Small businesses are a significant part of the U.S. economy. They create jobs, drive innovation, and contribute to their communities. But it’s not always easy to keep a small business afloat, especially in times of economic uncertainty.
To help small businesses thrive, the United States provides several tax breaks and incentives. One more recent incentive, created as part of the 2017 Tax Cuts and Jobs Act, is Section 199A of the federal income tax code, also known as the qualified business income deduction.
However, understanding whether you can claim it and calculating the amount to deduct can seem like a daunting task without step-by-step guidance.
What Is the Qualified Business Income Deduction?
The qualified business income (QBI) deduction is unique in that it’s not a business deduction. Instead, it reduces the taxable income reported on your individual tax return similar to the standard deduction or itemized deductions.
If you’re eligible to claim the QBI deduction, you can claim a tax break worth up to 20% of your qualified business income.
What Is Qualified Business Income?
For many businesses, qualified business income 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 interest income, dividends, and capital gains. It also includes income from businesses located outside of the U.S. For a complete list of the income types that don’t qualify, check out the IRS qualified business income deduction fact page.
What Business Types Qualify for the QBI Deduction?
The QBI deduction is for owners of pass-through businesses, which are companies that don’t pay corporate income taxes. Instead, the owner files the income on their personal income taxes. The income “passes through” to the owner.
That includes sole proprietorships, partnerships, limited liability companies (LLCs), and S corporations. The QBI deduction isn’t available to any company that elects to be taxed as a C corporation.
Before the QBI deduction, owners of pass-through businesses might pay tax rates as high as 37% on their business profits on their individual tax returns. Congress designed the QBI deduction to help them pay taxes at a rate closer to the corporate tax rate, which is 21%.
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.
Taxable Income
For 2021 tax returns, if your total income is less than $329,800 (married couple filing jointly) or $164,900 (single taxpayer), you can claim the 20% deduction from qualified business income.
Specified Service Trade or Business
If your taxable income is between $329,800 and $429,800 (married filing jointly) or $164,900 and $214,900 (single filer), 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 occupations like doctors, lawyers, accountants, consultants, professional athletes, financial advisors, performers, and investment managers.
The IRS’s FAQs 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 $329,800 and $429,800 (married filing jointly) or $164,900 and $214,900 (single taxpayers), the IRS limits your QBI deduction based on the business’s W-2 wages and qualified property. If your income is above that upper limit, you cannot claim a QBI deduction.
- If Your Business Is Not an SSTB: If your total taxable income is between $329,800 and $429,800 (married filing jointly) or $164,900 and $214,900 (single taxpayers), you can claim the full 20% QBI deduction. If your income is above that upper limit, the IRS may limit your QBI deduction based on your W-2 wages or qualified property.
W-2 Wage & Qualified Property Limitation
If you’re an SSTB business owner with income between the phase-out limits or a non-SSTB business owner with taxable income over the upper threshold amount, your QBI deduction is limited to the greater of:
- 50% of your share of the amount of W-2 wages the business pays
- 25% of your share of the W-2 wages paid the company pays plus 2.5% of the business’s qualified property
“Qualified property” includes all tangible, depreciable property the business owns 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 or shareholder, if you receive income from real estate investment trust (REIT) dividends or a publicly traded partnership (PTP), 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.
Overall Deduction
If you add REIT or PTP income to your calculation, you must apply one more overall limitation to your QBI deduction. Add the two deductions together.
You can’t deduct more than 20% of your taxable income for the year. For these purposes, that means your taxable income before taking the QBI deduction or net capital gains into account. Net capital gains include your short-term and long-term capital gains and qualified dividend income.
This overall limitation just ensures you don’t apply the 20% deduction to income already taxed at lower capital gains rates.
How to Calculate Your QBI Deduction
The QBI deduction is complicated, so it’s best to apply a four-step process to your business.
- Determine whether your business is an SSTB.
- Calculate your taxable income for the year. If your total taxable income is between $329,800 and $429,800 (married filing jointly) or $164,900 and $214,900 (single filer), then continue to the next step to calculate your deduction. Anyone below the bottom threshold can take the full 20% tax deduction either way. Anyone above the top number can’t claim the deduction at all.
- If your business is an SSTB with income in the phase-out range, 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 with the following characteristics:
- It pays out $100,000 in wages per year.
- It 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. Based on the business characteristics:
- 50% of your share of W-2 wages is $50,000
- 25% of your share of W-2 wages is $25,000, and 2.5% of your business’s qualified property is $1,250, for a total of $26,250
If your QBI deduction weren’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.
Form 8995 is a simplified version, and you use it if your taxable income is less than the $329,800 (joint return) or $164,900 (single) threshold. Otherwise, use Form 8995-A to calculate your deduction.
Final Word
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 eligible taxpayers want to handle on their own.