How the SECURE Act will affect business owners and the new 199a deduction
The SECURE Act was passed at the end of 2019, and with it came a variety of unintended and unexpected consequences surrounding tax planning. The tax analysis of the bill shows it’s expected to be a tax revenue generator for the government over the next 10 years.
The biggest driver in the bill is the removal of a popular tax benefit often referred to as “stretch” provisions for inherited retirement accounts like IRAs and 401(k)s. In the past, beneficiaries of inherited retirement accounts could stretch out the required minimum distributions (RMDs) from the account over their own life expectancy. Under the SECURE Act, beneficiaries will have to distribute the entire account over a 10-year period following the death of the retirement account owner.
This change from lifetime distributions to a 10-year distribution time period has three big impacts that cause taxes to rise. First, because the IRA is distributed faster, money inside the account has less time to grow in a tax-advantaged manner, meaning there will be less tax-deferred growth for the beneficiary.
Second, because the distributions are forced out over fewer years they are larger, increasing the beneficiary’s taxable income and with it their marginal federal tax rate.
Third, a higher taxable income can result in the loss of other tax deductions. One deduction in question was added by the Tax Cut and Job Act of 2017, or more commonly referred to as the 199A deduction.
While the first two items seem self-explanatory, let’s explore how the third reality of the SECURE Act affects business owners.
Let’s look at an example of distributing an IRA over 10 years. Your client is a 55-year-old business owner named Penny. Penny inherits a $1 million IRA from her parent who passes away in 2020. Under previous rules, the distributions per year would have been close to $25,000 a year.
However, after the SECURE Act, which went into effect for those who die after December 31, 2019, this IRA must be distributed by the end of 2030 (the tenth year following the year of the owner’s death.) Consistent yearly taxable distributions would be about $100,000.
Assume Penny is a single filer for taxes with an income of $135,000 before the IRA distribution. Under previous rules, a $25,000 distribution would have pushed her income up to $160,000. Under the SECURE Act, a $100,000 distribution would increase her yearly income to $235,000 and her marginal federal income tax rate from 24% to 35%.
How could higher taxable distributions impact the 199A deduction? Section 199A allows for a deduction of up to 20% of qualified domestic business income for pass-through entities such as sole proprietorships, partnerships, S-corporations, trusts, certain REITs or estates. Each trade or business (even within a single entity) can be treated as separate for reporting purposes, but a qualified business income (QBI) has to be computed from each.
You also have to know the business owner’s taxable income. The income-based limitations are as follows:
Single individual: $163,300 to $213,300 (2020)
Married filing jointly: $326,300 to $426,300 (2020)
If the business owner has less than the threshold amounts, the deduction becomes straightforward. Deduct 20% of the QBI against that specific trade or business. If the business owner’s taxable income is above the income limits, you have to determine if the business is a specified service trade or business (SSTB). Under 199A, a specified service trade or business is defined as:
any trade or business involving 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. [TCJA removed architecture & engineering].
If the business is a specified service business and the business owner’s income is within or over the ranges, the deduction is phased out and completely lost at the top of the phase-out range. For a non-specified service business, a new limitation is phased in over the course of the ranges. Depending on the business setup, this could still cause business owners to lose the entire deduction.
For a non-SSTB owner who earns over the income ranges, a potential limitation on the 199A deduction will phase in, and they’ll only be able to deduct the lesser of 20% of QBI, the greater of 50% of W-2 wages paid or 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of qualified property. If someone isn’t an SSTB business owner making more than the upper end of the ranges, renting their building and paying no W-2 wages, they’ll lose out on the 199A deduction completely.
Let’s look back at our example with Penny the business owner. She still has an income of $135,000, is a single filer and inherits a $1 million IRA under the 10-year distribution rules. We’re going a step further. Assume her income is all QBI and qualified for the full 199A 20% deduction. Before the IRA distributions, Penny falls well below the phase-out threshold with her income.
However, if her business was a specified service business, she now has $100,000 of additional taxable income that would increase her total income to $235,000. This amount is well above the phase-out threshold of $213,300.
Once the distribution kicks in, the 20% deduction on $135,000 of QBI is completely lost, which is a lost deduction of $27,000. At $135,000 of income with the 20% deduction, Penny’s total tax burden at the federal level would be roughly $25,000 (including FICA and federal taxes). However, after the $100,000 distribution total taxes, it’d rise to nearly $65,000. The $100,000 distribution results in a $40,000 increase in taxes, an effective tax increase on the $100,000 of 40%, which is higher than the highest federal marginal tax rate today.
The new SECURE Act rule changes could cause an unintended tax burden for business owners and result in the loss of the 199A deduction for many people. Advanced planning strategies are called upon to handle this issue. One strategy would be to do Roth Conversions before the IRA is inherited so the distributions would be non-taxable and wouldn’t raise the business owner’s taxable income.
The business owner could set up their own retirement account at the business to get a big income tax deduction. In some cases, the business owner could set up a 401(k) and a defined benefit plan and drive over $100,000 of deductions that could help manage their taxable income and protect their 20% deduction.
Additionally, the new IRA distributions could help fund the owner’s cash flow to set more money aside in a retirement plan. However, all of these strategies are very complex. If you’re a business owner or IRA account owner, take the time to work with a planner as the rules have changed and could unexpectedly cause huge tax issues and tax increases for many business owners.