The Tax Cut and Jobs Act of 2017 (TCJA) created a new deduction for small business owners who operate pass-through entities. That includes domestic companies operated as sole proprietorships or through S corporations, partnerships, certain LLCs, trusts, and estates. Income from such entities may allow business owners to deduct 20% of their qualified business income (QBI).
On the surface, the deduction may seem straightforward. However, some business owners may find taking the QBI deduction more challenging.
Learning the limits
The QBI deduction may be subject to limitation if the taxpayer’s QBI is from a trade or business that pays W-2 wages to employees or has certain qualified property. In addition, the deduction may be limited if the trade or business is one of certain specified service trades or businesses.
Both limitations apply only to taxpayers with taxable income over certain thresholds, which are adjusted annually for inflation. For 2019, the taxable income thresholds are $321,400 for married couples filing joint returns, $160,725 for married individuals filing separately, and $160,700 for single taxpayers as well as heads of household.
Taxpayers who have taxable income above those thresholds may find their QBI deduction reduced or eliminated altogether. In those situations, it may pay to contribute to retirement plans, bringing taxable income below the relevant threshold.
Business owners who already have a defined contribution plan in place, for instance, could explore setting up a defined benefit plan, as well. Our office can help you weigh the advantages and disadvantages of this strategy.
Even for business owners under the taxable income thresholds, a 20% QBI deduction might not be available. That’s because the QBI deduction is the lesser of 20% of QBI or 20% of taxable income less net capital gain.
Earnings don’t count
Business owners should be aware that QBI is meant to be net business income, after all claimed business deductions have been taken. Thus, the QBI rules exclude salaries to S corporation shareholders and guaranteed payments to LLC members. Those amounts are not QBI, so they don’t merit a 20% deduction.
Some S corporation owners may be tempted to lowball salaries and, thus, increase QBI. However, the tax code requires reasonable compensation for owner-employees. A business owner’s efforts to take a reduced salary in order to increase QBI may lead to an IRS audit, recasting net business income as earnings, and perhaps generating steep penalties.