The qualified business income (QBI) deduction is simply a deduction for the self-employed as well as other small business owners.
It is a tax deduction that allows eligible business owners to deduct 20% of their qualified business income or 50% of their wages on their taxes. This basically allows you to lower the amount of income tax you pay which is huge! If you have $200k in profit, that could be a $40k deduction for your business. This is something very few business owners I talk to know about. It’s also a huge reason why I do not think people should be self filing their taxes, especially business owners. Many miss out on claiming this due to lack of knowledge. Do not let this be you.
This deduction only applies to qualified business income. What exactly does that mean? It is defined as “the net amount of qualified items of income, gain, deduction, and loss with respect to any trade or business.” That pretty much just means your net profit. But… some things are not included like dividends, capital gains, interest income, certain wages/ guaranteed payments made to partners and shareholders, or income that is earned outside of the US.
A few points to note:
- You can take the QBI deduction even if you take the standard deduction.
- It does not lower your self-employment tax. It only lowers your income taxes.
- It can impact retirement planning. You cannot apply the 20% QBI deduction to money that is put into a pre-tax retirement plan. So if you put money in pre-tax, it lowers your profit which will lower your QBI deduction. This does not mean you should not do it, but just be aware as it makes the tax benefits a little less impactful. Think about it, if you had $200k in profit that would be $40k deduction. But if you put $22,500 in a 401(k), then profit becomes $177,500 which results in $35,500 vs $40,000 as the deduction.
Who qualifies for QBI and At What Income Levels?
For 2023, if you are single filer you must be under $182,100 to fully qualify. And if married filing together, then you need to be under $364,200 to fully qualify. These numbers are indexed to inflation each year. If you are above, the deduction starts to phaseout and you only get a partial deduction. Then there is a higher QBI threshold. If you are above $440,100 (married) or $220,050 single and are an SSTB then you get no deduction. If you are between them, then you can do:
- 50% of W-2 wages paid
- Or 25% of W-2 wages paid + 2.5% of depreciable property
So what does SSTB mean? It means businesses who are deemed “a specified service trade or business” (SSTB) like financial planners, lawyers, doctors, consultants, etc.
Here’s an awesome chart from keepertax.com to see this better.
This basically means that if the business is an SSTB and the taxpayer’s taxable income exceeds the higher income threshold, you no longer can take the QBI deduction. The exact amount of the limit depends on a formula that considers the W-2 wages paid by the business and the value of certain assets of the business.
Let’s go through a quick example to see how the numbers net out.
Let’s say you have a taxable income of $250,000, $100,000 of which is from your business. You also paid out $40,000 of wages and own a qualified property of $450,000.
You normally would take $20,000 QBI deduction from 20% of that $100k profit. But because it is over the income limit, you have 2 options:
- Option 1: $40,000 x .5 = $20,000 from the wages
- Option 2: ($40,000 x .25) + ($450,000 x .025) = $21,250
So you would go with 2 and it is a slightly higher deduction.
So who qualifies for QBI?
The QBI deduction is for owners who have pass through income. All that means is a business entity where business income flows through to your personal return. For those that don’t know, the entities that are eligible are:
- Sole proprietorships
- Limited Liability Companies (LLC’s)
- S Corps
It basically applies to most besides C Corps.
The QBI deduction is available to all these pass through entities, but if your business is an SSTB like we chatted about above, then your deduction can be limited or even disappear when it grows above the income limits we talked about before.
There are some tests that can be done to see if you qualify when you are over the income limit, but we will not get into that today. It can get complex fast.
And If you are NOT a specified service business, The IRS states you can take the lesser of these two deductions:
- The 20% QBI tax deduction
- Or The greater of (50% of W2 wages paid through your business) or (25% of the wages plus 2.5% of qualified property).
How Does The QBI Deduction Actually Work?
People often get confused as there are two different 20% figures as it relates to QBI.
- QBI deduction can be worth up to 20% of your taxable business income
- It cannot add up to more than 20% of your total taxable income when claiming this pass-through deduction. This matters when you have a spouse working, a side job, etc.
So what does that mean really? It just means that you cannot determine this number fully until you figure out your adjusted gross income (AGI) on your form 1040. Once that is done, then you can start calculating your QBI deduction.
How To Optimize For QBI?
There is a lot to go through here, but for the sake of this post we are just going to focus on some planning topics that can be considered to maximize your QBI deduction:
- If you are over the taxable income threshold, consider deferring income or accelerating expenses this year to maximize it.
- If over the income threshold, consider adding pre-tax retirement accounts to lower your income (SEP IRA, Solo 401(k), etc).
- Consider turning independent contractors into employees. You will pay the extra 7%+ for payroll taxes, but may help you get 20% QBI deduction and could be worth it.
- Employee your spouse or older children to reduce your QBI so you can take the deduction.
- Setup an S Corp and pay yourself a salary. Remember as I pointed out above, you can take the lesser of 20% of QBI or 50% of wages. The 2/7 rule can helps with this. It basically means you pay yourself 2/7 of the profit to get this to net out for the best deduction.
There are more options than this, but it is a good place to start and consider. Make sure you are working with your team to maximize your tax planning moves!