Under the new tax law, an employer contribution to an HSA may be well worth the money specifically for those who fall under the specified service trade or business.
The ability to receive a deduction requires testing under the new law. Generally, all pass-through entities will be able to deduct 20% of their qualified business income if the tax payer is able to meet those testing qualifications.
However, if a business owner categorized as a specified service trade or business, has a taxable income over the taxable income threshold amounts, their ability to receive a deduction under the new Code is unavailable.
Here’s one way your business owner clients can reap the benefits of the new income tax deduction while providing a valuable employee benefit.
Qualified business income deduction
Under the new Code section, all pass-through entities will be able to deduct 20% of their qualified business income if the taxpayer has an adjusted gross income of no more than $157,500 ($315,000 if joint return), adjusted for inflation after 2018.
For amounts above those figures, the deduction is phased out over the next $50,000 ($100,000 for joint tax filers) of income. This creates an effective top marginal rate of 29.6%.
“The term ‘qualified business income’(QBI) means, for any taxable year, the net amount of qualified items of income, gain, deduction, and loss with respect to any qualified trade or business of the taxpayer. Such term shall not include any qualified REIT dividends or qualified publicly traded partnership income.” –IRC §199A(c).
The calculation to determine what the taxpayer will be able to deduct for QBI is based on a few factors. First, combined QBI needs to be calculated.1 IRC §199A(b)(2) states that the combined QBI is equal to the lesser of:
20% of the taxpayer’s QBI or The greater of —
- 50% of the W-2 wages with respect to the qualified trade or business, or
- The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property.2
Once the combined QBI is determined the taxpayer moves to the next limitation, taxable income. The QBI deduction is the lesser of:
The combined qualified income amount of the taxpayer, or
An amount equal to 20% of the excess (if any) of—
- The taxable income of the taxpayer for the taxable year, over
- The net capital gain (as defined in section 1(h)) of the taxpayer for the taxable year.3
However, if the tax payer is classified as a specified service trade or business, as defined under 1202(e) (3)(A) and exceeds the phaseout amounts those individuals would be ineligible for the new 199A deduction.4
Individuals who fall into this category include any trade or business involved in the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees (engineering and architecture are excluded from this definition), or if the individual’s business involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interest, or commodities.5
Based on the above calculations, a married individual filing a joint tax return, would be eligible for a maximum deduction of $63,000 for those married individuals who are able to show $315,000 from qualified trade or business income as their only form of income.
Taxable income over $315,000 would start to see a reduction in the amount of the deduction, reaching an eligible deduction of $0 once the individual has a taxable income of $415,000 or more. If individuals falling within the specified service trade or business definition desire to receive the 199A deduction it will require individuals who are over the phaseout amounts ($415,000 for married couples) to find other deductions or ways in which to structure their income to reduce the amount of income they are showing as taxable income.
One solution has the effect of not only helping to reduce the amount of taxable income the business owner receives but also helps to retain and reward their employees. Below is an example of how implementing a HSA will affect the deduction available to specified service trade or business owners.
What will it cost an employer to contribute to her employees’ HSA plan under the new tax law
The following example is based on the below facts:
- Jill is an accountant, paid a W-2 wage of $85,000
- Jill owns 100% of her accounting practice, which distributes to her S-Corporation distributions of $300,000.
- Jill pays her office staff a total of $1,000,000
- Michael, Jill’s husband, is an office manager, paid a W-2 wage of $30,000
- Total taxable income for Jill and Michael is $415,000
- Before any structural changes are made or solutions implemented, Jill’s 199A deduction is currently at $0 because Jill and Michael are phased out of the eligible deduction.
Jill is concerned about employee retention. She is considering contributing to her employees’ HSAs as part of the established high-deductible health plan she implemented a few years ago. Let’s look at how that would affect Jill’s overall income, assuming the HSA contribution would be 100% deductible to the business.
Jill’s QBI deduction based on the above is calculated as follows:
- For taxpayers with taxable income between the lower and upper thresholds a partial wage and capital limitation apply: 20% of QBI, less an amount equal to a reduction ratio multiplied by an excess amount.
- The reduction ratio is calculated as the amount of taxable income in excess of the lower threshold amount of $315,000 (filing jointly) divided by $100,000. We determine the ratio by which the taxpayer’s income in excess of the threshold amount ($90,000) to the fully phased-in amount ($100,000), which is 90%.
- Next, we calculate the excess amount by determining the difference between the deductible QBI amount of the qualified business with no wage and capital limitation (20% of QBI), here $58,000 (20% X $290,000) and the deductible QBI amount of the qualified business with a fully phased-in wage and capital limitation (W-2 wages), here $0 as we are a specified service business.
- Using those figures we take $58,000 and reduce that by our reduction ratio (90%) multiplied by our excess amount ($58,000) to get $58,000-$52,200 = $5,800.
Jill’s ability to provide this benefit to her employees is very cost efficient. Providing this contribution to the employees’ HSA accounts now only requires Jill to pay out of pocket (business pocket) a total of $4,200 due to her ability to receive a deduction of $5,800.
Planning considerations to discuss with trusted tax specialists
Given the complexity of the new Code, there are several ways in which pass-through business owners may find tax advantages.
It is important to ensure that any other strategies are discussed as a whole in determining feasible, as the new Code is affected by structural changes to the manner in which your clients receive income. You may want to consult with a tax professional to determine the best strategies to implement with regard to the new code.
Ryan Patton, MBA, is with Nationwide’s Advanced Consulting Group.
1 I.R.C. §199A(a)(1)
2 I.R.C. §199A(a)(2)
3 I.R.C. §199A(a)(1)
4 I.R.C. §199A(e)(3)(A)(i)
5 I.R.C. §199A(e)(2)(A), I.R.C. §199A(e)(2)(B)
Ryan Patton, MBA, is with Nationwide’s Advanced Consulting Group.
