benefits of the deduction.

But the QBID can also create incentives for accelerating income. This is not what tax planners are accustomed to advising. Tax software used to prepare a 2017 tax return can be used to explore the consequences of different alternatives.

Let’s start with deductions. The QBID can be reduced, and perhaps even lost, if taxable income exceeds a threshold amount. This is $315,000 for someone married filing jointly.

If a taxpayer is in the range of taxable income that phases out the otherwise allowed deduction, which is $100,000 married filing jointly, creating an additional dollar of deduction can reduce taxable income by more than a dollar.

To illustrate, assume that a taxpayer has $200,000 of income from a business operated as a sole proprietorship. His wife has $149,000 of W-2 wages from a separate job. They use the $24,000 standard deduction and report taxable income of $325,000 ($349,000 gross income minus $24,000 deduction).

For QBID junkies, my example will assume the proprietor pays no W-2 wages and has no depreciable assets used in the business. Non-junkies should ignore this — it’s just in the column to save me from several weird e-mails.

The QBID would generally be $40,000 (20 percent of $200,000). Because the taxpayer is past the threshold of $315,000 and is 10 percent of the way through the $100,000 phase-out (no deduction is allowed when taxable income reaches $415,000), the QBID is reduced by 10 percent from $40,000 to $36,000.

The taxpayer chooses to make a $10,000 contribution to a simplified employee pension. This reduces taxable income to $315,000, and the QBID is now the full $40,000.

The $10,000 SEP contribution reduces taxable income from $289,000 ($325,000 — $36,000 QBID) to $275,000 ($315,000 — $40,000 QBID), an overall reduction of $14,000.

Just for fun, let’s say the taxpayer has business income of $349,000 and his spouse does not work. The 20 percent QBID is now $69,800 without limit, but is reduced by 10 percent, or $6,980, by the $325,000 taxable income.

Now, the $10,000 SEP contribution reduces taxable income by $16,980 by allowing the full QBID. There could be many other illustrations, but the point is that tax software can be used to play with various alternatives.

The two examples illustrate how we can leverage a classic tax planning strategy of creating deductions. The QBID simply changes the math.

But we may also want to create more income. The QBID has a second limit, which is 20 percent of the taxable income for the year. So, let’s say our attorney has $200,000 of QBI and his spouse does not work.

The 20 percent QBID is generally $40,000. But taxable income before the deduction is $176,000 after the $24,000 standard deduction. So the maximum QBID is now $35,200 (20 percent of taxable income).

If our taxpayer has a traditional IRA, he could choose to convert $24,000 to a Roth IRA. This raises taxable income to $200,000 and the allowed QBID is back to $40,000.

The $24,000 traditionalto-Roth conversion increases taxable income by only $19,200. This is 80 percent of the added income and reflects the benefit of the added income in raising the QBID by 20 percent of the income.

The added income need not be a Roth conversion. But every dollar of added income will add only 80 cents to taxable income, up to a total of $24,000 of income.

If our taxpayer actually itemized deductions and had $50,000 of such deductions, then the 80 cents per dollar would work for up to $50,000 of income. We can push the income up to the point where taxable income preQBID equals the QBI (i.e., both $200,000).

Some may call this an unintended consequence of the QBID, but who knows or cares if it was intended or not. The point is there’s more fun for the accountants.