How Do You Optimize Wages to Maximize the 20% QBI Deduction?

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The Tax Cuts and Jobs Act (TCJA) was signed into law on Dec 22, 2017, and provides sweeping tax changes for business and individual taxpayers. One of the provisions of the TCJA is to reduce the entity-level income tax rate of C corporations from a top rate of 35% to a flat rate of 21%. As an equalizing provision, a new section of the Internal Revenue Code, Sec. 199A, was created to bring the effective tax rate of sole proprietorship, S corporation and partnership owners closer to the new lower rate afforded to C corporations; possibly to a rate as low as 30%.

Sec. 199A attempts this equalization by affording the owners of flow-through entities a deduction of up to 20% of qualified business income (QBI) on the taxpayer’s 1040. This 20% deduction is subject to a number of limitations, phase-ins and phase-outs. We will focus on the language set out in Sec. 199A(b)(2) that limits the taxpayer’s potential deduction to the lesser of the following:

1) 20% of the taxpayer’s QBI with respect to the qualified trade or business.

Or

2) The greater of (A) 50% of the W-2 wages paid by the qualified trade or business, or (B) The sum of 25% percent of W-2 wages paid by the qualified trade or business plus 2.5% of the unadjusted basis immediately after acquisition of all qualified depreciable property.

These limitations become engaged once the taxpayer reaches a certain taxable income level per Sec. 199A(b)(3)(B). The taxable income limits are $157,500 for single taxpayers and $315,000 for taxpayers filing a joint return. The phase-in ranges for these limits are $50,000 and $100,000, respectively, and the taxpayer’s QBI deduction becomes 100% subject to the W-2 wages and Adjusted Basis limitations in Sec. 199A(b)(2) once taxable income exceeds the phase-in ranges. If the taxpayer’s taxable income exceeds the phase-in range by an amount less than the entire phase-in range, then the taxpayer’s QBI deduction will be limited by the percentage taxable income – less the taxable income threshold – to make up the phase-in range. For example, a single taxpayer with $170,000 in taxable income will be limited to 75% of their QBI deduction in excess of the Sec. 199A(b)(2) limits: 1 = 75%.

The following are examples of the mechanics of the limitations and planning opportunities for taxpayers qualifying for the Sec. 199A QBI deduction. These examples assume a sole proprietor taxpayer filing a joint return with the owner’s QBI income as the only source of taxable income. In this case, the W-2 wages used to calculate the Sec. 199A(b)(2) limits would be wages paid to the owner’s employees since sole proprietors – as well as partners – are not permitted to pay themselves W-2 wages. They are not considered employees in the eyes of the IRS.

The taxpayer exceeds the phase-in limitations in all three scenarios and is subject to the Sec. 199A(b)(2) limitations as a result; however, the third scenario presents a planning opportunity to increase the taxpayer’s QBI deduction. Assuming that the taxpayer has $40,000 in extra cash flow, paying out a $40,000 bonus before the end of the tax year could increase the taxpayer’s deduction by up to $20,000 (column 1 vs. column 3), despite the fact that the taxpayer fully exceeds the phase-in range.

Tax accountants can help their clients weigh this compensation planning option, along with other expense bunching strategies to minimize their tax liability. Given the complexity of Sec. 199A, taxpayers need to carefully examine their tax planning strategies since increasing W-2 compensation can either increase or lower their QBI deduction based on their taxable income levels. There are also special rules for service type businesses that include more restrictive limitations and phase-outs of the QBI deduction that need to be considered during tax planning.

Comments (7) Leave your comment

  1. Are proprietors required to deduct pension plan / IRA contributions for the purposes of calculating QBI? I have not been able to find guidance on this issue. A similar question relates to deductions for premiums for self-employed health insurance and self-employment tax.

    1. Publication 535 is silent on the issue of retirement contributions, so we’re awaiting clarification from the IRS. Self-employed health insurance and retirement contributions paid to partners and >2% S-corporation shareholders are treated as 707(c) guaranteed payments and amounts determining reasonable compensation, respectively. The regs specifically exclude these amounts from the determination of QBI; they will be treated as a deduction reducing distributable income/QBI at the entity level, but they will not be subsequently recognized as an increase to QBI at the partner/shareholder level.

  2. Hi Sam
    I think there is additional limitation of 20% of taxable income.
    Also, can you comment on s corp and employee-shareholder:
    Increasing payroll will increase fica taxes for getting additional deduction

    1. Hi, you can see the worksheet on irs.gov here: https://www.irs.gov/pub/irs-dft/p535–dft.pdf. See Worksheet 12-A, Qualified Business Income Deduction Worksheet, Part IV, on page 8.

      Increasing wages cuts two ways:
      – Increasing wages will reduce QBI and the 20% deduction.
      – Increasing wages will add to the wage base used in the wage / unadjusted basis of the all qualified property limit (see Part II on page 7).

  3. plus 2.5% of the unadjusted basis immediately after acquisition of all qualified depreciable property.
    How do you calculate/come up with the Qualified Depreciable Property?
    Is it all assets on the depreciation Schedule?
    Is it just the undepreciated balance on the depreciation schedule?
    Is it current year acquisitions?
    Does it include land?

  4. Since you use MFJ in all three of you examples; this entire solution would flow much smoother if you also used MFJ rather than Single in your example QBI Formula in paragraph #3….

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