The Tax Cuts and Jobs Act passed in December of 2017. It drastically cut the corporate tax rate, but it also introduced the Qualified Business Income (QBI) deduction.
The QBI deduction offers a way to lower the effective tax rate on the profits of owners of pass-through entities — trade or business where the income “passes through” to the owner’s individual tax return. These include the sole proprietorship (including independent contractors), partnerships, limited liability companies, and S corporations. Some trusts and estates may also be eligible to take the deduction. Income earned through a C corporation or services provided as an employee are not eligible, however.
The qualified business income (QBI) deduction can prove to be a significant tax reduction for those business owners who qualify. But because it remains a deduction and not a tax rate reduction, its effectiveness depends on an owner’s tax bracket. It represents a temporary measure in the tax law, which sunsets after 2025 unless Congress acts. It can also prove very, very complicated.
Here is a summary of what the deduction entails:
- The QBI deduction is a personal write-off for owners of domestic pass-through businesses where owners pay business taxes on their personal tax return.
- The deduction can be up to 20% of QBI minus the net capital gains.
- Business owners can take the deduction in addition to the ordinarily allowable business expense deductions.
- Deductions for higher-income individuals may be limited or ineligible.
- This deduction is in place for tax years 2018 through 2025.
Here are answers to some commonly asked questions about the QBI deduction that may help you understand whether you qualify and, if so, how to gain the most benefit possible.
What is a Qualified Business Income Deduction?
A qualified business income(QBI) deduction allows domestic small business owners and self-employed individuals to deduct up to 20% of their QBI plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income on their taxes, or 20% of a taxpayer’s taxable income minus net capital gains.
Qualified REIT dividends include most of the real estate investment trust dividends that people earn. Also, to qualify, you must hold the real estate investment trust for longer than 45 days. The payment must be for you, and it cannot be a capital gains dividend or regular qualified dividend. Qualified income from a PTP includes your share of income, gains, deductions, and losses from a PTP.
To qualify for the deduction, the 2019 taxable income must be under $321,400 for couples who are married filing jointly, $160,725 for married filing separately, or $160,700 for all other taxpayers. In 2020, those figures increase to $326,000 for couples married filing jointly and $163,300 for everyone else.
Anything higher and the IRS invokes a series of complicated rules that place limits on whether the trade or business income qualifies for a full or partial deduction. Deduction limitations include such factors as the trade or business type, taxable income, and the amount of W-2 wages paid by the company.
Some refer to the qualified business income (QBI) deduction as the Section 199A deduction. It does not really fit the description of a business deduction, however, even though it’s based on income. And it doesn’t reduce gross income like other business-related deductions. Take, for example, the self-employed health insurance deduction and one-half of self-employment tax. It doesn’t impact self-employment tax at all.
What the QBI deduction does offer is a personal tax deduction based on trade or income. You claim it on your individual income tax return (1040) as the owner whether you use the standard deduction or itemize personal deductions.
You get to take the deduction if you qualify for it. However claiming the deduction doesn’t require any purchase or outlay of cash, as with other types of deductions.
What is Qualified Business Income?
According to the IRS, qualified business income represents the net amount of qualified income, gain, deduction, and loss from any qualified trade or business. (Simply put, that means your share of the business’s net profit.) The trade or business must also be located in the U.S.
The IRS only counts items included in taxable income, such as:
- Payments to an S corporation owner
- Investments gains or losses
- Interest income on outstanding receivables.
Certain items are excluded from QBI deductions when figuring qualified income, including:
- Capital gains and losses
- Certain dividends and interest income
- Wage income paid to the S corporation owner
- Income earned outside the U.S.
- Commodities, transactions or foreign currency gains or losses
- Annuities, unless received in connection with the trade or business
- Amounts paid to a taxpayer acting outside of his or her capacity as a partner for services
- Reasonable compensation received by S corporation owner-employees
- Guaranteed payments received by partners.
