Key Takeaways:
- Pass-through businesses (sole proprietorships, partnerships, LLCs, C corporations). It needs up to a 20% deduction on qualified business income (QBI). Can be claimed as a standard or itemized deduction
- Doesn’t apply to Corporations, employee compensation, or certain investments. Specified service businesses (health, law, accounting, etc.) except for engineering and architecture
- The phase-out range for higher incomes. SSTBs lose deduction above the phase-out ceiling. Non-service businesses have limitations based on wages and property.
- Complex and depends on income and business type. Consult a tax specialist for accurate calculations.
What is a Qualified Business Income deduction?
Qualified business income deductions, also referred to as QBI deductions, are one of the most talked about changes of the 2017 Tax Reform. This new tax break allows individuals and some estates and trusts who own pass-through entities — partnerships, LLCs, S Corporations and sole proprietorships — to deduct 20% of their QBI from their taxable income. QBI deductions are allowed as both standard and itemized deductions.
According to the IRS, qualified business income is the net amount of income, gain, deduction and loss from any qualified trade or business that is effectively connected with a US trade or business.
While the deduction provides a clear benefit, it’s essential to understand its limitations and eligibility criteria. QBI is defined as the net income, profits, deductions, and losses from a qualified business connected to a US trade or business. However, several types of income are excluded, such as employee compensation, capital gains/losses, certain dividends, and interest income.
What is not eligible for Qualified Business Income deductions?
You cannot use income from corporations or a partnership, or employee compensation in this deduction. Furthermore, capital gains and losses, certain dividends and interest income are not considered as qualified business income.
Most businesses do qualify for the QBI deduction except for those classified as a “specified service trade or business” (SSTB). SSTBs include those in the fields of health, law, accounting, consulting, performing arts, financial services, and other businesses where the principal asset is the reputation or skill of one or more of its employees. However, engineering and architectural firms can make Qualified Business Income deductions. Engineering and architectural firms are not classified as an SSTB.
Ineligible Income
- Income from corporations
- Income from partnerships (except for individual partners owning and actively participating in the business)
- Employee compensation (wages, salaries, bonuses, etc.)
- Capital gains and losses
- Certain dividends and interest income
Ineligible Businesses
- Specified service trade or businesses (SSTBs): These include businesses primarily reliant on the reputation or skill of their employees, such as:
- Health professions (doctors, dentists, lawyers, etc.)
- Law firms
- Accounting firms
- Consulting firms
- Performing arts businesses
- Financial services businesses
What are the limitations of the Qualified Business Income deduction?
Just like other tax credits and deductions, there may be a limit on the amount of Qualified Business Income deduction. This limitation depends on the taxpayer’s taxable income before QBI deduction. For example, limitations apply within a phase-out range. That range is $315,000 – $415,000 for married filing jointly and $157,500 – $207,500 for all other filers.
Factors affecting such phase-out ranges include the following:
- Amount of W2 wages paid with respect to qualified trade or business
- Unadjusted basis of qualified property held by trade or business
The Phase-Out For QBI Deductions
A key limitation is the phased reduction of the deduction as your taxable income before the QBI deduction increases. This “phase-out range” exists for both individual and joint filers, with different thresholds depending on your filing status. Within this range, the deduction gradually decreases until it completely disappears at the higher end.
What Affects the Phase-Out In QBI Deductions?
Two primary factors influence the phase-out calculation:
W-2 Wages Paid: The amount of wages paid to employees through your business impacts the phase-out. Higher wage payments tend to reduce the phase-out effect, reflecting the intention of supporting businesses that create jobs.
Unadjusted Basis of Qualified Property: This refers to the original cost of depreciable business assets minus any accumulated depreciation. Owning more business property can influence the phase-out to a lesser extent.
How do you compute Qualified Business Income deduction?
At or below threshold
If the taxpayer’s taxable income before Qualified Business Income deduction is at or below phase-out threshold ($315,000 for MFJ and $157,500 for others), the above limitations do not apply. In this case, you compute QBI deduction as the lesser of the following:
- 20% of the taxpayers qualified business income plus 20% of the taxpayer’s qualified real estate investment trust (REIT) dividends and qualified publicly traded partnership (PTP) income
- 20% of the taxpayer’s taxable income minus net capital gains
Above threshold
If the taxpayer’s taxable income before QBI deduction is at or above phase-out ceiling ($415,000 for MFJ and $207,500 for others), specified service trade or businesses (SSTBs) cannot take any deduction. Non-service businesses’ QBI deduction is the lesser of:
- 20% of the taxpayer’s qualified business income with respect to qualified trade or business (initial deduction)
- The greater of (wages limitation):
- 50% of the W2 wages with respect to the qualified trade or business, or
- The sum of:
- 25% of wages; plus
- 50% unadjusted basis of qualified business properties
Within threshold
The complication comes in if the taxpayer’s taxable income before QBI deduction is within the phase-out range.
For non-service businesses, the QBI deduction is computed as the lesser of:
- 20% of the taxpayer’s taxable income minus net capital gains
- 20% of QBI reduced by the phase-out amount. Phase-out amount equals phase-out percentage multiplied by the excess amount (difference between 20% of QBI and wages limitation).
For SSTBs, you compute QBI deduction the same way as the non-service businesses. The exception is that business net income, wages and depreciable assets must be phased out first. Then, you can compute 20% of QBI and wages limitation.
Have more questions about Qualified Business Income deductions?
If you still have questions about the Qualified Business Income deductions and how it applies to your business specifically, schedule a consultation with us to discuss it further. Our expert tax accountants are equipped with years of experience and can help provide tailored advice and direction for your business.
No matter what you need, Cleer is here to help. If you have further questions or need assistance, feel free to contact us.
