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- January 6, 2024
Understanding the Qualified Business Income Deduction (QBI)
The Qualified Business Income Deduction (QBI) was introduced in the Tax Cuts and Jobs Act in 2017. It offers much-needed tax breaks to owners of pass-through entities. These entities include sole proprietorships, partnerships, S corporations, and some trusts and estates. This deduction, also known as Section 199A, provides great tax benefits to such business entity owners.
But only a few business owners have information on this topic. So we decided to come up with a detailed explainer to help you understand the complexities of QBI. So let’s get started.
QBI Deduction Overview
The QBI deduction is set at 20% of qualified business income. It’s designed for pass-through entities like partnerships, S corporations, sole proprietorships, and certain trusts. The core idea behind offering this deduction is to level the tax playing field between these entities and C corporations. As we all know C corporations often benefit from reduced corporate tax rates. So it makes sense to offer similar opportunities to other entities. Now If you are wondering what falls under Qualified business income, let’s put it in simpler words. It’s the net income generated from the business operations of the above-mentioned entities. Remember, QBI doesn’t include certain investment incomes or wages as an employee.
Now let’s understand the income threshold for QBI. If a taxpayer is a single filer and their taxable income falls below $182,100, they are eligible for full QBI deductions. But if a married couple is filing jointly, the eligible threshold will be $364,200. Remember, these thresholds are for the year 2023. They are adjusted annually for inflation.
When a filer’s taxable income exceeds these thresholds, the QBI deduction starts to phase out. Reason? Well, the idea is to help small and medium business owners, and not those with very high incomes.
How QBI is calculated?
Now let’s talk about the QBI calculations. QBI includes the total net income, gains, deductions, and losses from a taxpayer’s qualified business activities. In short, it’s important to take profits and losses accrued by the business during a particular year.
Most importantly, the QBI calculation excludes certain types of income. This includes investment income (like capital gains and dividends), interest income unrelated to the business, traditional wage income, and income from foreign sources. The reason is to target a business’s operational income only.
How do you calculate your QBI deductions?
If your income is falling below the above-mentioned threshold, the task is somewhat easy. The IRS offers a “Simplified Worksheet” to calculate the QBI deduction. You can find this sheet in the instructions of Form 1040 and easily determine your QBI deduction.
But if your income is above the threshold, that’s where the process becomes complicated. For those above the income thresholds, the process becomes more complex. You will have to take additional forms and face various limitations, such as restrictions based on the type of business, the amount of W-2 wages paid, and the unadjusted basis of qualified property used in the business under consideration. So in such cases, we strongly recommend consulting our QBI experts at CROWNGLOBE. They can help you with such complex calculations and optimize your taxes.
Deduction Limitations
Phase-out for High Earners
As we mentioned earlier, there is an income threshold limit for QBI deductions. The QBI deduction begins to phase out for taxpayers with incomes exceeding $182,100 (or $364,200 for married couples filing jointly). This phase-out particularly affects Specified Service Businesses (SSBs) like legal, health, and consulting services.
For SSB owners, the deduction completely phases out when their income reaches $232,100 (or $464,200 for joint filers). This means that, beyond these income levels, SSB owners cannot benefit from the QBI deduction.
W-2 Wages and Qualified Property Limits
For taxpayers above the income thresholds, the QBI deduction’s calculation integrates additional limits based on the W-2 wages the business pays and the unadjusted basis of qualified property used in the business.
Specifically, the QBI component of the deduction is the lesser of
- 1. 20% of the QBI or
- 2. A) a calculated amount based on either 50% of the W-2 wages paid by the business or
- B) 25% of these wages plus 2.5% of the unadjusted basis of the qualified property. You can use either (a) or (b), whichever is more favorable
This complex calculation ensures that larger businesses with significant wage expenses and capital investment are not overly advantaged by the deduction.
Other Considerations
Specified Service Businesses (SSBs)
SSBs, including fields like law, health, consulting, and several other professional services, have unique limitations under the QBI deduction rules. These businesses are subject to the phase-out rules mentioned earlier, where the deduction reduces and eventually becomes unavailable at higher income levels. The rationale behind these additional limitations for SSBs is to focus the QBI deduction’s benefits more on businesses with tangible goods and general services rather than those primarily offering professional skills and expertise.
Filing Requirements
To claim the QBI deduction, eligible taxpayers must use specific IRS forms. Form 8995 is typically used for this purpose. This form is designed to help taxpayers accurately calculate their QBI deduction, taking into account the various income thresholds and limitations.
Proper filing is crucial, as errors or omissions can lead to miscalculations of the deduction amount, potentially resulting in underpayment of taxes and subsequent penalties.
Wrapping Up
The QBI deduction offers significant tax advantages for owners of pass-through entities. But it’s extremely important to consult a QBI deduction expert. The reason? Well, you will have to take multiple factors into consideration. For e.g. your income levels, business type, and applicable limitations. And if your income goes above the income threshold decided by the IRS, the deductions become even more complex. So it’s always better to consult experts. We have been assisting a lot of business owners with their QBI struggles. So if you need any assistance on the matter, feel free to reach out. We are here to help.
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