If you’re self-employed or a small business owner, you may have noticed the qualified business income deduction while doing your taxes in the past few years. It’s a relatively new provision of the IRS code, also known as Section 199A.
The qualified business income deduction was established as part of the Tax Cuts and Jobs Act in 2017. It provides some significant tax benefits for non-corporate business entities, presumably to match the large corporate tax rate cut the legislation provided.
On its face, the deduction allows the self-employed or small-business owner to deduct up to 20% of their qualified business income (QBI) on their taxes.
But what exactly constitutes qualified business income? And who is eligible for the deduction? Let’s explore what QBI is, how to calculate QBI, and how to take advantage of the qualified business income deduction.
Qualified business income is defined as “the net amount of qualified items of income, gain, deduction and loss with respect to any trade or business.” Basically, it’s any business income that you report on your personal tax return, or your businesses’ “net profit.”
However, not all business income qualifies as QBI. Qualified business income does not include interest income, income earned outside of the U.S., capital gains or losses, dividends and certain wages and guaranteed payments made to partners and shareholders.
Income received from a C corporation is not eligible for the qualified business income deduction. However, if you receive taxable income from a pass-through entity (LLCs, S Corporations or sole proprietorships), you’re likely eligible for the deduction, plus up to 20% of publicly traded partnerships (PTP) and qualified REIT dividend income. Additionally, trusts and estates with qualified business income may qualify for the QBI deduction as well.
It’s important to note that a qualified REIT dividend must be held for at least 45 days, must be paid to you and does not include capital gains dividends. You can find the amount of qualified REIT dividends in Box 5 of your Form 1099?DIV.
Additionally, if your 2020 taxable income is less than $326,600 as a married couple filing jointly, or $163,300 with any other filing status, then you’ll be able to claim the qualified income deduction. No questions asked.
However, limitations apply if your income exceeds that threshold. For example, specified service trades or businesses (SSTBs) might not be able to claim the qualified business income deduction, or may face a limited deduction. SSTBs include businesses in the following industries:
SSTBs also include businesses dealing in securities, partnership interests or commodities. Any business with a principal asset of a reputation or skill of one or more of its employees or owners qualifies as an SSTB as well.
If your business qualifies as an SSTB and your 2020 taxable income is between $326,600 and $426,600 (married, filing jointly) or $163,300 and $213,300 (any other filing status), then your QBI deduction is subject to additional limitations.
These include the W-2 wage limitation and the W-2 wage and unadjusted basis limitation. These limitations are phased in and are based on taxable income. If your business is a qualified trade, and you’re above the previously mentioned tax threshold, your deduction is also subject to the W-2 wage limitation and W-2 wage and unadjusted basis limitation.
Qualified trade businesses include the following industries:
For individuals and businesses looking to calculate qualified business income for the deduction, Section 199A provides some guidance.
If your 2020 taxable income is less than $326,600 as a married couple filing jointly, or $163,300 with any other filing status, then your deduction is either 20% of QBI or 20% of modified taxable income, whichever one is less.
Once taxable income exceeds that threshold, the qualified business income deduction becomes a bit more complicated. It is the lesser of 20% of QBI with respect to any qualified trade or business; or the greater of:
If your 2020 taxable income is greater than $426,600 married, filing jointly, or $213,300 with any other filing status, you won’t be able to claim the deduction if your business is an SSTB. However, a QBI deduction is still available for a business that is not an SSTB and that has W-2 wages or qualified property.
1) Do rental properties factor into qualified business income or are they considered investment driven income?
Yes, but restrictions apply. Rental income is eligible if you qualify for the Revenue Procedure 2019-38 safe harbor. To qualify, you must maintain separate records for each rental real estate enterprise, perform at least 250 hours of “rental services” every year and maintain ongoing documentation of how you are fulfilling the 250 hours. Property used as residence for part of the year, such as a vacation home, does not qualify.
2) How does a net loss of QBI impact the deduction?
If your losses are greater than your business income, you don’t qualify for the qualified business income deduction. Instead, if your QBI is less than zero, you carry the loss forward into the next tax year. Your deduction is then delayed to a future taxable year.
3) When it comes to SSTBs, what qualifies as “consulting” services?
Section 199A defines consulting as “the provision of professional advice and counsel to clients to assist the client in achieving goals and solving problems.” This does not include the sale of goods, or conducting training and educational courses.
Understanding qualified business income can be tricky, and Section 199A in particular can be quite complicated. Hopefully this article provides a starting point for the self-employed or business owners who are curious about qualified business income, or how to take the QBI deduction.
And keep an eye out for updates from the IRS. As with any relatively new tax policy, there is always the possibility for new updates that provide further clarification to some of the policy’s more ambiguous parts.
©All Rights Reserved. March, 2021. DailyDACTM, LLC d/b/a/ Financial PoiseTM
Katherine Braden is a business communications professional with a background in journalism and experience working with clients in the financial services industry.
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