Most business owners are familiar with the term ‘Qualified Business Income’. QBI is the pass-through profit—excluding owner’s W-2 wages—that an S corporation or business partnership reports on its K-1 federal tax form. In recent years, it has been common for S corp owners to pay themselves lower salaries, so most of their income comes in the form of distributions, which are not subject to payroll taxes.
However, the recent tax law updates made the treatment of QBI permanent and expanded the income ranges for partial QBI deductions. These enhancements and stabilization mean business owners should optimize their compensation for the long-term. In fact, it might be a good time for business owners to increase their salaries—if a calculation of W-2 wages, QBI, payroll taxes, and deduction and income thresholds proves beneficial.
What is the Current QBI Deduction?
A QBI deduction allows individual business owners to take a 20% deduction on Qualified Business Income. However, it’s capped for higher-income taxpayers. Once the Section 199A threshold is reached, the QBI deduction becomes limited to the greater of 50% of wages or 25% of wages plus 2.5% qualified property basis.
The One Big Beautiful Bill Act expanded the income ranges where taxpayers can receive partial QBI deductions—increasing them from $50,000 for single filers and $100,000 for joint to $75,000 for single and $150,000 for joint filers above base thresholds. Additionally, these amounts will be indexed for inflation starting next year.
When Does Increasing W-2 Wages Become Beneficial?
If the 20% QBI deduction is limited or has been phased out by the wage-based formula in Section 199A, it can be advantageous to increase the W-2 wages of business owners. Although higher wages normally reduce QBI, there are instances where increasing W-2 wages unlocks more of the deduction than is lost by the lower QBI. This can reduce your total tax burden despite paying more in payroll tax.
In the past, S corporations that had high profits aimed to keep their payroll low to maximize the QBI deduction under wage limits while still paying themselves enough to satisfy the IRS’s reasonable compensation requirements. They didn’t want wages to be so high as to erode the QBI base, but higher salaries used in the limitation formula can expand the maximum allowable QBI deduction.
As a business owner, there is a fine line between paying yourself too much and too little to optimize your tax liabilities. It’s critical to run scenarios that calculate your total tax owed in light of the current environment before making income decisions for the coming year.
Sources:
https://fraimcpa.com/s-corp-qbi-deduction-strategy/
https://wiss.com/the-qbi-deduction-is-here-to-stay/
https://www.nkcpa.com/corporate-business-owners-is-your-salary-reasonable-in-the-eyes-of-the-irs