Demystifying the 20% QBI Deduction for Small Business

The Tax Cuts and Jobs Act reduced taxes for many small business owners and middle-income consumers, but it also introduced much confusion and speculation, particularly regarding the Section 199A deductions, also known as the Qualified Business Income (QBI) or 20% deduction for pass through businesses. Trying to simplify a complex concept that involved a number of what-if scenarios isn't easy, but I will try to highlight some of the things to look for and think about if you're a small business owner. After all, filing business taxes is the last thing you should be thinking about when you’re trying to run your business.

Perhaps your situation calls for maintaining the status quo, but if that's not the case, you may want to take action to ensure you take full advantage of the allowable deduction.

The Myth Demystified

The QBI deduction applies to small business owners structured as pass through entities such as S-corps, limited liability companies, partnerships, and sole proprietorships. Most of the confusion on whether the deduction is applicable comes from the definitions, exceptions, exemptions, and thresholds that determine whether or not a business owner can take all or a portion of the allowable 20% deduction. 

I've witnessed consultants mistakenly tell clients they couldn't take the deduction because they were Accountants or Lawyers, while also telling other types of business owners that they could take the full deduction regardless of how much income they have. Both statements are incorrect.

There are some service-type businesses that are not eligible if income exceeds a certain threshold but are eligible to some extent for income amounts below that threshold. "Specified-service" businesses that can be phased out of the deduction include doctors, lawyers, accountants, financial advisors, and musicians, among others. The IRS has been vague about specifically defining 'specified-service' businesses except for those specifically named. However, as a rule of thumb, the key determinant of whether a company is considered a specified-service business is directly attributable to the dependency of the business on the skill and/or reputation of one or more of its employees. Interestingly, and for reasons unknown to me, architects and engineers are excluded from the category.

The following highlights some of the definitions and thresholds to be mindful of if you are a business owner and you think the QBI deduction might be applicable to you.

The High-Level Breakdown

• The Income Threshold – business owners with taxable income below $157,500 for single filers (or married filing separately) or $315,000 for married filers need not worry about anything. It doesn't matter what type of business it is, if the business pays W-2 wages, or whether the company has depreciable assets. If taxable income is below these thresholds, the business owner benefits from the 20% deduction. Period. Don't go spending those tax savings all at once.
• The Specified Service Business – in cases where a business is categorized as a specified-service business, the QBI deduction will be phased out above the thresholds mentioned above. Up to taxable income levels of $157,500 for single or non-joint filers and up to $315,000 for married filing jointly filers, the full QBI deduction of 20% can be taken. For income levels above these amounts, the allowable QBI deduction is reduced in a straight line until single filers reach income of $207,500 and joint filers reach $415,000. At those levels, the deduction is phased out and the business owner cannot use any of it. For example, for every $5,000 above the $315,000 threshold, the QBI deduction is reduced by 1%. (A married couple filing jointly with income of $365,000 will be able to take a QBI deduction of 10%) At an income level of $415,000, the deduction is reduced to zero.
• The High Income, Non-Specified Service Business – for those businesses not considered specified service businesses, the phase out mentioned above doesn't apply, BUT the amount of the deduction is dependent on a combination of W-2 wages and/or depreciable assets. Specifically, the tax deduction for these businesses is limited to the greater of: 50% of W-2 wages; or 25% of W-2 wages plus 2.5% of unadjusted depreciable assets.

These businesses are also called 'qualified trade or business' and includes all other business not included in specified-service business. A manufacturer or retailer would fall into this category.

How To Maximize the QBI Deduction

Based on the high-level breakdown above, we could outline a few objectives that would help business owners maximize the deduction, whether each objective is pursued independently or in combination with others.

• Reduce income to levels below the thresholds.
• Evaluate the benefit of filing taxes as married filing separately.
• Reclassify or transform income from one type of business to another type.
• Reposition the specified-service business to one that is defined as a qualified trade or business.
•  Increase your W-2 wages.
• Increase the depreciable assets on the balance sheet.

The difficulty of achieving these objectives and the benefits realized from each will vary widely depending on the type of business, the level of income, and the specific techniques used to accomplish these objectives.

Over the next few weeks, I will outline specific strategies that will address one or more of these objectives to help business owners uncover ways to 'legally' take advantage of the qualified business income, in whole in part.

Because each business is unique, and each business owner is limited to the options available for his/her circumstances, solutions that might sound reasonable for some owners may not be feasible for others. A simple example is the option for a married couple to file separately instead of jointly if it would help reduce their tax liability via the QBI deduction. A single person wouldn't have that option.

Keep in mind that the ideas that will be presented are generic in nature but could help you identify solutions that may benefit your business specifically. Make sure you check with your CPA or Wealth Advisor about which objective and strategy will best suit your needs.