Summary/TLDR
The Qualified Business Income (QBI) Deduction allows owners of non-Corp entities to deduct up to 20% of their qualified business income from adjusted gross income, presenting business owners with a tremendous tax savings opportunity. As usual, however, this deduction comes with a dizzying number of exceptions, phaseouts, and other rules that result in many business owners leaving a tremendous amount of tax savings on the table. By working with a proactive and knowledgeable professional, you can learn how to pursue advanced strategies, such as changing your business entity, compensation model, or both, to maximize everything the QBI deduction has to offer.
Introduction
The Qualified Business Income (QBI) Deduction was introduced in 2017 for all non-C Corp business entities and is currently scheduled to go away in 2026. It presents businesses owners with an incredible opportunity for annual tax savings but remains widely misunderstood and poorly pursued. In today’s post, I’ll do my best to simplify this exceptionally complex deduction and help you understand how to maximize it for your business.
The QBI Deduction At A High Level
At the simplest level, the QBI deduction will allow business owners to deduct 20% of their qualified business income from their Adjusted Gross Income (AGI). And for most, this will be the case, plain and simple. This isn’t to say that these people wouldn’t benefit from additional planning, only that the method of deriving their deduction is quite straightforward – 20% of QBI.
The IRS would never allow such a simple figuration to exist in the tax code, however! Every line must be accompanied by a series of exceptions, phaseouts, limits, and alternatives. At “higher” levels of QBI (defined below), additional planning and optimization becomes necessary to realize all that this deduction has to offer. In these cases, the difference between good planning and no planning will be significant.
Income Phaseouts and Alternative Formulas
The Income Phaseouts
In 2024, the amount of the QBI deduction you may take begins to become limited once taxable income levels of $191,950 for single filers and $383,900 for joint filers are reached. And at taxable income levels beyond $241,950 for single and $483,900 for joint filers, the QBI deduction can be phased out entirely depending on the type of business you have. If the IRS considers your business to be a Specialized Service & Trade Business (SSTB), then you are not allowed to claim any QBI deduction once your taxable income exceeds the second threshold.
According to the IRS, an SSTB is:
a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading or dealing in certain assets, or any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.
The QBI Deduction for SSTBs and Non-SSTBs
There are therefore two “categories” of businesses to be cognizant of when considering QBI: SSTBs and non-SSTBs. The effect of the two income thresholds discussed above on non-SSTBs can be visualized as follows:
When taxable income exceeds the first threshold, the deduction will begin to be phased-out for these taxpayers, and when income exceeds the second threshold, an entirely new method is used to determine the deduction, which is the greater of:
50% of all W-2 wages paid by the business, OR
25% of all W-2 wages paid by the business, plus 2.5% of the unadjusted basis of depreciable property owned by the business.
For SSTBs, the situation past the first threshold is the same – the deduction will begin to be phased-out. Beyond the second threshold, however, the deduction becomes $0 which, unfortunately, provides very little in the way of planning opportunities for high income SSTB business owners.
Potential Solutions for Income Phaseouts (non-SSTBs only)
For non-SSTBs, there are a variety of things that can be done to maximize the QBI deduction, but we’ll focus only on a couple of the most common strategies. These generally fall into one of two categories:
Changing your business entity
Changing your compensation model
For business owners with taxable income below the first threshold, it could be beneficial to be a partnership as opposed to an S-Corp. Likewise, for businesses owners with taxable income above the second threshold, it’s often more advantageous to be an S-Corp. This is due to the fact that W2 wages are excluded from QBI whereas owner’s distributions are not.
For example, if my S-Corp had $250,000 in gross income (as a married taxpayer) and I paid myself a $150,000 W2 salary, then my QBI would only be $100,000, making my deduction only $20,000. However, if I were instead a partnership and took the $150,000 as distributions (not guaranteed payments), then the entire $250,000 in gross income would qualify as QBI and my deduction would be $50,000.
Likewise, if my partnership had $600,000 in gross income, my QBI deduction would be minimal – only 2.5% of the unadjusted basis of my depreciable property. This is because I can’t pay myself a salary when structured as a partnership. However, if I switched to an S-Corp and paid myself a $100,000 salary, my QBI deduction would become $50,000 (50% of W2 wages since I’m above the second income threshold). In fact, there’s an optimization rule in these circumstances called the “2/7ths Rule” that tells you the exact salary you should take to maximize the deduction. In this case, a salary of $171,249 will do the trick, giving me a deduction of $85,714. Since W2 wages aren’t included in QBI, my QBI would be $428,571 ($600,000 gross income minus my $171,249 salary), 20% of which also happens to give me the same deduction of $85,714.
Don’t Try At Home!
In all my posts on taxes, I emphasize that you shouldn’t try anything absent the counsel of a competent professional, and the QBI deduction is certainly no exception. This is especially the case when the law is scheduled to expire in two years and often requires dramatic action steps, such as changing your entity and compensation structure, to maximize. What I can tell you for certain, however, is that the advice of a competent professional will far outweigh the cost of one when it comes to the qualified business income deduction.
Related Posts
