How small business owners can maximize a potentially lucrative tax break

Pass-through business entities report their federal income tax items to their owners, who then take them into into account on their owner-level returns. The QBI deduction, when allowed, is then written off at the owner level, and it can be a big tax-saver. So, let’s discuss how to maximize your write-off.

QBI deduction planning in the current environment

Things have changed dramatically since the QBI deduction first became available back in 2018. We’ve had to deal with the various effects of the COVID-19 pandemic, and now record-high inflation and a possible recession have been added to the mix. How does all this affect planning to maximize QBI deductions for your small business? Good question. But let’s first cover the necessary background information. Here goes.     

QBI deduction basics

QBI means qualified income and gains from an eligible business reduced by related deductions and losses. According to the IRS, QBI from a business is reduced by: (1) the allocable deduction for a contribution to a self-employed retirement plan, (2) the allocable deduction for 50% of your self-employment tax bill, and (3) the allocable deduction for self-employed health insurance premiums. 

Income from the business of being an employee does not count as QBI. Ditto for guaranteed payments received by a partner or an LLC member treated as a partner for tax purposes for services rendered to a partnership or LLC (often called partner salaries). Salary collected by an S corporation shareholder-employee does not count as QBI, nor does salary collected by a C corporation shareholder-employee. 

On your Form 1040, the QBI deduction does not reduce your adjusted gross income (AGI). In effect, it’s treated the same as an allowable itemized deduction.

Unfortunately, the QBI deduction does not reduce your net earnings from self-employment for purposes of the self-employment tax nor does it reduce your net investment income for purposes of the 3.8% net investment income tax (NIIT) on higher-income folks. Sorry about that.  

QBI deduction limitations

At higher income levels, unfavorable QBI deduction limitations can come into play. 

For 2022, the limitations begin to phase in when your taxable income (calculated before any QBI deduction) exceeds $170,050 or $340,100 if you’re a married-joint filer. For 2022, the limitations are fully phased in once taxable income exceeds $220,050 or $440,100 for married joint-filers.

If you’ve not yet filed your 2021 return, the limitation thresholds are $164,900 and $329,800, respectively. For 2021, the limitations are fully phased-in once taxable income exceeds $214,900 or $429,800, respectively.

If your income exceeds the applicable fully phased-in number, your QBI deduction is limited to the greater of: (1) your share of 50% of W-2 wages paid to employees during the tax year and properly allocable to QBI or (2) the sum of your share of 25% of such W-2 wages plus your share of 2.5% of the unadjusted basis immediately upon acquisition (UBIA) of qualified property. 

The limitation based on the UBIA of qualified property is for the benefit of capital-intensive businesses like manufacturing or hotel operations. Qualified property means depreciable tangible property (including real estate) that’s owned by a qualified business and used by that business for the production of QBI. The UBIA of qualified property generally equals its original cost when it was first put to use in your business. 

Finally, your QBI deduction cannot exceed 20% of your taxable income calculated before any QBI deduction and before any net capital gain amount (net long-term capital gains in excess of net short-term capital losses plus qualified dividends).  

Special unfavorable rules for specified service trades or businesses (SSTBs)

If your operation is a specified service trade or business (SSTB), QBI deductions begin to be phased out when your taxable income (calculated before any QBI deduction) exceeds the applicable threshold. See the sidebar below for what counts as an SSTB.  

For 2022, the phase-out threshold is $170,050 or $340,100 if you’re a married-joint filer. Phase-out is complete when taxable income exceeds $220,050 or $440,100, respectively. 

If you’ve not yet filed your 2021 return, the phase-out thresholds are $164,900 and $329,800, respectively. Phase-out is complete once taxable income exceeds $214,900 or $429,800, respectively.

If your taxable income exceeds the applicable complete phase-out number, you’re not allowed to claim any QBI deduction based on income from any SSTB. 

Lower business income may mitigate the impact of limitations

Many small businesses may have lower net income this year for all the obvious reasons. Other things being equal, lower income translates into a lower QBI deduction. But lower income can also reduce or eliminate the impact of the unfavorable QBI deduction limitations. Confusing? You bet. Your tax pro can clarify your situation. 

