The Qualified Business Income (QBI) deduction is a valuable tool for owners of flow-through entities to reduce their income tax burden. However, there are many rules and considerations to take into account when trying to maximize this deduction. For example, whether your business is a Specified Service Trade or Business (SSTB), pays employee wages, has qualified property, or generates taxable income over certain thresholds can have a big impact on your ability to take the QBI deduction. Here is how non-SSTB owners with small employee workforces can determine the minimum amount of wages to be paid in order to maximize the QBI deduction.

The 2/7 Rule It’s important to note that once your taxable income exceeds $340,100 (married couples filing jointly) or $170,050 (single filers) in 2022, a wage limitation is phased in. Once this threshold is reached, the calculation for the QBI deduction is limited to the lesser of 20% of income or 50% of wages. Therefore, the amount of wages you pay yourself or your employees can become a significant factor in the QBI deduction you are able to take. The 2/7 rule can help you determine how to adjust your wages in order to maximize your QBI deduction.

Note that there is also a calculation that takes into account company assets, but this is beyond the scope of this article and will not be considered in the following examples.

Example 1

 XYZ, Inc. is an S-Corp with a net taxable income of $1,000,000 before wages paid for the 2021 tax year. XYZ is not an SSTB and has one owner and one employee, Jane Doe. Jane takes a modest salary from her company of only $50,000. The QBI Deduction before taking into consideration the wage limitation would be $200,000 (net income of $950,000 x 20%). However, because the company generates income that will put Jane over the taxable income thresholds, her QBI deduction is now limited to $25,000 (50% of $50,000).

So what should Jane have paid herself to maximize the QBI deduction? That’s where the 2/7 rule comes into play. Wages paid should equal 2/7 of business income. Therefore, Jane should pay herself a wage of $285,714 ($1,000,000*2/7). This means her net income would be $714,286 – 20% of the net income is $142,857, which would be the same as 50% of the $285,714 of wages. The 2/7 rule generated an additional QBI deduction of $142,857. This would equate to tax savings of $52,857 ($142,857 x the 37% tax bracket).

Example 2

What if you are a small business owner who has more employees than just yourself? In that case, you would need to take into consideration the wages of your employees along with your own.

Let’s use the same facts as Example 1, except this time XYZ, Inc. has employee wages of $200,000 outside of Jane Doe’s wages. Business income would be $800,000 before Jane’s wage to herself. Using the 2/7 rule, Jane would only need to pay herself $85,714 ($285,714-$200,000) to maximize her QBI deduction.

Additional Considerations:

While you may be concerned about the potential increase in payroll taxes that could come with higher wages, it’s important to consider that the 20% QBI tax benefit typically outweighs the 15.3% combined payroll tax. Additionally, the difference between the two increases once the social security wage base ($147,000 for 2022) is reached. At that point, you would only be responsible for paying Medicare tax at a rate of 2.9% to 3.8%, resulting in a spread of nearly 17%.

It’s also worth noting that S corporations have a requirement to pay “reasonable compensation” to owner employees. This means that the amount of salary paid should be based on what a reasonable salary would be for an employee performing similar work, rather than being based on QBI considerations. Therefore, if XYZ, Inc. already pays its non-owner employees more than the amount required to meet the QBI wage threshold, this does not mean that Jane does not have to take a salary. It’s important to remember the requirements of an S-corp in this situation.

As the fourth quarter of the year comes to a close, it is essential to speak with your tax advisors about your expected income and wages in order to ensure that you are taking advantage of the maximum possible QBI deduction. If you would like to discuss the QBI deduction and fourth quarter planning in more detail, please don’t hesitate to contact Moshe Mindick, CPA for assistance.