As we enter year three of the qualified business income (QBI) era, if you have not yet taken steps to maximize your deduction under this tax law – the time is now. Over the past two years, we have seen unique situations and challenges of being able to take the QBI deduction due to wage limitation and guaranteed payment restrictions. Below we dive into how to calculate the QBI deduction and ways to overcome barriers to taking advantage of the deduction.
Calculating QBI
As a reminder, the QBI deduction is equal to 20% of earned income for sole proprietorships, S Corporations and partnerships. For 2020, this general rule applies to single filers with taxable income below $163,300 and married taxpayers with taxable income below $326,600.
When taxable income exceeds these thresholds, the QBI deduction is limited to the lesser of:
- 20% of taxable income less net capital gains, or
The greater of:
- 50% of the taxpayer’s allocable portion of W-2 wages deducted by the business, or
- 25% of the taxpayer’s allocable portion of wages deducted by the business plus 5% of the taxpayer’s allocable portion of unadjusted basis of the business’s income-producing property.
There are additional limits for specified service trades or businesses (SSTBs) that operate in the following areas: healthcare, law, accounting, actuarial science, performing arts, athletics, consulting, financial services and brokerage services. The QBI deduction for these SSTBs phases out for single taxpayers when taxable income is between $163,300 – $213,300 and for married taxpayers when taxable income is between $326,000 – $426,000.
Wage Limitation Restrictions
In our experience, many small businesses are having their QBI deduction reduced or eliminated due to the 50% of wages limitation. This is most common for sole proprietorships or partnerships with little or no employees. A simple example illustrates the issue clearly:
- A married taxpayer with business income from a sole proprietorship or partnership with taxable income of $500,000 (all from a qualified business) and no allocable W-2 wages would receive a $0 QBI deduction.
- That same taxpayer, taxed as an S Corporation, with the same level of taxable income split between $250,000 of wages (paid to themselves) and $250,000 of K-1 income would be entitled to a $50,000 QBI deduction ($250,000 x 20%).
In this situation, the QBI deduction for a taxpayer in the 35% federal tax bracket would provide $17,500 of tax benefit. Assuming $250,000 is a reasonable level of compensation for this taxpayer, additional benefits of being tax as an S corporation in this situation include $9,500 of payroll and Medicare surcharge tax savings. To achieve similar tax savings for your business in 2020, you would need to make an election to be taxed as an S Corporation prior to the March 15, 2020 due date.
Guaranteed Payments
Another QBI hang-up for many partnerships is that guaranteed payments paid to partners are not considered to be allocable wages for QBI purposes. Additionally, guaranteed payments paid to a partner do not qualify as QBI for that partner. If your partnership is making guaranteed payments, a few simple tweaks to your partnership agreement and partner compensation structure can avoid this trap and result in a windfall of tax savings.
Please contact an Anders advisor to discuss these and other strategies to maximize your QBI deduction and minimize your tax burden.
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