The IRS also states, solely for section 199A, a safe harbor is available to individuals and owners of pass-through entities who seek to claim the deduction under section 199A for a rental real estate enterprise. It treats a rental real estate enterprise as a trade or business for purposes of the QBI deduction if specific criteria are met.
You must also reduce qualified business income by personal deductions connected to having that income. These include:
- Gain from transactions reported on Form 4797, including gain from the sale of business property
- Deduction for one-half of self-employment tax
- Deduction for self-employed SEP, SIMPLE, or other retirement plans
- Unreimbursed partnership expenses claimed by a partner on his or her personal return
- A self-employed health insurance deduction.
Special rules for the treatment of multiple businesses and the impact of losses apply. Also, in some cases, patrons of horticultural or agricultural cooperatives are required to reduce their deduction under section 199A of the tax code.
Do You Qualify for the QBI Deduction?
To qualify for the qualified business income (QBI) deduction, you must be an owner of a pass-through entity within the U.S., have qualified business income, and not be barred from taking the deduction due to having substantial income and operating in a particular type of business. This will be explained in detail later.
Sole proprietorships, partnerships, S corporations and limited liability companies (LLCs) are the pass -through entities eligible.
You do not qualify if your business is a C corporation or if you are simply an employee who does not own an interest in a pass-through entity.
It does not matter whether you are active in the day-to-day activities of the trade of business or merely a silent investor. Any eligible taxpayer with income from a trade or business may be entitled to the QBI deduction assuming they satisfy the requirements of section 199A. This is regardless of their level of involvement.
You also do not qualify if your taxable income exceeds the specified threshold amount in a given tax year, and you are in a specified service trade or business (SSTB).
The SSTB exception does not apply to the taxpayer’s taxable income below the threshold amount. In other words, SSTBs below the limit get the deduction just like any other business owner. Also, the deduction is phased in for taxpayers with taxable income above the threshold amount.
S corporations and partnerships qualify because they are typically not taxable and cannot take the deduction themselves. Instead, all S corporations and partnerships report each shareholder’s or partner’s share of qualified business income, W-2 wages paid, UBIA of qualified property, qualified real estate investment trust dividends, and qualified PTP income items on a Schedule K-1, which allow the shareholders or partners to determine their deduction amount.
Take the following steps to decide whether you qualify for the QBI deduction:
- Determine if your trade or business is a pass-through entity.
- Figure out the amount of net income from that business for the year. (Some income isn’t included.)
- Estimate your total taxable income. Keep in mind that the deduction amount may be reduced or eliminated if your income is over the limit.
How is the Qualified Business Income Deduction Calculated?
Calculating your QBI deduction is no easy task by anyone’s estimation. Fortunately, your tax return preparer or online tax return software can take care of that for you. To better understand the process, however, follow these steps:
- Start by gathering documents that list your eligible income. It’s helpful to have a copy of Schedule K-1, with the necessary information included.
- Calculate your taxable income. This is your gross income after subtracting your deductions and personal exemptions.
- Make a final determination. Decide whether the income is related to a qualified trade or business in which you have a business interest.
- Then it’s time to run the numbers. Calculate the qualified business income for each trade or business for the tax year and your net taxable income — the net amount of the business’s qualified items of income, gain, deduction, and loss.
- Calculate your QBI limitations. Once you have calculated your qualified business income for each business, move on to calculating your limitation. This will help you decide whether aggregating your businesses works for or against you when getting the highest deduction.
It is necessary to calculate your limits if you have an ownership interest in a trade or business, and your taxable income for tax year 2019 is more than $321,400 as a couple married filing jointly, more than $160,725 if married and filing separately, or $160,700 otherwise. If your taxable income is under these amounts, there is no need to calculate the limitation. You can take the straight 20% deduction.
Here is how to calculate the limitation.
Know the amount of W-2 wages paid and the amount of qualified property owned. Qualified property is personal or real property that is subject to depreciation. Land does not count as qualified property. Items like furniture, equipment, and machinery do.
This is where it can get complicated.
