The 20% Qualified Business Income (QBI) deduction was arguably the most complicated change taxpayers faced during the 2019 tax filing season. Coincidentally, it happened to be an area where we identified significant opportunities for clients to save tax dollars in future years by tweaking situations to maximize the benefits of the QBI deduction.
The Basics of QBI
The QBI deduction is fairly straightforward for taxpayers with taxable income below $315,000; the deduction is a flat 20% of flow-through income not to exceed 20% of taxable income. When a taxpayer’s taxable income exceeds $315,000, the 20% QBI deduction is limited by the greater of 50% of allocable W-2 wages or 25% of allocable wages plus 2.5% of the unadjusted basis of income-producing assets (UBIA). For small businesses, there’s generally not a whole lot of UBIA planning that can be done to substantially increase the QBI deduction, but we have seen significantly more planning opportunities as it relates to increasing the wage base.
Don’t Miss Out on the QBI Deduction
Below are a few scenarios that could result in lower than optimal QBI deductions.
Sole proprietorships and partnerships with a limited number of employees
Because sole proprietors and partners in partnerships don’t pay themselves a wage, they often miss out on some of the QBI deduction because 50% of their allocable wages from the business is less than 20% of their total income.
For example, a partnership with $750,000 of net taxable income and $100,000 of wages would be limited to a QBI deduction of $50,000 ($100,000 x 50%) rather than $150,000 (750,000 x 20%). Business owners in this scenario should weigh the pros and cons of electing to have their business taxed as an S Corporation and paying the owner(s) a salary to maximize the QBI deduction.
S Corporations with minimal shareholder wages
Many businesses are formed as S Corporations to avoid the excess payroll taxes shareholders would otherwise pay as sole proprietors or partnerships. However, oftentimes S Corporation shareholders keep their salaries artificially low, which compromises their ability to maximize the QBI deduction. In addition to reasonable compensation considerations, taxpayers need to weigh the cost of additional payroll taxes on wages versus the QBI deduction and possible retirement planning benefits associated with increasing shareholder wages.
C Corporations
C Corporations enjoy a flat 21% tax rate, but are still subject to a second layer of tax on dividends and are not eligible for the 20% QBI deduction. While a C Corporation is advantageous in many situations, the effective tax on C Corporation income after considering dividends may very well be higher than the tax paid on flow-through income at the shareholder level. Taxpayers should weigh the pros and cons of changing their corporate structure to remain as tax efficient as possible.
Now that the year is well underway, it’s time to do a deep dive into the tax planning opportunities that can make next April less painful. Contact an Anders advisor to discuss opportunities to maximize the QBI deduction.
