A new tax deduction is available for business owners this year. Many taxpayers could see tax savings in the tens of thousands. The Tax Cuts and Jobs Act (TCJA) created the Qualified Business Income (QBI) deduction for tax years 2018-2025. Essentially, certain elements (but not all) of a business owner’s income are getting a tax break.
What is the Qualified Business Income Deduction?
The QBI deduction allows most self-employed taxpayers and small business owners to exclude up to 20 percent of their qualified business income from federal income tax. Then, the taxpayer/business owner claims the deduction on their individual tax return.
Sometimes, the deduction is referred to as the pass-through deduction or section 199A deduction. Most tax incentives require specific action by the taxpayer (such as investments, purchases or hires). In contrast, the primary requirement for the QBI deduction is for the business to simply exist as a pass-through entity type.
What types of businesses qualify for the QBI deduction?
Most small businesses will qualify, but there are two prominent rules. First, it must be a pass-through entity. Second, certain service-based businesses are limited or excluded, even if they are a pass-through.
1. Pass-through businesses: a group of business entity types in which the income from the business goes straight to the owner. The owners then report the business income on their personal returns. Examples of these entities: partnerships and S corporations, sole proprietorships and single-member LLCs.
2. Specified Service Trades Businesses: or SSTBs have steeper limitations and are eliminated once taxable income reaches $207,500 ($415,000 for joint filers). These are trades or businesses where the reputation or skill of one or more of its employees is the reason for the revenue. (Examples: healthcare, law, accounting, actuarial science, performing arts, consulting, etc.)
How much could I save? Are there limits?
The calculation is complicated because there are so many factors to consider, but it’s common to see small businesses taking a $15-20k deduction.
The fundamentals of the calculation include adding the qualifying factors together and taking 20 percent of that number as the deduction. However, there are situations that require additional calculations, such as owning multiple businesses or reaching higher income levels.
Common factors that complicate the calculation:
• Multiple businesses. Taxpayers may take the deduction for any businesses in which they are the majority owner. QBI is calculated separately for each business and then combined into one deduction on the return.
• High earners. If the taxpayer(s) earn $157,500 ($315,000 if filing jointly) or above, there is a second calculation to be done. The CPA will do both and the lesser of the two is applied. The deduction may be reduced as a result.
• Investments. Investment income, interest, and gains do not count towards QBI. They must be removed from the calculation. This could act as a benefit to some taxpayers by keeping them within the limits, but it will likely act to reduce the overall deduction.
What counts towards QBI? Calculating the deduction.
Because the deduction is 20 percent of QBI, it’s logical that taxpayers want to determine that number first and foremost. Here’s what’s included and excluded:
• Excluded: investment related items (capital gains, losses, dividends), W-2 wage income, foreign wages, and income, guaranteed payments from a partnership, payments received by a partner other than in a capacity as a partner, REIT dividends and PTP income.
• Included: income, gain, deduction and loss (can’t be investment-related).
• QBI: The deduction is 20 percent of the final number in this calculation, assuming it’s within the thresholds.
These are only some of the key elements and factors and not a comprehensive guide because the calculations are complex. The value and potential savings is something all owners of small and medium-sized businesses should be exploring.
We’d be happy to review the QBI calculation factors that apply. Call or email us if you have questions pertaining to your situation.