QBID, or the Qualified Business Income Deduction, may be one of the biggest deductions available to you as a small business owner. Many owners aren’t even aware of this, and those filing taxes themselves can even miss out on thousands of dollars of tax savings by not taking this deduction. In short, the QBI deduction allows self-employed people to deduct up to 20% of qualified business income on their tax return. There are a few moving pieces to consider but this deduction could mean the difference in thousands of dollars of taxes.
How It Works
Also called the Section 199A deduction, the Qualified Business Income Deduction provides a massive benefit to small business owners. To understand the benefits, we must first define what income is. In general terms, the profits from the business are what qualifies as income for the deduction. However, there are some notable exceptions to consider, like guaranteed payments or wages paid out.
One of my clients is a minority owner in a partnership and cannot claim the QBI deduction because all of the profits are paid to her as guaranteed payments. There are more variables to consider than strictly optimizing for QBI as the sole objective, but it is important to understand the tradeoffs. In her case, she received $70,000 last year in guaranteed payments, of which up to $14,000 could be deducted if the partnership was structured differently. That could have been a $3,500 difference in taxes assuming a 25% tax rate.
Income is also net of the wages paid out in the business. Most business owners would normally assume this, but importantly this also applies to wages paid to yourself if you file taxes as an S-Corp. I wrote last week about the benefits of switching your tax status to an S-Corp and mentioned the trade-off in the QBI deduction. In an oversimplified manner, the wages work the same way as my client’s situation above. If she filed as an S-Corp and paid herself a $70,000 wage, she again would have $0 in income for the QBI deduction to take effect.
This becomes important for small business owners debating on switching to an S-Corp. While there are many variables to consider, the potential decrease in QBI deduction is important. For example, an owner who profits $100,000 for the year can have two options:
- Continue to file as a sole proprietor and take a $20,000 QBI deduction.
- Switch to an S-Corp and pay yourself a salary, say $60,000, and therefore claim a $8,000 deduction.
In isolation, option one looks preferable every time. In practice, it is possible that the benefits of an S-Corp in other tax areas can outweigh the $12,000 QBI deduction you lose. As with anything specific to your taxes, ask your CPA which is best for your situation.
The Variables
The IRS does set limits and restrictions on the QBI deduction. The most important limit is related to the owner’s taxable income. Taxable income must be below $191,950 for a single person or $383,900 for a married couple to take advantage of the 20% deduction. Without complicating it too much, there are actually two separate 20% numbers to calculate. The deduction is the smaller of 20% of Qualified Business Income or 20% of total taxable income (technically a modified version of taxable income, but I am ignoring that for now). For some owners, this is when the side gig, real estate enterprise, or spouse’s income starts to enter the mix. Especially for owners whose rental enterprise is considered as business income/profits, the deduction can be impacted by both business and personal income.
The IRS sets a phaseout range where you can claim a partial deduction, up to the phaseout income limit. If taxable income exceeds these amounts, not only does the QBI calculation change but the businesses that qualify for the deduction also change.
| 2024 Limits | Start of Phaseout | End of Phaseout |
| Single | $191,950 | $241,950 |
| Married Filing Jointly | $383,900 | $483,900 |
Once the phaseout income limits are surpassed and you are what the IRS considers a “specified service trade or business”, you can no longer claim any QBI deduction. A specified service trade or business (SSTB) is essentially where the owner is also the primary service provider. Financial planners, doctors, actors, and lawyers are good examples. Anyone whose entire company is dependent on the expertise and service of the owner could be considered an SSTB. If that is you, and your taxable income is above the limits, there is no further deduction available.
It is very important to understand whether your business is considered an SSTB or not. If the SSTB status does not apply, then those with income above the thresholds can still take advantage of the deduction but must use a new calculation for it. Once taxable income exceeds the end of the phaseout, the calculation changes to either 50% of W2 wages or the sum of 25% of wages and 2.5% depreciable property.
The Strategy
To maximize the deduction available, there are three main situations to look at:
- Taxable income under the phaseout range.
- Taxable income within the phaseout range.
- Taxable income above the phaseout range.
We must both identify where the current taxable income level is, as well as the SSTB status and whether it is an LLC or an S-Corp.
For business owners who stay under the income limits, there is not too much to calculate. Regardless of SSTB status and entity structure, the lesser of 20% of profits or 20% of taxable income could be deductible on your tax return. Usually, owners in this range may prefer the LLC over the S-Corp, as any wages paid out to the owner would only reduce the deduction, as explained above.
For those within the phaseout, the SSTB and entity status become critical. Especially for an SSTB, the beneficial strategy may just be to reduce your taxable income to get below the phaseout range. Strategies like deferring income, hiring new employees, or increasing retirement contributions could lower taxable income. Also, within this range, you must determine which entity status is preferable. An SSTB who loses all QBI deductions after the phaseout could reduce their income by paying out more owner wages through an S-Corp. A non-SSTB may prefer the LLC status to retain as much of the QBI Deduction as possible, as compared to the S-Corp forced to pay out more wages.
Finally, when taxable income is beyond the phaseout range, only a non-SSTB can utilize the QBI Deduction. At this level, since the calculation primarily changes to a derivative of wages and property, it may be more advantageous for an S-Corp than an LLC. It turns into a numbers game of which structure (and the amount of wages paid) can result in the highest QBI deduction. Sometimes even with the “cost” of paying FICA taxes on your wages, it could be outweighed by the QBI deduction potential.
Qualified Business Income
The government introduced this deduction to heavily incentivize small business owners. Few other tax topics can save business owners more in taxes. While the QBI deduction is extremely useful, it can also become complex. Take the time to understand your tax situation, and work with a tax advisor to see if this can work for you. Proper tax planning and taking advantage of the QBI deduction has the potential to save a business owner thousands of dollars in taxes.
TC Falkner 