2020 is the third year in which I’ll be eligible to receive a QBI deduction, that is, a tax deduction equal to 20% of Qualified Business Income based on IRS Section 199A.
The new 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.
This complicated section of tax code can be a real boon to many businesses, but it’s not easy to understand. I published an excellent guest post on tax reform and the QBI deduction in 2018, and have learned more as I’ve seen how it applies to my taxes these past few years.
Today, I’d like to share 10 tidbits that can help you determine if you might benefit and how to optimize your potential deduction.
10 Things You Should Know About the 20% QBI Deduction (Section 199A)
To be frank, there may be more than 10 things you need to know to maximize your QBI deduction, but what follows are some of the things I’ve learned and are among the most helpful nuggets as you attempt to navigate this bit of tax code.
If you have a real estate or other business with large amounts of depreciable assets, you will need to know more, as that’s one corner of the rule that I have not examined very closely.
The following tips should help most others, though.
1. W-2 income is ineligible.
If essentially all of your household income comes from employment as a W-2 employee, there’s very little in Section 199A for you. Hopefully, your corporate employer passed some of their tax savings on to you in the form of higher wages. I’m guessing that didn’t happen.
Note that even if all of your earned income comes from W-2 jobs, you may still qualify for a deduction on some of your investment income, so you’re not excused from reading further just because you’re an employee.
The QBI deduction on earned income, though, is for the owners of “pass-through entities.” That includes sole proprietors, S corporation shareholders, partners in a partnership, and real estate investors who can show at least 250 hours of material participation as a real estate business annually.
The self-employed and shareholders in small businesses are the ones who can benefit the most. How much they can benefit depends on a number of factors that we’ll explore below, but the maximum is essentially 20% of business profits, and it can easily be less.
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 businesses can be added to one another to reach your total potential QBI deduction.
For example, I own Physician on FIRE LLC, and as a pass-through entity, the income qualifies for a 20% deduction on qualified business income.
I also own a small piece of Passive Income MD LLC and The Physician Philosopher LLC, both of which generate qualified business income that passes through to me. Investments in a craft brewery and in a crowdfunded real estate investment set up as a partnership also contributed to my total QBI in 2019, with the latter contributing a small negative “addition.”
Add up the total earnings, subtract 80% and that could be the amount you can deduct from your taxable income. Of course, that depends on what your taxable income is and whether or not any of your sources of QBI come from a specified service or trade business. More on those below.
3. REIT income counts (and some RE funds).
Don’t forget to add in REIT income!
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.
Furthermore, some real estate investments that were set up differently in the past have transitioned to a REIT structure to allow investors to benefit from the QBI deduction.
Even if you’ve never purchased a REIT or REIT fund, you may still benefit. If you own a total stock market index fund like VTSAX in a taxable account, a portion of the dividends come from REITs.
Roughly 3% of VTSAX is invested in REITs. If I was not a small business owner and owned no individual REIT or REIT funds, I would still get to deduct 20% of $452.96 on my taxes.
That $90 deduction would only be worth about $25 in my pocket (assuming a 24% federal income tax rate and 4.25% state income tax), but I’d take it!
4. Your taxable income (and charitable giving) can limit your deduction.
Your final QBI deduction is the lesser of several calculations, and one of those calculations is your taxable income. As someone who donates generously, this fact has definitely impacted my deduction.
Let’s say your QBI from all small businesses, REITS, and other real estate investments add up to $300,000. Because you have large itemized deductions by virtue of donating half of the profits from the main source of QBI, you only have $200,000 in taxable income.
If not for the itemized deductions resulting from donated money, your Section 199A QBI deduction could be 20% of $300,000 = $60,000. The value of that deduction using the same 28.25% combined marginal tax brackets would be $16,950 in tax savings.
However, with taxable income at $200,000, your QBI deduction is the lesser of the $60,000 calculated above OR 20% of $200,000. Now you can only deduct $40,000 for a tax savings of $11,300.
That’s $5,650, or 5.65% of the difference between your calculated QBI savings and the one based on your taxable income. Granted, by donating $100,000, this taxpayer avoided paying $28,250 in income taxes.
Essentially, the value of the deduction from charitable giving was reduced from 28.25% to 21.6%.
5. Dividends and Capital Gains can reduce your deduction.
There’s an important clarification that isn’t always spelled out in summaries I’ve read describing Section 199A.
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.
Once again, just like in the example above, your QBI deduction is reduced from $60,000 to $40,000. The value of the deduction to you is reduced by $5,650.
6. Physicians (and other Specified Service Trade Businesses) may be eligible.
Oddly, only certain professions are allowed to take full advantage of the QBI deduction, but if your taxable income is below a certain threshold, it doesn’t matter how your small business makes money. Even physicians are eligible.
The cutoff to get the full deduction available to you is the same as the jump from the 24% to the 32% federal income tax bracket. In 2020, the top of the 24% bracket is $326,600 for couples married filing jointly and $163,300 for single filers. Those numbers rise to $329,850 and $164,925 respectively in 2021.
If your (pre-QBI deduction) taxable income is at or beneath those thresholds, you’ll qualify for the full QBI deduction no matter your profession.
When you get into the 32% bracket, the QBI deduction is phased out to zero in a linear fashion over the next $100,000 in income for couples or $50,000 for individuals in a specified service or trade businesses.
That’s right. The authors of the bill singled out a number of professions that can only claim the deduction with income in the ranges discussed above. Those whose businesses are not considered a “specified service trade or business (SSTB), but rather a “qualified trade or business” don’t need to worry about these income limits. They can deduct 20% of an unlimited amount of QBI.