QBI deduction planning moves

Remember that, as the tax law reads right now, the QBI deduction is essentially a use-it-or-lose-it deal, because it’s scheduled to disappear after 2025. Congress could extend it, but you probably shouldn’t bet on that happening. So, what can you do to maximize QBI deductions from now through 2025? Here are some ideas.  

1. Evaluate impact of claiming big first-year depreciation deductions or foregoing them 

You can claim 100% first-year depreciation deductions and/or big first-year Section 179 depreciation deductions for lots of business assets that are placed in service through the end of this year.  

First-year depreciation deductions reduce your QBI. That’s unhelpful for your QBI deduction. But first-year depreciation deductions also reduce your taxable income — which could reduce the impact of the unfavorable QBI limitations explained earlier. And, all things being equal, lower taxable income is a good thing. So, you may have to thread the needle with depreciation write-offs to get the best overall federal income tax result.

Key point: As mentioned earlier, the QBI deduction is a probably a use-it-or-lose it deal. In contrast, when you forego 100% first-year depreciation deductions or big first-year Section 179 depreciation deductions, you can depreciate the assets over a number of years under the “regular” depreciation rules. If tax rates go up, “regular” depreciation deductions claimed in future years could turn out to be worth more than big first-year depreciation deductions claimed in earlier years.             

2. Evaluate impact of making big deductible retirement plan contributions or foregoing them 

Deductible self-employed retirement plan contributions allowable to a business that generates QBI will reduce your allowable QBI deduction. By itself, that’s unhelpful. But deductible retirement plan contributions also reduce your taxable income — which could reduce the impact of unfavorable QBI limitations. And, all things being equal, lower taxable income is a good thing. So, you may also have to thread the needle with retirement plan contributions to get the best overall federal income tax result.

3. Evaluate aggregating businesses

Aggregating businesses can allow an individual with taxable income high enough to be affected by the limitations based on W-2 wages and the UBIA of qualified property to claim a bigger QBI deduction than if the businesses were considered separately. For instance, say you are a high-income individual who owns an interest in one business with lots of QBI but little or no W-2 wages and an interest in a second business with minimal QBI but lots of W-2 wages. Aggregating the two businesses can result in a healthy QBI deduction while keeping them separate could result in a lower deduction or maybe no deduction. However, you must pass tests set forth in IRS regulations to be allowed to aggregate businesses. 

Key Point: You cannot aggregate a SSTB with any other business, including another SSTB. 

4. If you’ve not yet filed your 2021 return 

If you’ve not yet filed your 2021 Form 1040 that will include income and deductions from a sole proprietorship business that could generate a QBI deduction or if the 2021 return for a pass-through entity that could generate a QBI deduction has not yet been filed, consider the ideas presented above before filing. 

The bottom line

The QBI deduction rules are explained in detail in IRS regulations that are, to put it charitably, lengthy and complex. Then there are the issues briefly explained in this column, which don’t make things any simpler. You may want to hire a tax pro to sort through it all and advise you on how to get the best QBI deduction results and the best overall federal income tax results in your specific circumstances. There are a lot of what-ifs to consider. It’s complicated!    

SIDEBAR: What Is a Specified Service Trade or Business (SSTB)?

In general, an SSTB is any trade or business involving the performance of services in one or more of the following fields:

* Health, law, accounting, and actuarial science. Weirdly enough, architecture and engineering firms aren’t considered SSTBs. Apparently, they had really good lobbyists. 

* Consulting, 

* Financial, brokerage, investing, and investment management services.

* Trading.

* Dealing in securities, partnership interests, or commodities.

* Athletics and performing arts.

* Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.

Before the IRS issued regulations, there was concern that the last definition could snare unsuspecting businesses like local restaurants with well-known chefs. Thankfully, the regulations limit the last definition to trades or businesses that meet one or more of the following descriptions:

* One in which a person receives fees, compensation, or other income for endorsing products or services.

* One that receives fees, licensing income compensation, or other income for the use of an individual’s image, likeness, name, signature, voice, trademark, or any other symbol associated with that individual’s identity.

* One that receives fees, compensation, or other income for appearances at an event or on radio, television, or another media platform.