Tax planning can be overwhelming, especially when it comes to maximizing deductions that could lead to substantial savings. One such deduction, the Qualified Business Income (QBI) deduction, is an often-overlooked opportunity for business owners and self-employed individuals. When optimized correctly, this deduction can result in tax savings of anywhere from $10,000 to $50,000, depending on the business’s profit and structure.
Here’s a breakdown of how the QBI deduction works, who qualifies, and how you can make the most of it.
What Is the QBI Deduction?
The QBI deduction was introduced as part of the Tax Cuts and Jobs Act in 2017. It allows eligible small business owners and self-employed individuals to deduct up to 20% of their business income, reducing the amount of income subject to tax.
The deduction is calculated as the lesser of:
- 20% of qualified business income (QBI)
- 50% of the wages you pay to yourself and any employees
For example, if your business generates $200,000 in profit, you could potentially benefit from a $40,000 deduction. Despite its potential, many business owners are unaware of this benefit, highlighting the importance of seeking professional tax assistance rather than handling it alone.
Who Qualifies for the QBI Deduction?
Eligibility for the QBI deduction depends largely on your taxable income. In 2024, the thresholds are as follows:
- For single filers, the full QBI deduction is available if taxable income is below $191,500.
- For married couples filing jointly, the limit is $383,900.
If your taxable income exceeds these thresholds, the deduction gradually phases out, and you may only qualify for a partial deduction. If you earn above $483,900 (single) or $241,950 (married), and your business falls under the category of a specified service trade or business (SSTB), you won’t qualify for any deduction.
SSTBs include fields like law, medicine, consulting, and financial services. These businesses are typically disqualified from the QBI deduction if their income exceeds the prescribed limits.
How Is the Deduction Calculated?
When calculating the QBI deduction, two factors are considered: the W-2 wages paid by the business and the business’s assets. Here’s an example to illustrate:
Let’s assume you’re a single filer with a taxable income of $250,000. Your business paid $100,000 in wages, leaving $150,000 in profit. Since you exceed the taxable income threshold, you must compare two options:
- 50% of $100,000 in wages = $50,000
- 20% of $150,000 in profit = $30,000
You’ll receive the lower amount, which in this case is $30,000, making the remaining $20,000 of potential deduction unavailable.
Eligible Entities for the QBI Deduction
The QBI deduction is available to owners of pass-through entities, such as:
- Sole proprietorships
- LLCs
- Partnerships
- S Corporations
C-Corporations, however, are not eligible. It’s also important to note that businesses that qualify as SSTBs may not be eligible for the full deduction or any deduction at all if income exceeds the thresholds mentioned earlier.
How Does the QBI Deduction Affect Your Taxes?
The QBI deduction applies to your business income but not to self-employment taxes. This is a key distinction because, while it reduces your income taxes, it does not impact the 15.3% self-employment tax rate. Additionally, the QBI deduction cannot exceed 20% of your total taxable income, which is a consideration if you have other income sources, such as a spouse’s income or side business.
Strategies to Maximize the QBI Deduction
If your taxable income exceeds the threshold but you want to maximize your QBI deduction, here are some strategies to consider:
1. Defer Income and Accelerate Expenses
One strategy to reduce taxable income is by deferring income to future years or accelerating deductible expenses in the current year. This can help bring your income below the QBI threshold, allowing you to claim the full deduction.
2. Contribute to Pre-Tax Retirement Accounts
Contributing to a SEP IRA or Solo 401(k) can lower your taxable income. By doing so, you may make yourself eligible for the QBI deduction, especially if your income is just over the threshold.
3. Hire Independent Contractors
Converting independent contractors to employees can increase your W-2 wages, which may lead to a larger QBI deduction. Although this could increase payroll taxes, the potential tax savings might outweigh the additional costs.
4. Employ Family Members
Hiring your spouse or children can reduce your business’s QBI by spreading income among family members. In addition, having your spouse contribute to a retirement account could further reduce taxable income, maximizing the QBI benefit.
5. Create an S Corporation
Setting up an S Corporation allows you to pay yourself a salary, which counts toward W-2 wages for the QBI deduction. With the right strategy, such as the 2/7 rule (paying yourself 2/7 of the business profit), you can optimize your QBI deduction.
Final Thoughts
The QBI deduction offers a significant tax advantage to business owners and self-employed individuals, but it’s essential to understand how it works and how to maximize it. Tax laws can be complex, and individual situations vary, so it’s always a good idea to work with a tax professional who can help you navigate the process and ensure you’re getting the most out of this valuable deduction.