Tax Policy Analyst
Tax lawyers are developing complex strategies, and lobbying the IRS as it writes regulations for the 2017 tax law, to maximize the law’s “pass-through” deduction for their wealthy clients, and here’s another reported strategy: high-income business owners can make themselves eligible for the deduction by increasing their contributions to their own retirement plans.
First, a little background: The 2017 tax law gives a 20 percent deduction on certain “pass-through” income — income that the owners of businesses such as partnerships, S corporations, and sole proprietorships report on their individual tax returns, which previously was taxed at the same individual tax rates as their wage and salary income. As we’ve said, there’s little policy rationale for this special tax break.
Business owners under certain taxable income thresholds — $315,000 for a married couple, $157,500 for single filers — face relatively few restrictions on their deduction, but those with higher taxable incomes face guardrails that can limit the deduction or disqualify them from it. For instance, for business owners in certain service-oriented industries such as law, health, and accounting, the deduction begins to phase out when a married couple’s taxable income hits $315,000 and phases out completely when it reaches $415,000.
High-income business owners have been looking for ways to access the deduction or increase its value, such as by reducing their taxable incomes to below the thresholds so that the industry restrictions no longer apply. Making large contributions to a retirement plan is one way to do this since they reduce a filer’s taxable income. That could include contributions to a 401(k) plan or a defined-benefit pension. In fact, Bloomberg reported that retirement planning companies are marketing defined-benefit pensions as a way to get around the deduction’s guardrails.
Consider an example from tax advisor Kevin Donovan, as reported by Tax Notes. A married accountant owns an accounting firm organized as an S corporation. She and her spouse have $415,000 of taxable income, including $200,000 in profits from the accounting business and at least $100,000 of wages that she pays herself from the business. Since she’s in the accounting industry, the $415,000 in total income would appear, at first glance, to disqualify the profits from the pass-through deduction.
But if she turns $100,000 of wages into contributions to a retirement plan, the couple’s taxable income drops to $315,000. Because the industry-based limit on the pass-through deduction doesn’t apply to married couples with taxable incomes below that level, they would receive the full 20 percent deduction, or $40,000, on the $200,000 of S corporation profits.
This strategy — turning $100,000 of wages into retirement contributions — effectively reduces their taxable income by $140,000: $100,000 in tax-deferred retirement contributions plus the $40,000 pass-through deduction. The pass-through deduction alone delivers a $9,600 tax cut (multiplying the $40,000 deduction by the 24 percent tax bracket that the couple is in) simply by rearranging the business owner’s compensation. And that’s on top of the considerable tax benefits that the retirement plan provides a couple at this income level. Donovan called this strategy a deduction “supercharge,” saying: “I’ve never seen anything like this, where you’re basically putting a dollar in the [retirement] plan and getting tax deductions of 120 and 140 percent of that number.”
That’s feasible because business owners can adjust their retirement plans to suit their tax needs, which is an especially attractive option for high-income business owners who have few, if any, additional employees. Business owners can also make retirement contributions that are far larger than the $18,500 annual limit on employee 401(k) contributions. They can contribute up to $55,000 (subject to certain restrictions) in combined employer and employee contributions since they are effectively both an employer and an employee. And defined-benefit pension contributions can be even larger depending on the details of the retirement plan. Bloomberg reports that for some employees, defined-benefit pension contributions can far exceed $100,000.
The high-income business owners who can use these strategies, by the way, are likely well prepared for retirement to begin with — far better than the roughly half of households near retirement that have no assets in a 401(k) or individual retirement account. Instead, these strategies are just examples of the many gaming opportunities that the pass-through deduction offers.