If your manufacturing company is organized as an S corporation, limited liability company, partnership or sole proprietorship, be sure that you are taking full advantage of the qualified business income (QBI) deduction, also known as the Section 199A deduction. It is important to understand how the deduction works to determine your eligibility and identify opportunities to maximize the potential benefits.

Understanding the deduction

The QBI deduction allows owners of these entities to deduct up to 20% of their allocable share of the company’s QBI. Generally, QBI is the net income from a qualified trade or business — excluding certain investment income, such as capital gains, dividends and nonbusiness interest income. Also excluded are wages received by an S corporation shareholder and guaranteed payments received by a partner.

The deduction was created by the Tax Cuts and Jobs Act of 2017. It is available only through 2025, unless Congress extends it.

Knowing your limits

The QBI deduction is subject to three limitations:

1. Overall Limitation. The maximum deduction for any business owner is equal to the lesser of:

• 20% of an owner’s QBI, plus 20% of any income from real estate investment trusts or publicly traded partnerships; or
• 20% of an owner’s taxable income, less any net capital gains.

This limitation applies to all business owners.

2. Wage and Qualified Property Limitation. For business owners subject to this limitation, the maximum deduction is equal to the greater of:

• 50% of the owner’s allocable share of the company’s W-2 wages; or
• 25% of an owner’s allocable share of W-2 wages, plus 2.5% of the owner’s allocable share of the original cost basis of qualified depreciable property.

The second test (25% of wages, plus 2.5% of qualified property costs) may typically be advantageous for manufacturers and other capital-intensive businesses with relatively low W-2 wages.

3. Specified Service Trade or Business (SSTB) Limitation. The QBI deduction is phased out altogether for certain service businesses, including consulting, professional services and financial services.

Note: The wage and qualified property and SSTB limitations apply only if a business owner’s taxable income exceeds $191,950 ($383,900 for joint filers) and take full effect when taxable income reaches $241,950 ($483,900 for joint filers).

Manufacturing and the SSTB limitation

Manufacturing is not an SSTB. However, the SSTB limitation may come into play if a manufacturer provides consulting services related to its products. Fortunately, the QBI deduction regulations allow manufacturers to provide some consulting services without triggering the SSTB limitation.

First, “consulting,” for purposes of the limitation, does not include services “embedded in, or ancillary to, the sale of goods or performance of services on behalf of a trade or business that is otherwise not an SSTB … if there is no separate payment for the consulting services.” Second, even if consulting services are paid for separately, they will not trigger the SSTB limitation if they account for less than 10% of a manufacturer’s gross receipts (5% if gross receipts exceed $25 million).

Planning for success

Owners of manufacturing businesses should investigate potential planning strategies for maximizing the QBI deduction. For example, if your deduction is reduced by one of the W-2 wage limits, you might consider increasing wages by shifting work from contractors to employees.

If your company provides substantial consulting services to customers, consider bundling those services with your products to avoid SSTB treatment. In addition, explore the possibility of avoiding deduction limitations by reducing your taxable income below the applicable threshold. You may be able to do this by increasing retirement plan contributions. It may also be possible to aggregate related businesses to increase your maximum deduction.

Cutting through the confusion

While the QBI deduction has been around for a while, it can be confusing. Your tax advisors can help you evaluate these and other strategies for making the most of the QBI deduction.

For more information, contact Brandon Vahl at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Manufacturing and Distribution Group. Sign up here to receive our blogs, newsletters and Client Alerts.