The Tax Cuts and Jobs Act drastically cut the corporate tax rate. But it also introduced the qualified business income (QBI) deduction. The QBI offers a way to lower the effective tax rate on the profits of owners of pass-through entities. These include sole proprietorships (including independent contractors), partnerships, limited liability companies, and S corporations.
The QBI deduction can prove a helpful tax reduction for those owners who qualify for it. But because it remains a deduction and not a tax rate reduction. So its effectiveness depends on an owner’s tax bracket. It represents a temporary measure in the tax law. And it sunsets after 2025 unless Congress acts. It also can prove very, very complicated.
What the Qualified Business Income Deduction is all about
Some also refer to the QBI deduction as the Section 199A deduction. But it doesn’t really fit the description of a business deduction even though it’s based on business 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.
The QBI deduction offers a personal tax deduction based on business income. You claim it on your own personal income tax return as the owner whether you use the standard deduction or itemizes personal deductions.
You get to take the deduction if you qualify for it. But claiming the deduction doesn’t require any purchase or outlay of cash, as with other types of deductions.
Do you qualify for the QBI deduction?
You have to be an owner of a pass-through entity within the U.S. You don’t qualify if your business is a C corporation or if you’re simply an employee who does not own an interest in a pass-through entity. It doesn’t matter whether you are active in the day-to-day activities of the business or merely a silent investor.
You need to have qualified business income (QBI), explained next, and not be barred from taking the deduction due to having substantial income and operating in a certain type of business, also explained later.
What is QBI
Qualified business income (QBI) represents the net amount of income, gain, deduction, and loss from a trade or business in the U.S. But you don’t take certain items into account in figuring QBI, including:
- Capital gains and losses
- Certain dividends and interest income
- Reasonable compensation received by S corporation owner-employees and guaranteed payments received by partners
Then you must reduce QBI by personal deductions connected to having business income, which include:
- Deduction for one-half of self-employment tax
- Deduction for self-employed SEP, SIMPLE, or other qualified retirement plan
- Self-employed health insurance deduction
There are also special rules for the treatment of multiple businesses, the impact of losses, and having rental real estate.
Importance of taxable income
Taxable income governs eligibility for the credit. Owners with taxable income (without regard to the QBI deduction) that does not exceed a set amount, which depends on their filing status, can take a 20% deduction of qualified business income (explained later), plus 20% of qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income. 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.
If taxable income exceeds the taxable income amount for your filing status, then use the following formula to figure the QBI deduction (subject to additional limits for specified service trades or businesses 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.
Specified service trades or businesses (SSTBs)
If you are in an SSTB and your taxable income exceeds your applicable limit, then the items taken into account in figuring the QBI deduction—QBI, W-2 wages, unadjusted basis of certain property—are phased out. Once taxable income reaches a certain limit, no QBI deduction can be claimed by an owner of an SSTB.
SSTBs refer to businesses providing services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, investment and investment management, trading, and dealing in securities. They also include any business where the principal asset is the reputation and skill of one or more owners or employees. Of course, every business depends on the reputation and skill of these individuals. Fortunately, regulations say that an activity is an SSTB only if the person receives fees or compensation for endorsing a product or service, licensing his or her image, voice, etc., or receiving compensation for appearing at an event or in the media.
If you’re confused about the QBI deduction, you’re not alone. It’s a very complex write-off. The good news is that your tax return preparer or tax software figures 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.