A significant tax break for pass-through entity owners within the Tax Cuts and Jobs Act is the qualified business income (QBI) deduction. The application of this 20% deduction is an important factor for individuals to consider when choosing to conduct business through a pass-through entity or C corporation.
Overview of the QBI deduction
Taxpayers with certain domestic QBI from a partnership, S corporation, or sole proprietorship can claim a 20% deduction of qualified business income. The deduction is subject to certain limitations and thresholds.
These business types experience a single level of taxation i.e., income is earned at the business level, but taxed at the individual level.
By comparison, C corporations are subject to double taxation. Income is first taxed at the business level, then shareholders pay tax on the dividends they receive from the corporation.
Trusts and estates are also eligible to take the QBI deduction.
The QBI deduction is a below-the-line deduction from adjusted gross income (AGI). It’s calculated for each separate business and is available for tax years beginning after Dec. 31, 2017 and before Jan. 1, 2026.
What is qualified business income?
QBI is ordinary income earned from a sole proprietorship, S corporation, or partnership. It doesn’t include wages earned as an employee. If you’re both an employee and sole proprietor/shareholder/partner, any wages you earn as an employee can’t be QBI.
QBI must be earned in a qualified trade or business, though the definition of “trade or business” is loosely defined by the tax law.
Many assume the IRC Section 162 standard applies – a business must be regular, continuous, and substantial. If so, QBI may include rental income. But, certain rental activities, such as a triple net lease where the owner has almost no regular involvement may not meet the definition.
The IRS is responsible for providing additional guidance on this bill, so this interpretation could change when the IRS proposes regulations.
QBI for a tax year is the net amount of domestic qualified items of income, gain, deduction, and loss with respect to a taxpayer’s qualified business.
QBI doesn’t include income that isn’t effectively connected with a U.S. trade or business. It doesn’t include guaranteed payments from a partnership or reasonable compensation from an S corporation.
What is a qualified business?
A qualified business doesn’t include trades or business such as accounting, law, health, or service businesses related to investing. Engineering and architecture trades are qualified businesses.
However, there are income thresholds for these specified trades or businesses that allow the deduction.
Who qualifies for the QBI deduction?
Generally, the 20% deduction of QBI is available to all taxpayers with taxable income less than $315,000 (married filing jointly) or $157,500 (other filing statuses).
If taxpayers have income above these amounts, the deduction is limited to 50% of W-2 wages or 25% of the W-2 wages plus 2.5% of the unadjusted basis of all qualified property – whichever is greater.
Limitations are fully phased in for taxpayers with incomes of $415,000 (married filing jointly) and $207,500 (other filing statuses).
The deduction starts phasing out at $315,000 (married filing jointly) or $157,500 (other filing statuses) for taxpayers with income from specified service businesses. It fully phases out over a $100,000 range for married filing jointly and over a $50,000 range for other filing statuses.
If your taxable income is less than the threshold amount for the year, you can forego the W-2 based limitations and deduct the 20% of QBI from your taxable income, regardless of whether the income is from a specified service business or not.
In order to maximize the QBI deduction, consider planning for bonus depreciation and the new expensing rules. Advantages still exist for pass-through entities depending on each taxpayer’s circumstance.
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