The Qualified Business Income (QBI) deduction is one of the most powerful tax planning tools for self-employed individuals and small business owners, yet many are unaware of how to leverage it. Optimizing this deduction can result in significant savings—some of my clients save over $100,000 a year simply by making the most of the QBI deduction.
What is the QBI Deduction?
Created by the Tax Cuts and Jobs Act of 2017, the QBI deduction allows eligible business owners to deduct up to 20% of their qualified business income. This deduction helps level the playing field for small business owners, especially after the corporate tax rate was lowered to 21%.
How Does the QBI Deduction Work?
For most small business owners, the QBI deduction allows you to deduct 20% of your business profits. However, once your Adjusted Gross Income (AGI) exceeds a certain threshold, the deduction begins to phase out. If you’re over the phase-out limits, you will be allowed to take the lesser of 20% of your business profits or 50% of your W-2 wages. Keep in mind that if your business is a Specified Service Trade or Business (SSTB), the deduction may not apply at all if your income surpasses the phase-out limit.
Example: Understanding the QBI Deduction
Let’s say your business generates $200,000 in profit. With the QBI deduction, you could claim 20% of that as a deduction, amounting to a $40,000 deduction. This would reduce your taxable income, saving you money based on your marginal tax rate. For instance, if you’re in the 22% tax bracket, this deduction could save you $8,800 in taxes.
However, there are additional considerations: if you own an S Corporation, the QBID may be impacted since you will be adding wages, which could reduce your profit. The goal is to keep your salary reasonable but low enough to maintain compliance and maximize the deduction.
Key Points to Note About QBI
- You can still take the QBI deduction if you opt for the standard deduction.
- This deduction lowers income taxes, but it does not impact self-employment taxes.
- Contributions to pre-tax retirement plans (like a SEP IRA or 401(k)) can reduce your profits, which in turn reduces the QBI deduction. While these retirement contributions are still valuable, they can slightly diminish the tax benefits of the QBI.
Who Qualifies for the QBI Deduction?
For 2024, single filers must have an AGI below $191,950 to qualify fully for the QBI deduction. For married couples filing jointly, the limit is $383,900. These thresholds are adjusted for inflation, so they will likely increase in future years. If your income exceeds these thresholds, the QBI deduction begins to phase out, and if you earn above $483,900 (single) or $241,950 (married) and operate an SSTB, you won’t qualify for the deduction.
If you are above the phase-out limit but are not in an SSTB, you can take the lesser of:
- 50% of W-2 wages paid to employees,
- or 25% of W-2 wages plus 2.5% of depreciable property.
What is an SSTB?
An SSTB, or Specified Service Trade or Business, includes professions like law, medicine, financial planning, consulting, and other service-based businesses where income is generated based on personal reputation or skill.
Example: Business with $1 Million in Profit
Let’s say your business has $1,000,000 in profit before wages. Here’s how the QBI deduction would play out:
- No Planning (Non-S Corporation): Without an S Corp structure, your QBI deduction would be limited to the lesser of 20% of profits or 50% of W-2 wages. In this case, without any wages, you would get $0 in deductions.
- No Planning (S Corporation): If you structure your business as an S Corp and pay yourself a salary of $100,000, you would get a 20% deduction on $900,000 of profit, which equals $180,000. However, the 50% of wages rule would limit your deduction to $50,000.
Optimizing the QBI Deduction
To maximize the QBI deduction, it’s crucial to plan strategically, especially towards the end of the year. In the example above, an optimal strategy would involve using the 2/7 Rule, where you calculate your ideal salary by adding your wages and profits together and multiplying the total by 2/7. Here’s how it works:
- Wages + Profits: $900,000 in profit + $100,000 in wages = $1,000,000
- 2/7 of $1,000,000 = $285,700
This would bring the optimal wage figure to $285,700, resulting in a $142,857 deduction. Compared to the earlier scenario where you only had a $50,000 deduction, this strategy yields an additional $90,000+ in deductions, leading to a tax savings of $20,000-$45,000 depending on your tax bracket and state taxes.
How to Optimize Your QBI Deduction
Here are some strategies to help maximize your QBI deduction:
- Deferring Income or Accelerating Expenses: If you’re over the income threshold, consider deferring income or accelerating expenses (e.g., using cash balance plans or contributing to a 401(k) profit share).
- Pre-tax Retirement Contributions: Contributing to a SEP IRA or Solo 401(k) can lower your taxable income, helping you qualify for the full QBI deduction.
- Paying Your Spouse or Children: If your business is profit-heavy, paying wages to your spouse or older children can reduce your overall profit and increase the QBI deduction.
- S Corporation Setup: If you haven’t already, consider setting up an S Corporation and paying yourself a reasonable salary to optimize the deduction.
- Using the 2/7 Rule: This calculation method helps determine the most tax-efficient salary, ensuring you maximize your QBI deduction.
Conclusion
Optimizing the QBI deduction can lead to substantial tax savings, but it requires strategic planning. By understanding the mechanics of this deduction and taking the necessary steps to optimize it, you can significantly reduce your tax liability. Whether it’s through smart use of S Corps, retirement contributions, or income deferral, planning ahead is the key to making the most of the QBI deduction.