The pass-through provision in the new federal tax law has some professionals salivating over a potentially substantial tax break.
However, the 20% deduction on pass-through business income doesn't apply to all taxpayers equally. Professionals who work in "service" businesses are ineligible for the pass-through deduction if their overall taxable income exceeds a certain limit.
Single taxpayers get the full deduction if their income is below $157,500; for married couples, the limit is $315,000.
The question becomes: If service professionals' taxable income exceeds these thresholds, how can they reduce it to claim the deduction on pass-through business income?
"It's profoundly expensive to be above $315,000 if you're married and the owner of a service business," said Leon LaBrecque, managing partner at LJPR Financial Advisors. "So I'm better off doing a whole bunch of other things [to reduce taxable income]."
Possible avenues include: making contributions to certain types of retirement plans, making large charitable gifts and buying new equipment for the business. The tax savings for taking these steps could be substantial.
Let's consider the hypothetical example of a married couple with pass-through business income of $300,000. The couple also has $15,000 in additional income, for a total taxable income of $315,000, making them eligible for the full pass-through tax break.
The couple would be able to exclude $60,000 (a 20% deduction on $300,000 in business income), and would pay taxes at a marginal tax rate of 24%.
The deduction is phased out for single filers with income between $157,000 and $207,500 and for couples with income between $315,000 and $415,000. At the higher limits, the deduction is totally phased out.
To stay below those income levels, certain strategies can be employed.
"The easiest, most obvious [strategy] is using a 401(k) plan," Mr. LaBrecque said.
Professionals could reduce their taxable income by a maximum $55,000 in 2018, which includes employer plus employee contributions, with a 401(k) plan. The maximum is $61,000 for those ages 50 and over.
So an older, self-employed professional with pass-through income of $370,000 can use a solo 401(k) plan to deduct $61,000 from income taxes and get the pass-through deduction, Mr. LaBrecque said.
"You're getting a double bang for your buck," he said.
Cash-balance plans can offer an even greater deduction, perhaps to the tune of a few hundred thousand dollars, advisers said.
"If the deduction you're trying to get is under $55,000 or $60,000, a 401(k) plan will typically work," said Jason Kolinsky, a financial planner at Kolinsky Wealth Management. "If you want to do more than that, that's when you're typically looking at a cash-balance plan."
These plans are a type of pension plan, but feel more similar to defined-contribution plans than to traditional pensions, he said.
The caveat, advisers said, is that owners should expect to establish cash-balance plans for several years and be willing to make plan contributions for employees during that time period. They're also generally more costly to administer than 401(k) plans, Mr. Kolinsky said.
Another important distinction: Cash-balance-plan contributions would reduce the net business income — the contribution is made at the business level, not the individual-owner level, said Timothy Steffen, director of advanced planning in the Private Wealth Management group at Robert W. Baird & Co.
For example, if a partnership with two 50% owners and $500,000 in profit makes a $50,000 pension contribution, it lowers the partnership's taxable income to $450,000, and each of the business owners' taxable income by $25,000.
(Again, the business owner's taxable income is what determines if he or she gets the 20% pass-through deduction.)
Making large charitable gifts is also a way to reduce taxable income, but professionals can only offset a certain percentage of their income through charitable donations, Mr. Steffen said.
They can offset up to 60% of their income in a given year by gifting cash to a public charity (like a donor-advised fund); a gift of stock only offsets up to 30%. So, those with taxable income of $1 million, for example, wouldn't be able to solely gift their way to the pass-through deduction.
The tax law changed the rules around bonus depreciation — through 2022, business owners will be able to write off 100% of the cost of a new piece of equipment in the year it was purchased, Mr. Steffen said. (It was 50% for 2017.) That percentage will then ratchet down in 20% increments, eventually hitting 0% in 2027.
The effect is a reduction in taxable income, via a reduction in business income. For example, let's say the sole owner of an business with $500,000 in profit buys a $200,000 piece of equipment. The owner can take a $200,000 write-off in 2018 and ink a $300,000 total profit.
"Advisers sitting marginally over the income threshold can look at what they want to do in their office, like new furniture or computers," Mr. LaBrecque said.