Qualified Business Income Deduction

The qualified business income (QBI) deduction is a tax break that’s been given to certain business owners and self-employed workers since 2018.

Offering a potential 20% tax deduction, it’s clearly a pretty big deal for anyone who has to pay self-employment taxes.

Unfortunately, that’s where the clarity seems to end. Because, as with many IRS concepts, the QBI deduction can be hard to wrap your head around. There are a number of stipulations about who can actually claim the deduction and how to go about doing it.

Let’s start with the basics.

What is the qualified business income deduction?

The qualified business income deduction (QBI) is a tax break that lets business owners with pass-through income write off up to 20% of their taxable income. This ultimately lowers the amount of income tax they owe.

Also known as Section 199A, the QBI deduction was added to the US Tax Code by the Tax Cuts and Jobs Act (TCJA). It’s been available to eligible freelancers, independent contractors, and business owners since January 1, 2018.

The history behind the QBI deduction

Business owners who have S Corps have a unique tax advantage: their business income is taxed at the owner’s individual tax rates and avoid the double taxation of a C Corp.

How does the QBI deduction work?

There are three important things to note about the QBI deduction:

✓ It doesn’t matter if you take the standard deduction or itemize

Both options qualify you for the QBI deduction.

✓ It doesn’t lower your self-employment tax

The QBI deduction only lowers your income taxes, not your self-employment taxes.

To lower your self-employment taxes, take advantage of business write-offs! Anything you buy for work can be used to lower your taxable income.

✓ It can impact retirement planning

You can’t apply the 20% QBI write-off to money that’s been put into a tax-deductible retirement plan, like a 401(k) or SEP-IRA.

Let’s take a step back to dig into the implications. When self-employed people put money into their 401(k)s, the amount they contribute can be deducted from their business income. But because taking that deduction lowers their business income, it also lowers the amount of their QBI write-off.

Because of this, business owners are faced with a decision between short-term and long-term savings. If you forego your retirement savings in favor of more QBI, you’ll reduce the amount of tax you owe the IRS right now. But the trade-off is, you’ll miss out on the long-term benefits of retirement plan contributions. Of course, you can always put the funds into an after-tax investment account to grow for the future.

Who’s eligible for the QBI deduction?

Let’s focus on the kinds of business owners that are eligible for the deduction.

Business owners with pass-through income

A pass-through business is one that’s not subject to corporate income tax. Instead, all its income “passes through” to the owner, who reports it on their personal tax return.

Business owners who have pass-through income include:

Sole proprietors: A single individual who owns an unincorporated business. This can include independent consultants or freelancers.

Members of Partnerships: Two or more people who made a formal agreement to run a business together, such as a CPA firm

S corporation shareholders: People who own interest in an S Corp and report the company’s corporate income, losses, deductions, and credits on their personal tax returns

Limited Liability Company (LLC) members: Owners of an LLC, which is taxed as either a sole proprietorship, a partnership, or an S corp

Unlike pass-through businesses, C corps can’t claim the QBI deduction because the C Corp pays taxes at the corporate level and then profits can be distributed to shareholders as dividends.

People with qualified REIT dividends or PTP income

In addition to business owners with pass-through entities, investors with qualified dividends from a real estate investment trust (REIT) or income from a publicly traded partnership (PTP) can also claim a 20% QBI deduction.

If you have both types of income, these QBI benefits actually stack. For example, if you have a sole proprietorship for your freelance work and also receive qualified dividends from an REIT, you can deduct 20% from your freelance income and 20% from your REIT dividends.

One requirement is that qualified REIT dividends must be held for more than 45 days to take the deduction. This is only for qualified dividends from a REIT and doesn’t include capital gains or regular qualified dividends.

What doesn’t count as qualified business income?

For deduction purposes, these types of income are excluded from QBI:

✓ Earnings from a W-2 job

✓ Income from business outside of the United States

✓ Interest income unrelated to a trade or business

✓ Annuities received from something other than a trade or business

✓ Guaranteed payments from a partnership

✓ Investment items like capital gains, capital losses, or dividends

How is the QBI deduction calculated?

Typically, your QBI deduction is the smaller amount between these two options:

✓ 20% of your QBI, plus 20% of your REIT dividends and PTP income

✓ 20% of your taxable income, minus net capital gains

If you’re a typical independent contractor, or small business owner, that’s really all you need to know.

