The new Qualified Business Income (QBI) deduction is an income tax game changer for owners of flow through entities. But there are many rules and nuances to getting the most out of the deduction.  Whether your business is a Specified Service Trade or Business (SSTB), pays employee wages, has qualified property, or generates taxable income over certain thresholds can create many opportunities or obstacles for maximizing the deduction. Here is how non-SSTB owners with small employee workforces can determine the minimum amount of wages to be paid in order to maximize the QBI deduction. 

The 2/7 Rule 

Remember, once your taxable income exceeds $364,200 (married couples filing jointly) or $182,100 (single filers) a wage limitation is phased in. Once the threshold is breached the calculation for QBI deduction is limited to the lesser of 20% of income or 50% of wages. Therefore, the amount of wages you pay yourself or your employees can become a major factor in the QBI deduction generated. The 2/7 rule can help you determine how to adjust your wages in order to maximize your QBI deduction. 
 
Note that there is an additional computation considering company assets, but that calculation is beyond the scope of this article and will not be considered in the following examples.   

Example 1  
ABC, Inc. is an S-Corp with a net taxable income of $1,000,000 before wages paid for the 2023 tax year. ABC is not an SSTB and has one owner and one employee, John Smith. John takes a modest salary from his company of only $50,000. The QBI Deduction before taking into consideration the wage limitation would be $190,000 (net income of $950,000 x 20%). However, because the company generates income that will put John over the taxable income thresholds, his QBI deduction is now limited to $25,000 (50% of $50,000).   

So what should John have paid himself to maximize the QBI deduction? That’s where the 2/7 rule comes into play. Wages paid should equal 2/7 of business income. Therefore, John should pay himself a wage of $285,714 ($1,000,000*2/7). That means his net Income would be $714,286 – 20% of the net income is $142,857 which would be the same as 50% of the $285,714 of wages. The 2/7 rule generated an additional QBI deduction of $117,857. This would equate to tax savings of $43,607 ($117,857 x the 37% tax bracket).   

Example 2 
What if you are a small business owner that has more employees than just yourself? In that case you would take into consideration the employees’ wages along with yours.

Let’s use the same facts as example 1 except this time ABC, Inc. has employee wages of $200,000 outside of John Smith’s wages. Business income would be $800,000 before John’s wage to himself. Using the 2/7 rule, John would only need to pay himself $85,714 ($285,714-$200,000) to maximize his QBI deduction.   

Additional Considerations 

• You might be worried about the additional payroll taxes incurred with higher wages, but the 20% QBI tax benefit outweighs the 15.3% combined payroll tax. Plus, the spread increases once the social security wage base ($16,200 for 2023) is met. Afterward you would only be left with Medicare tax of 2.9% to 3.8%, leaving a spread of nearly 17%.   

• S corporations also have a requirement to pay “reasonable compensation” to owner employees.  The determination of “reasonable compensation” should be based on what a reasonable salary would be for an employee performing similar work, not a variable based on QBI considerations.  Therefore, if ABC, Inc. already pays its non-owner employees more than the amount required to meet the QBI wage threshold, that doesn’t mean John doesn’t have to take a salary. It’s important not to forget the requirements of an S-corp.  

With the fourth quarter coming to a close, it is crucial to discuss your expected income and wages with your tax advisors to make sure you are getting the most out of your potential QBI deduction. Please contact Cray Kaiser if you’d like to discuss the QBI deduction and fourth quarter planning. 

Since the recent signing into law of the Tax Cuts and Jobs Act on December 22, 2017, the CK team has received many inquiries about its effect on future tax burdens. According to a recent survey from HubSpot, 88.5% of small businesses don’t understand the full impact of the tax bill. It’s apparent that business owners are seeking more clarity. As your trusted business advisors, we hear you loud and clear. To help you get through this transition, we will be posting our latest insights into the effects of the new law. You can subscribe here to receive our weekly email updates.

Last week, we discussed the Qualified Business Income (QBI) deduction for “specified service” businesses. For those businesses, the phaseout of the QBI deduction is aggressive – phasing out completely at taxable incomes above $415,000 for married filing jointly taxpayers and $207,500 for all other taxpayers. But what happens if your business is not a “specified service”?

Qualified Property

Although the computation is more challenging in this case, the good news is that the phaseouts are not as aggressive as for specified service businesses. As we spelled out in a prior blog, QBI is the lesser of:

• 20% of the taxpayer’s QBI or
• The greater of:
  1. 50% of the W-2 wages paid by the business, or
  2. 25% of the W-2 wages paid by the business plus 2.5% of the unadjusted basis of all qualified property.

What is the “unadjusted basis of all qualified property”? Qualified property is defined as tangible property subject to depreciation (inventory does not qualify) that is used in the production of qualified business income. The unadjusted basis means tax basis before tax depreciation. However, there is a special rule that excludes property where the depreciable period ended before the last day of the tax year. Further discussion of this point is beyond the scope of this article. Please contact us directly for more information.

Here’s an example:

A manufacturing company that is 100% owned by one married individual has: QBI of $500,000; paid company wages of $1,000,000; $100,000 of unadjusted basis in qualified property; and the individual has taxable income of $550,000. QBI is the lesser of:

• 20% of the taxpayer’s QBI ($500,000 * 20%) = $100,000 or
• The greater of:
  1. 50% of W-2 wages paid ($1,000,000 * .5) = $500,000, or
  2. 25% of W-2 wages paid ($1,000,000 * .25) = $250,000 plus 2.5% of unadjusted basis ($100,000 * .025) = $2,500 yields $252,500

In this case, the QBI is $100,000 as the manufacturing company’s wage limitation was much more than 20% of the QBI. The individual receives the full 20% QBI deduction despite having taxable income over the thresholds.

The key takeaways for all businesses considering the QBI are:

• For married individuals with taxable income less than $315,000 (or $157,500 for all other filing statuses), the 20% QBI deduction is not subject to the wage/asset threshold regardless of the type of business.
• For married individuals in “specified service” businesses, if taxable income exceeds $315,000 (or $157,500 for all other filing statuses), the 20% QBI deduction is phased out based on the amount of taxable income above the thresholds; the deduction is fully phased out at taxable income of $415,000 (married) or $207,500 (all others).
• For married individuals NOT in “specified service” businesses, if taxable income exceeds $315,000 (or $157,500 for all other filing statuses), the 20% QBI deduction is phased out based on the wage/asset thresholds discussed above. Even if taxable income thresholds are exceeded, the full QBI deduction may be allowable in a labor-intensive business.
• Allowing companies NOT in “specified service” businesses to use their unadjusted basis of assets as part of the QBI threshold computation will allow real estate ventures to qualify for the QBI, despite these generally not being labor-intensive businesses.
• Once the QBI deduction is computed, the individual taxpayer must still make sure that the QBI cannot exceed 20% of the excess of taxable income over the sum of any net capital gain. In other words, if there is no taxable income, there is no QBI.

As you can see, the provisions of the QBI are complex. We eagerly await regulations that will help define some of the terms of the deduction. Cray Kaiser will keep you informed as we learn more. If you would like to discuss the QBI deduction in more detail, please call us at 630-953-4900.