Qualified Business Income Deduction
The qualified business income (QBI) deduction allows eligible small business owners to deduct up to 20% of their qualified business income from their taxable income. This deduction is available for tax years 2018 through 2025 and will depend on your type of business, business structure, income sources, and income limitations.
No entrepreneur looks forward to filing their business taxes, but everyone looks forward to saving on their tax bill. One way to do this is to take advantage of tax deductions to lower your taxable income.
The Tax Cuts and Jobs Act brought a number of changes to business taxes. For corporations, it reduced the top tax rate from 35% to 21%.
But small businesses and self-employed people also got a big tax break: the qualified business income deduction. This deduction is available for tax years 2018 through 2025 and allows certain businesses to deduct up to 20% of their qualified business income.
It’s a big tax saving that the IRS expects will affect nearly 40 million taxpayers. If you might be one of those 40 million people, here’s what you need to know about the qualified business income deduction.
Qualified Business Income Deduction, Explained
Beginning in 2018, many small business owners got a big tax deduction: the qualified business income (QBI) deduction. It’s also known as the pass-through deduction—because it applies to pass-through entities—or the Section 199A deduction.
The qualified business income deduction allows eligible business owners to deduct up to 20% of the qualified business income from their taxable income. This deduction is in addition to other allowable business expenses that are deducted.
Requirements to Claim the Qualified Business Income Deduction
Generally, whether you qualify for the qualified business income deduction will depend on these four factors:
- Type of business
- Business structure
- Business income sources
- Income limitations
When publishing the tax law, the IRS didn’t re-define what is considered a business. According to the IRS, “An activity qualifies as a trade or business if your primary purpose for engaging in the activity is for income or profit and you’re involved in the activity with continuity and regularity.” Likely, if what you’re doing isn’t considered a hobby, you’re in business.
But is it a qualified business?
Again, the IRS doesn’t specifically list out everything that would be considered a qualified business. Instead, they say if you are self-employed or own a business that you deduct ordinary and necessary business expenses for, it is likely considered to be a qualified trade or business for the purpose of this new deduction.
They did, however, define a list of exclusions that aren’t considered qualified businesses: specified service trades or businesses (SSTB). The lengthy list of what is considered an SSTB and, therefore, is not a qualified business includes doctors, lawyers, consultants, and financial advisors.
But there is an exception to this exclusion. The IRS will consider an SSTB to be a qualified business if your taxable income is below or within the phase-out range for the deduction (covered below).
That might seem a little confusing, but just remember that if your business is a service-based business or trade that’s on the exclusion list, you can still qualify for this deduction if your income falls below the threshold amounts.
Once you know that your type of business passes the test, you need to make sure that your business type is right as well.
To be eligible for the qualified business income deduction, a qualified business must be a pass-through entity. A pass-through entity is a business type where the profits aren’t taxed at the business level. Instead, they pass through to the owner and are taxed on their individual tax returns.
Pass-through entities include:
- Sole proprietorships
Additionally, some trusts and estates may be eligible for the deduction. A C-corporation is not eligible for the qualified business income deduction because it’s not a pass-through entity.
For companies that file their own tax return, like an S-corp, the qualified business income deduction isn’t taken on the S-corporation tax return—it’s taken on the owner’s tax return.
Business Income Source
The qualified business income deduction is only allowable on what the IRS defines as qualified business income. The IRS defines qualified business income as “income, gain, deduction, and loss from your trades or businesses that are effectively connected with the conduct of a trade or business in the United States.”
Not all business income will qualify. Qualified business income does not include:
- Income from investments, like capital gains, losses, and dividends
- Interest income that isn’t related to a trade or business
- Income received from wages
- Income received from annuities (unless directly connected to the business)
You can find the full list of what isn’t considered QBI on the IRS website.
How much you make matters. There are two different income considerations to take when calculating your qualified business income deduction.
First, your taxable income must fall below a certain threshold to qualify for a qualified business income deduction. Second, the qualified business income deduction that you can ultimately take is limited by a percentage of your taxable income. Let’s explain further.
Taxable Income Thresholds
The maximum amount of the deduction is 20% of your qualified business income. To qualify for the full 20% qualified business income deduction, your taxable income before the deduction in 2019 needs to be $160,700 or less (if single) or $321,400 or less (if married filing jointly). For the 2020 tax year, these limits are increasing to $163,300 (single) and $326,600 (married filing jointly).
It’s important to note that this income isn’t just from your business income, it’s your entire income. So if you have income from other sources, you’ll need to factor that in when calculating whether you’re eligible for the deduction.
Over that income limit, the deduction begins to phase out when your income is between $160,700 and $210,700 (single) or $321,400 and $421,400 (married filing jointly) for the 2019 tax year. You can expect a similar range for the 2020 tax year. How much your qualified business income deduction is reduced depends on the wages that you paid to employees and involves a fairly detailed and confusing calculation. It’s a good idea to look to a tax professional to help you get this right.
Taxable Income Limitation
Once you know what your potential qualified business income deduction is, you have one final calculation to make. The qualified business income deduction that you are allowed to take on your tax return is limited to 20% of your taxable income, less net capital gain.
For example, say you have a qualified business income deduction of $20,000 and your taxable income (less net capital gains) is $150,000. You’d be allowed to take the entire qualified business income deduction because it’s less than 20% of your taxable income ($30,000).
How to Claim the Qualified Business Income Deduction
You can claim the qualified business income deduction on your personal income tax return, form 1040. You’ll enter the amount of the deduction on line 10. You don’t need to itemize deductions to take the QBI deduction.
The IRS has two worksheets to help you calculate your deduction: Form 8995 is the simple form that you can use if your total taxable income is below $160,700 for single filers and $321,400 for joint filers.
If your income is above that, you’ll need to use Form 8995-A.
Qualified Business Income Deduction Example
Jordan runs a business with his spouse Jean. They have a joint taxable income of $250,000: $200,000 from their business, $30,000 from other sources, and $20,000 in capital gains.
All $200,000 of the business income falls into the category of qualified business income. Because their total taxable income of $250,000 is below the 2019 threshold of $321,400, they can deduct the full 20% of qualified business income, subject to the taxable income limitation. The potential qualified business income deduction they can take is $40,000 ($200,000 x 20%).
The last step in determining the final qualified business income deduction they can input on their 1040 is to calculate their taxable income threshold. This taxable income threshold is 20% of their taxable income before the qualified business deduction, minus net capital gains.
Their total taxable income is $250,000 and they had $20,000 in capital gains. Their taxable income limitation is $46,000 ($250,000 – 20,000 x 20%). Their qualified business income deduction can’t be greater than $46,000.
Because their qualified business income deduction is $40,000, it’s less than the income limitation of $46,000 and they can claim the entire $40,000 as a deduction on their 1040 tax return.
The qualified business income deduction can be confusing—there are restrictions as to who can take it, what income qualifies, and how much of a deduction can be taken. But this is a very valuable tax deduction for small business owners. It’s worth taking the time to learn about it or to consult with a qualified professional to make sure you accurately calculate the maximum deduction you’re able to take.