All tax planning moves are not created equal.
Some deductions lead to $100's in savings while others can lead to $10,000+ in savings.
This one specifically has led some of my clients to $10,000-$50,000 in tax savings.
Here’s how to optimize the Qualified Business Income Deduction (QBID):
In 2017, Tax Cut and Jobs Act created the QBID - a tax benefit designed for self-employed individuals and small business owners. It allows eligible business owners to reduce their taxable income by letting them deduct the lesser of either:
This deduction serves as a valuable tool for reducing income tax payments.
If your business generates $200,000 in profit, you could potentially benefit from a $40,000 deduction.
Surprisingly, many business owners remain unaware of this deduction and how to maximize it.
This again highlights the importance of professional tax assistance rather than attempting to self-file.
Particularly for business owners who might overlook this opportunity.
Also… it’s important to know that:
So Who Qualifies for QBI and at What Income Levels?
In 2024, the qualification for the QBI deduction is based on your taxable income. For single filers, you must have taxable income below $191,500 to fully qualify. And for those married filing jointly, the threshold is $383,900 for full eligibility.
These income thresholds are adjusted for inflation each year.
If your taxable income exceeds these thresholds, the QBI deduction begins to phase out and you’ll only be eligible for a partial deduction.
However, there’s also a higher QBI threshold to consider.
If you’re married filing jointly and your taxable income exceeds $483,900, or if you’re a single filer with taxable income exceeding $241,950.
And your business falls into the category of a specified service trade or business (SSTB), then you won’t receive any deduction.
For those that have incomes that exceed the phase in threshold, you have two additional considerations and you’ll take whichever yields the greater deduction. This is really important to understand:
Whichever is lower.
“SSTB” stands for “specified service trade or business”.
It includes businesses engaged in professions such as financial planning, legal services, medical practices, consulting, and more. These businesses are usually disqualified from the QBID if they are above the income thresholds discussed above.
This chart below helps you understand how it works and if you qualify:
The deduction that you’ll receive is calculated using a formula that considers the W-2 wages paid by the business and the value of certain assets of the business.
Consider the following example to see how this would work out in a basic case:
Let’s say you’re a single filer and have taxable income of $250,000.
You paid out $100,000 in W2 wages from the business.
This leaves $150,000 in profit.
If you were under the taxable income threshold of $191,950, you’d simply take a $30,000 QBI deduction from 20% of that $150,000 profit.
But because you are over the income limit, you weigh these 2 options:
Option 1: $100,000 x .5 = $50,000 from the wages
Option 2: .2 x $150,000 = $30,000
You have to go with the lesser which is option 2 (not a choice).
You have $20,000 less in deductions because you did not optimize the QBID.
So who qualifies for QBI?
The QBI deduction is for owners who have passthrough income or are self-employed.
For those that don’t know, the following entities would be eligible for consideration:
- Sole proprietorships
- Limited Liability Companies (LLCs)
- Partnerships
- S Corps
Basically, C-Corporation owners are excluded. The QBI deduction is available to all these passthrough entities, but again, keep in mind that if your business is an SSTB. Then you may not qualify for the deduction or it is reduced when taxable income is greater than the allowed thresholds previously discussed. 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 reminder…if you are NOT a specified service business, the IRS states you can take the LESSER of these two deductions:
1. The 20% QBI tax deduction
Or
2. 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:
1. QBI deduction can be worth up to 20% of your taxable business income
2. 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 really mean?
Put simply, you cannot determine QBI deduction fully until you figure out your adjusted gross income (AGI) on your Form 1040.
How To Optimize For QBI
There are several strategic planning considerations to maximize your QBI deduction.
If you find yourself over the taxable income threshold, here are some steps you can take:
1. Deferring Income and Accelerating Expenses:
Consider deferring income to future years or accelerating deductible expenses in the current year to help bring your taxable income under the threshold for the full QBI deduction. (This usually means working with your vendors and clients depending on what accounting method you use)
2. Contributing to Pre-Tax Retirement Accounts
If you’re over the threshold, contributing to pre-tax retirement accounts like a SEP IRA or Solo 401(k) can effectively reduce your taxable income. Potentially making you eligible for the QBI deduction.
3. Hiring Independent Contractors as employees
Converting independent contractors into employees can increase your W-2 wages paid out, which may help you qualify for a higher QBI deduction. While this might entail additional payroll taxes, the potential deduction benefits could outweigh the extra costs. This calculation takes into account your entire tax situation. If you’re in a very high tax bracket, this could end up being a very effective way to minimize your tax burden.
4. Employing Family Members
Hiring your spouse or older children can help reduce your QBI by spreading income among family members. Combining this with your spouse making pre-tax contributions to a retirement account can make this even more effective.
5. S Corporation Setup
Creating an S Corporation allows you to pay yourself a salary, which is counted as W-2 wages. As mentioned earlier, the QBI deduction is based on the lesser of 20% of QBI or 50% of wages. Using the 2/7 rule (paying yourself 2/7 of the profit), you can optimize your deduction. Work with a qualified tax professional if you want to try and use this strategy as the S Corporation has rules surrounding shareholder salaries.
These are just some strategies to be aware of - everyone’s circumstances are different.
To make the best choices for your specific situation, consult with a qualified tax professional and financial planner to ensure you are maximizing this deduction
Financial Advisor