Assistant Vice President and ERISA Attorney, Benefits Consulting Group, John Hancock Retirement Plan Services
One provision of the Tax Cuts and Jobs Act (the “Act”) that has garnered a lot of attention is the deduction given to certain “pass-through entities” (e.g., partnerships, S corporations, LLCs, and sole proprietorships). This is an important provision since many, if not most, small businesses today are pass-through entities—meaning the profits from the business are passed through to the owners based on their respective ownership interests, and are taxed to them based on their individual tax rates.
How the deduction works
Under the Act, the owners of certain such entities may deduct an amount equal to 20% of the entity’s “qualified business income.” There are various limitations and exclusions respecting the calculation of the deduction, and its application, which are beyond the scope of this article. There are also many open questions that will need to be answered by subsequent technical guidance.
Generally speaking, the availability and calculation of the deduction is based on the business owner’s taxable income and tax-filing status. However, for the owners of “specified service businesses,” the deduction is phased out based on taxable income ($315,000 to $415,000 for married filing jointly, and $157,500 to $207,500 for single filers*). For this purpose, specified service businesses include law, health, accounting, consulting, actuarial science, performing arts, athletics, financial services, and other trades or businesses where the underlying business’s principal asset is the reputation or skill of one or more of its owners or employees.
The deduction as hurdle
Theoretically, there are some instances in which the 20% deduction on pass-through income would make today’s effective tax rate seem relatively low compared to the possible rate an owner might expect to pay in retirement. In the mind of the owner, this could negate advantages of offering—and participating in—a 401(k) or other qualified retirement plan.
Arguments in favor of a qualified plan
Of course, for many business owners, there is more to sponsoring a retirement plan than what the owner-employee can save on an individual basis. Front and center is the plan’s ability to attract and retain key employees.
But there’s another potential advantage for business owners: Maintaining a qualified plan may also, under certain circumstances, help a pass-through entity qualify for the 20% deduction. One key to the deduction is controlling taxable income. And with a qualified plan, the business entity or owner can take advantage of the plan contribution deduction, which, in turn, can help keep taxable income below the qualifying threshold.
Finally, business owners may also garner a straightforward tax benefit from participating in the underlying plan. They may be able to take advantage of their current tax rate by choosing to make Roth contributions in lieu of pre-tax contributions—or by making in-plan Roth conversions over time. Either method provides for tax-free distributions when the business owner presumably is in a higher tax bracket following retirement.
The 20% deduction afforded to certain pass-through entities under the Act will undoubtedly have retirement plan implications. To some small-business owners, the deduction may prove to be a disincentive to plan sponsorship.
Yet, others may discover new advantages to offering a qualified plan, including (for some) the ability to qualify for the newly available deduction.