The 2017 Tax Cuts and Jobs Act introduced a deduction for qualified businss income (QBI) that provides a significant tax break to many business owners. The newly created Section 199A of the federal tax code lets certain owners of sole proprietorships, partnerships, LLCs, S corporations, trusts and estates – but not C corporations — deduct up to 20% of QBI on their individual tax returns. Here’s what you need to know about this deduction.
The creation of the QBI deduction was seen as a way to balance the 2017 law’s reduction of the C corporation tax rate from as high as 35% down to 21%. However, it may not last forever. Unless Congress extends it, the QBI deduction expires in 2026.
Basically, the deduction allows taxpayers to deduct 20% of the QBI from qualified businesses owned by the taxpayer. However, there are a number of limitations and exclusions that can reduce or eliminate a business owner’s ability to use the QBI deduction.
Who the QBI Is for
To begin with, the QBI deduction is only available to owners of pass-through entities. These are business entities that are not taxed directly. Instead, business profits pass through directly to the owners, where they are taxed at the owners’ individual tax rates. Pass-through entities include sole proprietorships, partnerships, LLCs and S corporations but not C corporations. Profits from a regular C corporation can’t be used for a QBI deduction. Nor can wages earned working as an employee. QBI also can’t include investment gains or dividends.
In addition, the amount of income earned from the business or other sources can affect the QBI deduction. The income threshold started in 2018 at $315,000 for a married couple filing jointly and $157,500 for single individuals, married people filing separately and heads of households. It is indexed to inflation each year. For 2020, the thresholds are $326,600 for married individuals filing joint returns and $163,300 for other filers.
The type of business is also a factor. This is where the income thresholds come into play. If the taxpayer’s income is below the threshold, the type of business doesn’t matter. But for certain types of businesses, called “specified services trades or businesses” (SSTBs), the income thresholds may limit the taxpayer’s ability to use the QBI deduction.
SSTBs include businesses that provide services in the areas of health, law, accounting, performing arts, consulting, athletics, financial services and investing. Manufacturers, retailers and providers of other services such as engineering firms, on the other hand, are examples of businesses that are not SSTBs.
If the business is an SSTB and the taxpayer’s taxable income exceeds the income threshold, it can limit the amount of deduction that can be taken. The exact amount of the limit depends on a formula that considers the W-2 wages paid by the business and the value of certain assets of the business.
QBI Forms and Paperwork
Only business profits – not losses — can be used to figure the QBI deduction. If a business loses money, the owner can use the loss as a deduction the following year. Business income from sole proprietorships that may qualify for a QBI deduction usually can be found on the filer’s Schedule C. It may also or instead be on a Schedule E, which is used to report income from rental real estate, royalties, partnerships, S corporations, estates and trusts. Schedule K-1, which reports on partnership income, is another possibility. A 1099-DIV form, which reports non-wage income from other sources, may also have business income that could be used for the QBI deduction.
Calculating a QBI deduction can become complicated, particularly when taking into account the phased-in limits applied to higher-income business owners. Tax software does these calculations automatically, however. All the taxpayer has to do is enter the requested information. Worksheets and instructions telling most taxpayers how to calculate the QBI deduction can be found on IRS Form 1040. Taxpayers whose income exceeds the thresholds can find worksheets and instructions in IRS Publication 535.
The Bottom Line
The QBI or qualified business income deduction can offer significant savings at tax time for owners of many businesses. Taxpayers can deduct up to 20% of the QBI generated by businesses they own. Only pass-through business entities can take advantage of a QBI deduction. The type of business and the amount of the taxpayer’s taxable income may limit availability of this deduction. Businesses that have lost money during the year in question can’t create a QBI deduction. Wages earned as an employee also can’t be used for a QBI deduction.
Tips on Filing Taxes
- Consider working with an experienced financial advisor if you are a business owner who may qualify for the QBI deduction. Finding the right financial advisor who fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in as little as five minutes. If you’re ready to be matched with local advisors who will help you achieve your financial goals, get started now.
- Business owners don’t have to itemize their deductions to take the QBI deduction on their tax returns. Taxpayers who elect to take the standard deduction are also eligible for the QBI deduction. Also, a free tax calculator can give you a good idea of what you will owe.
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