With the Tax Cuts and Jobs Act (TCJA aka Trump tax reform), one of the new additions to the tax code is Section 199A.

You can read the code here: https://www.law.cornell.edu/uscode/text/26/199A

What it created is the Qualified Business Income (QBI) deduction.

You might have heard of it as the 20% pass through tax break.

What I am going to do in this article is walk you through the math of how to maximize this deduction, where maximization is required.

The good news is that if your pass through income is less than the threshold of 157,500 for single filers or 315,000 for join filers, then you just get a simple deduction of 20% of your pass through income.

If you are over the threshold fillings, then you may want to optimize because your deduction goes like this:

Lesser of ( 20% of pass through income OR greater of ( 50% of wages paid by entity OR 25% of wages paid by entity AND 2.5% of qualified property ) )

Got that? This is defined in S.199A(b)(2)

Because we have a lesser of element to the deduction, the deduction will be maximized when those two components are equal.

In other words 20% pass through income = 50% wages.

I'm going to ignore the qualified property part of the formula in this walk through because a) it doesn't apply to most businesses and b) it's a bit late in the year to be buying up property anyways.

I am also going to assume that you already have wages meeting or exceeding the social security maximum of $128,400.

I am going to further assume you are not in the specified services category where your deduction is eliminated.

So let's go back to our maximizing formula:

20% pass through = 50% wages

But your pass through income includes wages.

So it becomes 20% ( net income ex wages - wages ) = 50% wages

Or

20% net income ex wages - 20% wages = 50% wages

Or

20% net income ex wages = 70% wages

Or

net income ex wages = 3.5 wages

So if you operating income before wages is 3.5 times the amount of wages, then you are at the maximum QBI deduction.

Clear as mud? Good. Let's look at an example.

Example

Let's say your business has top line revenue of 2,000,000 and total expenses, not counting wages, is 700,000.

Before Optimization

Currently total wages paid by the business is 150,000, mostly to you. So that gives an operating income of 550,000.

20% of 550,000 is 110,000.
50% of 150,000 is 75,000.

So your QBI deduction is 75,000.

After Optimization

You can see that there is a big mismatch here. So if we optimize and make our wages 1/3.5 of the 700,000, then we get wages of 200,000.

So now our operating income is 500,000.

20% of 500,000 is 100,000.
50% of 200,000 is 100,000.

QBI deduction is 100,000.

So our deduction has increased by 25,000.

But if we assume that the wage increase went to the owner then there is 50,000 more on the wages line, which is offset by 50,000 less on the pass through line.

This is why I mentioned the social security max.

If your wage is already over the social security max, then the additional payroll tax on the extra 50,000 is only medicare and additional medicare (Obamacare) taxes of 3.8%.

So you are paying 3.8% on 50,000 in exchange for 25,000 of deduction on your top marginal rate, which is probably 33%-37% (plus whatever state rate).

So your payroll taxes go up by $1,900 and your income taxes go down by $8,750 (assuming 35% rate). Net tax benefit is $6,850 and you help delay the collapse of Medicare by a few minutes.

What to Do Next

If this is an issue for you, don't just go off some pro-forma you found on the internet. Talk to your tax adviser and figure out what is best for your individual situation.