QBI deduction for S Corps and how to maximize it

First, let's break down the QBI deduction for S Corps and explain how it works. After that we will jump into the tax saving strategies.

The Section 199A deduction flows through to your individual tax return, but it depends on your taxable income from your S Corporation and other income sources. Here’s a simplified explanation of the Qualified Business Income (QBI) deduction formula for S Corps:

The deduction is the lesser of two calculations:

1. 20% x (Qualified Business Income - Shareholder W-2 Wages)

or

2. The greater of:

   • 50% of S Corp wages, or

   • 25% of wages + 2.5% of qualified property

     
     

Let’s go through an example to make this clearer. Suppose you earn $100K, pay yourself $10K in wages, and have no assets in your S Corp. Here’s how the calculations would look:

1. 20% x ($100K - $10K) = $18K

   or

2. 50% x $10K = $5K

   
   

The rule is to take the lesser amount, so in this case, your QBI deduction would be $5K (the smaller of $18K and $5K).

This example shows how your QBI deduction can shrink if you pay yourself a small wage. Without wages, there’s no deduction because the formula results in zero wages, and consequently, zero deduction. While paying smaller wages saves you on self-employment taxes, it can also expose you to an audit on reasonable compensation and cost you the tax benefit from the QBI deduction.

While there are nuances to consider, the general guideline for the ideal salary-to-net income ratio is around 27-28%. However, you can’t just pay yourself this amount to maximize tax benefits. Your salary must comply with reasonable compensation rules, which we explain here.

How can we maximize the QBI deduction for S Corps? Here are a couple of strategies:

• Employ family members like your children or spouse to increase your S Corp wages.

  
  

• Invest in property, as referenced in the second formula above.

  
  

• Aggregate QBI activities: If you own multiple companies, and only one pays W-2 wages, you could aggregate them to maximize your QBI deduction by using the wages from one company to benefit others. Without aggregation, companies without W-2 wages won’t qualify for any QBI deductions.

  
  

If your business is a Specified Service Trade or Business (SSTB) and you exceed certain income thresholds, your QBI deduction will phase out. The definition of an SSTB is complex, but the key takeaway is that if your S Corp qualifies as an SSTB and you earn too much, the QBI deduction will be reduced or eliminated.

For SSTB businesses operating as S Corps, consider these tax planning options:

• Separate income streams: For high-profit SSTBs approaching the threshold, try splitting your business income into SSTB and non-SSTB categories. For example, a doctor's practice is an SSTB, but selling medical devices is not. This can help you retain a portion of the QBI deduction.

  
  

• Defined benefit plans: Setting up a retirement plan like a solo 401(k) can help reduce taxable income and keep you under the SSTB phase-out thresholds.

  
  

• Income deferral: Deferring income—such as delaying contracts or sales—can help you stay below the SSTB income limits and avoid the deduction phase-out.

And now, a little bit of self-promotion: If you ever need help with your S Corp taxes, please reach out. We've helped numerous S Corp owners with their pesky taxes. You can read more about our services here.