As a business owner the Qualified Business Income Deduction (QBID) is a powerful tool for reducing taxable income. But many entrepreneurs fail to fully optimize this deduction, leaving huge potential tax savings on the table. A key strategy to maximize your QBID is the 2/7 Rule, a simple method that can make a significant difference in your tax liability.
Let’s dive into what QBID is and how the 2/7 Rule can help you get the most out of it.
What is the Qualified Business Income Deduction (QBID)?
The QBID is a tax break introduced in the Tax Cuts and Jobs Act of 2017. It allows eligible business owners to deduct up to 20% of their qualified business income (QBI) on their tax return. QBI generally includes income earned from an LLC, S-Corp, partnership, or sole proprietorship.
There are two main distinctions to remember when dealing with QBID. Your business is either categorized as a Specified Service Trade or Business(SSTB)Qualified Business Income Deduction for Specified Services or a non SSTB. This post is specifically for those who are non SSTB. For many solo or small business owners, you are classified as non SSTB, but it is industry specific.
Here are the income limitations:
Income thresholds: For 2024, if your taxable income exceeds $383,901 (married filing jointly) or $191,951 (single filers), the deduction begins to phase out.
Wages paid: The deduction is limited to the lesser of 20% of qualified business income or 50% of W-2 wages paid by the business.
This is where the 2/7 Rule comes into play, helping you optimize how much of the deduction you can claim.
How the 2/7 Rule Works
The 2/7 Rule is a simple ratio that helps business owners strike the right balance between salary (W-2 wages) and distributions. Essentially, you want to ensure your W-2 wages equal 2/7 of your total business income to maximize your QBID.
Here’s why this ratio works:
Wages and QBID: The QBID is limited to either 20% of your business income or 50% of the W-2 wages paid by your business, whichever is lower. The 2/7 Rule ensures your W-2 wages are high enough to avoid leaving any potential deduction on the table.
Distributions: By keeping wages at 2/7 of business income, you still leave room for distributions, which are taxed at lower rates than wages, but not so low that it diminishes your QBID.
Example: Maximizing QBID with the 2/7 Rule
Let’s say you’re a business owner filing taxes single with $500,000 in total income from your S-Corp in 2024.
Scenario 1: Without the 2/7 Rule
You take a salary of $50,000 and leave the rest as distributions.
Under the QBID, you can deduct 20% of your net income($450,000*20%=$90000), but because of the income phaseout, you’re limited to 50% of W-2 wages. That means your deduction would be $25,000 (50% of $50,000).
You miss out on a larger deduction because your salary was too low.
Scenario 2: Applying the 2/7 Rule
You adjust your salary to $142,857, which is 2/7 of your total income.
Now, 50% of your wages is $71,428, which equals 20% of your adjusted business income.
By increasing your W-2 wages, you maximize your QBID and save over $25,000 in federal taxes.
This strategic adjustment ensures that you’re taking advantage of the full deduction without paying more in wages than necessary.
The Benefits of the 2/7 Rule
Maximize Tax Savings: The 2/7 Rule helps you maximize your QBID by balancing wages and distributions to hit the optimal ratio.
Increased Flexibility: By maintaining a healthy balance between W-2 wages and business profits, you retain flexibility in how you structure income.
Better Retirement Contributions: With a higher salary, you can also increase contributions to retirement accounts like a Solo 401(k) or SEP IRA, further reducing taxable income.
Key Considerations
While the 2/7 Rule can be a game changer, it’s not a one-size-fits-all solution. Here are a few things to consider before applying it:
Stay within reasonable salary limits: The IRS requires that salaries be "reasonable" for the work performed. Setting your salary too low could invite an audit.
Income fluctuations: If your income changes dramatically year-over-year, you may need to adjust the ratio to align with your new earnings.
Work with a tax professional: The QBID, wage structuring, and S-Corp salary requirements can be complex. Consulting with a tax advisor ensures you’re complying with the law while optimizing deductions.
Take Advantage of the QBID with Strategic Planning
The QBID is a valuable deduction that many business owners in CRE and other industries fail to fully utilize. By applying the 2/7 Rule, you can strike the perfect balance between salary and distributions, saving thousands in taxes each year.
In an industry where income fluctuates and tax efficiency is crucial, small adjustments like these can make a big impact on your overall financial plan. Be proactive and ensure your tax strategy works as hard as you do.
Need help optimizing your QBID and other tax strategies? Contact WealthBound for personalized advice on how to maximize your business income and minimize your tax burden.
Disclaimer: None of this should be seen as advice. This is all for informational purposes. Consult your legal, tax, and financial team before making any changes to your financial plan.