Sifting through the new tax laws to find potential deductions can be tricky. While the standard deduction has increased for individuals, deductions for qualified business owners can be a little more complicated because of the new Qualified Business Income Deduction (QBID) introduced at the beginning of 2018.
QBID allows business owners to deduct 20% of their taxable business income reported up to $315,000 for married couples and $157,500 for individuals. The tricky part is that, as the business owner’s taxable income rises, they may no longer qualify for the deduction or it will be reduced based on employee wages and the business’ depreciable assets. However, while individuals qualified for deductions under the old tax law based on adjusted gross income, QBID eligibility is based on taxable income. That means owners of qualified businesses who have a taxable income that is too high to qualify, can requalify by making a gift to a vetted charity or opening a Donor-Advised Fund (DAF) and using that philanthropic vehicle to make tax-deductible contributions.
Here’s how it works. Joe is a doctor in a private practice. His net profits for the year are $250,000. He has capped state and local tax deductions of $10,000 and $25,000 of mortgage interest deductions. This leaves Joe with $215,000 of taxable income. This level of income surpasses the maximum to qualify for the QBID. However, when Joe opens a Donor-Advised fund with a $60,000 gift, he reduces his taxable income by $60,000 and he gets the normal federal tax benefit of a charitable deduction. In Joe’s case, this deduction is worth $19,450 ($15,000 X 35% federal rate + $42,500 X 32% federal rate + $2,500 X 24% federal rate). More importantly, Joe now qualifies for the QBID, a deduction of the remaining $155,000 of business income X 20% Qualified Business Income Deduction rate or $31,000. This new deduction reduces his federal taxes by an additional $7,440 ($31,000 x 24%). By making this charitable contribution, Joe’s $60,000 gift saved him $26,890 in federal taxes and, through the DAF, Joe can recommend grants from his DAF to any qualified charity of his choosing.
Taking it one step further, capital gains taxes may be avoided if the business owner donates highly appreciated assets including marketable securities, real estate, closely held business interests, life insurance, intellectual property, and mineral interests just to name a few. If the DAF is funded with a non-cash gift, however, the deduction is limited to 30% of AGI. That being said, if Joe wanted to liquidate assets such as a rental property he owns or a life insurance policy, rather than making a gift of cash, depending on the appraised value of the assets, he could do so at the lowered AGI rate and still requalify for the QBID.
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