This is Part 2 of a four-part series on the qualified business income deduction. Read Part 1 here.
Last week I told you about a line on your tax return — $403,500 if you are married, half of that if you are single. Cross it, and the 20% deduction most business owners count on stops working the way they think it does. I talked about "Dev," who went over it without knowing. (Missed it? The Part 1 link is here.)
Everybody in Dev's business got a paycheck last year except Dev. It cost him about $24,000. That number is the whole point of understanding the QBI wage limitation before it costs you the same way.
Once you are over that line, three things determine how much of the 199A deduction — the qualified business income deduction — you actually keep: what your business pays in paychecks, what kind of business you're in, and what you own. Today we are talking about paychecks, which is where the QBI wage limitation lives.
Dev's company made about $600,000 last year, after he paid his two employees. Twenty percent of that is $120,000. That's the deduction he was counting on all year. Instead, he got a $45,000 deduction.
The rule that cut it down is one most owners don't understand until it's already cost them. Once you're over the line, your deduction can't be bigger than about half of what your business pays out in paychecks. That is the W-2 wage limitation, and it comes on gradually. Dev was far enough past the line that the full limitation applied.
Dev is a sole proprietor. His two employees get paychecks. He doesn't. He takes money out of the business when he needs it, which is how plenty of people do it, and there's nothing wrong with it. But money you take out isn't a paycheck.
And almost everything else in that business is contracted out. Fulfillment, ads, design, the developer who runs the site. Real people doing real work, every one of them paid, and not one of them on payroll. That money goes out on an invoice. It isn't a paycheck either. That's how a business doing several million dollars a year ends up with two names on its payroll.
So the only wages that counted were his two employees' — $90,000. Half of that is $45,000, and that became his ceiling. Two numbers, and he gets the smaller one. His profit said $600,000. His paychecks said $45,000.
The rest of it just wasn't there. In real money, depending on his bracket, that cost him about $24,000. If you looked up that line on your own return last week and it came in smaller than you expected, the QBI wage limitation is one of the reasons why.
That $90,000 was final on December 31. It was printed on his employees' W-2s in January. Nobody ran the math on it until March. Nobody sat him down in year three and said the way you pay yourself is going to become the most expensive line on this return.
His bookkeeper records what happened. His payroll company runs payroll for the people they were told about. His CPA files a year that already ended. Every one of them did their job. That conversation doesn't happen unless somebody makes it happen.
One more thing — the line is about your taxable income. Not your sales. It's the number at the very bottom of your return, after everything has come out. For 2026 it starts at $403,500 if you're married and file together. Half that if you file single. If nobody has told you which side of it you're on, please ask.
And if your business is the size Dev's is, don't bother asking. You're past it. You have been for years. Nothing left in this series is optional reading for you. It's the whole thing.
Read Part 3 now: Dev fixed this. Then he went too far.
Once your taxable income is above the Section 199A threshold, your qualified business income deduction is capped. One version of the cap limits the deduction to 50% of the W-2 wages your business pays (there is an alternative that also factors in property). If your payroll is small relative to your profit, this limitation can sharply reduce the deduction.
No. Money a sole proprietor or partner takes out of the business as a draw is not a W-2 wage. Only actual payroll wages reported on W-2s count toward the wage limitation, which is why sole proprietors and heavily outsourced businesses can be hit hardest.
No. Amounts paid to independent contractors on invoices (reported on 1099s, not W-2s) do not count as wages for the QBI wage limitation, no matter how essential that work is to the business.
For 2026 the phase-out begins at $403,500 of taxable income for married couples filing jointly, and half that amount for single filers. The threshold is based on taxable income — the bottom-line number on your return — not on your sales or revenue.
Options can include changing how the owner is paid — for example, electing S corporation status so the owner takes reasonable W-2 wages — or reviewing the entity and payroll structure. The right move depends on your facts, so it's a conversation to have with your tax advisor before year-end, not after.
Above the income threshold, the wage limitation replaces the automatic 20%. If your business pays little in W-2 wages relative to its profit, your deduction is capped at roughly half of those wages — which can be far below 20% of what the business earned.
This is Part 2 of the series. Start at the beginning and keep going:
These are composites and I've rounded the numbers to keep them readable. Your situation depends on things I can't see from here, so take this as a reason to ask your own tax advisor a question — not as advice about your return. And if you want to schedule time to talk through this, you can book a time with me here
Disclaimer: This article is for general educational purposes only and does not constitute tax, legal, or accounting advice. The QBI wage limitation, income thresholds, and related 199A rules depend on your specific facts and circumstances. Please consult a qualified tax professional before relying on anything discussed here.