What is the Qualified Business Income (QBI) deduction?
The QBI deduction is one of the most important deductions for business owners to be aware of. It was created as part of the 2017 Tax Cut and Jobs Act, and essentially provides a 20% deduction on all business income for most small business.
The deduction is calculated on net business income and taken in addition to either the standard or itemized deductions. That means you can use this deduction regardless of if you itemize or not. Note that because the deduction is based on your final net business income, it only reduces your income tax, not your self-employment taxes.
How do you qualify?
The QBI deduction is available to “pass-through entities,” which are basically the entities that don’t pay taxes at the entity level. So sole-proprietors, partnerships, LLCs, and S-corps all qualify. C-corps do not.
What are the limitations?
This is where it gets slightly more complicated. Below are income limits for 2021:
Married Filing Jointly: $326,600
Head of Household / Single: $163,300
Married Filing Separately: $163,300
If your taxable income (before the QBI deduction) is below the limits above for your filing status, you don’t have anything to worry about: you’ll simply take 20% of your business income as a deduction. If you’re above the above limits, your ability to take the deduction is subject to limitations. You can only take the lesser of:
1) 20% of QBI
2) 50% of W-2 compensation OR 25% of W-2 compensation plus 2.5% of unadjusted basis of qualified property (whichever is more favorable).
Since test #2 is a mouthful, here’s a brief explanation. W-2 compensation is the total compensation paid to employees (including any amount they deferred into a retirement plan), the ‘reasonable salary’ you paid yourself as an S-corp employee, and any amount reported to you on a K-1 as part of a partnership.
Unadjusted basis of qualified property is the basis of tangible property, such as equipment and machinery, before any depreciation. It only includes property that has not reached the end of the depreciable period or 10 years after it’s been placed in service, whichever is later.
What is an SSTB?
A specified service trade or business (SSTB) is a business that replies on the “reputation or skill of its owner”. The following are listed explicitly as SSTBs:
- Actuarial science
- Brokerage services
- Financial services
- Health services, such as performed by doctors and nurses
- Investing and investment management
- Law, including lawyers
- Performing arts
If you work as an SSTB, your ability to claim the QBI deduction is eliminated above the income thresholds mentioned above.
If this sounds complicated, that’s because it is. In fact, the QBI deduction passed a few years ago and the IRS is still trying to clear up questions on it. (There’s been a running controversy about if rental income can qualify, for example.) The good news is that you don’t really need to know the nuts and bolts of how it works in order to get the deduction. Let us worry about that.