Note: This blog post has not been updated for the Section 199A final regulations that appeared over the 2019 Martin Luther King Jr. holiday weekend and which clarified the way retirement plan contributions get handled for purposes of Section 199A. However, our “Maximizing Section 199A Deductions” ebook has been updated. We will update this blog post as soon as possible.
Someone recently asked me a really good Section 199A question: Does a pension fund contribution such as to a SEP-IRA or 401(k) plan lower one’s qualified business income deduction.
The qualified business income deduction, also known as the Section 199A deduction, gives business owners and some real estate investors an extra bonus deduction equal to potentially 20% of the profit they earn in the business or on the real estate. But the question is, is there a retirement savings Section 199A deduction connection?
The short answer to this question is, “Yes, but it’s complicated.” So let me discuss how the accounting works.
How Qualified Business Income Deduction Works
To provide concrete details about how all this works, let’s look at a simple example.
Suppose you earn $100,000 in a sole proprietorship. This sole proprietorship profit is your qualified business income—the income that potentially you get to use to create a qualified business income deduction.
Further suppose you’re married and that your spouse earns $24,000 in W-2 wages working for the “man.”
Your total income then equals $124,000.
But let’s throw some deductions into the mix. To keep the numbers round and our math easy, say $13,000 for self-employed health insurance and $7,000 for self-employment taxes.
And, oh yeah, $24,000 for the new standard deduction.
Your total deductions then equal $44,000.
With these data points, your qualified business income equals, as noted earlier, $100,000.
And your taxable income equals $80,000 (the $124,000 in total income less the $44,000 of deductions.)
The qualified business income deduction equals the smaller of these two amounts: 20% of the $100,000 of qualified business income or 20% of the $80,000 of taxable income.
Obviously, qualified business income exceeds taxable income, so the qualified business income deduction equals 20% of the $80,000 of taxable income, or $16,000.
What Happens When Retirement Saving Added
So the question my friend asked: What happens with a retirement contribution? Does it reduce qualified business income? Or the qualified business income deduction? What, exactly, happens?
And here’s where things get “complicated.”
In the case of an S corporation, a retirement contribution will directly reduce the qualified business income because the retirement contribution deductions appear on the S corporation tax return (either as wages paid to the shareholder-employee or as a corporation pension expense).
Another way to say this same thing: For an S corporation, the retirement contribution deduction counts a Section 162 business expense and so is “effectively connected with the conduct of that trade or business.”
Section 162, by the way, is the chunk of tax law that says the ordinary and necessary expenses of running a business count as valid business deductions. And the chunk of tax law that says paying salaries to employees and then fringe benefits (including retirement plan contributions) are, obviously enough, “necessary” and “ordinary.”
And then a note about this “effectively connected” phrase. This phrasing matters. For an item of income or deduction to be included in qualified business income, the item needs to be “effectively connected” as per the actual Section 199A statute (See Section 199A(c)(3)(A))
In the cases of a sole proprietorship or partnership, the retirement contribution deductions for a proprietor or partner don’t count as a business deduction that appears on the 1065 partnership tax return or on Schedule C inside the taxpayer’s 1040.
That accounting should mean the deductions aren’t “effectively connected” and therefore don’t reduce the qualified business income.
But even if so, the different accounting treatment often doesn’t make much difference.
Why? Because the retirement contribution deduction for a sole proprietorship or partnership, even though it’s not ‘”effectively connected,” still reduces the taxable income. That reduction in turn reduces the qualified business income deduction.
Revisiting the Earlier Example
Let’s revisit that earlier example. The one where you make $100,000 as a sole proprietor, your spouse earns $24,000 as an employee, and you guys have three deductions on your tax return: a $13,000 self-employed health insurance deduction, a $7,000 self-employment tax deduction, and that new $24,000 standard deduction.
With these facts, as noted earlier, the qualified business income deduction equals the lesser of either 20% of your $100,000 of qualified business income… or 20% of your $80,000 of taxable income. And since taxable income is less than qualified business income, the actual qualified business income deduction equals 20% of the $80,000 of taxable income, or $16,000.
So what happens if you add a $20,000 retirement saving deduction to the return (perhaps for a Solo 401(k), for example)?
The $20,000 401(k) contribution doesn’t reduce your qualified business income. But it absolutely will reduce your taxable income from $80,000 to $60,000, which means your retirement saving does indirectly reduce your qualified business income deduction: 20% of $60,000 equals $12,000.
Do We Know for Sure How Accounting Works?
Neither the Section 199A statute that creates the qualified business income deduction nor the Section 199A proposed regulations which appeared a couple of weeks ago give an absolute clean bill of health to the bookkeeping approach this blog post describes.
Section 199A does provide a little bit of information about how the accounting works (see Sec. 199A(c)(3) for example), but not a lot of detail. Accordingly, many folks understandably wonder whether the approach described here is correct.
Nevertheless, five reasons support the tax accounting described above:
- The taxable income limitation described above means that most sole proprietors and partners see their qualified business income deduction decrease as a result of retirement saving. As result, the question about whether or not retirement saving reduces qualified business income for these folks is moot.
- For Subchapter S corporations, as already noted, retirement saving does reduce qualified business income of shareholders, because one way or another the retirement saving deduction appears on the corporate tax return. For all S corporations, then, retirement contributions do reduce both qualified business income and taxable income.
- Congress did in the Section 199A statute specifically exclude some items from qualified business income. The wages an S corporation shareholder earns and the guaranteed payments a partner earns, for example, get excluded. But Congress did not exclude retirement savings for sole proprietors and partners. (Congress also didn’t exclude self-employed health insurance or the employer’s half of self-employment taxes either.) If they had wanted to do that, they could have.
- Connecting the deductions for Section 199A and stuff like retirement savings, self-employed health insurance and self-employment taxes makes the math complicated and circular. Yet often Congress and the Internal Revenue Service don’t do that. To look at the way that self-employment taxes work, for example, sole proprietors and partners pay self-employment taxes on 92.35% of their self-employment earning and then get a self-employment tax deduction equal to half of the Social Security and half of the Medicare tax paid. That approach indirectly means these folks don’t pay self-employment taxes on the employer’s share of the self-employment taxes. But there’s no circularity in the calculation. And the calculation delivers a sort of rough justice.
- The approach described here for the new 20% Section 199A “qualified business income” deduction mirrors the accounting for the old 9% Section 199 “domestic production activities” deduction, which effect the new deduction replaces.
This final comment: Stay alert to any future guidance the Internal Revenue Service provides related to whether or not items like partner and proprietor pension contributions (as well as self-employed health insurance and self-employment taxes) count for determining qualified business income.
What I describe here reflects guidance from the Internal Revenue Service through August 2018. And I think we can for now tentatively plan as if these adjustments don’t count.
But we want to stay alert for additional guidance in this area.
If you’re thinking about the way Section 199A connects to retirement planning, you may find these other related posts useful:
Section 199A Changes Retirement Saving talks about how the Section 199A qualified business income deduction may change the way some people save for retirement.
Section 199A Changes Investment Portfolio Construction reviews the ways Section 199A may cause investors to change the way they invest.
Finally, if you’re a real estate investor, you may be interested in two posts that discuss Section 199A issues relevant to real estate: How Section 199A and Section 1031 work together (or more accurately maybe how these two tax laws don’t work together) and then a review of how Section 199A works for rental property investors.