The Tax Cuts and Jobs Act (TCJA) has created some changes to the tax code, much of which are beneficial for businesses. One of those changes is IRC Provision 11011 Section 199A. This provision allows eligible taxpayers a deduction of up to 20% of qualified business income (QBI) from a domestic business operated as a sole proprietorship or through a partnership, S corporation, trust or estate. You get the full 20% deduction up to $315,000 if married filing jointly, $157,000 for all other tax payers. This can apply to; Individuals, trusts and estates with qualified business income, qualified REIT dividends or qualified PTP income.
So, what does this mean in English? It means; if you’re a business owner that’s married (filing jointly) and you can keep your taxable income from your business under $315,000, $157,000 for all other tax payers, you will only be taxed on 80% of that income. So, if you’re income is $300,000 you potentially may only be taxed on $240,000. If you’re a high-income earner the tax savings can be substantial. There are some limitations to the type of business this applies to, but for the sake of brevity, I’ll ask you to reach out to me directly to determine if your business is eligible.
If you and/or your accountant cannot seem to get the business expenses under the threshold to take advantage of section 199a, you should consider a 412(e)3 plan. This is commonly overlooked and can offer a six or seven figure tax deduction.
A 412(e)3 plan, may also be referred to as a Fully Insured Defined Benefit Plan, or sometimes a Pension Plan. Eligible businesses for this plan are; Sole proprietors, C Corporations, S Corporations, Partnerships, Limited Liability Companies, and Family Limited Partnerships. This plan is primarily used for pass through entities, so we rarely see them for C Corps.
I know reading about this topic is too exciting for you to lose interest, but just in case there are a few readers out there who are losing interest. Let me highlight some key advantages and disadvantages of a 412(e)3 plan.
To summarize some of the key advantages:
- A fully insured 412(e)(3) DB plan can provide substantial retirement benefits without market risk;
- From a retirement standpoint, it gives the largest tax deduction under the law.
- Can provide guaranteed income you cannot outlive, a maximum annual benefit of about $220,000 a year.
- Reduces, diversifies or potentially eliminate market risk.
- Allows you to buy estate planning tools on a pre-tax basis.
- Because benefits are funded based on the contract guarantees, the 412(e)(3) fully insured DB plan can provide a maximum current tax-deductible contribution for the business;
- There is no full-funding limitation under IRC Section 404(a)(1)(A);
- No quarterly contributions are required; and
- There can be no under-funding because contributions are based on the guaranteed provisions of the level premium contracts.
While all the above sounds great, there are some disadvantages to this plan:
- It requires large contributions that must be made each year;
- No policy loans are available;
- There is no flexibility in contribution allocations; and
- It must be funded exclusively through annuity and life insurance contracts (in order to remove all market risk).
Section 412(e)3 of the IRS code allows the largest tax-deductible contribution to a qualified retirement plan under the law. In most cases this gives a business and/or individual a 6-figure tax deduction. We have even seen cases in which it offers 7 figures in deductions, the largest we've seen being a $2.2 million deduction.
A thought to keep in mind; generally, the older the individual, the larger the contribution they can make. Remember, the benefit is defined, not the contribution. This means that when an individual is older, they can “catch up” to the maximum defined benefit through larger contributions.
To give you a real-world example; we had a client come to us that operates as a sole proprietorship. After this individual worked with their CPA and deducted all their qualified business expenses (QBE), their QBI was still $425,000 for the calendar year 2018. We then worked with our client and their CPA to put in place a 412(e)(3) plan making an annual contribution of $115,000 a year. This reduced their QBI to $310,000 and made them eligible to take full advantage of section 199A, giving them an additional 20% deduction on the $310,000.
If you’ve made it this far in the article/newsletter I’d first like to applaud you for having a greater attention span than most. I’d also like to thank you for tolerating my dull writing on this subject. If we have raised any questions, or if you’d like to see if you’re eligible for this strategy, please feel free to reach out to our office or contact me directly. We are happy to provide our subscribers a free cost savings analysis for this strategy.
Founder, Managing Partner
Finance For Thought
O: (212) 534-1200