As discussed in the last blog post, QBI is a 20% deduction for pass-through entities. For a basic refresher and how to use this deduction, here is what to know about QBI. The qualified business income deduction may be phased out entirely for higher-earning business owners. The phase-out creates tax planning snags for businesses owners needing to maximize deductions. In short, there is no QBI deduction for those businesses that fall under a specified service trade or business (SSTB) when taxable income is above the top income threshold of $440,100 (Married Filing Joint) and $220,050 (Single).
You might be in luck with a non-SSTB above the QBI threshold, as there are still ways to capitalize on a QBI deduction via wages paid. In addition, if your business doesn’t pay wages, this blog post may present opportunities to consider.
Whether you currently pay yourself a wage, have W2 employees, or considering switching to an S Corp, you might be able to increase your QBI deduction by determining an optimal salary.
Enter the 2/7 rule.
As mentioned above, once taxable income exceeds the highest threshold for the QBI deduction, non- SSTB businesses or self-employed professionals may get to use the lesser of 20% of income or 50% of wages. Wages paid suddenly become a significant factor in the equation.
Most business owners elect S Corp taxation to keep their salary as low as possible (within reason) to avoid self-employment taxes. While this is a valid strategy, the 2/7 rule can determine the appropriate balance for your salary to capture a larger deduction.
Before we get started with an example, why do we use 2/7? Because 28.57% (2 divided by 7) is the sweet spot for the percent of W2 wages versus business income. So, to simplify into a round number, we use 2/7.
Let’s look at a real-life example.
Adam is the sole owner and only employee of a non-SSTB business (S corp). His business income is $800,000, and he takes a reasonable salary of $$90,000/year. Unfortunately, the total income puts him above the highest QBI threshold, so Adam cannot deduct 20% of his business income. So instead, he uses 50% of wages paid for the QBI deduction, which is limited to $45,000 (50% of $90,000).
To maximize QBI, Adam applies the 2/7 rule to determine an optimal salary. In this case, Adam’s salary should be 2/7 of the total business income or $228,571 (2/7 X $800,000). Resulting in a QBI deduction of $114,285 (50% of $228,571).
Consider the spreadsheet below, which calculates Adam’s current versus the 2/7 rule salary.
What happened here? By increasing the salary, the net business income was reduced to $571,429. When we take 20% of this net business income, we get $114,285 (he doesn’t qualify this way), which is the same as 50% of the $228,571 salary using the 2/7 rule (he does qualify this way!). We have magically found the wages sweet spot for QBI!
If you have W2 employees other than yourself, their wages are included in the total for the 2/7 rule.
Expanding on the example above, consider that Adam pays W2 wages to employees of $100,000 and $90,000 to himself. In this case, the total wages are $190,000. Applying the 2/7 rule again, we again determine the optimal wages are $228,571 (same as the previous example). $190,000 is paid as wages, which means Adam only needs to adjust his salary to $128,571 (or give employees raises) to maximize the QBI deduction ($228,571 – $100,000 (employees) = $128,571).
Specific Service Trade or Business. If your business is considered an SSTB with taxable income above the QBI phase-out range, you don’t get a QBI deduction, so the 2/7 rule won’t apply.
Self Employment Taxes. For most business owners, increasing their W2 salary may incur additional self-employment taxes or (payroll tax). This tax consists of social security and medicare tax. Keep in mind, in 2022, you only pay social security tax on the first $147,000, so any salary above this is not subject to social security tax. Medicare tax increases 0.9% on earnings over $200,000 (Single) and $250,000 (Married Filing Joint). Generally, the 20% QBI deduction compensates for the additional 15.3% self-employment/payroll tax.
Don’t make decisions based solely on taxes. Of course, taxes are essential but consider your entire financial picture before implementing a strategy with taxes being the primary driver. In other words, don’t increase wages only for additional QBI deduction without understanding the impact of the rest of your financial plan.
Reasonable Salary. An S Corp election requires a reasonable salary. Don’t over-optimize QBI and leave yourself with a salary that’s not reasonable in the eyes of the IRS. This is especially important if you have other W2 employees to calculate total wages.
QBI is a powerful but complicated deduction, especially when income is above the phase-out range for non-specified service trades and businesses. The 2/7 rule illustrates the importance of having a proactive tax plan for your business and personal financial plan. It’s also important to note that this isn’t a “rule” but rather a formula for analysis. Before taking action, it’s worth the investment to seek a professional who can guide you through an analysis. If you want to take the first step in optimizing your tax and financial planning, start here.