Managing Taxable Income Levels for Cash Savings

June 2018 | Article

Everyone has a general curiosity about what their taxable income will be. Will it be higher or lower than last year? And, then there’s the natural follow-up question, will I owe more tax?

But, with the passage of the Tax Cuts and Jobs Act last December, that general curiosity, for many individual taxpayers, should turn to more of a “need to know” item. Why? The new tax reform legislation made some changes that, if handled properly, will provide an opportunity to save, or defer, taxes, creating positive cash flow through the management of taxable income levels.

For example, Individual A, an independent health care consultant, is married and files a joint return. Based on last year’s return, Individual A anticipates the consulting business to be a little better, netting $450,000 for 2018. After allowable deductions, estimated taxable income would be $420,000. Based on that taxable income level and using the new 2018 tax brackets and rates, but assuming no other benefits from changes included in the tax reform legislation, Individual A will pay a little over $98,000 in federal tax, with the highest rate of tax being 35 percent. However, if Individual A did some planning and actively managed his taxable income level, things could pan out much better for Individual A.

New Internal Revenue Code section 199A provides a potential 20 percent deduction for small business owners like Individual A. The only problem is that Individual A’s consulting business may be considered a professional health service entity, which would be excluded from receiving the full benefits of section 199A. However, if Individual A could reduce his taxable income, Individual A could qualify for the section 199A deduction, even if only in part.

The 20 percent qualified business income deduction under section 199A is allowed on a taxpayer’s qualified business income, without limitation, when taxable income on a joint return is under $315,000 ($157,500 for other taxpayers). If taxable income is over $315,000, then a phase out of the 20 percent deduction can apply over the next $100,000 of taxable income. However, if taxable income exceeds $415,000 on a joint return, then there are various limitations that become fully effective and can further reduce or eliminate the deduction.

Now, with all this information in hand, Individual A starts to consider his options for reducing 2018 taxable income. Individual A could:

  • purchase and depreciate needed equipment for his business
  • make year-end allowable supplies and other pre-payments
  • make a new or additional retirement plan payments, or many other similar payments that would reduce taxable income while benefitting his business operations.

Through the above efforts, let’s assume Individual A reduces the 2018 taxable and business income by $70,000. As a result, using the new 2018 tax brackets and rates, as well as the benefits of 199A that resulted from Individual A’s ability to reduce taxable income, Individual A will pay approximately $65,000 in federal tax, with the highest tax rate being 32 percent. This creates a $33,000 reduction in tax to be paid for 2018. 

Some may point out that Individual A had to spend $70,000 to get the $33,000 reduction in tax. However, considering that it’s a 47 percent tax benefit even before any state income tax benefits are factored in, it’s not a bad trade off. And this way, Individual A still gets the direct benefit of the $70,000 spent.

To learn more about how an active approach to managing taxable income can minimize tax burden and create positive cash flow, contact your Eide Bailly professional.

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