As an entrepreneur, it’s critical to have your taxes organized before the end of the year.
There are plenty of tax write-offs, tax credits, and self-employment tax loopholes you can use to save money when tax season rolls around.
One of these tax deductions is the qualified business income deduction — or QBI deduction.
Created in the 2017 Tax Cuts and Jobs Act, the qualified business income deduction has provided a way for small business owners to write off 20% of certain business income.
However, this write-off doesn’t apply to everyone, especially those who have a high personal taxable income.
In this guide, we’ll talk about qualified business income to show you how you can save a substantial amount on your next tax return.
What Is Qualified Business Income?
The qualified business income deduction — or the Section 199a deduction — is the amount of income, gains, deductions, and losses small business owners can write off under the 2017 Tax Cuts and Jobs Act.
Not all businesses can utilize this deduction — the business of the taxpayer, the amount of net income, and the business owner’s total personal taxable income must all be taken into consideration.
Business owners are able to write off up to 20% of their qualified business income.
This deduction can be used on top of other allowable business expense deductions.
The deduction is valid from tax years 2018-2025.
Business owners must consider three aspects before taking the deduction.
In order to redeem, they must operate a pass-through business — which we’ll explain below — and consider which types of business income falls under the QBI and below the IRS income threshold for total personal taxable income.
First, let’s look at what types of businesses qualify for the QBI deduction.
1. Types of Businesses
Only pass-through business owners are able to redeem this deduction, not corporations.
A pass-through business is one that allows the business owners to put business income on their personal tax return.
The following business types are considered pass-through businesses.
- Sole proprietorships and single-owner LLCs: Must file federal income taxes with a Schedule C
- Partnerships and multiple-owner LLCs: Must file a partnership return
- S-corporations: Must file with Form 1120-S
A C-corporation is not eligible for the QBI deduction since the owners’ business and personal tax returns are filed separately.
Before you start to figure out your deduction, you need to fully understand what is included in qualified business income.
2. QBI Inclusions and Exclusions
Qualified business income includes income, gains, deductions, and losses from the services and operations of your business.
Your QBI includes the performance of services and production your business provides, but not necessarily all of its income.
Income that’s derived from investment instruments isn’t included in a business’s QBI.
To simplify this, just think of QBI as income that a company actively produces.
Since investment income is more of a passive source of income, it isn’t included.
A company’s QBI includes the following qualified items of income.
- Income generated from sole proprietorships, partnerships, and S corporations
- Deductible tax amounts on personal income, insurance, and contributions to a retirement plan
Now let’s look at what isn’t included on a company’s qualified income.
The following list of QBI exclusions is by no means fully comprehensive.
There are even more exclusions that aren’t included, such as:
- Income from outside the United States
- Net capital gains and losses
- Dividends, including qualified real estate investment trust (REIT) dividends
- Interest income not derived from business
- W-2 wages that are paid to the S-corporation owner
- Guaranteed partner payments
- Reasonable compensation to business owners
- Commodity transactions
- Foreign currency gains and losses
- Annuity payments
- Service payments by a partner
There are going to be exceptions from these listed, so make sure not to take this as gospel.
There will be circumstances where inclusions and exclusions may be a little blurry, so it’s best to consult with a certified public accountant (CPA) or your tax preparer.
Now let’s go over total personal taxable income so we can calculate your QBI deduction.
3. Total Personal Taxable Income
Total personal taxable income is a business owner’s personal income from all sources.
To receive the QBI deduction, your total taxable income must be under $157,500 if you’re filing an individual return or $315,000 if you’re filing jointly with a spouse.
Your total personal taxable income combines your personal employment income, capital gains, and your business income that’s passed through to your personal yearly earnings.
In some cases, specialized service trades or businesses (SSTBs) are not eligible for the QBI deduction if the business owner’s total personal taxable income surpasses the amounts mentioned above.
These types of qualified trade and service businesses can include the following:
- Performing artists
- Investment managers
- Actuarial scientists
- Financial service advisors
You can think of it like businesses with income primarily driven from an individual’s expertise in a certain field.
Since this tends to be confusing, let’s walk through an example to give you an idea of how you’d calculate your qualified business income deduction.
Calculating Your Qualified Business Income Deduction
Calculating whether or not you can use the qualified business income deduction is relatively straightforward, but there are some exceptions.
Here is the general calculation for those who file single and joint returns.
- Single Return: $157,500 > (Total Taxable Income – Qualified Business Income)
- Joint Return: $315,000 > (Total Taxable Income – Qualified Business Income)
Once you’ve determined whether or not you fall below one of these thresholds, you’ll simply multiply your qualified business income amount by 20% to see an estimate of your tax deduction.
A real-world example can help us better explain this.
Consider Susan who owns and operates her own graphic design firm as a side business.
She is a single-owner sole proprietor who files her taxes under Schedule C.
Her company was able to generate $50,000 in qualified business income.
Susan also has a full-time job at an advertising agency where she gets paid for her design services.
She made $60,000 in personal wages over the past year.
This means her total taxable income is $110,000.
If we look at the calculations above, you’ll see that if Susan were to file under single status, she would be under the $157,500 threshold amount.
She can then take her qualified business income of $50,000 and multiply that number by 20%.
Susan’s qualified business income deduction will be around $10,000.
If Susan filed a single return and made more than $157,500, she wouldn’t qualify for the QBI deduction.
She also wouldn’t qualify if she and a spouse combined their incomes under a married filing jointly tax return, and their total combined salary surpassed the $315,500 threshold.
For those who don’t qualify, it doesn’t necessarily mean you’re out of luck.
You can still receive some deductions.
However, they are limited.
You’ll take whichever of the following is greater:
- Half of an individual’s W-2 wages from a qualified business
- One-quarter of W-2 wages from a qualified business, plus 2.5% of the unadjusted basis after the acquisition of qualified property
If you think you qualify for the QBI deduction, let’s look at how you would add this deduction to your tax form.
Putting the QBI Deduction on Your Tax Return
Sole proprietors will calculate their QBI deduction differently from multiple-owner partnerships and S-corporations.
For sole proprietors, you’ll use a worksheet within the IRS Form 1040 Instructions to calculate your deduction.
After you’ve totaled everything, you’ll take the amount and write it into Line 9 on your personal owner’s 1040 form.
On the other hand, partnerships and S-corporations will need to take an additional step to split partnership income.
First, the qualified business income must be calculated in the same way we mentioned above.
The difference is that now the QBI deduction must be split among the owners of the company.
Each filer will get only a portion of the company’s QBI.
Calculate each owner’s share of the QBI and input that number into your Schedule K-1 tax form.
The K-1 form is used to show your individual share of a business’s income in a partnership or an S-corporation.
Do You Qualify for the QBI Deduction?
Tax laws can be confusing.
As a small business owner, you want to find as many deductions as possible so you can get higher than your typical standard deduction.
The qualified business deduction is a sure way to save money on your next taxable year.
If you have more questions regarding the QBI deduction, head to the IRS website.
You can also check out our guide to filing your independent contractor taxes if you’re a freelancer.