Entrepreneurs pour their hearts and souls into building a small business from the ground up. The IRS recognizes these efforts and their positive impact on the economy, and therefore rewards small business owners with certain tax breaks designed to alleviate their financial burdens and keep businesses afloat.
If you own a pass-through entity, you may qualify for a significant new tax reduction known as the qualified business income (QBI) deduction. As part of IRS Section 199A, the QBI deduction will run from 2018-2025 and it’s available to qualified business owners operating a pass-through entity such as:
- Sole proprietorship
- Partnership
- Limited Liability Company (LLC)
- S Corporation
It will not diminish your business income. If you’re a self-employed individual filing a 1099-MISC, the QBI deduction will not decrease net earnings for self-employment tax.
The deduction comes off your adjusted gross income (AGI) as if it were a standard or itemized deduction—there is a special line for the QBI deduction on the IRS Form 1040. If you are eligible, it effectively reduces the tax rate you pay on your business profits by up to 20%; for example, a taxpayer in the 32% tax bracket who is qualified without limitations could receive a 25.6% tax rate on their QBI.
What is the QBI?
Your qualified business income refers to profits from a pass-through trade or business. Bear in mind that a “pass-through” entity is a special type of business structure which does not pay taxes at a corporate level and may not apply to all self-employed tax returns. Not all business income qualifies. The QBI excludes:
- Dividends
- Capital gains or losses
- Interest income
- Income earned outside of the U.S.
- Certain wages and guaranteed payments made to partners and shareholders
How do you calculate the QBI?
The QBI deduction is confusing for several reasons. First of all, your total taxable income matters, not just your business income. As of 2018, you can most likely claim the full 20% deduction on your taxable business income if your total income level is below:
- $157,000 for single filers
- $315,000 for joint filers
Keep in mind that your deduction cannot exceed your taxable income minus any capital gains. For example, say you are a sole proprietor with a net profit of $80,000 (with zero excluded items) on your Schedule-C Form and your taxable income is $100,000 (with no capital gains), then your QBI deduction equals $80,000 x 20% ($16,000).
If your income exceeds this level, then a number of different limitations come into play. Determining your QBI deduction will depend largely on the nature of your business, specifically whether you operate a specified service or trade business (SSTB). The IRS defines an SSTB as a business in which the principal asset of such trade or business is the reputation or skill of one or more of its employees. Examples include services in the fields of:
- Law
- Health
- Financial and Brokerage Services
- Accounting
- Consulting
- Actuarial Science
- Performing Arts
- Athletics
Many high-earners in these fields will not be able to claim the QBI deduction due to the maximum income limit. The deduction disappears, as of 2018, once income levels hit:
- $207,500 for single filers
- $415,00 for joint filers
Even if your business qualifies, it may not enjoy the full 20% QBI reduction, as the tax break is phased out for some businesses. The exact formula for determining the deduction, excluding the special rules for income from Real Estate Investment Trusts (REITs) and publicly traded partnerships, is the lesser of:
- 20% of your QBI, or
- The greater of
- A) 50% of W-2 wages or
- B) 25% of W-2 wages + 2.5% of unadjusted basis immediately after acquisition (UBIA) of qualified property
If you’re not sure whether you’d qualify, a QBI deduction calculator can help determine whether your entity is eligible and at what rate.
The new QBI deduction is part of Trump’s Tax Cuts and Jobs Act; whether or not it effectively helps home-based businesses has yet to be decided. However, if your small business does not qualify for the QBI deduction, you may still find tax breaks with the:
- Earned Income Tax Credit (EITC)
- Residential Energy Efficient Property Credit
- Real estate taxes
- Retirement contributions
- Deductions on travel expenses, home office costs, advertisement, and many more
For more advice on self-employed tax returns, don’t miss our piece on the 5 Things You Should Know About Taxes.
