The 2/7 Rule for Wages and Maximizing QBI Deduction

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 $315,000 (married couples filing jointly) or $157,500 (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 2018 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 ($128,400 for 2018) 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.