Your qualified business income is limited to either 20% of your QBI or one of these options:
- 50% of the company’s W-2 wages
- The sum of 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property.
Choose whichever of the two wage options above gives you a higher deduction.
6. That’s it! Once you make that determination, you have successfully calculated your deduction amount.
To claim the QBI deduction for 2019, complete Form 8995, Qualified Business Income Deduction Simplified Computation, or Form 8995-A, Qualified Business Income Deduction. Both forms take you through the process of adding up your qualified business income, real estate investment trust dividends, and PTP income to determine the amount of your deduction.
Use Form 8995 if your taxable income is less than the income threshold and Form 8995-A if your taxable income is more than the specified threshold. Attach the form to your tax return. That’s Form 1040 for most business owners.
QBI Deduction Examples
These two examples illustrate how the process works for a business owner who qualifies for the QBI deduction without limitations and one who qualifies but with limitations:
Jill owns a retail business that generates $100,000 in qualified business income. She is married and does married filing jointly.
Her taxable income is less than $321,400 for couples married filing jointly. Her business paid $30,000 in wages and has $50,000 in qualified property.
Because Jill’s taxable income is less than the threshold, she can claim the full 20%, which in her case is $20,000.
Jack owns a warehouse storage company. He is also married, but rather than filing jointly chooses to file separately, so his threshold to qualify is $160,700 for the tax year 2019.
His qualified business income is $125,000. He paid $50,000 in wages and has $150,000 in qualified property. His taxable income, however, is $415,000, which is over the threshold. That means he cannot automatically claim the 20% deduction and has to calculate his limitation.
Jack performs both wage tests to find the highest deduction.
Test 1 is 50% of the company’s W-2 wages or 50% x $50,000 for a total of $25,000
Test 2 is 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property, which comes to $16,250.
Jack chooses the higher deduction, so his total QBI deduction amount is $25,000.
There’s one more item to note: Whatever the amount of your QBI deduction, it can’t exceed more than 20% of your total taxable income without the QBI deduction. So, calculate the numbers to determine if the qualified business income deduction is within IRS guidelines.
Other QBI Deduction Factors
Here are some other factors to take into consideration when calculating QBI deductions.
- If the net amount of your combined qualified business income during the tax year is a loss, you carry it forward into the next tax year.
- You can deduct 20% of qualified real estate investment trust dividends, cooperative dividends, and PTP income, but don’t include these items when calculating your QBI.
- You can combine multiple sources of income to calculate your total QBI.
- If you have two or more qualified businesses (i.e., pass-through business), the IRS allows you to combine the qualified business incomes, W-2 wages, and basis of qualified property for each, and then apply the W-2 wage and qualified property limitations. You are not required to combine (or aggregate) your businesses, although it is allowed and may increase the QBI deduction amount and lower your tax bill.
- If you have a loss on one trade or business and profit on another (including aggregated trades and businesses), you must net their qualified business income, including losses. The negative QBI from one business will offset positive QBI from other trades or businesses in proportion to the net income of the trades or businesses with positive QBI. If the total QBI from all of your businesses is less than zero, then you have a negative amount that you must carry forward to the next year.
Is Qualified Business Income an Itemized Deduction?
The qualified business income deduction is a personal write-off that you can claim whether or not you itemize your tax return using Schedule A or take the standard deduction. That is different from other deductions, which require you to itemize.
Importance of Taxable Income
Taxable income governs eligibility for the credit. Business owners with taxable income that does not exceed a set amount can take a 20% deduction of qualified business income plus 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income. This is without regard to the QBI deduction and it depends on their filing status.
The taxable income amounts are adjusted annually for inflation. This straightforward deduction applies regardless of the type of business you’re in. For those with taxable income over their applicable limit, things are not so straightforward.
Qualified Business Income Deduction Formula
If taxable income exceeds the taxable amount for your filing status, then use the following formula to figure the qualified business income deduction. This is all subject to additional limits for a specified service trade or business, explained below.
