Qualified Business Income Deduction (QBI):
A Change in the Strategic Use of Charitable Donations

October 2, 2020

Recently the IRS issued draft instructions for forms 8995 and 8995-A.  The original 2017 Tax Cuts and Jobs Act had significant tax benefits for entrepreneurs, self-employed individuals, and investors who are owners of flow thru entities used to calculate Qualified Business Income (QBI) for the 20% deduction. The new instructions indicating that QBI should be reduced for charitable deductions was not part of the 2017 Act covering QBI and has a negative effect on the taxpayer.  

For example, assume an owner of a flow thru entity has QBI of $500,000. The owner of this entity is able to deduct 20% of the QBI, in this case $100,000 ($500,000 x 20%) on the tax return. Depending upon the tax bracket you are in, will determine the tax savings. Let's assume a 42% Federal and State tax bracket - the QBI deduction has saved $42,000 in federal and state taxes ($100,000 x 42%). Note that some states such as Connecticut, New Jersey and New York do not allow the QBI deduction.

In the event you are considering making any charitable contributions at the entity level, we suggest you distribute the cash to the owners so they personally make the contributions so that the QBI will then be greater, thus mitigating the reduction of QBI for flow thru entities.  By doing this, the entity's QBI will be increased thereby increasing the 20% QBI deduction and ultimately reducing the overall tax liability for the owners. This is the same concept as classifying former guaranteed payments as distributions to increase QBI.

While in situations where flow thru entities have unrelated owners, it may be difficult to utilize this strategy, it can be beneficial to employ the strategy for closely held entities. It is important to note that the QBI calculation is very complicated – and this tax treatment (reduction of the QBI for charitable donations) does not agree with the Treasury Regulations on QBI that were released previously. If you have any questions regarding this Tax Alert, please speak with your contact Partner at Perelson Weiner.