One weird trick in the new tax law can increase charitable deduction value

I’ll admit it. I was so excited to be able to use the “one weird trick” clickbait meme – and actually mean it!

As I have written before, the new tax law provide negatives (fewer people itemizing) and positives (no Pease amendment reductions, higher income limitations, higher combined state and federal capital gains tax rates after the new SALT cap, higher federal income tax rates for some, and higher combined state and federal income tax rates after the SALT cap for many) for charitable deductions. But, in reviewing all of those changes, I failed to cover this “one weird trick.” Although obscure, it’s a trick that may become particularly important at the end of the year.

One of the biggest changes in the new tax law was the creation of the Qualified Business Income Deduction. Business owners can deduct 20% of their business income if the taxable income they report on their personal returns is below certain thresholds, $315,000 for married couples and $157,500 for individuals. As taxable income rises, the deduction is either phased out altogether, e.g., for law firms, accounting firms, and doctor’s offices, or is reduced by factors related to wages paid and depreciable assets owned by the business.

The old tax law was already full of benefits that phased out at different income levels, such as the earned income tax credit, the adoption credit, the child tax credit, the American Opportunity Credit, the Lifetime Learning Credit, the deductibility of qualifying student loan interest, and the eligibility to make Roth IRA contributions. But, all of these phase outs were based upon some form of adjusted gross income or modified adjusted gross income. The new Qualified Business Income Deduction – and here is the source of the weird trick – phases out based on TAXABLE INCOME. 

In case I just lost you, taxable income is income left AFTER your charitable deductions. All of the other tax benefits phase out based on income BEFORE your charitable deductions.

What this means is that a business owner can find herself phased out of the Qualified Business Income Deduction due to high taxable income and then, by making charitable donations, phase herself right back into that deduction. For this business owner, the charitable deduction creates a DOUBLE benefit. She still gets the direct benefit of the charitable deduction (reducing taxable income reduces her taxes owed). But, now she also gets the BONUS benefit of phasing back into the Qualified Business Income Deduction (because her taxable income is lower).

Let’s look at an example. Suppose Mary is a retired partner in a law firm where she received net profits of $240,000. She has state and local tax deductions capped out at $10,000 and $22,500 of mortgage interest deductions. This leaves her with $207,500 of taxable income ($240,000 - $10,000 - $22,500). At this level of taxable income, she cannot use the Qualified Business Income Deduction. But, being cleverly advised, Mary decides to make a $50,000 charitable gift. As a result, Mary reduces her taxable income by $50,000 and she gets the normal federal tax benefit of a charitable deduction. For her, this charitable deduction is worth $16,225 ($7,500 X 35% federal rate + $42,500 X 32% federal rate). But, she has also phased herself back into the Qualified Business Income Deduction. This results in a deduction of the remaining $157,500 of business income X 20% Qualified Business Income Deduction rate or $31,500. This new deduction reduces her federal taxes by an additional $7,560 ($31,500 x 24%). Thus, Mary’s $50,000 gift generated $23,785 of federal tax benefits. If Mary lives in California, she also gets a state tax benefit of $4,650 ($50,000 deductible charitable gift X 9.3% California tax rate), which will likely not impact her federal deductions due to her property taxes and the new state and local income tax (SALT) deduction cap. Thus, even though Mary ends up at a marginal federal tax rate of only 24%, her $50,000 charitable gift generated tax benefits worth $28,435 or 57 cents of every donated dollar.

There are many complications and uncertainties in interpreting and applying the new Qualified Business Income Deduction, so the actual details in any real situation can get complicated quickly. But, the bottom line is that your clients, donors, and their tax advisors need to know that if they get phased out of the new Qualified Business Income Deduction, they can phase themselves right back in by making charitable donations.

So, there is your one weird trick in the new tax law that can increase the value of a charitable deduction!