One of the major provisions from the Tax Cuts and Jobs Act that was enacted in 2018 (and runs through 2025) is the qualified business income deduction (QBI deduction). It is a special deduction claimed on the individual tax return for the owner or co-owner of an S corporation, LLC, partnership or sole proprietorship.
Essentially, you take 20% of your qualified business income from a trade or business plus 20% of qualified real estate trust dividends and qualified publicly traded partnership income. The deduction is ultimately intended to help business owners with an additional tax benefit. There are three limitations of the QBI deduction you need to know about, though:
1. Specified Service Trades or Businesses
High-income taxpayers are deterred from being able to convert wages or compensation for personal services into qualified business income. Certain trades and service businesses will be subject to this limitation, including law, consulting, health services, financial services, athletics and brokerage services. The QBI deduction (also known as the Section 199A deduction) will not apply for these specific trades or businesses when taxable income exceeds $426,600 for joint filers and $213,300 for single filers. Some taxable income ranges below these will allow a partial deduction.
2. Unadjusted Basis Immediately After Acquisition (UBIA)
All businesses above those taxable income limits notable above will be subject to the limitation that states the QBI deduction cannot exceed the greater of:
• 50% of taxpayer’s allocable share of W-2 wages, OR
• 25% of wages plus 2.5% of unadjusted basis in depreciable property immediately after acquisition
3. Taxable Income Limitation
Regardless of net capital gain income, the QBI deduction is limited to 20% of taxable income. This limit applies to the taxpayer’s combined qualified business income from all businesses that contribute to their income. The two limitations listed above are only applied to qualified income from one specific service trade or business.
If you are looking to maximize your QBI deduction, there are some strategies you can use. Here are a few tips you can follow, according to the tax experts at Illumination Wealth:
This applies to a specific service trade or business (SSTB) that is subject to a QBI deduction limitation. You may consider filing separately instead of jointly. You may also consider establishing a separate business entity, such as a C corporation. There are some specific rules around this tactic, so make sure you know what you are doing and structure everything appropriately to avoid audits and tax penalties.
If none of your income qualifies as QBI, look for opportunities to become an owner in the business or be considered a “consultant” rather than employee. Of course, the QBI deduction shouldn’t be the only factor in such a move. Make sure you aren’t losing employee benefits or taking some sort of other hit by changing your employment status.
If you are subject to the wage and UBIA limits, then you will want to restructure your employment system. Hire employees rather than consultants and independent contractors. Increasing wages, buying certain business assets and becoming an S corp (instead of a sole proprietorship or partnership) are also smart strategies—only if all the numbers make sense in the end. You don’t want to end up paying a lot more to your employees than you would save from any QBI deductions!
If you are subject to the 20% taxable income limit, you may want to consider trying to increase your taxable income with a second job or new business investment.
If you are over the taxable income threshold, you may want to defer some of your income and accelerate other expenses to reduce your taxable income. One idea is to make an additional retirement plan contribution at the end of the year to lower your final taxable income.
There are a number of other strategies that you can use to optimize your QBI deductions and minimize the effects of the limitations. You will want to talk to your tax advisor or financial planner to refine your plan and maximize your QBI tax deductions. As we prepare to enter Q4 of 2020, it is a great time to review all your personal and business finances, so you can make strategic year-end moves to lower your tax liabilities and increase your returns.
For all your financial planning and tax planning needs, contact Illumination Wealth today and schedule an introductory consultation.