Qualified Business Income Tax Deduction
The Tax Cuts and Jobs Act introduced a non-corporate tax deduction called Section 199A Qualified Business Income (QBI) Deduction to incentivize taxpayers to set-up businesses as pass-through entities.
The QBI deduction provides taxpayers a deduction of up to 20% of their qualified business income (net profit) from a pass-through entity for tax years 2018 to 2025. Since the profit from a pass-through entity is reported as the owner’s personal income the QBI deduction is taken by the taxpayer and calculated on their individual tax return. The amount deducted is not subject to federal income tax, but it is still subject to self-employment tax.
What are the different types of pass-throughs?
- Sole proprietors (including self-employed and independent contractors)
- Limited Liability Companies
- S Corporations
- Partnerships
Qualifying Income Thresholds
A small business owner can qualify for the full deduction if their income does not exceed the annual taxable income threshold of $326,600 for joint filers (or $163,300 for single filers). The 20% QBI deduction is limited to the lesser of qualified business income or total taxable income less net capital gain.
See the example below of a joint filer who has qualified business income from a pass-through entity. The taxable income of $117,700 is greater than the qualified business income of $100,000. Therefore the 20% tax break will be applied to the QBI instead of taxable income.
- Net profit from business: $100,000
- Spouses income: $70,000
- Contributions to SEP-IRA (20,000)
- Deductible Portion of SET (7,500)
- Standard Deduction (24,800)
- Taxable Income before QBI Deduction = $117,700
Specified Service Based Business
The deduction may be limited for business owners who have a specified service trade or business (SSTB). An SSTB is any trade or business performing services in the areas listed below:
- Health, law, accounting, and actuarial science, athletics, performing arts, consulting, financial or brokerage services
- Involves investing, investment management, trading, and dealing in securities or commodities
- Any trade or business where the principal asset is the reputation or skill of one or more of its employees or owners.
If the taxpayer has income from a SSTB the deduction phases out when the owner’s personal taxable income is between $163,300-$213,300 for single filers, and $326,600-$426,600 for joint filers. If their income is above $213,300 filing single ($426,600 filing married) they do not qualify for the deduction.
Taxpayers with SSTB income within the phase-out range (see above), will have a QBI deduction limited to the greater of:
- 50% of W-2 Wages paid by the business
- 25% of the W-2 wage plus 2.5% of the unadjusted tax basis in the business property
For taxpayers that do not have SSTB income that exceeds the threshold, (taxable income is above $213,300 for single filers and $426,600 for married filers), the QBI deduction will also be limited to the greater of:
- 50% of W-2 Wages paid by the business
- 25% of the W-2 wage plus 2.5% of the unadjusted tax basis in the business property
How to Maximize the Qualified Business Income Deduction?
This can be a complex deduction to take due to the various rules and restrictions that apply. There are some strategies a taxpayer can use to decrease their taxable income to maximize their QBI such as:
- making deductible retirement plan contributions
- adjusting the salary
- changing entity classification
- bunching charitable donations
- claiming bonus depreciation on assets
- making deductible health savings account contributions
