The qualified business income (QBI) deduction was created by the federal tax overhaul, which was signed into law in December 2017. It's a strong tool in reducing your tax liability, but calculating the deduction can be tricky. Regardless, it's important to consider when deciding to operate your business as a C corporation or pass-through entity.
Generally, you can deduct 20 percent of QBI, qualified cooperative dividends, qualified REIT dividends and qualified publicly traded partnership (PTP) income to reduce your taxable income. QBI must come from a pass-through entity that includes partnerships, S corporations and sole proprietorships.
QBI is the net amount of the business’s qualified items of income, gain, deduction and loss. QBI isn’t income from foreign pass-through entities, amounts paid for services that are your reasonable compensation, guaranteed payments to a taxpayer for services performed, amounts paid to a taxpayer who’s acting outside of his/her capacity as a partner for services, qualified REIT dividends, qualified cooperative dividends, qualified PTP income or any investment-related items. You can deduct 20 percent of qualified REIT dividends, qualified cooperative dividends and qualified PTP income, but these aren’t included in calculating the total QBI amount.
To claim this deduction, you must have an ownership interest in a qualified trade or business. The current tax law doesn’t clearly define trade or business, but many assume the IRC Section 162 standard applies: the business must be regular, continuous and substantial. However, a qualified trade or business doesn’t include accounting, law, performing arts, health, consulting and actuarial science. These types of businesses are specified service trades or businesses. If you're involved in these businesses, you can’t claim the QBI deduction unless you're below certain income thresholds.
If your taxable income is less than $315,000 (married filing jointly) or $157,500 (single), you can claim this deduction. Period. Even if you're part of a specified service trade or business. You don't need to calculate a limitation.
However, if your taxable income is more than those amounts, you must calculate your W-2 wages and qualified property limitation.
Start by calculating your QBI separately for each of your qualified businesses. Eventually, you'll combine them all as a single amount on your individual tax return. You can aggregate your businesses to calculate your total QBI, but certain rules apply. Make sure you know these rules if you plan to aggregate.
After you've calculated QBI for your businesses, you should calculate your limitation. Going through this calculation can help you determine whether aggregating your businesses will hurt or help your total deduction amount. Here's how:
First, know how much the business paid in W-2 wages and how much qualified property it owns. These limit the deductible amount. Then, the total QBI will be limited to the lesser of:
1) 20 percent of your QBI
2) 50 percent of the company’s W-2 wages allocated by ownership with respect to the trade or business, or the sum of 25 percent of the W-2 wages plus 2.5 percent of the unadjusted basis of all qualified property. You can choose whichever of these tests provides a greater deduction.
Calculating each of those scenarios and selecting the lesser deduction will give you the total deduction amount you can claim on your tax return. Please note that the limitation also is limited to 20 percent of modified taxable income.
The QBI deduction is a welcome tax break for some, but claiming it isn’t simple. When you have multiple sources of QBI or eligibility questions, it can quickly become complex. If you think this deduction applies to you, reach out to a tax professional who can help you maximize the benefits of this deduction.