The Tax Cuts and Jobs Act (TCJA) included the most substantial changes to the tax code that we have seen in over 30 years. The change which has garnered the most attention amongst financial advisors, though, is the new 20% deduction for Qualified Business Income (QBI). What’s unique about the QBI deduction (also known as the IRC Section 199A deduction, or the pass-through deduction) is not just the size of the deduction (as a deduction of up to 20% of certain business income is certainly appealing!) but the fact that many financial advisors themselves will be eligible for a QBI deduction, albeit subject to some “high-income” limitations that some financial advisors will need to plan for in order to avoid having their QBI deduction phased-out entirely.
In this guest post, Jeffrey Levine of BluePrint Wealth Alliance, and our Director of Advisor Education for Kitces.com, examines how financial advisors (and other Specified Service Businesses) can maximize their QBI deduction through business entity selection, including why employee advisors may want to convert to being independent contractors, why S corps may want to convert to partnerships, LLCs, or a C corp (or not!), and why sole proprietors may not need to make any changes at all.
A key to understanding the new QBI deduction is how the “high-income” phaseout works. For QBI purposes, any Specified Service Business owner (including a financial advisor) who files a joint tax return with more than $315,000 of taxable income, or an individual who files under any other status with taxable income of more than $157,500, will be considered “high-income”. And being “high-income” triggers a partial phaseout of the QBI deduction, and culminates in a total phaseout once taxable income exceeds $415,000 (joint) or $207,500 (other tax filers). Notably, since these thresholds are based on taxable income, it includes income from any sources (investment, spouse, etc.), even though the QBI deduction itself is calculated based on the business’ income.
The reason business entity selection influences an advisor’s QBI deduction is that not all compensation to an advisor (or other small business owner) is considered qualified business income eligible for the deduction in the first place. For instance, financial advisors who receive W-2 wages as an employee advisor are not eligible for a QBI deduction for those wages… which is why employee advisors may want to consider converting to become independent contractors (if their employer will allow it), as their sole proprietor income would be considered QBI. Income from partnerships or LLCs taxed as partnerships will generally be considered QBI, with the exception of guaranteed payments made to partners (which may mean advisors utilizing operating agreements with substantial guaranteed payments may want to reconsider this structure in light of QBI considerations). The good news for S corps is that so long as advisors can reasonably claim a lower salary, profit distributions (though not the wages portion) will avoid self-employment taxes and be considered QBI (although this extra incentive to push the boundary of what may be considered reasonable salary will also likely mean extra IRS scrutiny of S corp income). For C corp owners, wages again are not considered QBI, although such owners may still benefit from the newly reduced corporate tax rate of only 21%.
Ultimately, the key point is to acknowledge that business entity selection plays a key role in maximizing a QBI deduction as a specified service business owner (which includes financial advisors). And although many financial advisors (and other specified service business owners) may totally phase out the QBI deduction due to their high income, choosing the right business entity structure can help advisors preserve as much QBI deduction as possible!Read More…