If you own a business, the qualified business income (QBI) deduction can be one of the most impactful deductions on your tax return. Hence, it’s important that you understand what QBI is, how to calculate the deduction, who qualifies, and how it can impact your taxes.
What is the Qualified Business Income Deduction?
The QBI (sometimes called Section 199A) deduction is a tax benefit for small business owners. It became part of the Tax Cuts and Jobs Act (TCJA) in late 2017.
Moreover, the QBI deduction allows eligible self-employed and small business owners to deduct up to 20% of their qualified business income on their taxes. However, the rules around who qualifies for this deduction can be complex.
Furthermore, the QBI comes from a pass-through entity, meaning it covers businesses organized as sole proprietorships, partnerships, S corporations, and some trusts and estates.
The reduction in taxable income leads to smaller federal tax liability. Furthermore, eligible business owners can lower their taxable income by deducting up to 20% of their business income. The QBI deduction is a below-the-line deduction.
Will the QBI Discount Expire?
The Qualified Business Income (QBI) deduction will expire at the end of 2025. The end of the QBI deduction was part of the TCJA.
If the QBI deduction expires, it means that eligible business owners will no longer be able to take a 20% deduction on their qualified business income beginning in 2026.
However, because the political climate is constantly changing, it’s hard to predict if the deduction will actually be allowed to expire. Furthermore, Congress may decide to extend the QBI deduction or alter it in some way before its scheduled expiration date.
What Businesses Qualify for QBI?
To qualify for the Qualified Business Income (QBI) deduction, a business needs to meet certain criteria:
Type of Business:
The business should be a pass-through entity. In short, this includes sole proprietorships, partnerships, S corporations, and some trusts and estates.
The income must be from a trade or business within the United States. Furthermore, investment-related items, reasonable compensation, or guaranteed payments to partners are not qualified income.
Specified Service Trade or Businesses (SSTBs):
These businesses may face limitations or exclusions if the taxable income exceeds certain threshold amounts. SSTBs are businesses whose principal asset is the reputation or skill of one or more of its employees or owners. Examples include health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, investing and investment management, and dealing in certain assets.
For digital businesses, the following business should qualify for QBI deductions.
These generally qualify for the QBI deduction as long as they operate as a pass-through entity. For example, an individual running an online store as a sole proprietor or a partnership operating a larger e-commerce site could be eligible.
SaaS and Software Developers:
Software as a Service (SaaS) and software development businesses also typically qualify.
When it comes to software development, it’s worth noting that if a software business’s reputation relies primarily on the “reputation or skill” of one or more employees, it could fall into the SSTB category and be subject to limitations or exclusions. It must be remembered that this can be a gray area, and professional advice may be necessary.
Common reasons a business might not qualify for QBI:
- Businesses structured as C corporations do not qualify for the QBI deduction. Income from C corporations is not pass-through income.
- If your business classifies as an SSTB and the business owner’s taxable income exceeds the threshold amounts, the QBI deduction may be limited or completely phased out.
- Income derived outside of the United States is not qualified business income.
Remember that tax law is complex, and the QBI deduction rules have numerous exceptions and nuances.
How Much Can I Save with a QBI Write-Off?
How much you can save with the QBI deduction depends on several factors, including your qualified business income and tax rate.
To provide a brief and simplified example: Let’s say you’re a sole proprietor with a qualified business income of $100,000, and you’re in the 24% tax bracket.
Without the QBI deduction, you would owe income tax on the full $100,000, which at a 24% tax rate would be $24,000.
With the QBI deduction, you would first subtract 20% of your qualified business income, which is $20,000 ($100,000 * 20%).
In that case, this reduces your taxable income to $80,000 ($100,000 – $20,000).
If you apply the 24% tax rate to this reduced income amount, you would owe $19,200 in taxes.
So, by taking the QBI deduction, you’ve saved $4,800 in taxes in this scenario ($24,000 – $19,200).
How to Calculate Your Savings
Calculating your Qualified Business Income (QBI) deduction and potential tax savings involves several steps. In short, here’s a simplified step-by-step guide:
1. Determine your QBI:
Your QBI includes the net amount of income, gains, deductions, and losses from your U.S. business or trade.
2. Calculate 20% of your QBI:
The basic QBI deduction is 20% of your QBI. For example, if your QBI is $100,000, your basic QBI deduction is $20,000 ($100,000 x 20%).
3. Determine your taxable income:
This is your total income for the year minus deductions. Furthermore, it includes income from all sources, not just your business.
4. Check if you’re above the income threshold:
For 2023, the income threshold is $182,100 for single filers and $364,200 for joint filers. Therefore, you can take the full 20% QBI deduction if your taxable income is below these thresholds. The deduction may be reduced or eliminated if your income is above these thresholds and your business is a SSTB.
5. Consider the W-2 wage and property limitation:
However, if your taxable income is above the threshold, your QBI deduction may be limited by the greater of 50% of the W-2 wages paid by your business or 25% of the W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition (UBIA) of all qualified property.
6. Calculate your taxable income with the QBI deduction:
Then, subtract your QBI deduction from your taxable income.
7. Determine your tax without the QBI deduction:
Apply your tax rate to your taxable income without the QBI deduction.
8. Determine your tax with the QBI deduction:
Apply your tax rate to your taxable income with the QBI deduction.
9. Calculate your tax savings:
Lastly, subtract the tax with the QBI deduction from the tax without the QBI deduction.
It’s important to note that this is a simplification. All in all, the actual calculation can be much more complex, especially for higher-income taxpayers and certain types of businesses.
Final Thoughts on the Qualified Business Income Deduction
The Qualified Business Income Deduction (QBI) is a significant saving for many small business owners. Also, it allows for a tax deduction of up to 20% of a business’s qualified income, reducing tax liability.
It’s important to be careful when calculating the QBI deduction because the calculation can be complex and includes consideration of the type of business and entity structure.