On the other hand, maybe you have a more complicated situation — like earning high self-employment income or working in certain service businesses. In that case, there will be limits placed on the amount of QBI you can claim.

There are also special circumstances with people who own multiple businesses.

Limitations on QBI deductions

If your taxable income is above a certain threshold — or generated by certain trades — you may only be able to claim a portion of the deduction. At certain levels, you stop being eligible for the deduction altogether.

Let’s go over when these limitations apply to the amount you can deduct.

If your taxable income is above the IRS’s thresholds….

When it comes to the QBI deduction, there are actually two income thresholds you have to deal with.

The Lower QBI Threshold

The lower threshold is what you need to stay below to get the full 20% deduction. This income limit changes every year based on inflation. For the 2023 Tax Year, it’s:

✓ $182,100 for a single filer

✓ $364,200 for a joint filer

Once you hit these limits, your QBI deduction will start to “phase out,” meaning you only receive a partial deduction. But you won’t yet hit a hard limit based on the amount you’re paying out in wages to your employees — which does apply once you reach the second income threshold.

The Higher QBI Threshold

At the second, higher income threshold, things start to change again. In 2023, these income limits are:

✓ $232,100 for a single filer

✓ $464,200 for a joint filer

For most businesses, once you hit those numbers, your deduction will be capped at the greater of either:

✓ 50% of the W-2 wages paid by your business, or

✓ 25% of the W-2 wages, plus 2.5% of qualified depreciable property (like buildings and equipment)

There are exceptions based on your industry.

Finding your QBI deduction after you pass the higher threshold

To give an example, let’s say you have $300,000 of taxable income, $100,000 of which is from your business. You also paid $30,000 of wages and you own an office building — a qualified property — worth $480,000.

Normally, you would be able to claim a $20,000 QBI deduction on your business income of $100,000 ($100,000 x 0.20 = $20,000).

But because your taxable income exceeds the limit for single filers, you have to use the calculations above to figure out your QBI deduction.

Here’s how that would look:

✓ Option A: $30,000 x 0.50 = $15,000

✓ Option B: ($30,000 x 0.25) + ($480,000 x 0.025) = $19,500

In this scenario, option B results in a higher deduction.

If you own a “specified service trade or business”

A specified service trade or business (SSTB) is any trade or business where the main asset is the skill or reputation of at least one employee or owner.

What counts as an SSTB?

SSTBs include service businesses in:

✓ Healthcare

✓ Law

✓ Accounting

✓ Athletics

✓ Consulting

✓ Performing arts

How QBI limits work for SSTBs

The QBI deduction an SSTB can claim is also based on their income level and filing status. What makes the SSTB designation unfortunate, is that — unlike everybody else — you can’t claim any deduction after you hit the income ceiling.

Here are the figures for the 2023 tax year:

Filing status

Taxable income

Eligible QBI deduction

Single tax filer

Less than $182,100

20%

Single tax filer

$182,100 – $232,100

Partial deduction

Single tax filer

More than $232,100

Married filing jointly

Less than $364,200

20%

Married filing jointly

$364,200 – $464,200

Partial deduction

Married filing jointly

More than $464,200

There’s also a limit to the QBI deduction that can be claimed by someone who recently acquired partnership interest. (This restriction is most likely to apply to partners who own real estate businesses.)

Fortunately, most small business owners don’t have to deal with this limit, because it’s a little complicated. It’s calculated as a percentage of their wages, plus a different percentage of the “unadjusted basis immediately after acquisition” (UBIA). (“Unadjusted basis” just means how much it originally cost to purchase the partnership’s property.)

In a nutshell, people in this situation have their QBI deduction capped at the sum of:

✓ 25% of the W-2 wages paid

✓ 2.5% of its UBIA

The UBIA used to calculate the partner’s QBI deduction must be calculated by the individual or entity that directly conducts the qualified business.

Now that we’re all clear on who can claim the QBI deduction — or portions of it — let’s move on to how you go about it.

For people with multiple businesses

If you own multiple pass-through businesses, you can opt to aggregate your business interests, which, in some circumstances, may give you a larger QBI deduction.

There are some limitations to who’s allowed to aggregation. For instance, your businesses can’t be SSTBs and need to be connected in some meaningful way.

If you have questions, please contact us so that we can learn more about your situation.