Professions considered specified service trades or businesses include those in:
- Actuarial science
- Financial Services
- Brokerage Services
- Investment Management
- Product endorsement (i.e. celebrity branding)
7. The 32% income bracket is important for two reasons.
We already covered one reason that the 32% bracket matters. Doctors and others that fall under the SSTB category see their deduction decrease and eventually disappear as they begin to fill up the 32% federal income tax bracket.
The phaseout of this deduction is a big deal.
In the phaseout range, an extra $1,000 of income for a married couple filing jointly results in an additional $320 of income tax plus the loss of $157 in potential QBI deduction for a total of $477. Add in $29 in Medicare tax, and that’s a total of $506 for a marginal tax rate > 50% before state income taxes are factored in.
How did I come up with $157? The maximum deduction for those in a specified service trade or business, like physicians, lawyers, and consultants, is 20% of $326,600 = $65,320. In the 24% bracket the value of that deduction is $15,677. Losing 1% of that deduction by earning another $1,000 adds $157 to your tax bill.
The other reason the 32% tax bracket matters applies to anyone with a lot of qualified business income, whether or not it comes from an SSTB.
In and above the phaseout range, i.e. in the 32% and above federal income tax brackets, your QBI deduction is limited to 50% of the W-2 wages paid by the qualified trade or business. There’s yet another calculation for businesses with plenty of depreciable property, but that’s beyond the scope of today’s discussion.
Let’s say you have a qualified business or trade with $500,000 in profits. In this income range, your deduction isn’t $100,000 but rather the lesser of a)50% of W-2 wages or b)20% of (after-wage) profits.
If you pay no W-2 wages, your QBI deduction would be based on 50% of 0. That would be zero. You must pay W-2 wages in this income range if you want to benefit from Section 199A, which you absolutely do.
In this scenario, you could file as an S corp, paying yourself (and any other true employees) a W-2 wage and take a distribution for the remainder. What’s the optimum ratio? Keeping in mind that we should be paying a fair wage for the work done, we’ll run the numbers using a bit of algebra.
Yes kids, I still use algebra.
8. The magic fraction for an S Corp is 2/7.
Ideally, we’d like half of the 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 be able to justify the wage level in the event of an audit.
Again, if your profits don’t stretch into the 32% tax bracket, you don’t have to pay yourself or anyone else a wage. You can simply deduct 20% of the profits to calculate your potential deduction. You’ll still be subject to the 20% of taxable income (less dividends and capital gains) limitation.
I’ll remind you that I’m a retired physician and blogger, but not a tax professional or CPA. Consult the latter before making any moves based on what you read here.
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.
Let’s say you are married, filing jointly, and have $300,000 in income from one business. If your taxable income (net dividends and capital gains / before QBI deduction) is at least $300,00, you’ll have a QBI deduction of $60,000 for a final taxable income of $240,000.
If you sock away $57,000 into a solo 401(k) or SEP IRA, your QBI deduction will be 20% of $243,000, or $48,600.
You just lost $11,400 of your QBI deduction, which is, of course, 20% of the $57,000 tax-deferred contribution.
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.
Also, realize that tax-deferred contributions also lower your taxable income, so if your taxable income (after subtracting capital gains and dividends) is going to be lower than your qualified business income due to large itemized deductions, Roth contributions may be the answer.
10. Filing as an S Corp can help you… or hurt you.
This fact was mostly teased out above, but I didn’t really highlight how an S corp can hurt you. This is also a good place to mention that you do not need to formally form an S corporation for your business to file as an S corp at tax time. It’s an election you can choose when it comes time to file.
If your business income is in the 24% bracket (under $326,600 in 2020 when married filing jointly), 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.
Now, if the work you do is not in the medical field, and could be considered to have a much lower fair wage, there may be a benefit to S corp status. You could save quite a bit in Social Security taxes with a $50,000 wage and $250,000 distribution, and you’d still have a QBI deduction of $25,0000. You would want to be able to justify that wage for the work you do, and as my CPA likes to say, “pigs get fat; hogs get slaughtered.”
How Valuable Can the QBI Deduction Be?
Let’s say you are hampered by virtue of being a physician or any other profession categorized as an SSTB. You are married and you tax plan ideally, tweaking your business profits to match your taxable income (minus dividends and capital gains, before QBI deduction) at exactly $321,450 in 2019.
You qualified for the maximum deduction of $64,290. Your final taxable income was $257,160.
Using Turbotax TaxCaster (which as of the date this is being published, has not been updated for 2020), let’s compare the federal taxes due on $321,450 versus $257,160. I’m giving this hypothetical family two kids under 17 and no daycare expenses.
That’s a federal income tax savings of over $15,000. There will also be Social Security taxes, and potentially some state and local income tax (where additional savings can be found as most places use your final federal taxable income to calculate the state and local tax due).
If your business is a qualified trade or business, the value of the deduction is only limited by how much you earn! You could be deducting hundreds of thousands or even millions of dollars in the 37% federal income tax bracket.
Consult a professional!
Now that I’ve inundated you with all of this material, it’s time to consider how your business makes money, what its tax filing status is, and whether or not what you’ve done in the past is optimal.
I have learned enough to better understand how this complex deduction applies to my own tax situation as a blogger and investor, but your situation is undoubtedly different.
Please consult someone who studies the tax code for a living before making any decisions based on what you’ve learned today.
I’ll do my best to answer questions in the comments below, but as someone who is definitely not a tax professional, I don’t have all the answers. Still, I hope these ten tips have given you something to think about and can help you in your tax planning as we head into the end of the year.
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Did you receive a QBI deduction in prior years? Have you made any changes in your business or investments to better take advantage of Section 199A?