One of the top-of-mind questions business clients look to accounting professionals for guidance on is, "Which entity type will maximize my tax deductions and minimize tax liability?"
With the Qualified Business Income tax deduction of 20% set to expire in 2025 (unless it's extended), clients who are starting a business may wonder how their choice of entity will impact their QBI deduction and ultimately their bottom line.
While all pass-through entity types are potentially eligible for the QBI deduction, various factors impact whether a client may take the deduction and how much of a QBI deduction they're entitled to include on their federal income tax returns.
Considerations include:
- The pass-through entity's tax election;
- Whether the client's business is in a specified service trade or business; and,
- Whether the business owner's taxable income is below, within or above the IRS phase-in range.
In this article. I'll share some key points worth sharing with clients about the QBI deduction, discuss some of the considerations when calculating QBI, and provide some insights regarding how pass-through entity types compare in terms of their QBI deduction potential.
What clients should understand
Below are some key points about the
- Owners of
corporations (other than S corporations) are not eligible for the deduction because corporations are not pass-through entities. - The deduction is applied to the individual's federal income tax return.
- QBI is calculated using only items included in taxable income connected with a U.S. trade or business. (Capital gains and losses, certain dividends, interest income, W-2 income, amounts received as reasonable compensation from an S corporation, amounts received as guaranteed payments from a partnership, and payments received by a partner for services are not included in QBI.)
- The deduction does not reduce a taxpayer's self-employment obligations.
- Pass-through businesses in a specified service trade or business have a reduced QBI deduction or are disqualified from taking a deduction if their taxable income is within or over the IRS phase-in limits.
- SSTBs include trades or businesses providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, trading or dealing in certain assets. Also, any trade or business where the principal asset is the reputation or skill of one or more of the company's employees or owners is considered an SSTB. There are additional guidelines and rules about SSTBs.
- Taxable income phase-in ranges (income before the QBI deduction and not reduced for net capital gains) for tax year 2023 are:
- Married filing jointly: $364,200 to $464,200;
- Married filing separately: $182,100 to $232,100; and,
- Single and head of household: $182,100 to $232,100.
- Taxable income phase-in ranges (income before the QBI deduction and not reduced for net capital gains) for tax year 2024 are:
- Married filing jointly: $383,900 to $483,900;
- Married filing separately: $191,950 to $241,950; and,
- Single and head of household: $191,950 to $241,950.
Considerations when calculating QBI for clients
The math for computing the QBI deduction can get complicated, especially when the taxpayer's taxable income extends into or beyond the IRS phase-in range.
Here's a high-level summary of what goes into the QBI calculation for taxpayers according to whether their taxable income falls below, within or above the phase-in ranges for clients whose business is an SSTB:
- Taxable income below the phase-in range: The QBI deduction of 20% applies to the lesser of the following: QBI or taxable income before QBI but after reduction for net capital gains on the taxpayer's personal federal income tax return.
- Taxable income in the phase-in range: The QBI deduction is limited by both the phase-in range and wages/qualified property limitations.
- Taxable income above the phase-in range: No QBI deduction is allowed.
For clients whose business is a non-SSTB:
- Taxable income below the phase-in range: The QBI deduction of 20% applies to the lesser of the following: QBI or taxable income before QBI but after reduction for net capital gains on the taxpayer's personal federal income tax return.
- Taxable income in the phase-in range: The QBI deduction is partially limited by the wages/qualified property limitations.
- Taxable income above the phase-in range: QBI deduction is subject to the full wages/qualified property limitations.
Which business entity types get a bigger QBI deduction?
Many variables affect the QBI deduction calculation, including whether an organization is SSTB or non-SSTB, whether the business pays wages or guaranteed payments to its owners, and the taxpayers' taxable income levels. So there's no single definitive answer regarding which entity type will deliver a more substantial QBI deduction.
Generally speaking …
- With taxable income below the phase-in range:
LLCs , partnerships and sole proprietorships tend to yield larger QBI deductions than S corporations. - With taxable income within the phase-in range: LLCs, partnerships and sole proprietorships tend to yield larger QBI deductions than S corporations when taxable income is on the lower end of the phase-in range.
- With taxable income above the phase-in range: S Corporations tend to get larger QBI deductions than LLCs, partnerships and sole proprietorships.
Determining whether an entity will deliver a more beneficial QBI deduction for its owners — and whether that deduction creates a more favorable tax outcome overall — requires careful assessment. A higher QBI deduction may or may not result in the lowest possible tax burden for a business owner. The QBI deduction isn't the only thing to consider! The self-employment taxes that LLC members, sole proprietors and partners pay will negate some of the benefits of the QBI deduction. To some level, that's also true for S corporation shareholders who get W-2 wages because they pay half of their Social Security and Medicare taxes
The QBI calculations for clients within and above the phase-in ranges become complicated, which makes analysis highly variable. Therefore, it's important to advise on the best entity for tax purposes only after evaluating a client's specific situation.
