The new qualified business income (QBI) deduction created by the 2017 Tax Cuts and Jobs Act could be a serious game-changer for many small (or big) businesses.
The deduction is available to any business (including sole proprietors) except C corporations. The long story short is that, if you’re married filing jointly and make LESS THAN $315,000 in combined taxable income (salary plus any pass-through income), then you get to take a deduction for 20% of your pass-through income only, no questions asked.
Several potential planning strategies arise when trying to figure out how to maximize your QBI deduction. Notable among these strategies, and perhaps most applicable to our average client, your boss should fire you as a W-2 employee and re-hire you as a sole proprietor.
Why, you ask?
Well, as a sole proprietor, you would be able to take a QBI deduction.
Take for example, Bob. Bob is an electrician who works for Electricians United as a W-2 employee making $75,000/year. Bob’s boss agrees to fire him as an employee and rehire him as a sole proprietor for the exact same job at $80,000/year (increased pay reflects change in who’s paying the employment taxes for a relative break-even).
First benefit, Bob can now deduct more as business expenses. Obviously he’ll have business expenses he didn’t previously have, as his employer was providing all of those things, but he can also deduct other unreimbursed employee expenses that aren’t deductible as miscellaneous expenses for someone who itemizes.
Second benefit, whatever’s left after deducting expenses is subject to the QBI deduction. If Bob was able to justify $30,000 in business expenses, reducing his pay from $80,000 to $50,000, then he would receive a $7,500 QBI deduction (I'm aware 20% of $50,000 is $10,000, not $7,500, but the equation is slightly more complicated than that).
In this example, Bob would save nearly $6,000 in taxes between deductible business expenses and the QBI deduction.
Idea for this example taken from an article by Jeffrey Levine posted by Michael Kitces, found here (https://www.kitces.com/blog/small-business-owner-section-199a-qualified-business-income-qbi-deduction-strategies/).
- There are a lot of details and caveats to the new rules, so you should consult a professional on your specific situation BEFORE making a decision of this nature.
- This example does not consider employer provided benefits like health insurance and retirement that would now be the employee’s responsibility should his split off as a sole proprietor.