Max Out the Benefits of the QBI Deduction
Since the enactment of the Tax Cuts and Jobs Acts of 2017, I have spent A LOT of time learning about and planning for the Qualified Business Income (QBI) deduction. What is the QBI deduction, you ask? In a nutshell, it is a 20% deduction for individual taxpayers on taxable income received from sole proprietorships, S corporations, partnerships and limited liability entities. If you are eligible, this is a very nice feature of the TCJA; however, the qualification rules can get murky.
Is the QBI deduction available to all taxpayers? It’s complicated!
Your maximum QBI deduction is 20% of income from flow-through entities. If you receive $100,000 of income from a qualifying entity, you receive a $20,000 tax deduction. If you are in the 24% tax bracket (which many taxpayers are), the QBI deduction saves you $4,800 in tax.
Easy, right? Yes and no. If your taxable income is at or below $329,800 (for married taxpayers, half that for singles), your deduction is as straightforward as the previous example. However, once your income climbs over $329,800, the deduction becomes subject to wage limitations for some taxpayers and phases out completely for other taxpayers.
The wage limitation works like this. A higher income taxpayer cannot take a QBI deduction greater than 50% of wages the business paid during the year. This is best explained by an example.
If you are a 30% owner in a business with taxable income of $100,000 and wages paid of $24,000, your allocated share of taxable income and wages paid is $30,000 and $7,200, respectively. Ordinarily your QBI deduction would be $6,000 (20% of $30,000). However, if you are a higher income taxpayer subject to the wage limitation, your QBI deduction is $3,600 (50% of $7,200).
Special rules cover real estate entities that pay little to no wages. The QBI deduction for these entities is limited to 25% of wages plus 2.5% of qualified property basis. Again, these limitations only come into play if you have taxable income over $315,000.
Specialized Services Trades or Businesses (SSTB’s)
I mentioned previously that certain taxpayers forfeit the QBI deduction entirely once income hits a certain level. These unfortunate taxpayers are owners of specialized services trades or businesses, or SSTB’s. These are accountants, attorneys, doctors, financial advisors, and other businesses that rely primarily on the reputation and skill of the owners and key employees. The deduction begins to phase out at taxable income of $329,800 and goes away completely once income hits $429,800.
If you are an owner in a flow-through entity or a sole proprietor with taxable income less than $329,800, then you likely qualify for the QBI deduction without any planning. If you are a higher income taxpayer, then you may need to work a little harder for that deduction. Here are a couple of planning considerations:
Accelerating deductions into this year while deferring income into next year are common year-end planning tactics, especially if you are trying to avoid climbing into the next tax bracket. This is more important now if you are a business owner at or around the $329,800 income level. Because you make this income assessment at the personal level, your entire arsenal of business and personal income deferrals and deduction accelerators is available to help you max out the benefit of the QBI deduction.
If, despite your best efforts, your current business tax structure is boxing you out of the QBI deduction, consult with your tax advisor and legal counsel about changing your entity structure. In the past year, we have converted sole proprietors to S corporations and S corporations to C corporations to pay less tax. However, you would be wise not to make these decisions in a vacuum – an entity change can affect more than just your current year tax situation – so seek counsel to map out both the short- and long-term consequences of a switch in your tax entity.