So, you happen to be lucky enough, unlike us lowly accountants, to own a business that is a qualified business under Section 199A (stated differently, you are not a Specified Service Trade or Business). Lucky you. Unlike us, your total taxable income will not preclude you from taking advantage of the 20% Qualified Business Income Deduction (QBID), as discussed here. As a reminder, an SSTB is typically a business that generates income from the services of professionals in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners.
This, as you might imagine, does not mean that you’re just automatically going to receive the full 20% QBID. In fact, those same pesky income thresholds that SSTBs have to make sure to stay below come into play once again. For a Qualified Business, however, being above the thresholds does not mean that they will be phased out of the deduction IF they have enough W-2 wages and/or fixed assets to allow for the deduction. Specifically:
Method 1: You can deduct up to 50% of the W-2 wages that your percentage of the business represents
Method 2: You can deduct 25% of the W-2 wages that your percentage ownership of the business represents PLUS 2.5% of the unadjusted basis of fixed assets.
Of course, in both of the above options, the deduction cannot exceed 20% of the net taxable income of the entity.
We’re huge fans of examples to clarify complex verbiage, so let’s try one out here. Assume you have a Qualified S Corporation that has net taxable income of $200K and you own 50% of the company, so you get a K-1 for $100K. Let’s also assume the entity paid total W-2 wages of $100K. You would be allocated $50K of those wages for purposes of the QBID calculation since you’re a 50% owner. Next, let’s presume the business had $2,000,000 of fixed assets (prior to factoring in any depreciation). Your allocation of those assets is thus $1,000,000 ($2,000,000 x 50%). Last, let’s presume that your taxable income on your personal income tax return is $500K before factoring in the QBID.
Method 1: 50% of $50K W-2 wages = $25,000
25% of $50K W-2 wages = $12,500
+ 2.5% of $1M in fixed assets = $25,000
In this case, you would choose Method 2 since it results in a deduction that is $12,500 greater than the result of Method 1. Recall, however, that the 20% deduction would have only entitled you to a $20K deduction on your $100K that was reported on your K-1. So, instead of taking a $37.5K deduction, you are limited to $20K.
So, as you might have guessed, because of the above mechanics it can behoove you to increase W-2 wages and/or increase your fixed asset purchases. Also, reducing your capitalization threshold could help this endeavor as it will result in higher fixed assets, but more of a burden to track the assets through disposition. Many taxpayers like to use the De minimis Safe Harbor election so that they can expense more of their fixed asset purchases without the administrative burden of adding them to their depreciation schedules and fixed asset ledgers, but depending on the situation, there could be a case for not making that election.
On the W-2 front, you may actually be in a better spot by paying yourself (or your employees) more W-2 wages to unlock more of the QBID. Of course, it should be noted that Reasonable Compensation rules also encompass paying yourself too much for the services you provide to the Corporation. That being said, it is our observation that most S Corporations could stand to pay their owner-employees more than they currently do. In this scenario, you'll pay more in payroll taxes, but the corresponding QBID could be a greater savings than the additional payroll taxes.
Some combination of the above as well as some of the items mentioned on the previous blog entry (Maximizing the 20% Pass-Through Deduction) can go a long way in utilizing the Qualified Business Income Deduction. Since there are so many moving parts here that involve both your business and personal tax situation, it would be wise to contact one of our Stallion CPAs at Dark Horse here: https://darkhorsecpa.com/contact
About Dark Horse CPAs
Dark Horse CPAs provides integrated tax, accounting, and CFO services to small businesses and individuals across the U.S. The firm was founded to save small businesses (and their owners) from subpar accounting and tax services and subpar client experiences. These small businesses are Dark Horses among their larger and more well-known competition. Being a Dark Horse CPA means advocating for small businesses by bringing them the tax strategies and accounting insights previously reserved for big business. Get a quote today.