Optimizing the Qualified Business Income (QBI) Deduction as an S-Corporation Owner

As an S-Corporation business owner, you have unique opportunities to reduce your taxable income. One such opportunity is the Qualified Business Income (QBI) Deduction, a tax advantage introduced by the Tax Cuts and Jobs Act of 2017. If your taxable income falls under certain thresholds, you may be eligible for this potentially significant deduction.

Understanding the QBI Deduction
The QBI deduction allows eligible business owners to deduct up to 20% of their qualified business income from their taxes. However, the QBI deduction is subject to various limitations, particularly for higher earners.

For S-corporations, two key limitations come into play:
1. The QBI deduction cannot exceed 20% of taxable income minus net capital gains.
2. Once the taxable income surpasses a certain threshold ($329,800 for married filing jointly or $164,900 for single filers in 2023), the QBI deduction is limited to the lesser of 20% of QBI or the greater of 50% of W-2 wages or 25% of W-2 wages plus 2.5% of the unadjusted basis of all qualified property.

The second limitation brings a key element into play for S-Corp owners: the allocation of income between W-2 wages and business profits.

Balancing W-2 Wages and Business Profits
As an S-Corp owner, you have the flexibility to allocate your income between W-2 wages (which are subject to payroll taxes) and business profits (which aren’t subject to payroll taxes but are considered for QBI).

Here’s a simplified example to illustrate: Let's say you have an S-Corporation that generates $2M in profits. If you pay yourself a reasonable W-2 wage (let’s say $572,000, which is about 28.6% of the total profit), you'll have $1,428,000 remaining in business profits (K-1 income).

The QBI deduction is calculated as the lesser of:

- 20% of QBI ($285,600, which is 20% of $1,428,000), or
- 50% of W-2 wages ($286,000, which is 50% of $572,000)

So in this case, you'll get a QBI deduction of $285,600.

Finding the Sweet Spot
Now, you might be wondering, wouldn’t you be better off increasing your W-2 wages even more? This way, the 50% of W-2 wages limitation would also increase, leading to a higher QBI deduction. But there's a catch.

When you increase your salary, you're subject to additional payroll taxes, including the employer and employee portions of Social Security and Medicare taxes. The 28.6% figure in this example is roughly where you maximize your QBI deduction before the increasing payroll taxes outweigh the benefits of a higher QBI deduction. This is why it's called the "sweet spot."

It's important to note that the "28.6%" is a rough guideline and the exact optimal balance can vary depending on various factors such as total income, the nature of the business, wages paid to other employees, and more. It's advisable to consult with a tax advisor who can provide personalized advice based on your specific circumstances.

The QBI deduction provides a meaningful opportunity to lower your taxable income. By carefully balancing your W-2 wages and business profits, you can optimize this deduction and potentially save thousands of dollars on your taxes. However, as with any tax strategy, it's crucial to seek the advice of a tax professional to ensure compliance with tax laws and regulations and to optimize savings based on your specific situation.

Ascent Wealth Strategies provides strategies for financial/estate and/or tax planning. These strategies do not constitute tax or legal advise. Consult legal or tax professionals for specific information regarding your individual situation.

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