Strategies for Small Businesses and Sole Proprietors to Save Money on Taxes -Part 3 of 10
The Qualified Business Income (QBI) deduction, courtesy of the Tax Cuts and Jobs Act (TCJA) of 2017, is a massive tax-saving opportunity for small businesses and sole proprietors. If you qualify, this deduction can shave up to 20% off your taxable income, delivering some serious savings. But, as with most things tax-related, the QBI isn’t exactly straightforward. The rules are complex, and not every business qualifies for the full deduction. Here, I’m breaking down what the QBI deduction is, who qualifies, and how you can make the most of it.
1. What Exactly is the QBI Deduction?
The QBI deduction—also known as the Section 199A deduction—allows qualifying small businesses and sole proprietors to knock up to 20% off their qualified business income on their personal tax returns. This isn’t your typical deduction that reduces the business’s taxable income directly. Instead, it’s taken at the individual level, meaning the deduction is “below the line” and directly lowers the taxable income on your personal return.
So, what qualifies as a “pass-through entity” for this deduction? Here’s the list:
- Sole proprietorships
- Partnerships
- S corporations
- Certain trusts and estates
If you’re a part of one of these setups, keep reading. But know that not every dollar of income from these entities counts as “qualified business income” (QBI). Specific limitations come into play—especially if you’re a high-income earner.
2. What Counts as Qualified Business Income (QBI)?
Qualified Business Income is basically the net of your business’s income, gain, deduction, and loss. But certain income types don’t qualify as QBI. Here’s what does—and doesn’t—count:
Included in QBI:
- Net income from U.S.-based business activities, minus expenses (wages, rent, utilities, materials, etc.)
- Income from eligible businesses operating within the U.S.
Excluded from QBI:
- Capital gains or losses
- Dividends or interest income (unless tied to the business’s core activities, like a lending business)
- W-2 wages
- Certain income linked to C or S corporation shareholder activities
One important note: QBI deductions come on top of other business expense deductions. You can deduct your regular expenses first to get your net profit, then apply the QBI deduction.
3. Who Qualifies for the QBI Deduction?
Most small business owners and sole proprietors qualify, but there are a few eligibility rules worth noting:
A. Business Type
- Qualified Trade or Business: You must be running a “pass-through entity” like a sole proprietorship, partnership, S corporation, or LLC.
- Specified Service Trade or Business (SSTB): Certain service-based businesses—think law, healthcare, financial services, consulting, and performing arts—face income limitations. But some fields, like architecture and engineering, are excluded from these restrictions.
B. Income Limits
If your taxable income is below the thresholds for your filing status, you’re likely in the clear for the full deduction:
- $182,100 for single filers
- $364,200 for married couples filing jointly
If your income exceeds these amounts, things get more complicated, particularly if you’re in an SSTB. High-income earners may still qualify for the deduction, but certain limitations kick in, especially around wages and property.
C. Wage and Property Limits
If you’re over the income threshold, the QBI deduction could be limited by:
- 50% of wages paid by your business
- Or 25% of wages plus 2.5% of the original cost of certain depreciable property
4. Making the Most of the QBI Deduction if You’re Under the Income Limit
If your income is under the threshold, you’re in luck. You can take the full 20% QBI deduction without worrying about any of the additional rules or phase-outs. Here’s how to maximize it:
- Keep Detailed Records: Accurately track all your business income and expenses to ensure you’re getting the most out of the deduction.
- Separate Business and Personal Finances: This makes it easier to track eligible income and expenses and helps ensure nothing gets left out when tax season rolls around.
5. Strategies for High-Income Earners (Especially in SSTBs)
If you’re in an SSTB and your income is over the threshold, maximizing the QBI deduction takes a little more planning. Here are a few ideas:
- Reinvest in Qualified Property: Purchasing additional business property can help with the 2.5% property limitation. Think equipment, machinery, or real estate—anything that’ll help you meet the threshold if you’re in a higher bracket.
- Restructure the Business: For those with multiple lines of business, separating your SSTB activities from non-SSTB activities could help. By isolating non-SSTB income, you may be able to avoid phase-out limitations on that income.
- Time Your Income and Expenses: Shifting income or expenses between years to stay under the income limit can be effective. Deferring income to next year or accelerating expenses into this year might help you qualify for a bigger deduction.
6. W-2 Wages and Property Tests for Non-SSTB Businesses
If your business isn’t an SSTB and you’re above the income threshold, your QBI deduction might depend on W-2 wages and property:
- Pay Yourself a Salary: If you’re structured as an S corporation, paying yourself a W-2 wage helps meet the 50% wage limitation.
- Increase Payroll: Hiring more employees or adjusting wages can help you qualify, especially if you’re looking to meet the 50% wage test.
- Invest in Property: For businesses with large capital investments, acquiring additional property that qualifies for the 2.5% property test can help you maximize your QBI deduction.
7. Real-Life QBI Examples
Here’s how the QBI deduction might look in different scenarios:
- Example 1: Low-Income Sole Proprietor: A freelance graphic designer makes $80,000, below the single filer threshold. She can claim a $16,000 deduction, reducing her taxable income to $64,000.
- Example 2: High-Income SSTB: A consultant makes $250,000 as a single filer, above the threshold. They may decide to defer income or invest in qualified property to reduce their taxable income.
- Example 3: Non-SSTB with Wages and Property: A manufacturing business owner (filing jointly) with $500,000 in income hires more employees and increases payroll to $150,000, meeting the wage requirement and securing the full QBI deduction.
8. Stay Organized to Maximize Your Deduction
The QBI deduction can add up to significant tax savings, but you’ll need to keep things well-organized:
- Accurate Record-Keeping: Use software to track income, expenses, and qualified property.
- Consult with a Tax Professional: The QBI rules are complicated, especially for high-income earners and SSTBs. A tax pro can help you navigate and ensure you’re taking advantage of all available deductions.
- Stay Up-to-Date: Tax laws change, and the QBI deduction is no exception. Keep an eye on any updates that could impact your eligibility.
Conclusion
The QBI deduction is one of the most valuable tax-saving tools for small business owners and sole proprietors, potentially reducing your taxable income by up to 20%. With a solid understanding of the requirements, some strategic planning, and good record-keeping, you can make the most of this deduction. And remember—tax planning is all about putting more of your hard-earned money back into your business. So, talk to a tax advisor, make a plan, and keep that cash working for you.