The deduction is the greater of: (1) 50% of W-2 wages (wages paid by the business, including amounts to S corporation owner-employees), or (2) 25% of W-2 wages, plus 2.5% of the unadjusted basis (usually cost without regard to any depreciation) of property that hasn’t reached the end of its recovery period set by law.
How to Maximize Your QBI Deduction
If you find that you are above the qualified business income threshold, there are certain planning strategies you can employ to maximize QBI deductions, whether yours is an SSTB or not. Consider using some of the following procedures:
- Keep your income under the threshold. Below the threshold, the deduction is less restrictive.
- Consider filing your tax return separately if you are married. If you file jointly, your trade or business is a specified service subject to the phase-out.
- Create a separate entity that provides business and administrative support to a disqualified business. Forming a new LLC to offer such services is best.
- To get a larger deduction, decrease the compensation you as the owner receives as long as the amount is still reasonable.
- Increase the amount of wages paid to employees, if possible, or purchase assets.
- Take a second job to increase taxable income.
- Aggregate multiple businesses to optimize the three components and limitations (QBI, Wages, UBIA). Complicated rules govern the ability to aggregate businesses, however, so take all factors into account. Also, SSTBs do not qualify for aggregation.
- If you have a high-deductible health insurance plan, make a pre-tax contribution to a Health Savings Account for up to $3,550 for an individual plan or $7,100 for a family plan in 2020.
- Make a retirement plan contribution to lower the taxable amount in the current year.
- Lump several years worth of future expected charitable giving contributions into the current year. It may put you over the standard deduction limit and let you reap the tax benefits of itemizing a large charitable gift.
- If you can control the timing of your business income, delay future projects until the following year to keep income levels below the threshold. You could also accelerate the payment of some expenses to the current year to reduce income levels.
This list is not an exhaustive list of options, so speak with your CPA or tax preparer for advice on how to qualify for a full or partial QBI deduction.
Specified Service Trade or Business (SSTBs)
A Specified Service Trade or Business (SSTB) refers to a business providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investment and investment management, trading, or securities.
This also includes any business where the principal asset is the reputation or skill of one or more owner or employee. Of course, every business depends on the reputation and skill of these individuals. Fortunately, regulations say that an business is an SSTB only if the person receives fees or compensation for endorsing a product or service, licensing his or her image, likeness, or voice, or receiving payment for appearing at an event or in the media.
The SSTB line can be a bit fuzzy as to what professions are subject to the guidelines. For example, under IRS regulations, consultants — those who provide professional advice — are considered SSTBs, but salespeople who offer sales training courses are not. Similarly, physicians fall under the “health” definition and qualify as an SSTB, but fitness instructors do not.
To complicate matters further, some businesses can be a combination of SSTB and non-SSTB. In those cases, the de minimus rule applies. If income from the SSTB side is below a certain threshold, the business can be fully eligible for the QBI deduction.
Regardless, if you are in a specified service trade or business and your taxable income exceeds your applicable limit, the items taken into account in figuring the qualified business income deduction — QBI, W-2 wages, the unadjusted basis of certain property — are phased out. Once the taxable amount reaches a specific limit, no QBI deduction can be claimed by an owner of an SSTB.
For the tax year 2019, those figures are as follows:
If your taxable income is between $321,400 and $421,400 for those married filing jointly, between $160,725 and $210,725 for those married filing separately, or between $160,700 and $210,700 for single filers, your deduction is subject to additional limitations. If it is higher, then you are fully phased out and not eligible for the QBI deduction.
Conclusion
If you’re confused about the qualified business income deduction, you’re not alone. It’s a very complex write-off that many businesses fail to claim. It is a deduction you should be concerned with, however, if your trade or business is a pass-through entity because it provides a generous tax break for qualifying businesses.
One thing is sure: Determining who can claim the QBI deduction and calculating it is no easy task. The good news is that your tax return preparer or tax software can figure the deduction for you. To learn more about the QBI deduction, check out IRS FAQs as well as instructions to Form 8995 and Form 8995-A.
Image: Depositphotos.com
