Since the Tax Cuts and Jobs Act went into effect, owners of pass-through entities have been allowed to deduct up to 20% of their qualified business income. However, the benefits may be reduced or eliminated if an owner's taxable income exceeds certain thresholds.
If you exceed the thresholds, one potential strategy is to transfer portions of your business to multiple trusts for the benefit of your children or other heirs. But there's a possible wrench in the works — regulations prevent the use of multiple trusts as a tax avoidance device.
If you have a very profitable sole proprietorship, partnership, S corporation or LLC, read on to learn how you can still enjoy the valuable tax advantages of the qualified business income deduction.
Important Limits
There are two important limits on the ability of higher-income taxpayers to take advantage of the QBI deduction. First, owners of specified service trades or businesses (SSTBs) — such as healthcare providers, accounting and law firms, consulting firms, financial services firms, and brokers — are ineligible for the deduction. Second, the deduction is limited to the greater of 1) 50% of the owner's share of the business's W-2 wages, and 2) 25% of W-2 wages plus 2.5% of the original cost basis of qualified business assets.
Both limitations are gradually phased in beginning at taxable income of $163,300 ($326,600 for joint filers) and fully applicable when taxable income exceeds $213,300 ($426,600 for joint filers) for 2020. So, for example, a single SSTB owner with taxable income over $213,300 is ineligible for the QBI deduction. And a single non-SSTB owner at that income level is subject to the wage and asset limitations. If the business has no W-2 wages or qualified assets, the allowable deduction is zero.
On the other hand, an owner whose taxable income is below $163,300 ($326,600 for joint filers) is eligible for the full deduction. This is true regardless of the type of business or the extent of its wages or qualified assets.
READ MORE: Tax Reform: Ways to Maximize the New QBI Deduction, Bonus Depreciation
Trouble with Trusts
For purposes of the QBI deduction, the taxable income threshold for a trust is the same as that for individuals. So a trust that's taxed as a separate entity and has taxable income of $163,300 or less qualifies for the deduction — even if it receives income from an SSTB or a business with no wages or qualified assets.
The IRS was concerned that business owners otherwise ineligible for the QBI deduction would divide their businesses among several trusts, each with income under the threshold, to avoid the deduction limits. To discourage this strategy, final regulations issued in January 2019 contain an anti-avoidance provision.
For purposes of the deduction, two or more trusts will be aggregated and treated as a single trust if
- They have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and
- A principal purpose for establishing such trusts (or contributing additional property to them) is to avoid federal income tax.
Since the anti-avoidance rule applies only to trusts with the same primary beneficiary or beneficiaries, it's possible to maximize eligibility for the QBI deduction by establishing a separate trust for each beneficiary.
READ MORE: How Business Owners can Aggregate to Maximize the Qualified Business Income Deduction
Raising Tax and Nontax Issues
Before you decide you want to transfer your business's interests to multiple trusts, contact us for assistance.
This strategy for maximizing the QBI deduction can raise several tax and nontax issues. For example, trusts are subject to income tax at the highest federal rate at much lower levels of taxable income ($12,950 in 2020).
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