No More Surprises

There is a new approach for small business owners who had pass-through type entities. These are S corporations, LLCs, LLPs, sole proprietorships, and other kinds of business enterprises where the income from the business “passes through” the laboratory to the personal federal income tax return of the owner. Since 2019, Section 199(a) of the tax code allows up to certain levels of the qualified pass-through business income to be eligible for a 20% deduction when appearing on the personal federal income tax return prior to the tax bill or refund being calculated. In a hypothetical situation, if the laboratory owner has $100,000 of income from his or her business, the amount to report as taxable federal income would be reduced by 20% to become $80,000, and the personal federal income tax would be due on the $80,000 worth of income.

There are many points to consider that should be discussed with the financial advisor or CPA prior to understanding what this all means because of certain restrictions on the amount of qualified business income permitted on which the 20% deduction may occur. Some of the restrictions require processing all of the personal income of the dental laboratory owner, including dividends, interest, capital gains, and other items of personal income.

The 20% deduction right off the top of the qualified business income sounds very good, but to make sure that it can be achieved, the laboratory owner’s income from the laboratory cannot be above a certain level when added to other income that he or she may be reporting on their personal federal income tax return. The tax advisor or financial planner should be consulted about this. There may be some appropriate business approaches that were not previously considered when analyzing income tax deferrals prior to the 2018 federal income tax filing time.

One of the safest and most productive methods to reduce taxable income and to protect the funds that have been used to defer that income is the implementation of a qualified employer-sponsored retirement plan for the laboratory and its employees and owner. As long as the income reported is considered earned, and it appears as income on a W-2 or as self-employment income on a K-1, then it counts toward the retirement plan deduction. Unearned income from such things as dividends, interest, and capital gains does not count. There are many items to consider when making a decision about the adoption of this type of idea and the use of the qualified employer-sponsored retirement plan.

Many small business owners faced with these decisions wonder: “How much will I get, and how much will I have to give to my employees?” The types of qualified employer-sponsored retirement plans that most people have heard of are the 401(k) plus profit-sharing plan or simply the 401(k) without a profit-sharing plan attachment. These are defined-contribution plans for which the amount of contribution is governed by law. With the 401(k) plus profit-sharing plan, W-2 earners and those with self employment income can defer up to $18,500 and $24,500, respectively, based on being not yet age 50 or having attained age 50 or older, respectively. That amount of money comes from the employees and the owners individually. After these amounts are deferred by the individuals, the business enterprise or the laboratory then has a decision to make about how much it wants to contribute, if anything, if there is a profit-sharing plan as part of the 401(k) retirement plan document. There are also questions of “safe harbor” and other points to consider that should be discussed with the financial planner or CPA for the laboratory.

Up to this point, the out-of-pocket cost for the owner of the laboratory is the organization cost of the retirement plan with the actuary who designed the plan with the help of the laboratory’s CPA or financial advisor and whatever the employer cost is based on their input. Since discrimination is not allowed in the plan, all full-time employees must be included as participants. The definition of “full-time” should be discussed with the laboratory owner’s advisors for more information. The formal adoption of these types of retirement plans by the laboratory will assist in reducing its taxable income and help reach a threshhold for the ability to use the 199(a) format where an additional 20% of the income may be deductible before federal tax. 

Certain other retirement plans can yield a greater income tax reduction. A defined-benefit plan will provide certain owners and key employees with deductions over $100,000 or more per year. Implementing such a plan is complex and very sophisticated, and requires fairly consistent earnings with high tax consequences. 

A defined-benefit plan is unlike the 401(k) or any other type of qualified employer-sponsored retirement plans that are governed by law and allow certain deductions based on whatever the law permits. For example, the limit for this year is $18,500 for those not yet 50 years old and $24,500 for those age 50 and older. There may be an employer contribution, but that amount is limited based on certain percentages of income and the total of the employees’ earnings. This type of plan is known as a defined-contribution plan, meaning that the contribution is defined, not the benefit paid once the employee has reached retirement age. A simple definition of the defined-benefit plan is that the contribution to the plan is not defined but the benefit received is defined. 

Bruce Bryen, CPA, CVA, is the principal in the firm of RKG Tax and Business Services, LLC, in Fort Washington, Pennsylvania.