By Dan Miller, WCI ContributorThe QBI (Qualified Business Income) deduction was passed as part of the Tax Cuts and Jobs Act in 2017 as an attempt to give small business owners a break comparable to the substantial corporate tax cuts on C Corporations in the same legislation. The IRS says that many owners of sole proprietorships, partnerships, S Corporations, and some trusts and estates may be eligible for a QBI deduction. Here's more on the QBI deduction and how you can use Section 199A to your advantage.
What Is the 20% QBI Deduction from Section 199A?
The QBI deduction is a tax deduction equal to 20% of Qualified Business Income based on IRS Section 199A. This is a complicated section of the tax code that can be helpful to many businesses, but it’s not always easy to understand. The QBI deduction allows eligible taxpayers to deduct up to 20% of their QBI as well as 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income.
10 Things to Know About the QBI Deduction
#1 W-2 Income Is Ineligible
If essentially all of your household income comes from employment as a W-2 employee, there’s almost nothing in Section 199A for you. The QBI deduction on earned income is for the owners of “pass-through entities.” That includes sole proprietors, S Corp shareholders, partners in a partnership, and real estate investors who can show at least 250 hours of material participation in a real estate business annually.
#2 You Can Add Up Different Sources of QBI
You might be an owner in several small businesses. If that’s the case, the deductions from each business can be added to one another to reach your total potential QBI deduction. That can help you maximize your QBI deduction.
#3 REIT Income Counts
In general, it’s not very tax-efficient to own Real Estate Investment Trust (REIT) funds or individual REITs in a taxable brokerage account. However, Section 199A makes it less disadvantageous to do so. REIT income can also be eligible for the QBI deduction.
More information here:
Section 199A (Pass-Thru Business Deduction) Tips for Physicians
#4 Your Taxable Income (and Charitable Giving) Can Limit Your Deduction
Your final QBI deduction is the lesser of 20% of your taxable business income and 20% of your total taxable income. So, if you have a significant amount of tax deductions (like charitable giving), you may end up not being able to take the full QBI deduction amount. Consult with a tax-planning professional to see how to minimize the overall tax that you pay.
#5 Dividends and Capital Gains Can Reduce Your Deduction
The taxable income used in the calculation above is actually only a portion of the taxable income reported on your 1040. When calculating for the QBI deduction, all dividends paid and capital gains realized are subtracted first.
If you report a taxable income of $300,000 on your 1040 but $100,000 of that came in the form of dividends and realized capital gains from selling assets, your QBI deduction would be limited to 20% of $200,000. Your QBI deduction would be reduced from $60,000 to $40,000. The value of the deduction to you is reduced by $5,650.
#6 Physicians Have Different Eligibility Rules
The threshold for the 2024 tax year to get the full QBI deduction is $191,950 for single taxpayers and $383,900 if you're Married Filing Jointly. But there are always exceptions that come into play depending on the nature of your business.
Only certain professions are allowed to take full advantage of the QBI deduction, and physicians are one of the businesses that are considered a “Specified Service Trade Business” (SSTB), along with lawyers, investment managers, financial planners, and actors (among others). Those falling into this category won’t qualify for this tax break, because it disappears once you hit a total taxable income of $241,950 for single taxpayers and $483,900 for those MFJ in 2024.
More information here:
How the 199A Deduction Impacts 401(k) Decisions and Tax Rates
#7 The 32% Income Bracket Is Important for 2 Reasons
The threshold for doctors and others who are considered SSTBs is the same as the threshold that marks the start of the 32% federal income tax bracket ($191,951 single and $383,901 MFJ in 2024).
The 32% tax bracket also applies to anyone with a lot of qualified business income—whether or not it comes from an SSTB. Starting with those in this income bracket, the QBI deduction is limited to 50% of the W-2 wages paid by the qualified trade or business.
#8 The Magic Fraction for an S Corp Is 2/7
To maximize the QBI deduction, you would want half of your Wages (W) to equal 20% of the distribution. The distribution is equal to Profits (P) minus Wages (W).
- 0.5W = 0.2(P-W)
- 0.5W = 0.2P -0.2W
- 0.7W = 0.2P
- W = (2/7)P
So, our W-2 wages in a perfect world are 2/7 (or 28.57%) of the company’s profits. Since the QBI deduction is half of the wages, our deduction will be exactly 1/7 of the profit.
QBI deduction = P/7
With $500,000 in profits, if you paid exactly $142,857 in wages, you’d have a QBI deduction of $71,427.50, which happens to be exactly 20% of the $357,143 distribution.
That’s not quite as good as 20% of the full $500,000, but it’s 71.5% as good. Note that wages being less than 30% of your total business profits may or may not be considered reasonable, depending on how your business makes money. This is a subjective area, and you’ll want to have the ability to justify the wage level in the event of an audit.
#9 Tax-Deferred Retirement Contributions May Be Less Valuable
In the 24% bracket, your tax-deferred retirement contributions normally net you a 24% savings on your federal income tax. However, those contributions are subtracted from the profit calculation that determines your QBI deduction.
Another way to look at it is that you are only reducing your taxes by 19.2% (80% of 24%) with tax-deferred contributions when you are reducing your QBI deduction by doing so. This can make Roth employEE contributions more attractive, and you may also consider Roth employER contributions via the Mega Backdoor Roth
More information here:
Section 199A Deduction (QBI) and Retirement Accounts
#10 Filing as an S Corp Can Help You . . . or Hurt You
If your business income is in the 24% bracket (under $383,901 in 2024 when MFJ), the tax savings an S Corp gives you (for many professionals, it’s the 2.9% Medicare tax only) can easily be more than offset by a more substantial loss of your QBI deduction.
Let’s say your business income (after accounting for any tax-deferred retirement account contributions) is $300,000 as a physician working as an independent contractor. Filing as a sole proprietor, you could have a $60,000 QBI deduction worth (24% of $60,0000) = $14,400.
If, instead, you paid yourself a “reasonable wage” of $150,000 to save 2.9% in taxes on the distribution of $150,000, you would save yourself $4,350 in Medicare taxes. By doing so, you’d also be cutting your QBI deduction in half, effectively adding $7,700 back to your tax bill. That’s not a tradeoff any informed person would make. It’s a $3,350 mistake.
The Bottom Line
If this is the first you have heard of the QBI or Section 199A deduction, you'll want to spend some time thinking about how your business is making money, what its tax filing status is, and whether what you’ve done in the past is optimal. Every situation is different, and what works for one physician may not work for others. Like with most complicated tax matters, it's a good idea to consult someone who studies the tax code for a living before making any decisions based on what you’ve learned about the 20% QBI deduction.
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With regard to #4 and #9, one important thing to know is that although retirement contributions might be less valuable, they might be crucial for allowing a 199A deduction at all. Suppose you have $500K in 1099 income. If you are in SSTB you are out of luck. But, if you can deduct enough to get under the 32% bracket, then you can take 199A deduction.
In other words, to get the deduction you need to reduce your taxable income to under $329,850 (joint). Itemized deductions with large charitable contributions or retirement plan contributions do that. To do this, I contribute to a solo defined pension plan, that allows me to adjust my contribution so that I am just under the limit.
Excellent point.
This is all, of course, getting even more interesting with the discussion of a limitation on this deduction going on in Congress right now. We may go back from doing a MBDR contribution (which is also perhaps being outlawed) to doing a tax-deferred contribution.