Small businesses are a significant part of the U.S. economy. According to the United States Small Business Administration, they generate around 44% of our gross domestic product. They also create jobs, drive innovation, and contribute to the communities in which they operate.
To help small businesses continue to thrive, the U.S. tax code provides several tax breaks and incentives. One of the newer incentives is Section 199A of the tax code, also known as the qualified business income deduction.
However, understanding who can claim the deduction and calculating the amount to deduct is no easy task.
What Is the Qualified Business Income Deduction?
The qualified business income deduction allows certain businesses to claim a tax break worth up to 20% of its “qualified business income.”
For many businesses, qualified business income (QBI) is the same as net income. However, there are several types of income that don’t count as QBI. The list includes investment income, such as dividends and capital gains. It also includes income from businesses located outside of the U.S. For a full list of the income types that don’t qualify, check out the IRS qualified business income deduction fact page.
Pro tip: If you have any questions about the QBI deduction and how it might affect your taxes, contact a tax advisor from H&R Block. You chat online with a tax expert and have all your questions answered.
Who Can Claim the QBI Deduction?
The QBI deduction is for owners of pass-through businesses, including sole proprietors, partnerships, LLCs, and S corporations. The term “pass-through” refers to the way these companies are taxed. In a pass-through business, income “passes through” to the owner, who pays income tax on the business income on their individual income tax return.
The QBI deduction isn’t available to C corporations or LLCs that elect to be taxed as a C corporation.
It sounds pretty straightforward. But once you’ve established that your business is a pass-through, you need to know about income limits, specified service trades or businesses, W-2 wages, qualified property, and an overall limitation. Let’s tackle each of these one at a time.
Taxpayers with total income less than $315,000 for married couples filing jointly or $157,500 for single taxpayers can claim the 20% deduction from qualified business income.
Specified Service Trade or Business
If your taxable income is between $315,000 and $415,000 if married filing jointly or $157,500 and $207,500 for single filers, you need to determine whether your business is a specified service trade or business (SSTB).
An SSTB includes any service-based business other than engineering or architecture in which the company depends on the employees’ or owners’ reputation or skill. That’s a broad definition, but it typically includes doctors, lawyers, accountants, consultants, professional athletes, financial advisors, performers, investment managers, and similar occupations.
The IRS’s frequently asked questions page for the QBI deduction includes additional information to help you figure out whether your business is an SSTB. Once you figure that out:
- If Your Business Is an SSTB: If your total taxable income is between $315,000 and $415,000 for married couples filing jointly or $157,500 and $207,500 for single taxpayers, the IRS limits your QBI deduction based on the business’ W-2 wages and qualified property. If your income is above that upper limit ($415,000 for married couples or $207,500 for single filers), you cannot claim a QBI deduction.
- If Your Business Is Not an SSTB: If your total taxable income is between $315,000 and $415,000 for married couples filing jointly or $157,500 and $207,500 for single taxpayers, you can claim the full 20% QBI deduction. If your income is above that upper limit ($415,000 for married couples or $207,500 for single filers), the IRS may limit your QBI deduction based on your W-2 wages or qualified property.
W-2 Wage & Qualified Property Limitation
For SSTB business owners with income between the phase-out limits and non-SSTB business owners with taxable income over the upper thresholds, the QBI deduction is limited to the greater of:
- 50% of your share of the W-2 wages paid by the business
- 25% of your share of the W-2 wages paid by the company plus 2.5% of the business’s qualified property
“Qualified property” includes all tangible, depreciable property owned by the business at the end of the year. You must use that property to produce qualified business income during the year, and its depreciation period (typically 10 years) cannot have ended before the close of the tax year.
Real Estate Investment Trust Dividends & Publicly Traded Partnership Income
As the business owner, if you receive income from real estate investment trust dividends or a publicly traded partnership, there’s a second deduction worth up to 20% of that income. So you can add that to the QBI deduction for your business income.
After calculating the two deductions outlined above, add them together. That figure is subject to an overall limitation equal to 20% of the excess of taxable income (before considering the QBI deduction) divided by net capital gains (including qualified dividends taxed at capital gains rates).
This overall limitation ensures you don’t apply the 20% deduction to income already taxed at lower capital gains rates.
Step-by-Step Guide to Calculating the QBI Deduction
As you can see, the QBI deduction is complicated. It’s best to take a four-step process to apply it to your business.
- Determine whether your business is an SSTB.
- Calculate your taxable income for the year. If it’s less than $157,500 if single or $315,000 if married filing jointly, then you don’t need to worry about whether or not your business is an SSTB. You can take the full 20% tax break. If your company is an SSTB and your total taxable income is more than $207,500 if single or $415,000 if married filing jointly, your income is too high. You can’t claim the deduction. If your total taxable income is between $157,500 and $207,500 if single or $315,000 and $415,000 if married filing jointly, then continue to the next step to calculate your deduction.
- If your business is an SSTB with income in the phase-out range, you’ll calculate your deduction by taking 20% of your qualified business income and applying the W-2 wage and qualified property limitation.
To illustrate, say you are a 50-50 owner in a non-SSTB business that pays out $100,000 in wages per year and has $50,000 of qualified property. Your share of the qualified business income is $400,000. Your taxable income for the year is $500,000, so you are over the taxable income threshold and need to apply the W-2 wages and qualified property limitation.
- 50% of your share of W-2 wages would be $50,000.
- 25% of your share of W-2 wages would be $25,000, and 2.5% of your business’s qualified property would be $1,250. Those two numbers combined are $26,250.
If your QBI deduction wasn’t limited, it would be $80,000 (20% of $400,000). But since we have to apply the limitation, your deduction would be $50,000 because $50,000 is greater than $26,250.
The IRS instructions for Form 1040 and IRS Publication 535 contain worksheets you can use to calculate the deduction. Then you need to complete Form 8995 or 8995-A and attach it to your Form 1040 tax return.
If you think calculating the QBI deduction sounds really confusing, you’re right. That’s why it’s a good idea to discuss the QBI deduction with a qualified tax professional who can handle the heavy lifting for you.
While it can be a generous tax break for business owners who qualify, it’s not something most taxpayers want to handle on their own.
Will you take advantage of the QBI deduction this year? Do you feel comfortable calculating it on your own, or will you work with a tax pro?