The Impact of QBI on Your Business Withdrawal Strategy
We get a lot of questions about the best ways to take money out of a business and how this money is taxed. Essentially, for S-Corporation owners, there are two main ways to do this: Owner’s Draw or W2 Wages. However, there is a deeper, and possibly more important question that is worth addressing: the Qualified Business Income (QBI) Deduction. Let’s start by talking about the two main ways to take out money from an S-Corp and then dig deeper into the QBI Deduction.
Taking Money Out of a Business via Owners Draw
Owner’s draw is where a business owner or sole proprietor takes money out of a company for personal use. An S corporation is a pass-through entity, which means that the corporation itself is not taxed, unlike a C-Corporation. At the end of the year, the business owner is taxed based on the amount of profit, not the amount of money you take out. The money taken out (owner’s draw) does not count as a deductible expense.
Taking Money Out of a Business via W2 Wages
The other way to take money out of your business is to take a W2 wage. Contrasting W2 wages to Owner’s draw, W2 Wages do count as an expense, and by doing so you also increase the amount of employee taxes that you pay.
QBI & Tax Planning
If your only goal is to take money out of your business, either option will work, but one can be better than the other for income tax savings based on a few options.
What is the Qualified Business Income (QBI) Deduction?
Owner/Operators of an S-Corp are required to pay a commensurate wage to themselves. “Commensurate” can be roughly defined as the fair market value of what you would have to pay someone else to do the job you will be doing yourself. While this can be a fairly flexible threshold, we want to be sure we are close to fair market value AND maximize the Qualified Business Income Deduction (QBI). Many people have heard of this deduction but do not actively plan around it to maximize their income tax savings. This is normally a great year-end tax planning activity that a competent tax advisor can help you with. The qualified business income deduction by definition applies to “qualified business income,” or QBI. Qualified business income is defined as “the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business.” Broadly speaking, that means your business’s net profit.
QBI excludes:
- Capital gains or losses.
- Interest income.
- Income earned outside the U.S.
- Certain wage and guaranteed payments made to partners and shareholders.
The QBI deduction is dependent upon your S-Corporation profit. The higher the profit, the higher the deduction. It can be up to 20% of your net profit. If you have $1MM in profit, you will receive about $200k in QBI deduction. This is potentially huge for an S-Corp owner.
Who qualifies for the QBI Deduction?
Entities eligible for the qualified business income deduction include:
- Sole proprietorship
- S corporations.
- Limited liability companies (LLCs).
However, there is a major limitation: the business owners adjusted gross income. For single filers, you would begin phasing out of the QBI deduction at $164k and the deduction ceases to exist at $214k. For married filers, this phase out range occurs from $329-429k (these phase out limitations are based on the tax season 2021 data). If your income is above this limit, you may only qualify to receive the QBI deduction up to the amount of wages the corporation pays, or up to the unadjusted basis of assets (UBIA) the business has acquired. In other words, if you don’t plan correctly, you may lose access to the QBI deduction entirely. This means, you may deliberately increase your wages to a point so that you can come to a number where you are maximizing the amount of QBI deduction and paying the least amount in employee payroll taxes. This may sound crazy now that you understand that W2 Wages essentially increase the amount of taxes paid due to the increased cost of payroll taxes you would need to pay on these wages, but that is why this calculation is so important to do every year for tax planning. It can be worth paying more in payroll taxes to save even more money in income taxes and effectively reduce your overall tax bill.
There is a threshold in which you cap out paying into social security. For most people, the payroll taxes come to 15%. If you are making over roughly $142,800, the payroll taxes decrease by over 12% because you no longer need to pay into social security. This allows us to pay more in W2 wages in order to unlock more of this QBI deduction and not pay as much in payroll taxes.
In Conclusion
The W2 wages are essentially a lever you want to pull in order to maximize tax savings. Any additional money can be pulled out of the business via owner’s draw (which does not impact profit), but it is still taxable to the owner. Either way the money is taxed, so let’s be sure that the tax savings is maximized. With all these moving parts, you will want to be sure to consult with your tax advisor as everyone will fall into a different tax bracket and there are other factors such as the trade or business you are in. Call us at 281-440-6279 if you would like to learn more about this deduction and discuss your situation with one of our education-focused tax advisors.
Additional Information…How to Withdraw Money from a C Corporation
We’ve covered fairly in depth how to take money out of an S Corporation, but a C Corporation functions differently. C Corporations pay taxes and are not a passthrough entity like S Corporations. This tax rate used to be 35%. Now, it is 21% due to the passing of the Tax Cuts and Jobs Act on December 15, 2017. There was potential legislation in 2021 that proposed increasing this tax rate, but it did not pass.
Money from a C Corporation can be taken out as a Dividend or as W2 Wages. With dividends, no extra taxes are be paid by the C Corporation, but the Corporation doesn’t get to deduct this as an expense so this may mean a higher profit to be taxed on at the end of the year for the Corporation. The business owner also needs to pay taxes on this amount.
The business owner also can take money out as W2 wages. This can sometimes be the best route, especially if you have already capped out on the $142,800 social security earnings cap. The Corporation gets to count these wages as an expense which reduces taxable Corporation profit and the owner also pays taxes on these wages at his or her individual tax rate, but payroll wages are normally lower than the tax rate on profit for Corporations.
Kevin Molen, EA
Tax Advisory Manager
