How to Maximize Your 2022 Qualified Business Income Deduction
Prior to 2017, C-Corporation tax rates averaged 35% and, for that reason, individuals and small businesses operated as sole proprietors, S-Corporations, partnerships and LLCs instead to keep the total tax burden down. Remember that C-Corporations also have a double tax, where you pay another layer of tax on the dividends. In 2017, the Tax Cuts and Jobs Act (TCJA) capped C-Corporation tax rates at 21%, reducing the “penalty” of operating as a C-Corporation. At the same time, the TCJA also introduced the Section 199A – Qualified Business Income (QBI) deduction to benefit individuals and small businesses not operating as C-Corporations.
So what is QBI? According to the IRS, “Qualified business income is the net amount of qualified items of income, gain, deduction, and loss from any qualified trade or business, including income from partnerships, S-Corporations, sole proprietorships, and certain trusts.” It’s important to understand how the QBI deduction (QBID) is calculated at different income levels and how your business operations throughout the year can impact that calculation. In simple terms, QBI is business income, with some exceptions listed below.
Who qualifies for the QBI tax deduction?
Since 2017, the QBID helps individuals with one or multiple pass-through businesses and/or real estate investments reap the tax benefits of income from those entities. Owners of pass-through entities can claim a deduction of up to 20% of their QBI on their personal tax return. What qualifies as a pass-through entity since C-Corporations do not qualify?
- Sole proprietorships
- Limited liability companies (LLCs)
- Some trusts and estates
What does not count as qualified business income?
The most common items our clients ask about, that cannot be included in QBI, are investment activities like capital gains and losses, interest income, dividend income, and guaranteed payments. The full list, from the IRS, of what is NOT qualified business income includes:
- Items that are not properly includable in taxable income
- Investment items such as capital gains or losses
- Interest income not properly allocable to a trade or business
- Wage income
- Income that is not effectively connected with the conduct of business within the United States
- Commodities transactions or foreign currency gains or losses
- Certain dividends and payments in lieu of dividends
- Income, loss, or deductions from notional principal contracts
- Annuities, unless received in connection with the trade or business
- Amounts received as reasonable compensation from an S-Corporation
- Amounts received as guaranteed payments from a partnership
- Payments received by a partner for services other than in a capacity as a partner
- Qualified real estate investment trust (REIT) dividends
- Publicly traded partnership (PTP) income
- Most royalty payments
(List Source: IRS)
How is QBI calculated?
Calculating your QBI deduction starts with determining your taxable income limitations. If your 2022 income was under $170,050 as a single filer or under $340,100 as joint filers, you can simply calculate your QBI deduction using Form 8995. (Note that these thresholds will rise to $182,100 for single filers and $364,200 for joint filers in 2023.) In most cases, this is as simple as taking 20% of your QBI as your QBID. There is a taxable income limit that kicks in and in some cases you will take 20% of your taxable income instead of 20% of your QBI.
For those earning over $170,050 as single filers or $340,100 as joint filers, the calculation is more complex, using Form 8995-A, and often determined by a CPA firm, especially for high net worth individuals with multiple pass-through entities. Especially for high earners, QBI is not just a straightforward 20% deduction. There are limitations that can reduce your potential deduction, such as the type of business, W-2 wages paid by that business, and Unadjusted Basis Immediately after Acquisition (UBIA) of any qualified property held by that business. QBI also needs to be adjusted for items such as self-employment taxes and self-employed/officer health insurance payments. A simple QBI calculator unfortunately will not get you the answers an experienced tax accountant can.
When income is over this threshold, it’s also important to understand if your income comes from a specified services trades or business (SSTB). According to the IRS, a SSTB “is a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading, dealing in certain assets or any trade or business principal asset is the reputation or skill of one or more of its employees or owners.” You can find more granular details to determine if your business is a SSTB here. After a certain level of personal income, SSTBs cannot contribute to QBI so it’s important to work with a CPA to understand the nuances of how this may or may not apply to your business.
It’s also important to note that if your qualified business income is below zero, you can’t claim a QBI deduction for that tax year and you are required to carryover the loss to the next tax year.
How can you maximize your QBI deduction?
Tax preparation involves calculating prior years’ QBI deduction for your business, but tax strategy means planning your business operations to maximize next year’s QBI deduction. There are several measures you can take to fully utilize the 20% QBID, including:
- Paying sufficient wages, especially if you’ve had a profitable year
- Year-end bonuses if wages weren’t sufficient throughout the year
- Aggregating pass-through entities
We regularly work with clients on aggregating pass-through entities to optimize tax benefits. For example, if you have two operating companies and only one pays wages to W-2 employees, this is a prime example of needing to aggregate. Without aggregating, the entity without W-2 employees will result in zero QBID. By aggregating, you may be able to get the full 20% QBID deduction. This is due to the 50% W-2 limitation.
Let’s take an example of having a $500K profit in both entities with one business paying $400K in wages. Without aggregating, you have a QBID of $100K. By aggregating, you can take the full $200K QBID. Be aware that if total wages were only $300K, you would be limited to a $150K QBID. The 50% of W-2 wages paid comes into play far more than the 2.5% of UBIA or the hybrid method. There are some exceptions, especially in the real estate world, but we see the 50% W-2 limitation kick in about 95% of the time.
In order to aggregate for the purposes of the Section 199A deduction, there are four rules that must be met:
- The same person/group of people own directly, or by rules of attribution, 50% or more of each trade or business for a majority of the tax year including the last day of the tax year.
- All of the items attributable to the trades or businesses must be within the same year.
- None of the trades or businesses can be a SSTB (specified service trade or business, including health, law, accounting, athletics and others listed here)
- Two of the following three must be true:
- The trades or businesses offer similar product lines or services.
- The trades or businesses must share a similar back-office (accounting, HR, etc.).
- The trades or businesses are operated in coordination or reliance with the other businesses in the aggregated group.
How can you determine QBI for rental properties?
In 2019, the IRS issued a “safe harbor allowance” for some real estate rental activities to be included in qualified business income. The safe harbor rule consists of three requirements:
- You must keep separate books showing income and expenses for each rental real estate business.
- You must perform at least 250 hours of real estate rental services each year.
- You must have records documenting your real estate services performed for each year.
If you pass all three of the above requirements, your rental real estate is considered a trade or business for purposes of Section 199A and therefore the qualified business income deduction is applicable. If you have multiple real estate businesses, you can combine the time spent at each property, but you cannot combine residential real estate activities with commercial real estate activities.
How will QBI evolve in the future?
Like most tax policies, the future of QBI will depend on which party holds the majority vote in our government. If the flat 21% C-Corporation tax rate ever changes, it’s likely that the QBI deduction will be affected, since both were established in the same legislation in 2017. Generally, we expect thresholds to increase slightly each year to account for inflation.
If you’re trying to maximize your QBID for 2022, or improve your strategy for maximizing QBID in the future, we’d love to talk. Schedule time with us here. Our firm specializes in working with high net worth individuals owning and operating multiple businesses across industries and geographies. Let us help you make sure those pass-through entities are benefiting you come tax time.