What is the 20% QBI Tax Deduction?
In the tax world – and at Robert P. Russo, CPA – everyone is talking about QBI. QBI stands for qualified business income, and it’s the key to unlocking a 20% QBI tax deduction for certain business owners.
The 20% QBI tax deduction is outlined in section 199A of the Tax Cuts and Jobs (TCJA) Act, signed into law in December 2017. Of all the new rules and opportunities in the TCJA, section 199A is getting the most attention…and generating the most questions.
Here’s what you need to know…
Who Can Take the 20% QBI Tax Deduction?
The 20% QBI tax deduction is limited to “pass-through” business entities (after all it’s qualified “business” income) in specified industries. Let’s break this down:
Pass-Through Entities: A pass-through entity is a business structure where the income “passes through” to the owner, who then takes the income on their personal return This includes:
- Sole proprietors and LLCs (Schedule C)
- S Corporations
The QBI deduction is available to all of these pass-through entities. However, if your business is a specified service trade (SSTB) or business, your QBI deduction can be limited and disappear once your taxable income has reached a certain threshold.
Specified Service Industries (SSTB): This includes everything from lawyers to accountants, doctors to graphic designers to financial advisors (the exceptions are the fields of engineering and architecture). The IRS says it’s anyone whose principal asset is the skill of the owner or its employees. This is very complex, and it’s important to check with a CPA first to decide if you fall into a specified service industry or not.
Great! I’m a Lawyer Set Up as an LLC, Making $200,000 – $250,000 a Year – So I get up to a $50,000 Deduction? Awesome.
Sorry to burst your bubble, but the IRS set limitations on the 20% QBI tax deduction for SSTBs.
For 2023 you are only eligible to take it if you have under $182,100 in QBI. Married couples are limited to $364,200 in QBI to be eligible. After those caps, the 20% QBI tax deduction is incrementally reduced. If your QBI is above $232,100 or $464,200 (for married couples)? You are no longer eligible for ANY QBI.
What? I am Losing Out on Thousands in Tax Savings?
There’s still hope. First, if you are NOT a specified service business, The IRS states you can take the lesser of these two deductions:
- The 20% QBI tax deduction, OR
- The greater of (50% of W2 wages paid through your business) or (25% of the wages plus 2.5% of qualified property).
By paying wages, you reduce your QBI – and might then be able to take that 20% QBI tax deduction, or at least deduct paid wages.
Ok, Tell Me How I Can Get the 20% QBI Tax Deduction in 2023!
If you are on the verge of losing out on the 20% QBI tax deduction, here are 5 ways to preserve it.
1) Turn Independent Contractors into Employees
Now might be the time to talk to your contractors. Yes, you will need to pay 7% in payroll taxes – but if it means you’re able to take a 20% QBI tax deduction – it might be worth it.
2) Employ Your Children…
Are you paying your 12-year-old an allowance? Could she instead be paid wages for helping you with office work? There are many tax advantages to employing your own children. There are no age limitations (although asking a toddler to file reports probably won’t work). Paying your kids is a great way to reduce your QBI and potentially take the 20% QBI tax deduction.
3) …or, Employ Your Spouse!
Consider paying your spouse a salary or wages for assisting you with your business. Yes, this may help you preserve the 20% QBI tax deduction.
4) Set Up an S-Corp and Pay Yourself a Salary
Unlike an LLC, an S-Corp allows you to pay yourself a salary. Setting up an S-Corp is an involved process but it may be worth it so you can take the 20% QBI tax deduction. Learn about creating an S-Corp, here.
Now, since it’s near mid-year, only the QBI recorded after you set up the S-Corp will be reduced by your new salary. It is not retroactive. Still, it may be a good move to make now. Here’s how it works:
- If your profit is $200,000, you can pay yourself a reasonable salary of $70,000 (and pay about $5,000 in payroll taxes), then your profit (or QBI) is now $125,000. So, 20% of $125,000 is $25,000. But your total taxable income is $195,000. This is in the “phaseout” zone (above $182,100 but below $232,100) – and you should consult with a CPA to determine how much of a deduction you can take.
- But remember, the IRS says you must take the LESSER of (20% of QBI or 50% of salary – less the phaseout percentage) OR the lesser of 1 or the taxable income. Yes, it’s a complicated calculation. This is when hiring an accountant is a good idea!
5) Create a Separate, Capital Intensive Business
Another strategy to ensure you can take the 20% QBI tax deduction is to move income to a separate entity. For example, you could set up a law practice management company that handles your billing, HR, payroll, and general office management. It is not clear yet if the IRS would allow this, check with us first before moving ahead.
What if I Had Another Incoming-Generating Entity Outside of My Law Firm? Like a Rental Property?
The IRS does allow income generated from a rental property business to be eligible for the 20% QBI tax deduction. However, the IRS is unclear if QBI is combined between entities. Let’s say your law firm generates $180,000in QBI for 2023. But your rental property generates $10,000 in income. Oops! You’re now over the $182,100 threshold – and you won’t get the full 20% QBI tax deduction (if the IRS requires you to combine QBI).
However, if the IRS views the QBI separately, you would be able to take the 20% QBI tax deduction on both entities. That would mean a $2,000 deduction for the rental property – and $30,000 for your law firm.
At the end of the day, there are still more questions than answers regarding the 20% QBI tax deduction. All of us at Robert P. Russo CPA are on high alert – always looking at the latest IRS rulings and notices.
Until then, if you foresee yourself earning over $182,100 in 2023…don’t wait. Contact us today so we can strategize ways for you to maximize your tax savings. Otherwise, you could miss out on thousands in tax savings.