QBI Deduction: Maximize It Before It’s Gone

The Qualified Business Income (QBI) deduction, introduced by the Tax Cuts and Jobs Act (TCJA), offers a valuable opportunity for business owners to reduce their tax liability by up to 20% of eligible business income. This deduction applies to income from sole proprietorships, partnerships, S corporations, and other pass-through entities, as well as some dividends and income from real estate investment trusts (REITs) and publicly traded partnerships. However, the QBI deduction is scheduled to expire after 2025, making it essential for eligible individuals to maximize the deduction before it is gone.

Key Features of the QBI Deduction

The QBI deduction allows eligible individuals to deduct up to 20% of qualified business income from a sole proprietorship, single-member LLC, or pass-through entities such as partnerships and S corporations. The deduction applies to qualified REIT dividends and income from publicly traded partnerships. However, it does not reduce adjusted gross income (AGI) or net earnings for self-employment tax purposes.

QBI refers to the income and gains from an eligible business, reduced by related deductions such as retirement plan contributions and self-employment taxes. Employee wages and guaranteed payments to partners do not qualify for the deduction.

Income Limitations:

The QBI deduction is subject to limitations based on taxable income. The deduction can be significantly reduced or eliminated for individuals with taxable income above certain thresholds, especially for specified service trade or businesses (SSTBs).

In 2023, the limitations begin to phase in if taxable income exceeds $182,100 ($364,200 for married joint filers). The deduction is fully phased out once taxable income exceeds $232,100 ($464,200 for married couples). For 2024, the phase-in thresholds increase to $191,950 ($383,900 for married couples), and complete phase-out occurs at $241,950 ($483,900 for joint filers).

For non-SSTBs, the deduction is limited to the greater of 50% of W-2 wages paid or 25% of W-2 wages plus 2.5% of the unadjusted basis of qualified property (UBIA). Qualified property includes depreciable tangible assets like real estate.

Special Rules for SSTBs:

Certain service-based businesses, called SSTBs, face stricter QBI limitations. If your business is classified as an SSTB (e.g., health, law, accounting, consulting, financial services, etc.), the QBI deduction starts phasing out when taxable income exceeds the applicable threshold and is eliminated if income exceeds the full phase-out amount.

An SSTB is generally a business where the primary asset is its employees’ or owners’ reputation or skill. Specific exceptions exist, such as for businesses earning income from endorsements or using one’s image.

Strategies to Maximize the QBI Deduction

1. Aggregate Businesses: High-income earners may benefit from aggregating businesses to combine QBI with W-2 wages or UBIA from multiple businesses. By doing so, you can increase the QBI deduction. However, aggregation is not allowed for SSTBs or businesses that don’t meet specific criteria set by the IRS.

2. Forgo Large First-Year Depreciation Deductions: While the Section 179 deduction and bonus depreciation can reduce taxable income, they also lower QBI, which reduces the potential deduction. Choosing not to take large first-year depreciation deductions could preserve QBI and maximize the deduction over time, especially if tax rates rise in the future.

3. Limit Deductible Retirement Contributions: Retirement contributions to plans that are allocable to QBI can reduce the allowable deduction. However, they also reduce taxable income, which may help reduce the impact of income-based QBI limitations. Carefully managing retirement plan contributions can help optimize the deduction.

4. File Separately for Married Couples: If you and your spouse have significant business income, filing separately could help reduce the phase-out of the QBI deduction. This strategy may not be beneficial in all cases, so analyzing the numbers is important to determine if it results in a higher deduction.

Impact on Future Returns

For tax years 2023 and 2024, business owners should consider the above mentioned planning strategies before filing their returns. For high-income earners, effective tax planning can minimize the impact of the QBI limitations and ensure they take full advantage of the deduction before it expires in 2025.

Conclusion

The QBI deduction is a valuable tax benefit that allows business owners to deduct up to 20% of eligible income, reducing their tax liability. However, with the deduction set to expire after 2025, it’s crucial to take steps to maximize the benefit while it’s available. This includes understanding the qualifications, limitations, and potential strategies such as aggregating businesses, managing depreciation deductions, controlling retirement contributions, and filing separately. By proactively planning, individuals can take full advantage of this deduction and minimize their tax liability before it’s gone.