Qualified Business Income Deduction for Small Businesses and Self-Employed
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As a small business or self-employed individual, you want all of the tax breaks you can get. The qualified business income deduction (also called a QBI deduction or a section 199A deduction) allows you to deduct up to 20% from your company’s income. The qualifications for this tax break are determined by entity type, income level, and income type.
While completing the paperwork for a qualified business income deduction can be complicated, the deduction can significantly help taxpayers. Let’s take a look at whether you qualify for the qualified business income deduction and how you can take advantage of it.
What is a qualified business income deduction?
The qualified business income deduction enables pass-through business owners to claim up to a 20% tax deduction from their qualified business income.
A pass-through entity’s business income “passes through” to the owner’s individual tax return, instead of a C corporation that pays corporate income taxes. Pass-through businesses include:
- Sole proprietorship
- Limited liability company (LLC)
- S corporation
QBI deductions are outlined in Provision 11011 Section 199A of the 2017 Tax Cuts and Jobs Act (TCJA).
What counts as qualified business income?
Qualified business income is the net total of a company’s income not counting investment management income (e.g., capital gains, losses, or dividends), income from overseas businesses, and investment income not properly allocable to a business or trade.
In 2022, your total taxable income must be under $170,050 if you’re a single filer or $304,100 for joint filers to qualify for the QBI. If your business exceeds the limit, you may still earn a partial deduction or adjusted tax rate, so it’s best to consult a tax pro.
Who is eligible for qualified business income deductions?
Qualified business income deduction eligibility is based on three factors:
- Entity type
- Income level
- Income type
As we discussed earlier, only pass-through entities, or entities in which business incomes appear on the owner’s personal tax return, are eligible for this deduction. Many small businesses and self-employed individuals are pass-through businesses.
If you file a Schedule C as a sole-proprietor or LLC, a partnership return as a partnership or multi-member LLC, or a Schedule K-1 as an S corporation shareholder, you are a pass-through entity and may be eligible for the qualified business income deduction.
If you file a separate tax return for your business tax and your individual taxpayer’s taxable income, then you’re a corporation and you don’t qualify for the qualified business income deduction.
Your total taxable income for the prior tax year (including your business and personal gross income) must be at or below the QBI deduction threshold amount. The amount is $170,050 for single filers or $340,100 for joint filers (also called married filing for partnership incomes). The threshold adjusts for inflation each year.
However, if your income is above these limits, you might still be eligible for the qualified business income deduction depending on the nature of your business. You might not be entitled to the full 20% tax rate deduction, but you might qualify for a partial deduction.
If your business is a Specified Service Trade or Business (SSTB), then you have a bit more wiggle room for qualified business income deduction eligibility. SSTBs include individuals and companies that work in a niche position based on reputation or skill. Types of individual SSTBs include:
- Financial planners
Common industries that typically have small business SSTBs include actuarial science, health care, financial services, investing, brokerage services, and performing arts.
If you count as an SSTB, then you qualify for the qualified business income deduction if your total income is under the income limit of $214,900 for single filers or $429,800 for a joint return.
Most of your business’ net income counts for the qualified business income deduction. The IRS bases eligibility on the "net amount" of "qualified items of income, gain, deduction, and loss," which includes health insurance and any itemized deductions for contributions for a qualified retirement plan.
But there are some exceptions. Qualified business income does not include:
- Items not properly included in business income
- Income from overseas entities
- Wage income
- Income received as reasonable compensation from an S corporation
- Income received as guaranteed payments
- Income received as a payment by a partner for services other than in a capacity as a partner
- Items treated as net capital gains or losses
- Dividends and dividend equivalents
- Interest income not properly allocable to a qualified trade or business
- Commodities transactions or foreign currencies gains or losses
- Income, loss, or deductions from notional principal contracts
- Annuities not received in connection with the trade or business
- Qualified REIT dividends and PTP income
Keep in mind that the qualified business income deduction is only on business income for federal income tax purposes and doesn’t include a small business owners’ self-employment tax deduction.
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How to calculate your qualified business income deduction
Like other tax-related calculations, calculating your qualified business income deduction can get really confusing really fast. Let’s break it down.
Step 1: Determine whether you qualify as an SSTB
You probably have a good idea whether your business counts as an SSTB, but if you aren’t sure about your type of business, ask a tax professional. You can always review the IRS’ FAQs about the qualified business income deduction, but it’s better to be safe than sorry when it comes to tax law.
Step 2: Calculate your taxable income for the year
Determine your total net income for the fiscal year and subtract any exceptions if applicable using Schedule C (single owner) or Schedule K-1 (multiple owners). If the net total is under the phase-out amount of $170,050 (single) or $304,100 (joint), then you qualify for the full 20% deduction no matter what kind of business you have.
Here’s where things get complicated.
- If your business is an SSTB and your total taxable income is greater than $214,900 (single) or $429,800 (joint), then you will not qualify for the deduction
- If your business is not an SSTB and your total taxable income is between $170,050 and $214,900 (single) or $304,100 and $429,800 (joint), you’re eligible for the complete deduction
- If your business is an SSTB and your total taxable income is between $170,050 and $214,900 (single) or $304,100 and $429,800 (joint), you’re eligible for a partial deduction
Step 3: Crunch the numbers
If you qualify for the deduction, then you can calculate your total by taking 20% of your QBI and applying the limitations of:
- 50% of your amount of W-2 wages paid by the business, or
- 25% of those wages plus 2.5% of your share of any qualified property you purchased on an unadjusted basis immediately after acquisition (UBIA)
You’ll compare the total of both the 20% QBI and limited QBI and deduct the smaller amount.
Use IRS Form 8995 to calculate your deduction and attach it to your tax return. If you’re an SSTB or have a more complicated situation (like owning multiple businesses), then you’ll use IRS Form 8995-A.
How to claim your deduction when filing your tax return
Enter your calculated QBI deduction on line 13 of your Form 1040 or 1040-SR. Attach Form 8995 or Form 8995-A to demonstrate how you calculated your deduction. It’s like showing your work on a math problem, so the IRS knows you aren’t pulling numbers out of thin air.
Qualified Business Income Deduction FAQs
Let's tackle some of the questions we’ve had multiple clients ask about qualified business income deductions.
Can I claim qualified business income deductions on my rental property?
Possibly. If you own real estate rental properties, you might be entitled to the qualified business income deduction if you can show how you qualify as an SSTB. Every situation is unique, so if you want to explore the possibility of a qualified business income deduction for your real estate business, then you should get in touch with a licensed tax pro.
Can I combine the qualified business income deduction with the standard deduction?
Yes. If you don’t itemize your business deductions and prefer to use the standard deduction, then you can still take advantage of the qualified business income deduction. The 2022 standard deduction is $12,950 for singles and $25,900 for joint filers.
Does the deduction reduce earnings subject to self-employment tax?
No. Per section 1402, the qualified business income deduction doesn’t reduce your self-employment net earnings. Under section 1411, it also does not reduce net investment income.
A better way to Deel with qualified business income
If you have more questions, that’s entirely okay. The qualified business income deduction is one of the more complicated aspects of self-employment and small businesses payroll taxes. But the tax break is within reach.
Deel helps businesses hire employees and contractors from over 150 countries including the United States without having to become a tax or payroll expert. Request your demo today and see how Deel can work for you.
This post is provided for informational purposes and should not be considered legal or financial advice. Talk to a tax professional for more info.