The pass-through deduction created by the new federal tax law has inspired a raft of planning opportunities for financial advisers looking to minimize business clients' tax bills.
The provision provides a 20% tax deduction on qualified business income from pass-through entities, which include partnerships, limited liability companies, S corporations and sole proprietorships — basically, any entity other than a C corporation.
Following are some strategies that advisers and tax professionals have discussed using with clients who own pass-throughs.
(Because advisers are still awaiting guidance from the Internal Revenue Service on the pass-through provision, it's hard to know how the agency will judge certain tax strategies that have emerged.)
Married filing separately
It often makes financial sense for married couples to file joint instead of separate tax returns. But the pass-through deduction could change the calculus.
The strategy would isolate the business owner's taxable income from the other spouse's. For service businesses, such as lawyers, accountants and financial advisers, overall taxable income determines eligibility for the deduction.
For example: A wife has $150,000 of taxable income, the majority of which is pass-through income from a service business. Her husband has $300,000 of taxable income. Their combined taxable income disqualifies them from the deduction, because it exceeds the $415,000 ceiling applying to married couples filing jointly. However, the wife would qualify for the deduction if she were to file separately, since the upper limit for individuals is $207,500.
One caveat: Filing separately has "a lot of implications across your tax return," said Tim Steffen, director of advanced planning at Robert W. Baird & Co.'s Private Wealth Management group.
Convert independent contractors to salaried employees
This option is particularly relevant for high-income business owners whose pass-throughs aren't considered service businesses, Jeffrey Levine, CEO and director of financial planning at Blueprint Wealth Alliance, said in an article laying out several pass-through strategies.
These owners, such as engineers and architects, still qualify for a tax deduction even if their taxable income exceeds the limits mentioned above, but the deduction's value is determined by a wage-and-property test.
The deduction becomes the lesser of two things:
• 20% of business income, or
• The greater of: (a) 50% of W-2 wages, or (b) 25% of wages plus 2.5% of the cost of depreciable assets in the business.
A business that solely uses independent contractors and doesn't have depreciable assets wouldn't get a deduction. But converting contractors to employees would generate W-2 wages, and a resulting deduction.
Reducing guaranteed payments to partners
"One of the easiest ways that an adviser can help certain business owners increase their QBI deduction is by helping them revisit their partnership arrangements," Mr. Levine said.
The new tax law excludes guaranteed payments made to partners from being considered qualified business income subject to the pass-through deduction, he said.
Amending a partnership agreement to eliminate guaranteed payments and reflect a change in ownership stakes means that every dollar of the partners' earnings can qualify for a pass-through deduction, Mr. Levine said, resulting in a larger deduction. (This assumes their taxable income is low enough to qualify.)
Shifting employees, equipment, real estate to other entities
This approach involves shifting depreciable property and employees out of a business.
For example, a high-income law firm can create a separate pass-through entity that houses the company's non-service functions, such as administrative functions, the mail room or the IT department. The lawyers can then "hire" the other entity to perform their normal job functions for the firm.
The benefit: While the law firm's partners likely cannot claim a deduction on the law firm's profits, given that they're high earners in a service business, the separate entity can claim a deduction on its profits, Mr. Steffen said.
The same concept applies to depreciable property. A high-income doctor with a radiology practice can spin off MRI and X-ray machines as well as other medical equipment into another business, and the radiology practice can lease back the equipment, Mr Levine said. The spun-off entity can claim a pass-through deduction on its profits.
This radiology practice could also spin off its medical office building (assuming the business owns it) into another pass-through and have the medical practice rent space in the building, Mr. Levine said. The new entity's profits may be eligible for a deduction.
Change to an S corporation
Some business owners — including those with sole proprietorships, partnerships and LLCs taxed as partnerships — aren't allowed to pay themselves a salary, Mr. Levine said. If these individuals also don't service businesses and their taxable income exceeds the deduction threshold, they should consider switching to an S corporation.
These entities allow the owner to take a salary, therefore potentially granting a deduction through the aforementioned W-2 wage calculation.
Mr. Levine provides this example: The owner of a sole proprietorship with no W-2 employees has business profits of $750,000, making the person ineligible for a deduction. But what if the individual converts to an S corporation and takes a $300,000 salary, with net business profit of $450,000? This grants the same total income, but also a $90,000 pass-through deduction (which is 20% of $450,000).
Minimizing taxable income
Owners of service businesses who cannot claim a deduction because their taxable income is too high have options available outside of their business to reduce taxable income. Contributing to retirement plans and reducing investment income (by structuring a portfolio to derive less income from investments in a given tax year) are two examples, Mr. Steffen said. Even having one spouse work less is a potential way to reduce taxable income for the household, he added.
Transferring business ownership to trusts
Clients can transfer business ownership interests to non-grantor trusts, if those interests wouldn't provide a deduction to the current owner or to trust beneficiaries when transferred to them directly, Mr. Levine said.
This way, beneficiaries like children can indirectly get a pass-through deduction via profits generated from business interests held in the trusts.